Currency Dilemmas in Eastern Europe

by Claus Vistesen

We are certainly getting a fair share of the market action in Eastern Europe at the moment. Of course, such a perspective will depend on the bias of the observer but I definitely think that recent events within the Eastern European economic edifice suggest that the economic climate is beginning to steer towards downside risks as well as markets in some spheres are decidedly jittery. Moreover, the market focus and discourse has also turned from a focus on the down side economic effects from the credit crisis to a focus on the risks of lingering and increasing inflation.
This is natural I think but the main tendency remains not least in the context of Eastern Europe. In short, we are now moving into a period where the global economy, in key areas, will be dominated by stagflation.

Not too long ago we learned that the Baltic countries with all probability have entered a recession going out of Q4 2007. Now, economies move up and down as we know but the situation in the Baltics is still quite remarkable since with a real economy grinding to a screeching halt you would not exactly expect wage growth in the double digit territory. Yet, this is exactly what we are observing across the Baltics and indeed in the rest of the Eastern European edifice; the recent alarming numbers from Estonian Q1 wage cost being a case in point. A hard landing it is then as Bloomberg also tries to define as follows:

An economic ``hard landing'' is when fast growth spurs inflation, which in turn erodes consumers' buying power and quickly leads to a recession.

This not quite true I am afraid since what we have on our hands in the Baltics and what we are likely to see across many other Eastern European countries is stagflation. And note that this is an entirely different kind of stagflation than the Disney World variety keeping central bankers in Washington and Frankfurt awake at night. No no, this is a regular Alfred Hitchcock specimen. We are consequently talking about a major correction here which may likely turn into deflation at some point. The problem, as I have outlined before, is that these countries are now effectively out of labour which means that there is simply no slack in the economy to fall back on, hence the lingering inflation even in the context of a rapid de-acceleration of growth. Obviously, this cannot go on. Just as well as the unemployment rate cannot drop to 0 the price level will have to correct but the process will most likely be very inelastic and especially so in a context of fast paced global headline inflation pressures.

If this represents the dire economic prospects of many Eastern European countries what might they do to steer clear of the worst casualties?

This question coupled with a renewed focus on the risks of persistent inflation shores up at a major dilemma with respect to management of the currency not least for countries currently pegging to the Euro. The Baltics fall in this category. On the one hand, the rampant inflation levels suggest that the exchange rate be loosened to allow appreciation and thus pour water on the roaring inflation bonfire. On the other hand however the Baltics, as well as many other CEE countries, are saddled with extensive external deficits financed by consumer and business credit denominated in Euros. It is not difficult to see that this represents a regular vice from which it will be very difficult to escape since as long as the peg remains deflation seems the only painful alternative as a mean of correcting. But at this point nobody knows quite how long such a process should undergo as well as whether it would be politically viable. If the peg is abandoned though, two important reservations should be made. First of all I am not at all sure that the exchange alone can quell the inflationary pressures and secondly it is not certain that the currencies will appreciate at all once de-pegged since the current account deficits may well weigh so much as to move the currencies in the other direction. Of course, initially they will but you can easily imagine a situation in which interest rates would have to be kept in recession provoking territories in order to ensure that the inflows are obtained.


Looking beyond the Baltics, the dilemma of letting the exchange rate appreciate to combat inflation versus the risk of a prolonged slump as it proves impossible to restore competitiveness can hardly be better illustrated at the moment than by the flurry surrounding the chain of commands at the Ukrainian central bank and the currency over which it presides. Obviously, the spectacle in Ukraine has the added flavor that it has essentially thrown the central bank into limbo as internal authorities wrestle for the final say. Edward has an excellent and quite amusing overview of the debacle here.


Basically, it has been recognised for a while now that with inflation running at some 30% on an annual level the central bank has been under considerable pressure to allow the Hryvnia to trade more freely against (e.g.) the USD. A week ago we thus learned that the Hryvnia was already beginning to nudge upwards agains the USD in the interbank markets, climbing as far as to 4.74, because traders speculated that the central bank had quietly abandoned the daily market operations to keep the Hryvnia within the official rate of 5.05 to the USD (with a band at 4.25-5.05). At this point deputy governor Oleksandr Savchenko cautioned as per reference to the dilemma cited above that the Hryvnia would only be allowed to appreciate if it coincided with an amelioration of the external deficit. Little could it be known that the topic, which at the time seemed highly speculative, was to race to the forefront of the agenda last week as the Ukrainian central bank has scrambled to agree with itself on what actually to do.

As such, internal differences of opinion within the central bank were made embarrassingly obvious as the board vetoed a decision by Governor Volodymyr Stelmakh to restate the official USD/HRY rate to 4.85 in an attempt to put a lid on inflation. Once again the dilemma of how to combat inflation while harboring a large current account deficit hovered the debacle as Petro Poroshenko, head of the central bank council noted that such an appreciation would be out of tact with realities of the Ukraine's external balance. Thus the rate of the USD/HRY was restated to the original 5.05. This value looks increasingly unrealistic however as the Hryvnia is trading persistently out of the band. This means that in due time we will probably see an attempt, by the central bank authorities, to lift the trading band.

The trials faced by Ukraine are not without an immediate precedent since only two months ago Hungary moved in to scrap the trading band keeping the Forint in the relatively wide band at 240.01-324.71 to the Euro. As with the debate on in Ukraine the decision by Hungary was taken in a similar light. When the decision was made the Forint was trading much closer to the 240 mark which indicates that the Forint was allowed to trade freely in the anticipation that the Forint would move in a direction which could help quell inflation. As with Ukraine who is visibly in a state of confusion about what exactly to do the decision in Hungary cannot be said to have been an easy one. At the time I stated the following which I feel is still a relevant point.

By letting the Forint flow freely they are consequently hoping that the ensuing appreciation will help the central bank in its uphill struggle to bring back inflation within target. I put emphasis on hoping here since it is far from certain I think that the Forint can be expected to stay elevated vis-à-vis the Euro. So far though the markets seem to be indulging the central bank in its move. After having been the emerging market whipping boy of this year the Forint saw a hefty appreciation on the back of the move. Yet, as noted, this may not last. Moreover, the scrapping of the trading band has also effectively opened up the door to all those unhedged liabilities which the households and cooperations and households have taken up.

(...)

