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Monday, November 24, 2008

Are Baltic Devaluations Now In The Works?

Now this is a very interesting question, isn't it? The only honest answer I can give is that I don't know, and indeed I haven't the faintest idea. The government of Latvia (the Baltic state which is currently most rife with "rumours" about imminent devaluations) works in its own wondrous ways, and neither we (nor Latvia's citizens) have any idea at all how they plan to lift their country out of the deepest depression they have experienced in many a long year.

What I do know is that, economically speaking,the present situation is simply unsustainable, and something is going to have to be done. Indeed the country's government is in talks with both the IMF and the EU Commission about this very topic as I write. My own opinion is that domestic consumption is now dead (as a growth driver) for as far ahead as the eye can see (and maybe even further), that the country's citizens now need to start to save rather than borrow more, and that the only way Latvia can turn itself around is by exporting more than it imports. But for a country which ran a 23% current account deficit in 2007 this is going to be very difficult objective to achieve, since after two years of very strong inflation Latvia's relative prices with the rest of the world are completely uncompetitive.

Historical experience has taught us that it is not an easy thing to tell people "we are going to cut your wages by between 5 and 10% this year, next year, and then possibly the year after". Apart from the fact that voters don't like to hear this kind of talk, you can also enter into a deflation dynamic which then comes to be very hard to break out of. Hence, according to conventional economic wisdom, devaluation tends to be the preferred option. And it is my opinion that, despite all the attendant difficulties, devaluation is the best option among the unappetising list of unpleasant options presently available to Latvia (and the other Baltic states, and Bulgaria). Unfortunately, having reached this point there are simply no "pleasant" options available.

The curious thing is that for voicing this opinion I could go to prison in Latvia.

According to the Baltic Course online newspaper Ventspils University College lecturer Dmitrijs Smirnovs was detained for two days recently on suspicion of spreading rumors about the devaluation of the Latvian currency. He was detained in connection with an opinion that he had expressed during a debate about the development of the Latvian economy and the future of the Latvian banking and credit system. His arrest followed the publication of his opinion in Ventspils' local newspaper Ventas Balss. According to the newspaper report he said the following:

"The U.S. problems are trifling, compared to what awaits us. They have now reached the bottom and will start to recover. Problems in the European Union have only just begun and we may be hit by a crisis that is ten or maybe twenty times worse than that in the United States. The Swedish banks will no longer be able to offer inexpensive loans through their subsidiary banks in Latvia. They will tell us to pay back the debts! How will we pay them – with the real estate? We have no assets to pay back the debts! [..] The pyramid has been built and now we have to wait until it collapses. [..] The only thing I can suggest now: first of all, do not keep your money in banks, second: do not save money in lats, as it is very dangerous at the moment."

Dmitrijs Smirnovs appears to have been detained by members of the Latvian Security Police, who seem to have been charged with the special mission of protecting the integrity of the Lat at this very delicate point in Latvian history. And while some of the advice Smirnovs offered to his audience may have been ill-advised (given the delicate nature of the problems involved), they are opinions, and in a free and democratic society he should be at complete liberty to express them.

In fact Smirnovs is not the only such case to have arisen in recent days, and Baltic Course report that two more people are "under investigation" by the State Security Police. According to Latvian newspaper the Telegraf Latvian police previously detained a journalist under suspicion of spreading rumors about the Baltic nation's financial system during the global market crisis (also see this report and debate in comments about the same issue in Baltic Business News, while the same source reports that in the Finish newspaper Kauppalehti - which is evidently not controlled by the Latvian Security Police - they are simply discussing whether the Lat will be devalued before Xmas or in two to three months time).

The police held a journalist working for a Latvian newspaper yesterday evening in an investigation that started on Oct. 6 due to ``rumors about the Baltic country's financial system,'' police spokeswoman Kristine Apse-Krumina said, according to the Russian- language newspaper. She gave no details on what rumors the journalist is accused of spreading. Another investigation has been started following a run on currency exchange booths in the capital Riga last weekend that was caused by rumors about a devaluation of the lats, she added.

