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Friday, August 8, 2008

The Czech Central Bank Lowers Interest rates

Now this is news. Monetary policy makers at the Ceska Narodni Banka (the CRs central bank) cut what is the European Union's lowest key interest rate to 3.5 percent at today's meeting. This was the first decrease in more than three years, and was evidently an attempt to counter the koruna's record appreciation in order to try to revive economic growth which is fading rapidly.

Rate setters seem to have decisively switched their focus from the current high levels of inflation to countering the koruna's 13-month rally on concern a high Koruna will continue to have a negative impact on exports, investments and employment. Central Bank Chief Zdenek Tuma warned last month that the koruna's recent advance could cause inflation to undershoot the central bank's 3 percent target next year, justifying the then hypothetical possibility of rate cuts. Since then, the koruna has lost 4.1 percent against the euro.

The central bank lowered its forecast for economic growth for this year to 4.1 percent from the previous 4.7 percent outlook. In 2009, economic growth the bank expect growth to decelerate further - to 3.6 percent - which compares with the 6.6 percent rate achieved in 2007. So the bank is worried that the economy is slowing excessively quickly.

In fact the Czech economy expanded at the slowest pace in more than three years in the first quarter as consumer spending weakened. Gross domestic product rose 5.3 percent, compared with a revised 6.3 percent in the previous quarter. The economy's rate of expansion slowed for a third consecutive quarter after peaking at a record 6.8 percent in Q2 2006.

If we look at the q-o-q chart we can see the slowdown even more closely. Basically the economy hit a quarterly 1.8% in Q1 2007, and since that time it has been slowing to Q1s 0.9% (or an annual rate of 3.6%). Clearly Q2 will be weaker and we could see q-o-q of 0.5%, which mean if the rate of de-celleration continued we might get negative growth in Q4. This would clearly be a soft landing, but it is preoccupying for an emerging economy nonetheless.

The inflation rate increased to 6.9 percent in July from June's 6.7 percent, surpassing the central bank's goal for the 10th consecutive month. The CR now has negative interest rates of some 3.4 percent. That is, monetary conditions in the CR are extremely accommodative.

And wages have been rising much more rapidly than prices in recent months, that is real wages have been rising.

Which is not really surprising, since the labour market has been steadily tightening as the number of unemployed has dropped steadily. Which makes the issue of why consumption has been falling back much more of a mystery. This situation is very different from what we are seeing at present in Bulgaria or Romania, or even Slovakia.

Now it is not hard given the sharp rise in the Koruna to understand why Czech exports slowed significantly on a year on year basis in June. They were up a touch on May, but down on April and February, and were only very slightly up y-o-y. Exports rose an annual 1.7 percent, to 215.8 billion koruna and imports totaled 201.9 billion koruna, a 1.1 percent decline in the year.

But why is consumer demand slowing at this point? This is much harder to understand, yet it is. Why are people not simply borrowing cheap money and building houses and buying cars? Seasonally adjusted retail sales, however, only grew at a very moderate rate in May (up by 0.6% month-on-month and by 2.5% year-on-year).

And the construction boom is long since over, with output actually contracting year on year in May. Indeed the last construction boom seems to have blown out in Q1 2007.

Now this is all frankly rather worrying, and it is doubly worrying for me, because I think I have seen this before in Portugal and in Hungary. The rising Koruna may well choke exports but there is no reason whatsoever why it should be choking domestic demand, indeed quite the contrary. So why is domestic demand so weak, that is the question?

If we look at a longer term chart for year on year household consumption growth, we will see that the last "long wave" of this peaked in Q1 2007. We can expect the performance in Q2 2008 to be even worse, and the question, the quite deep theoretical question really, is why this should be happening?

Now here's a rather similar chart for Hungary. As we can see, Hungary had it last local peak in Q1 2006.

And as we can see, Portugal's last big "wave" ended in Q1 1999. So my question is really, is it possible that the CR is now where Portugal was in Q1 1999 and where Hungary was in Q1 2006? My feeling is that it is possible, and indeed this is where we may well now be. The thing is we need to understand the theory which explains the dynamics behind all this much better. But if it isn't like this, then I don't understand why consumption is now simply fading out.