Having said all this however, I do think that this move was the only reasonable way that Hungary can begin, ever so slowly, to wriggle herself out of the wrench in which she is now situated. The problem is that the scrapping of the band in order to do something about inflation as well as to stay credible in the face of increasing market pressure may not work out as expected in the longer term. This is not an argument for not doing it though but inflation is not Hungary's own problem and what we thus need to realize is that Hungary effectively is the first economy to really have entered the malice of stagflation.

So far the move by Hungary seem to have paid off in so far at the Forint has not weakened materially as it is currently trading at around the 245 mark to the Euro. In fact, if we look at the three months in which the Forint has traded freely it has strengthened from around 263 to its current value of 245ish.

So, given the recent battle of wills at the Ukrainian central bank the apparent successful comparative strategy in Hungary should the Eastern European economies (including of course Russia here) steadily let their currencies climb to take up the fight against inflation? Well, if we leave aside the obvious question that allowing for free trading of your currency does not exactly mean that you get it what can we say about the viability of this strategy?

Be careful what you wish for

Basically, the discussion about exchange rate regimes in Eastern Europe can be expanded into a much wider debate about emerging markets resisting nominal appreciation of their currencies vis-à-vis the US dollar and the Euro. Recently, the Economist had a large piece on global inflation which ties in with this discussion as well as Morgan Stanley's Stephen Jen recently noted how exchange rate appreciation might in fact be inflationary. It is thus important to understand that it is far from certain that letting the currency appreciate will have any material effect on inflation. In fact, in an Eastern European context this will only increase the purchasing power of the consumers thus fuelling already overheating economies. Another point which is specifically tied to Eastern Europe is that if domestic nominal interest rate increase to keep up with inflation rates it will have a strong substitution effects towards Euro denominated loans. This can become a dangerous cocktail should the tide turn against the currencies.

In light of the comments made above I think that the following points are important to take away.

There has been decisive change in market discourse from a focus on growth to a focus on inflation. This has lead to expectations by investors that emerging economies will allow their currencies to appreciate more swiftly against the G3 currencies. Apart from the usual suspects in the context of the petro exporters and China this has also lead to investors punting on revaluations (essentially decisions to let the currency float) in the context of Eastern Europe as well as in Russia.

In an Eastern European context I believe that such expectations may be unfounded or at least that they do not adequately take into account the downside risks. Obviously, the market's reaction to the recent debacle in Ukraine is mixed. As such, S&P moved in noting how inflation was likely driven by non-monetary factors and that the move, given the market's initial reaction, would almost definitely worsen the external position. Ironically, all this is based on an ex-ante assumption that the Hryvnia will actually now appreciate steadily as per function of market movements. This is far from certain I feel.

Demographics may be able to help us here. Basically, the global economy is characterised by a process where money goes for top line yield. In this context rising interest rates and nominal currency appreciation act as a very strong magnet for inflows of funds. In such a situation it takes a strong and essentially balanced demographic profile to be able to carry the load without running into a spiral of overheating. Brazil may indeed have an adequately strong demographic edifice but Eastern Europe and Russia decidedly have not.

In fact, what we are missing at the moment is indeed economies with the adequate capacity to suck up the excess liquidity; especially as the US has dropped the baton of the global consumer of last resort. This is why I feel that encouraging a process of steady currency appreciation in an Eastern European and Russian context may ultimately lead to a severe pro-cyclical effect and thus even more overheating. The risk is that when the backdrop comes it will be all the more grim.


Stephen Jen may actually be right when he says that currency appreciation is inflationary in a world where excess liquidity goes for yield. As I have said before I don't think that any of this warrants complacency vis-à-vis inflation but currency appreciation driven by either higher nominal interest rates and inflows will, in many cases, lead to overheating. No where is this more true I feel than in Eastern Europe. To peg or de-peg and to fix or let float? These two questions seem to be high on the agenda for many Eastern European central banks. In many ways, this is understandable. Strong headwinds from global inflation as well as an increased focus on this in the market discourse may eventually be what forces many countries to loosen the reigns on their currency. After Hungary and now Ukraine the Baltics, with their pegged currencies, seem set to enter the spolight. If we apply the prevailing market logic there is certainly enough inflation to go around even for a sharp currency appreciation. However, as I try to point it is not certain that you get what you want in the context of de-pegging and actually you may end up getting more than you bargained for. One thing is thus certain. If liquidity moves in favor of Eastern Europe at this time in the cycle the only viable way for these economies to correct will be through a prolonged period of deflation. The thing is that given their demographic structures nobody knows how far such a process would be and whether politicians can see it out, this latter point being particularly important in Hungary and Ukraine.

Polish Central Bank Leaves Interest Rates Unchanged in May

Poland's Monetary Policy Council left interest rates unchanged in May for a second consecutive month as it awaits more data on inflation and economic growth before making any further increases. Rate setters kept the seven-day reference rate at 5.75percent at their meeting this morning.



The central bank has raised rates seven times in the past year to curb inflation as rising salaries and record-high employment spur consumer demand.

Poland's inflation rate unexpectedly fell back in April, a factor which has also evidently influenced today's decision. The rate slipped to 4 percent from 4.1 percent in March. Consumer prices gained 0.4 percent in the month.




Unemployment has been falling steadily, and using the EU harmonised methodology there were 1.313 million Poles unemployed in March (the latest month for which we have such data) and the seasonally adjusted unemployment rate was 7.7%.



Polish retail sales continued to grow at a healthy clip in April, if rather more slowly than in March, a factor which may well have influenced the central bank policy decision. Retail sales rose 17.6 percent from a year earlier and 2.9 percent from March.



On the other hand Polish industrial output growth accelerated in April, although this whole situation is clouded somewhat by the timing of easter this year, and the fact that April thus had more working days than March. Production rose an annual 14.9 percent, compared from 1 percent in March. Month on month, production was up 4 percent over March.





The zloty has gained 5.6 percent against the euro and 12.7 percent vis a vis the dollar this year, driven by strong economic growth, the prospect of euro adoption and rising yield differentials as the central bank has steadily raised rates.

The Polish government now forecasts that growth will slow to 5.5 percent this year from the decade-high 6.5 percent in 2007.



Central bankers are concerned that slowing growth won't prevent higher wages and employment from speeding up inflation. Average corporate wages rose an annual 12.6 percent in April, while employment increased 5.6 percent from a year ago. It remains to be seen whether the current policy rate will be sufficient to continue to hold back inflation given the vigour of the current expansion and the steadily dwindling pool of appropriately trained and educated workers.