One of the other cases under investigation by the State Security police appears to be a member of the Latvian pop group "Putnu balle" based on statements made during a pop concert in Jelgava on November 9. Kristine Apse-Krumina, aide to the Security Police chief, stated that the cases was opened following a complaint from a bank, which alleged that lead singer Valters Fridenbergs had urged the people to withdraw their money from Parex banka and Latvijas Krajbanka during the warm up to the concert. According to band manager Anete Kalnina what actually happened was:

"As it often happens at concerts, the band members communicated with the public, telling jokes about themselves as well as many other things. The band had performed two songs when the guitarist Karlis Bumeistars had to tune his guitar, which is when Valters Fridenbergs started talking to the public," Kalnina said. Commenting the current situation in Latvia, Fridenbergs said that the audience had better hear the concert to the end, and only then rush to ATMs. "The people at the culture center got the joke, and laughed. It was not an encouragement" to withdraw money from banks, said Kalnina.

Evidently State Security Police charged with the investigation of seditious devaluation rumours have no such sense of humour, although maybe having to attend a few more pop concerts wouldn't be a bad therapy for them.

I myself received what could be termed a "mild threat" on my Latvian blog, following my publication of an opinion by Bank of America analyst, David Hauner, about the need to devalue:

``They will keep the pegs at the current exchange rates well into 2009, but reset the rates to devalue against the euro later, when markets have calmed,'' Hauner said.

This attracted the following warning from unidentified commenter LV, who would seem to me to quite possibly be a member of the above mentioned "Keystone Cops" group.

Apparently you are disseminating false information about the Latvian financial system. Please note that this may constitute a crime under Latvian law. In order to prevent the spreading of false rumours regarding the Latvian financial system the Latvian Security Police has also opened a telephone hot line so that false rumour spreaders can be reported and tracked down.

He then cited some rigmarole in Latvian which he invited me to use a Google translator to understand. I replied as follows:

Well I don't know what the Latvian law says, and quite frankly I don't especially care. You stopped having a dictatorial system when the old Soviet Union broke up, and there is a UNIVERSAL right to express an OPINION under any concept of democracy I know.

Actually the extract you cite comes from an analyst from Bank of America, and it is an opinion and not a fact. As far as I know he has no priviledged information, but if you have any doubts better you contact him direct.

My OPINION is also that the peg is impossible to hold in the longer term (ie it needs to be corrected before euro entry, for the reasons I explain), and logically since there is then a further delay in entering the euro after the devaluation it is better to do it sooner rather than later.

This is my opinion as a mecro economist and specialist in the Latvian economy, if expressing this opinion is illegal in Latvia, then really I don't know what Latvia is doing in the EU, let alone thinking about euro membership. For tyhis kind of thing you'd be better off with Putin and Medvedev. Open economies don't work that way, or didn't you notice, 22 world leaders just met to affirm that the best way out of the present financial crisis is to have the maximum TRANSPARENCY possible.

As I say above, this is all a very delicate issue, and university lecturer Dmitrijs Smirnovs was undoubtedly ill-advised to use the specific wording he did, not because he committed any known offence, but simply becuase he could have provoked a run on the banks, and this would only make the matter worse. On the other hand - and assuming they do have to devalue - it is a very unfortunate state of affairs that all those who actually know and understand what is happening have already changed their money over, while "ordinary Latvians" (like those in Smirnovs' audience) who have no idea what is happening, but (ill-advisedly perhaps) like to trust their leaders will simply lose a significant part of their savings.

Better never to have come to this point, but then, saying that doesn't help very much, does it?

Back in August 2007 I was asked the following question by a reader of my Latvian blog:

I want to thank you for your continuing efforts to explain what is happening in the Baltics in general and Latvia in particular. I live in Latvia and will be heading to the bank tomorrow to move our family's savings out of Lats and into Euros while the peg is still intact. (Or is there a better idea?).

To which I diplomatically replied as follows:

I wish I could be the bearer of better tidings. I think history has been so unkind to all the peoples of Eastern Europe, they really do seem to be entitled to be dealt a kinder set of cards than the ones they actually have. Really, I think you will appreciate that, even if I could hardly claim to be widely read on this blog, I do want to be responsible, and thus am unlikely to say anything which I feel could be in any way damaging to the Latvian outlook.