Basically one thing that these three countries have in common is declining population (or at least in the Portuguese case declining population at the time when consumption blew, as a result of prior EU freedom of movement related out-migration). Declining and ageing population. As we can see in the first chart, the population of the CR has declined in a variety of ways since the late 1980s. It has started to increase again since 2004, but it seems to me the consumption bust was already in the pipeline by that point. What is really, really surprising to me is just how sensitive the whole system is to what appear to be really quite small movements in population size.

Of course it isn't simply the size that matters, it is more the structure, and as we can see from the median age chart below the CR has been ageing quite rapidly for some time now, and will continue to age as we move forward. Having more children and accepting more immigrants (both of which are very advisable) are the only things which will slow all this down.

Of course you won't read about any of this in the economics text books (yet), but the picture is reasonably clear, and it is also perfectly compatible with life cycle savings and consumption model as presented by Franco Modigliani. You simply need to apply it to population rather than simply to individuals.

Tuesday, August 5, 2008

Where Now for CEE and Baltic Currencies?

By Claus Vistesen Copenhagen

Ever since the illusive credit turmoil began sentiment in the market place has been fickle and essentially, like the assets of which it consists, volatile. We started off with an adamant focus on downside risks to growth which then turned into a focus and fear of inflation. Now, as the cyclical data has turned for the worse in Europe and many places in Asia the focus seems to be reverting to growth. Now, I won't go into the whole decoupling v recoupling discussion at this point since I think that this dichotomy is a false one. It never was about de-coupling à la traditionelle but moreso about two interrelated points. The first would be the extent to which the world already has decoupled from the US in the sense that a key group of emerging economies are now set to ascend in economic prowess. The second would be the extent to which the de-coupling thesis always built on a fallacy. The main point would be that the main fault line of slowdown was observed across economies with external deficits; something which, I am sure most will agree, is sure to impact surplus economies too.

Now, that does not completely let the ECB off the hook since by maintaining a focus on inflation it also assumed the role, if only temporary, of the new anchor in a re-wamped version of Bretton Woods II as the Euro ascended to new highs. This bet on global re-balancing was always going to end in tears and in this light the Eurozone could not decouple from the US; that much, I think, is true.

The key issue here however, as I have argued time and time again is represented in two crucial interlocked questions which together form a key structural trend in the global economy. One is what happens when the surplus economies slow down and there is not sufficient demand to pull the economy back up? Demographics and a high median age are key variables to watch in this regard. The second question is the extent to which hitherto deficit nations can turn the boat around and increase savings (i.e. rely more on exports) and what it will mean for global capital flows when they begin this process?

In the context of the CEE economies the themes above are also present. In a recent note I detailed the change in sentiment from growth to inflation and what it might mean for Eastern Europe's economies and their respective currencies. The key situation as I sketched it was one of a dilemma.

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.


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.

Now that the focus seems to be changing back again it appears to be a good time to revisit the situation

Within this global nexus of what exactly to do with inflation relative to growth, many Eastern European economies has so far opted to go for inflation by raising interest rates. At an initial glance this seems quite reasonable and in many ways the CEE central banks merely latched on to market sentiment and expectations that many emerging economies would seek to use nominal appreciation as a tool to flush out inflation.

Consequently we have seen how both Ukraine and Hungary have chosen to loosen the peg to the Euro as well as other floating currencies in Eastern Europe have seen their yield advantage increase in an attempt to flush out inflation. This has not been without problems though or more specifically it is not clear that an appreciation of the currency is all for the good. Two points here would seem particularly important. One is the simple question of whether in fact an appreciation is deflationary in a world where capital flows, and in particular the hot kind, act strongly on yield. However, another point would be specifically tied to the situation in Eastern Europe. As such, nominal appreciation of the currency also increases the purchasing power which is not what many CEE economies need at the present time as they stand before the task of correcting a rather large external balance. Moreover, rising domestic interest rates will increase and exacerbate the credit channel by which loans denominated in Euros and Swiss francs become more attractive. I have shown this to be true, for example, in the context of Lithuania. The important thing to do note here would what would happen to the servicing of these liabilities should the domestic currencies depreciate.

What happens next then? Or more concretely, even though CEE currencies, in general, have enjoyed a rally on the back of market expectations of nominal appreciation fed by hawkish central banks what happens if and when central banks reverese course?