Hungary's Central Bank Raises Interest Rates Again in May

The Monetary Council of Hungary's central bank (NBH) decided again today to raise its benchmark rate by 25 basis points to 8.50% (I really do hope that these people know what they are doing, he says under his breath). This was the third consecutive meeting when the MPC decided on monetary tightening, but it may well now be the last such move in the mini rate hike cycle the bank started back in March. But even if there are no move moves in the pipeline it may be quite some time before the bank are able to bring rates back down again (hence my cryptic comment).

The increase brought Hungarian interest rates to their highest level since the 9.0%rate of January 2005.




The National Bank of Hungary (NBH) has also raised its forecast for 2009 annual average inflation to 4.2% from 3.6% in its latest quarterly Inflation Report released on today. This provides I think a big part of the explanation for the logic of today's decision.


Essentially it seems to me that with the forint trading band now abolished the currency will be very likely to come under sharp attack if any indication is given of downward movements (and this despite the recent record highs, which may well have been about taking the "ride up" on todays decision) and especially if Hungary's stagnant economy shows no signs of revival, which with interest rates at this level and fiscal policy tightening, and the eurozone slowing it is hard to see how it can (where would - apart from agriculture - the growth come from).

True, inflation remains stubbornly high:



but domestic demand is still declining. Retail sales, for example:




or construction:



and the rate of increase in industrial output has weakened considerably:



while GDP is now almost stationary:

Monetary Chaos Breaks Out at the Ukraine Central Bank

Does anyone happen to know offhand the "official" dollar rate of the Ukrainian currency, the Hryvnia? I am asking this question since clearly over at the central bank they are having difficulty deciding at the moment, since - like the legendary character Hydra - they seem to be speaking with two "heads" at the same time, and the only question I can ask is: would the real representative of the Ukraine central bank please stand up!

This issue unfortunately is neither a small nor a comic one, since Ukraine is currently running a 30% plus annual inflation rate, and letting the currency rise against the dollar is one of the few serious anti inflation policies anyone has on the table at the present time.

Essentially the story to date is that the Ukraine central bank had been keeping the "official rate" for the national currency - the Hryvnia - at 5.05 to the dollar (within a broader target band of 4.95-5.25) since August 2005 - although traders have generally been saying that the bank effectively stopped intervening around February-March. However during the last 24 hours the "official rate" has become a highly contested issue, with one part of the bank's monetary policy structure suggesting that the official rate has now been revalued to 4.85 to the dollar, while another part is denying this and maintains the rate is still 5.05. Basically one part of the structure is challenging the right of another to take decisions.

Of course the reaction of the financial markets to this state of affairs is not that hard to predict (at least in the immediate term), and Ukraine's hryvnia fell the most against the dollar in a single day in over eight years yesterday, falling 4.01 percent on the day to trade as low as 4.7875 per dollar by 6:04 p.m. in Kiev, down from 4.5550 late Wednesday, making it the worst performer among the 178 global currencies being tracked by Bloomberg yesterday.

The fall at this point may, however, be more part of the internal tussle which is taking place in the bank itself than any knee-jerk financial markets reaction (although that could well be to come as central bank credibility at this point must be tending towards zero), and a according to Agata Urbanska, an emerging-markets currency strategist in London at ING Bank "They (the central bank, or part of it) are back in the market................This is all about the central bank weakening the currency.''


The latest incident is only one more episode in a long term tug-of-war which has been going on inside the central bank (and of course, inside the Ulraine parliament itself, since, it will be remembered, President Viktor Yushchenko was recently physically prevented from giving his state-of-the-nation address before parliament by legislators loyal to Prime Minister Yulia Tymoshenko who blocked access to the speaker's chair). The immediate problem started on Wednesday when Ukraine`s central bank board (note here the key term board) announced that it had decided to strengthen the official rate of the hryvnia to 4.85 to the dollar from the previous level of 5.05.

This move was not entirely unexpected since the bank has been under constant pressure to revalue or liberalise the hryvnia since inflation began rising dramatically in the autumn of last year, and Central Bank Governor Volodymyr Stelmakh had announced back in late April that there would soon be a "move" on the exchange rate front. However in a statement which now assumes rather more significance than it did at the time, the bank`s council (yes, note the COUNCIL - not the board - since the council is the other main player in this game) explicitly repudiated Stelmakh and rejected the idea of broadening the band on the very same day. From that moment on it should have been clear that monetary policy at the Ukraine National Bank was in for a bumpy ride, and so it has been.


Not to be upstaged by the decisions of the Board, Ukraine's central bank council itself met yesterday and formally rejected the hryvnia revaluation which had been decided on by the bank's board only one day earlier, and issued a press release stating that the official rate still stood at 5.05 to the dollar. This was the first example of one body vetoing another since the bank was founded when Ukraine became independent in 1991.

The bank council has 14 members, including the governor, parliamentary speaker Arseniy Yatsenyuk, and a number of parliamentary deputies. Stelmakh himself abstained at yesterday's vote while the other members all backed the veto of the board's decision.

"Today, the action of the board of raising the official rate to 4.85 was rescinded. Therefore, the official rate stands at 5.05/$," Petro Poroshenko, the council's head, told a news conference after a council meeting. He also advised the bank's board to re-examine the issue on Friday and suggested the board could only overturn the council's decision with a two-thirds majority.

Now for those of you who are - like me - a little bit confused by this somewhat Byzantine institutional structure, perhaps I should make plain that the board is effectively the bank's executive, while the council is a body created to formulate a framework for ongoing monetary policy. But now we find the board hold that the hryvnia is valued at 4.85 to the dollar, while the council maintain that the "official" value is still 5.05. So which is it? Well at this point your guess is as good as mine - and this is certainly "pluralist" monetary policy in action - but the board do seem to want to insist that they are going to have the last word, since late last night Reuters reported that the board had decided to overturn the councils veto and had issued a statement saying the hryvnia's rate on Friday would stand at 4.85 to the dollar -- unchanged from the rate it had set for Thursday, revalued from 5.05, before the council imposed its veto.

The Ukraine parliament - the Verkhovna Rada - have however voted to summon central bank of head Volodymyr Stelmakh to give an explanation of his actions (by 382 votes out of a possible total of 447) following a proposal put forward by the parliamentary groups of the Party of Regions, the Block of Lytvyn, BYuT, and CPU.


Anyway, I do know how many of you are able to follow all of this? Personally my head is already whirling. And the whole situation became even more bizarre late last night when central bank officials declined to comment on whether the board had in fact overturned the earlier council veto decision, effectively sidestepping the problem posed by head of the council Petro Poroshenko earlier in the day when he stated only a two-thirds vote on the board could do this.


Basically the background to all of this is that until recently, the central bank had been intervening regularly, buying and selling currency to maintain the hryvnia within a prescribed tight-corridor of 5.0-5.06. As a rseult the hryvnia had been hovering around 4.7-4.8 since the central bank stopped intervening in February-March, but in recent days it had begun to soar, touching at one point 4.6 to the dollar, following comments from various central bank officials indicating a revaluation was coming soon, and pressure from credit ratings agencies and multilateral bodies like the IMF to allow the currency to rise in an attempt to soak up some of the globally imported inflation.

Earlier this week a rapid (and possibly speculative) surge in demand took the market rate to 4.6 leaving a gap of about nine percent between the interbank and the official rates, leading the bank`s deputy chairman, Oleksander Savchenko, to state on Monday that decisions would be taken "in the next few days" to tackle the hryvnia`s "highly volatile rate". Effectively it was the developing gap between the official and the interbank rates which precipitated the move on the part of the bank BOARD.


So the problem here is inflation and what to do about it. Ukraine's inflation rate was once more up sharply in April - passing the threshold of the 30% annual rate - as the bickering continued between Prime Minister Yulia Tymoshenko's government and the office of President Viktor Yushchenko over economic policy and how to handle the problem. Inflation was up 3.1 percent month on month (running at an incredible 37.2 annualised rate), and although this was lower than the 3.8 percent monthly increase registered in March (which was a 9-year record) it was still far higher than most analysts were expecting.

Annually, inflation reached a huge 30.2 percent - aided by an almost 50 percent jump in food prices - and the cumulative price rise for the first four months of this year was 13.1 percent, a 'mere' 3.5 percentage points above the government's whole year 2008 target of 9.6% which the government has yet to revise.

The Ukraine central bank has been trying to soak up hryvnia liquidity since the start of the year, twice raising the refinancing rate (which is now at 12 percent, up from 8 percent at the end of last year) and issuing a large amount of depository certificates.

The bank has also repeatedly said that it sees a strengthening of the hryvnia as a means to combat inflation. And of course the bank has been under continuing pressure to revalue or liberalise the hryvnia after inflation began to accelerate in the middle of last year.

When the decision to change the official rate was announced by the board on Wednesday the ratings agency Standard and Poor`s immediately called the move a step towards curbing price rises.

"Liberalising the exchange rate regime should help to curb inflation of tradeables, and in particular commodities such as gas and food, which are priced in dollars," the agency said in a statement. It has currently a rating of BB- for Ukraine.

However ones the smoke finally clears on all this we will be left with a number of outstanding questions. Not least of these is whether in the mid term the hryvnia is not more likely to move DOWN than up. Certaily Ukraine's economic problems are now substantial ones. This was explicitly recognised by Standard and Poor's in its comments following the decision by the bank`s move board, and they painted a bleak picture for Ukraine, saying inflation was boosted by non-monetary factors and that a stronger hryvnia would ultimately harm exporters, raising the current account deficit.

"In the first quarter of 2008, nominal government expenditures increased just under 50 percent, pushing up public sector wages and sending a highly inflationary signal to the private sector," it said. "Loose income policy continues to affect goods prices via second-round effects."

The agency also lambasted the government of Prime Minister Yulia Tymoshenko in January, calling its fiscal policies "populist" after it began paying compensation to people who`s Soviet-era savings were wiped out by hyperinflation during the 1990s.

Tymoshenko has repeatedly promised that the government would be able to bring inflation under control in just a few months, and some officials had even predicted deflation during the summer months due to bumper food harvests (which are more than possible, the harvests, not the deflation, and this may mean in the short term that economic growth and inflation only accelerate).

Meantime Ukraine is currently running a current-account deficit, a deficit which has widened to $4 billion since the beginning of the year, and many analysts estimate it may exceed $15 billion by year-end. In fact the IMF estimate that it will reach 7.6% of GDP this year.




Conclusion

By way of conclusion I would like to make three simple points about this strange affair. The first of these is that the situation in the Ukraine to some extent parallels the situation in Russia, since both countries are facing a major inflation problem, and both are under pressure to allow the currency to rise to soak up some of the inflation. The political battle in Ukraine also mirrors the one in Russia in this sense, since the Putin/Medvedev group have been making it quite clear that they favour going for growth over the need to tackle inflation, and thus will resist currency revaluation pressures, even though the inflation itself will at some point almost inevitably undo all this solid growth performance due to the instability which will eventually follow, as I attempt to explain in this post.

The second point would be that the ability of simple currency appreciation alone to handle the kind of overheating Ukraine is experiencing is in fact rather questionable. Basically letting the currency appreciate can soak up some of the global dimension in Ukraine inflation, but it will not in and of itself resolve the internal overheating dimension. Ukraine, like Russia, has a declining population and a declining working age population. Unlike Russia Ukraine has out-migration and not inward migration. This means that the labour shortage issue in Ukraine is expecially acute when growth is in the 5 to 7% pa range. Basically Ukraine does not have the human capital resources to grow this quickly, and having a steady stream of remittances from those working abroad fueling consumption and construction only adds to (and does nothing to help resolve) these underlying problems.

Lastly, it is clear that Ukraine is now locked in to some sort of "boom-bust" cycle, but the bust may well not be imminent: that is to say we may well go up further before we finally fall back to earth. The reason for this is the current high in wheat prices, and the fact that Ukraine may well have a bumper harvest this year.

Economic analysts (and CEE specialists) 4Cast are predicting a significant recovery in agricultural performance across the entire East European region this year, driven by a massive rise in crop yields and farming output. They say weather conditions seem favourable in many countries in the region. Gábor Ambrus, analyst at 4Cast in London. believes the effect will be most visible where the share of farming is high, i.e.: Ukraine and Romania, while Poland, for example, may not benefit especially as it was spared from much of the regional draught in 2007.