An initial warning shot across the bow was handed to us as the governor of the Czech central bank mused that he might lower rates come next meeting due to the strenght of the Koruna and the subsequent effect on exports. Also Poland recently opted to abandon the hawkish stance as rates were kept steady. In light of this event Macro Man managed, as ever, to hit the proverbial nail on the head.

There is little more bearish for a currency these days than abandoning the inflation fight in a pursuit of growth; this is particularly the case when the market is heavily positioned the other way.

This is exactly the issue which now confronts many Eastern European economies. What to do as growth visibly tanks at one at the same time as inflation stays high. One thing here would be for the central banks to hold their raising cycle which in itself should ease the pace of appreciation but what if they need to lower rates.

Now the numbers above do not, in themselves tell anything remotely interesting. For one, the difference between the economies are quite big. For example the Czech Republic has been able to gain, with a comparatively low interest rate, currency appreciation which has actually helped the external balance in so far as it has made imports cheaper. Obviously, at this point the benign effect on the trade balance is just as much down to decreasing domestic demand as the value shield of a dear currency. On the other hand, if we consider especially Ukraine, Romania, and Hungary the price has been dearer and the subsequent effect on inflation less pronounced. One could always argue that the situation would have been much worse, but one thing is certain; the ensuing loss of competitiveness has not been compensated for with a decrease in inflation. And one has to wonder whether pushing nominal interest rates ever higher would be a sound solution.

The key here is that these high interest rates carry with them a high lock-in premium which makes it difficult to reduce them without causing substantial pain to the currency. Add to this that as long as interest rates stay in this territory the incentive to borrow in foreign currency remains very appealing. In fact, the incentive structure here is quite disruptive as many of these economies have higher rates on domestic currency deposits and lower rates on foreign credit. This incites consumers and companies to place their deposits in local currency while funding themselves in foreign currency. Finally, there is of course the more standard economics 1-0-1 point that whatever nominal rate is ascribed to a currency and an economy the latter needs to be able to provide the structural demand for which to satisfy the yield. Otherwise you just pour more gasoline on an already raging bonfire.

Obviously, as long as the local currency remains strong and on an upwards march or the trading band is kept in place the show goes on. But the longer this structure lingers the more difficult it will be to break free; and break free they must since I am quite sure that Eurozone membership is off, for the immediate future at least.

Another more hard hitting point would simply be that whatever growth momentum these economies had going into 2008 it is now steadily levelling off. Now, these economies need to rebalance their external accounts at the same time as they labour under the yoke of slowing growth, high interest rates which are difficult to reduce and/or a quasi fixed exchange rate to the Euro. Can you feel the chilling cold of deflation blowing across the Urals? I can.

Basically, the past years' rapid process of nominal convergence will now need to be kicked into reverse, since it is quite obvious that many CEE economies have been riding a blade too tough.

Be Careful Indeed

Last time I massaged this specific topic I summarised by ominously stating that the CEE economies and their central banks should be careful what they wished for in terms of using higher interest rates and subsequent nominal appreciation of their currencies to flush out inflation. The key point was that the effect would likely be limited and only further worsen the imbalances in the economies. And thus, here we are.

Another more subtle point in the context of market reactions would be the boomerang effect which comes from the currency appreciation as interest rates are increased (and the peg/band abandoned) to the subsequent plunge when the economic tide turns. In line with the change in global sentiment towards growth and deflation (see e.g. here) and the fact that other hitherto strong yielders (e.g. the Kiwi and Aussie) are beginning to falter we may be at an inflection point in the whole discourse of upwards movement in CEE currencies. Stephen Jen's recent tour of global FX markets is a fine addition to this argument.

As ever, this is obviously still a dilemma for most of these economies since inflation continues to rage ahead. In Romania for example the PPI rose at its highest pace since 2004. However, as long as the credit tap stays open and as long as the purchasing power is increasing so will the the demands for higher wages stay strong. This is particularly true in the context of the CEE economies as these are in possession of structurally broken population pyramids after two decades worth of lowest low fertility and, in the cast of the latter decade, net outward migration.

The main point I would like to emphasise here is that correction is coming and that it will only become harder the higher the currencies move upwards. In a more general light this correction will not be a small one and it most certainly will not be felt exclusively in Eastern Europe. Basically, the big hidden data point in all of this is the dependence of Germany on CEE imports. So far, this has moved along just nicely but Germany is in for a rude awakening once the link breaks ... and break, I am afraid, it will.