Ambrus sees Romania and Ukraine as particularly likely to benefit from an agricurally driven boost to headline GDP effect. (The share of Romanian agriculture in GDP is 7-8%, so even a 30% increase in farming output may boost GDP by 2pp above expectations.) The effect on Ukraine is even larger with agriculture having something like a 17-18% share in GDP. The crop estimates being offered by UkrAgroConsult indicate a 35% increase in crops, and this could boost GDP by as much as 6pp over 2008, offsetting much of the slowdown coming from other sources, Ambrus argues. Of course this estimate may well be on the high side, but nonetheless Ukraine should get a substantial GDP boost, which means we should watch out, since this train may well now be about to accelerate before coming to what looks like it will inevitably be a "sudden stop".

Anyone interested in a rather fuller explanation of the underlying human capital resource problem could do worse than read this post I wrote some months ago on the topic.

Update

Well it is less than an hour since I put the post up, and already I am updating. I suspect this may happen more than once in the coming days. The latest news is that - unsurprisingly - Ukraine`s central bank chairman Volodymyr Stelmakh publicly confirmed this morning the bank's change in the official hryvnia rate to 4.85 per dollar from 5.05. The show goes on.

“The bank’s board made decision to confirm the change of the rate. We are confident that we do everything right, and we will defend our position”, V.Stelmakh said. According to him, the bank`s council had no right to decide on economic or legal issues and he saw the bank`s change of the official rate as merely eliminating imbalances in the market, and based on economic factors, rather than a "revaluation".

Latvia Unemployment April 2008 - Where's The Correction Mechanism?

According to data from the Latvian State Labour Board, Latvian unemployment in April was at 52,897 (or an umployment rate of 4.8%) this was up from 52,806 in March, but only slightly (93 people to be exact, although obviously there are seasonal factors to take into account here. But this figure was still substantially down from the 67,154 (by about 14,350 people) registered in March 2007. Given that the Latvian economy is contracting I think this result is significant.




and the unemployment rate has been dropping steadily.




And the picture doesn't change substantially if you look at unemployment using the EU harmonised methodology. According to Eurostat unemployment in Latvia was running at 4.6% in March 2007 and 4.5% in March 2008, ie it is still down year on year, even though GDP was growing at a strong rate a year ago and is contracting now.

The economy has gone into recession without generating sugnificant unemployment. Of course the labour market does follow movements in GDP with a lag, and we still haven't had the "hard landing", but still, this is a surprising result.

It also helps explain why the rate of wage growth - according to the laytest data we have which is for the last quarter of last year - has't slowed dramatically, although it may now do so.



The position isn't that different in Estonia, since according to the latest data from the Estonian Labour Market board the rate of unemployment in April was still incredibly low there too - running at 2.7% - with only 17,098 people registered at the employment offices. Using the EU hrmonised methodology, the rate is rather higher - some 5.5% in March which is the latest data we have from Eurostat - but to get a comparison this is not up enormously from the 4.9% rate recorded in March 2007 using the same methodology. ie on whichever measure you use unemployment has risen, but not that much, at this point, which would explain in part why wage rises have been so stubborn in coming down in terms of their annual rate. There simply is not that much "surplus labour capacity" in Estonia, and this is of course part of the whole inflation - and now stagnation - issue.




Basically I hate to be a bore, or "party spoiler" at this point, but this is the issue that has been worrying me from the start about the whole Baltics situation, the absence of the ability of the labour market - due to years of very low fertility and substantial out-migration - to correct during a recession.

Without getting too theoretical here, there simply is no homeostatic mechanism to fall back on here to guarantee stability. Since the cohorts leaving the labour force at the upper end are going to be consistently bigger than those enetering at the bottom, there is no build up of surplus labour in the "deposit" during the slowdown.

Leaving aside the length of the present slowdown and its possible severity, we are left with the very unfortunate situation that when growth eventually does start to pick up again, there may be very little surplus labour capacity available to fuel the growth, and logically inflation would then simply start to shoot up yet one more time. Basically I would say that finding a longer term solution to this problem is now one of the most urgent questions facing the Latvian (and Estonian, and Lithuanian) government.

IMF Warn That The Estonian Economy May Contract In 2008

The IMF have this morning suggested in a report that the Estonian economy may in fact contract this year (whole year 2008) as consumption wanes and exports falter.

The report was presented at a conference held in the Estonian capital of Tallinn. The IMF have not yet posted the report on their website, but the conference is being covered by Bloomberg's Ott Ummelas.

Sensibly the IMF saying that it is ``too early'' to make new ``numerical forecasts'' on the economy (this is my own personal position) but todays report already marks a substantial shift from April's WEO forecast, where the IMF said it expected economic growth to slow to 3 percent this year from last year's 7.1 percent, before accelerating to 3.7 percent in 2009. I think all these numbers just got scratched.

Estonian Finance Minister Ivari Padar is quoted as saying "In principle, we agree with the IMF's conclusions".

The core of the issue is summarised in the IMF view that a recovery will depend on the competitiveness of local industries, and a revival of exports or investment, adding that the slowdown will ``test'' the banking system. This is something I have been arguing from this blog for the last six months now. Basically It was always unrealistic given the pace of the slowdown to anticipate positive growth (let alone 3% plus growth) in Estonia this year (and it is far too early to start talking about 2009). Essentially continuing inflation (in the context of the currency peg to the euro) is eating away month by month at the vitals of Estonian export competitiveness.

Since Estonian domestic demand now looks to stay flat for the foreseeably future, the economy willneed to have export competitiveness to attract the inbound investment component. So everything now depends on getting relative prices straight, and without changing the peg quite frankly I don't see how Estonia is going to do this.

Basically when Estonia emerges from this crisis my feeling is that we will see an export driven economy on the pattern we can already see in some Scandinavian countries, and the reason for my holding this view is based on an appreciation of consumer demand dynamics in the context of a rapidly ageing population.

Have the Baltics Entered a Recession?

by Claus Vistesen

As any mildly astute economist will know it is extremely difficult to call the exact turning point in an economic cycle and thus the point in time where a recession starts. Usually, such issues are resolved post mortem when the economic data has been firmly revised. Moreover, the actual determination of a slowdown's or a recession's starting point also quickly turns into a battle royal between economists as the alphabet soup of different national account measures easily ties up the discussion as we end up comparing apples and pairs. However, at this point in time I don't think we have the luxury to engage in such a battle among economic gentlemen. I don't think so because the Baltics' (and many of the other Eastern European countries') situation is a bit more complex than your average US type recession where a you clean up the mess with a couple of quarters of negative growth. What we consequently need to understand is that, depending on the turn of events and response from markets, the current slowdown may turn out to have quite far reaching consequences for the region. With these ominous remarks let us turn to the evidence suggesting that the tide is now finally turning in the Baltics.


In fact, we can only at this point say something decisive about Latvia and Lithuania since Estonia has not yet posted Q1 08 figures. The pace of growth however has been consistently lower in Estonia throughout 2007 compared to 2006 and in Q4 Estonia posted a growth rate of 0.9% q-o-q which is of course more than respectable but a significant slowdown in relative terms. What remains to be seen now is whether Estonia will kick off 2008 with negative growth rates or just eek out a positive showing. Indicators for retail sales suggest that Estonia may be lagging Latvia so I would not be surprised if Estonian Q1 is positive on a q-o-q basis. In the context of Latvia my colleague Edward Hugh has been keeping a watchful eye. Back in March he asked the question of whether we were heading into a recession in Q4 2007? At the time, strong circumstantial suggested that this was the case and now with the recent flash estimate from Q1 it is safe to say the coffin has now been supplied the final nails;

(...) in constant price terms - Latvian GDP hit a peak at some point between Q2 and Q3 2007 (lets say August 2007) and since that time has been steadily CONTRACTING. Now I know there are probably hundreds of different ways of skinning a chicken, and of course you can read data everywhichway you want to, and there are seasonal factors to take into account, but as far as I am concerned there is no getting away from it, on any reasonable criterion the Latvian economy is now in recession, and has been since the middle of last year.

This leaves us with Lithuania. Since we just recently got Q1 2008 GDP figures (provisional estimates too) we should have a fairly strong picture of what is going on. First, we will have the visual inspection;









As can be observed in the figure above Lithuania stalled sharply from Q3 to Q4 and now posting a contraction in Q1 08 on a q-o-q basis. On a y-o-y basis the economy is still growing but this figure is basically pointless in so far as goes the determination of where the economy is at in the present time. The first graph speaks for itself and in this context the two additional graphs plotting the indexed values of GDP do not really add much to the general picture. I still think they have merit though. Especially the last one is interesting as it shows the 'momentum' of the slowdown. Basically the chart shows the rate of expansion relative to the previous period without saying anything about the level of growth (which is shown in graph number two).

In Summary

I have been very cautious in pulling out the R-word in connection with the Baltics let alone Eastern European in general. I still am. However, what is clear at this point is that we are now observing a hard landing. The rate of the slowdown since it began in the middle of 2007 leaves no other conclusion I think. What happens next then? This question is not at all insignificant. What we now have on our hands in the Baltics is, in macroeconomic terms, quite a predicament. Basically, the economic momentum now seems to be unwinding far too fast relative to the pace by which the inherent imbalances present in these economies can be expected to respond. Large external deficits and pegging currencies here are important since it means that the latter cannot adjust. The only possible alternative if the rout continues is consequently a transition into price and wage deflation. It is still early to say whether this will materialize but it is now a real risk rather than a theoretical possibility. Additionally, we now need to watch all those foreign banks who have set up shop across the Baltics helping to finance all those credit inflows. Will they stay or more specifically can they afford to? This is also now a question which must be considered as more than an academic question.

I am really sorry to start this week on such a nasty note but I do think that the genie is out of the bottle in the context of the Baltics. Now we need to watch carefully where it goes from here. If economic momentum (or lack thereof) continues to linger in the current territory we should be a prepared for a rapid change of fundamentals in the Baltics.

Russia's Growing Inflation Headache

Russia's inflation rate rose to an annual 14.3 percent in April, the highest since April 2003, led by rising food costs. The inflation rate rose from 13.3 percent in March, while prices rose 1.4 percent in the month, compared with 1.2 percent in March, the Moscow-based Federal Statistics Service reported last week. Prices have already increased by 6.3 percent so far this year (January - April).



Food prices increased a monthly 2.2 percent in April, according to the statistics office. Bread prices rose 6.4 percent and sunflower oil prices increased 8.6 percent in the month.

Russia, which is the world's biggest energy exporter, is struggling in what now appears to be a vain attempt to reduce the inflation rate to 10 percent this year as food and energy prices and rising wages and living standards take what appear to be a relentless toll. Russia's inflation rate reached 11.9 percent in 2007, topping the government's 8.5 percent target rate by a good margin.


Letting The Ruble Rise


As a result of the difficulties which the Russian government are having containing prices speculation is now mounting that one of the first policy decisions Dmitry Medvedev take after he's sworn in as Russia's new president this week will be to allow a stronger currency.


Merrill Lynch, Goldman Sachs and Deutsche Bank are forecasting the currency may rise by as much as 4 percent over the next six months. They suggest the central bank will come under increasing pressure to let the ruble appreciate to try to stem inflation even if it risks damping profits of oil and energy exporters, which according to Merrill Lynch currently fund more than half of the federal budget. The last time Bank Rossii allowed the ruble to strengthen was last August, when the inflation rate was "only" 8.5 percent. It's now up to 14.3 percent, and in all probability is still be rising.

The central bank attempts to "steer" the value of the ruble, setting the price against a currency basket made up of 0.55 dollars and 0.45 euros. It allowed the currency to appreciate against the basket three times last year, by a total of about 1.3 percent. The central bank also estimates the pass-through rate - or the rate at which and increase in the ruble would cut inflation - to be 0.3, that is to say a 1 percentage point increase in the ruble against the currency basket would cut inflation by 0.3 percentage points.

The downside of a stronger ruble for Rosneft is that it may diminish profit because half the oil produced by the company is sold into the dollar-denominated export market.

Interest rates aren't changes are thought not to as effective in controlling inflation in Russia as in more developed economies since Russia doesn't have a highly developed consumer-credit market, with mortgages and credit cards little-used outside larger cities, while the corporate sector has access to foreign currency denominated loans carrying lower interest rates which may not look especially risky given the background of potential ruble rises.

Many observers now fear that Russia is riding so high on rising oil and gas prices that it has little incentive to diversify economic activity beyond commodities. The energy industry produced more than two-thirds of the nation's export earnings and more than a third of the state's 2007 revenues, which totaled $315 billion.

The government has ignored advice from the World Bank and other organizations to invest in other industries, start-up companies and infrastructure. Instead, the central bank has amassed $530 billion in gold and foreign-currency reserves; Putin has put $130 billion of that in a sovereign-wealth fund that would provide no more than a two-year cushion if energy prices fall.

``This route may lead to a dead end,'' Economy Minister Elvira Nabiullina said at a Finance Ministry meeting last month. ``We no longer have the advantages of a cheap ruble, cheap labor'' after a decade of average annual economic growth of 7 percent that pushed up wages and the currency, making Russia less competitive.

Russia, the world's biggest energy exporter, has expanded an average of about 7 percent a year since President Vladimir Putin, 55, took office in 2000. During that time, the price of oil has risen almost fivefold to a record $119.93 a barrel. The economy will grow 6.6 percent this year, more than five times the 1.2 percent average of the G-7, according to Merrill Lynch.

Slovakia's Euro Entry Bid Accepted

Slovakia today won EU approval to adopt the euro on Jan. 1 2009, thus becoming the 16th member of the European single currency zone. The EU Commission announced today on its Web site that Slovakia had reduced both the fiscal deficit and inflation sufficiently to qualify. At the same time the Commission announced that they were terminating the excess deficit procedure, a move which is a mandatory to joining the euro region.

EU finance ministers must now endorse the commission's recommendation in July. Not everybody is entirely convinced it seems, and the European Central Bank still has "considerable concerns'' about the sustainability of the inflation path, according to a report published by the bank today in Frankfurt. I share many of these concerns - as I have already explained at great length in this post here.

Even in Slovakia itself people retain their own reservations as according to a survey conducted by the Slovak Statistical Office between March 1-7 some 72 percent of respondents had a negative attitude towards the proposed change due to the perception that - in a way which is similar to what happened in countries like Spain and Greece after adoption - prices may well rise faster than anticipated and household budgets become strained.


However I do think that today is really not the time to pursue these concerns, since at this point they would smack more of sour grapes than of anything else. I would really simply like to take this opportunity to congratulate Slovakia on all the hard work they have put in to preparing their membership bid, and wish them every success in the introduction of what now looks like it is soon set to become their new currency.

``To ensure that the adoption of the euro is a success, Slovakia must pursue its efforts to maintain a low-inflation environment, be more ambitious with regard to budgetary consolidation and strengthen its competitiveness position,'' EU Monetary Affairs Commissioner Joaquin Almunia

Of course eyes well beyond Slovakia will now be watching the month by month movements in the Slovak CPI, since should the more optimistic expectations on the future inflation path not be fulfilled, then this will only make further applications from other EU10 countries - Bulgaria, Latvia, Lithuania, the Czech Republic, Estonia, Romania, Poland and Hungary - much more difficult in the future.

Update 13 May 2008


Slovakia's inflation rate rose in April to a 17-month high, increasing pressure on the government to convert the koruna to the euro at the strongest possible rate before Jan. 1 adoption to tame price growth. The rate advanced to 4.3 percent from 4.2 percent in March, the Bratislava-based Slovak Statistical Office said in a statement today. Prices rose a monthly 0.2 percent, compared with a 0.3 percent gain in March.




To adopt the euro, Slovakia has to keep its 12-month average inflation rate, using the EU HICP methodology no the one reported on here, to within 1.5 percentage points of the average 12-month rate of the three EU nations with the slowest price growth.

If final approval for Slovakia's application is secured, the Central Bank and the government may well try to lock the koruna rate to the euro one - at a higher rate -final time before the national currency is discontinued. Securing the strongest exchange rate possible at the time of adoption is seen by many as a way of continuing the damping effect the Slovak koruna now has on capping imported prices, thus helping tame inflation once the koruna no longer exists. This approach, however, does have its dangers, as It may make exports more expensive in the future, especially if Slovak prices and wages get a strong kick upwards from euro adoption. Thus Slovakia - if she is not careful could face the difficulty of having a longer term trade deficit.

Foreign Credit in Lithuania

by Claus Vistesen


As my regular readers will know a part of my analysis on Eastern Europe and the Baltics has been to look at the Eastern European edifice through the lens of Lithuania. Last time I did that I showed an update in terms of the labour market as well as I did a more thorough analysis of Lithuania's external position. At this point I probably should move in with a lot of updated graphs on the labour market and economic activity. However, I won't since we have not gotten a lot of new data and what we have got confirms what we already knows. Inflation continued its upward increase in the first months of 2008 where the HICP index touched nearly 12% y-o-y. This is not at all good news. As we can currently observe across a wide range of Eastern European countries inflation is lingering even as economic growth slows down considerably. Meanwhile of course Lithuania's capacity to work its way out of this seems quite shaky since unemployment is at all times low which means that the structural pressures for wage increases and productivity eroding inflation is now a fundamental part of the economic structure. A combination of rapid economic growth as per expected on the basis of the convergence hypothesis and a structurally broken population pyramid and net outward migration is now taking its visible toll. Provisional estimates for Q1 GDP suggests that Lithuania expanded at 8% y-o-y which is still way too fast given the underlying capacity constraints. Official authorities in Lithuania narrate this as if the economy is on track towards a soft landing. I can only hope they are right but I am not confident. Signs of a slowdown are beginning to emerge ever so slightly in the labour market where unemployment has risen a tad going into 2008. Obviously, as Lithuania slows further this development should increase. As ever though, the risk is of a rapid reversal of economic conditions loom on the horizon in the context of the global financial and now also food crisis thundering along with all the increased risks that such events bring with it in the context of a small emerging market such as Lithuania.

What risks we should watch out for is what I will investigate further here.

Better late than never an old adage goes. In this way, IMF's recent World Economic Outlook as well as its Global Financial Stability Report comes with a timely warning in the context of the current financial and food/energy related crisis (the latter point which I will deal with later and where you, in the meantime, could do a lot worse than read Macro Man's recent tale of the 800 lb gorilla). As per usual, IMF's center piece publications are littered with information but the part of it I most noticeably latched on to was the chapter about emerging markets and their resilience. More specifically, I took note of the part dealing with the resilience of the CEE and Baltic economies' external position. Now, this story has already been well summarised by RGE's Mary Stokes in her excellent investigation of foreign banks' presence and exposure to the Eastern European markets and thus, by derivative, Eastern's Europe dependence on credit inflows to finance external borrowing (often done in foreign currency just to make it a bit more complicated). Since I have also sketched this situation many times before I am going to quote myself from a previous note in which the stylised facts are laid out ...

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?

Especially, the last question is important to be aware off and essentially this is also at the heart of the inquiry Mary and IMF are making. In the context of Lithuania the dependence on foreign loans reveals itself on two accounts. Firstly, we have the composition of the external balance where we can see how the liabilities (i.e. the break up of the negative net investment position) is made up disproportionately much of bank loans compared to the more traditional components of portfolio flows and direct investments. Secondly, we have also seen how, as a result of the pegged Litas to the Euro, many of these loans are denominated in Euros. This is about balance sheet risks then in the context of translation risk which basically arise in connection with loans denominated in Euros and cash-flow/deposits where an overweight is in Litas. Obviously, this works well as long as the peg holds but in light of the discussion sketched above the risk is of course that the foreign banks suddenly retreat and/or that the Lithuanian currency is subjected to a pressure to depreciate as the external position becomes unsustainable. Quite clearly, any kind of market moves here would require the ECB to shield the peg since the currency board itself cannot be expected to keep the peg if the unwind really begins.

The main question I am asking here is what actually provided the build-up of foreign denominated loans in the first place and what the main driver is? Well, we are finally getting to the visual part of this note. As the first set of of graphs we have the formal illustration of what translation risk potentially means. Note that the graphs are updated with the latter part of 2007, a rather important point for the rest of the analysis (click on the pictures for better viewing).





Quite simply, translation risk can be measured by the extent to which these two figures are not alike. As we can see the loan composition does not match domestic deposit composition thus making the servicing of the debt vulnerable to potential currency movements. Moreover, these figures tend to underestimate the real translation risk since one thing is deposits another thing is the cash flow itself used to service the loans. In this light, one of the questions that has haunted me a bit lately when I looked at the charts is what exactly drives the fluctuations and general discrepancy between these charts.. One obvious explanation is that, per function of the strong foreign bank presence, the liquidity of the Euro credit market is a lot deeper than the corresponding market for Litas denominated loans. And as we shall see below this seems to correspond to reality since a deeper more liquid market quite simply translates into lower funding costs.







The three graphs above tell an important story about the market for credit in Lithuania and thus I imagine in the Baltics. As can be immediately observed borrowing in Euros is substantially cheaper than borrowing in Litas. Over the sample period in question the average interest rate spread in favor of Euro denominated loans has been 123 basis points (sd: 35 basis points) which should be more than enough to induce a considerable cross-price demand effect. Another interesting observation is that the trend in loan taking now seem to be parting ways with respect to currency denomination. In this way, the volume of outstanding loans denominated in LTL is beginning to decline where as it seems as if steam is still left in the Euro credit flows. Obviously, there may be both stock and flow effects where the latter would be how Litas loans were simply rolled over into Euro loans or, in the context of flows, simply that the amount of Litas loans were falling.

So, what on earth is all this good for?

Well, I think there are two main issues to note. First of all I should thoroughly try to formalize the connection between the interes rate spread and the composition of Litas vs. Euro denominated loans. As can be seen it seems as if the hump of the interest rate spread is indeed reproduced in the graph of the currency composition of the total loan portfolio. In order to investigate this I developed a small rudimentary regression model with the change in the differnce between Litas and Euro loans as a dependent variable and the change in the interest rate spread as an indepedent variable. This produces the following relationship (R-sq = 0.147, F: 6,20 (p; 0.0176).




If you really want the equation just drop me a note in the comments. The formal interpretation of the model is that a 1 basis point increase in the interest rate spread in favor of the Euro translates into a 32 basis point change in the difference between Euro and Litas denominated loans. E.g. if the interest rate spread widened .25% (25 basis points) in favor of the Euro (i.e. Euro loans got .25% cheaper relative to Litas loans) the change in the difference between Euro and Litas denominated loans would be 8% (800 basis points) in favor of Euro loans. Please note that this is not a very strong model in statistical terms but it does show that a relationship exists.

The second issue which is more pertinent in our present context is just what we can expect from interest rates going forward. Clearly, as Mary shows above (and as is widely detailed in the IMF report) foreign banks are now visibly beginning to wobble. As an appetizer of this we learned recently that a batch of Swedish banks recently suffered a dent in their Q1 profits on the back of the slowdown in the Baltics. We need to understand that this is just adding further to the perils of these banks since they are obviously already under attack on several other fronts not least in the context of securing financing for their operations in the interbank market. All this points to higher borrowing costs for those Euro denominated loans. Should that be a problem then? Well, not necessarily since as long as the credit market and currency peg is there the denomination of the loan is in fact all about where the low interest rate is. However, as I stressed above Lithuania need those foreign bank loans to finance their external position and if these suddenly dry up because the banks reduce activity and/or borrowing costs rise so much as to make them unattractive we are getting into trouble. In this context I don't see a major move out of Euro denominated loans at this point but that does not mean that the costs of servicing these won't increase. Basically, the banks can do two things. Follow the economy down raising rates and curbing lending or they can write off their losses. In reality it seems as if a process of 'a bit of both' has already begun and now it remains to be seen whether the squeeze becomes so tight elsewhere that some of these banks opt to significantly reduce activity. In this light, Lithuania in itself can hardly bring down any but perhaps a local bank but as Mary warns the contagion risk is not insignificant. Moreover, the issue of the inflows themselves are important since Lithuania, and the rest of the Eastern European gang, has an external deficit to cover. If suddenly, the inflows in the form of foreign bank loans retreat (and they will to some extent) there will be a short fall and since the Litas cannot correct we could see a rather rapid transition from rapid inflation into deflation as this would be the only way to correct the external position.

Ultimately, I am not trying to pull another doom and gloom rabbit out of the hat here. The risks I have pointed to here represent nothing new in the general discourse. What we do need to understand though is that; if the inter-relationship between the foreign banks and Eastern European and Baltic consumers/corporations hitherto was in a honeymoon stage with plenty of mutual benefits for both it is now set to become a dance macabre (or a tango if you will) and we know that this takes two to tread.