However, if you ask me this question:

"Or is there a better idea?"

Then I have to say that I personally can't think of one. For the rest, at this point, you will have to read between the lines I'm afraid.

I will try, when I find the time, to treat the currency peg issue in a somewhat theoretical fashion, but I fear it is reality itself which will put it back on our collective agendas in a much more practical one. I simply don't see how you can have the level of cost inflation (and the wage increases have still to feed through to producer prices and the end customers over many months) and still hope to sell exports. And if you are going to cut domestic demand, which is what they are doing, then selling exports is the only effective way to live.

Basically, as the observant reader will note, my core discourse has not changed very much over the last 18 months or so, nor will it - Latvian State Police or no Latvian State Police.

Will They Be Investigating The EU Commission?

One of the very sad and ironic aspects of the present case is that the Latvian government is currently, as I indicate at the start of this post, in discussions with both the EU Commission and the IMF about the future of the Latvian economy, and I think it is hardly a closely kept secret that both these institutions favour a floating currency, and thus logically a "flexibilising" of the Lat peg as a way forward out of the present crisis,

The European Union was really as explicit as it could be at the end of last week when it make clear that it is more than ready to provide financial assistance to Latvia, but that any aid will be conditioned on a programme to underpin balance-of-payments stability. And what could bring more stability to the Latvian balance of payments (ie induce more exports and suck in less imports), well evidently a change in the relative values of the Lat and the Euro - really at this point there are no other alternatives.

The EU, in their statement said they were "in close consultations" with Latvian authorities, and with the International Monetary Fund in order to develop a joint response to what were described as the "growing tensions'' in Latvia's financial markets.

``The EU stands ready to participate in a coordinated financing package with the IMF conditional upon a strong commitment by the Latvian authorities to implement a rigorous and credible adjustment program in order to underpin balance-of- payments sustainability in Latvia".

The statement did not specify when the aid would be granted or the amount involved. As regards the Latvian extenal position, the chart below of the current account deficit says it all. There is a whopping imbalance, and even though the deficit will be less this year, this is largely due to a collapse in imports as domestic demand has collapsed, and the need to export competitively issue still remains to get to grips with.

And Maybe They Should Check Out The IMF While They Are At It

Also it looks more and more likely that the International Monetary Fund is insisting Latvia abandon its currency peg in return for a bailout.

“Eventual Fund help might…be conditional on giving up the currency board regime and allowing faster real exchange rate depreciation to rebuild competitiveness,” according to economists at BNP Paribas SA in a research note.

And as Citigroup economist David Lubin notes: "The IMF’s own credibility was severely damaged as a result of its decision to continue financing Argentina’s currency board in the run-up to that country’s December 2001 devaluation, and we think it is unlikely that the IMF will want to repeat that mistake".

So maybe the lads and lasses of the State Security Police better hop on an airplane over to Washington, with a notepad and well sharpened pencil handy perhaps, just to see if they can gather any signs or sedition, or even, who knows, even "conspiracy" over at that end.

Dwindling Reserves

Meanwhile Latvia's foreign exchange reserves continue to dwindle, since the Latvian central bank announced today that they bought 130.3 million lati ($232.7 million) in the domestic foreign exchange market last week to support the currency after it weakened to the limit of its trading band. The lats fell to 0.7098 against the euro for the eighth consecutive week, prompting the bank to step in and buy it. Under the Lavian currency board system the currency is allowed to rise or fall 1 percent from a midpoint with the euro. The previous week the central bank acted to support the currency when it bought 189.8 million lati, which was the biggest weekly purchase it has made in at least two years.

The central bank has now bought 613.4 million lati over the last eight weeks. Foreign currency reserves have fallen about 18 percent since the end of September to around $5.4 billion at the end of October, it said. This month's moves have decreased the reserves to about $4.9 billion.

And Latvia's three-month interbank lending rates surged to their highest in a decade today as banks effectively stopped trading with each other, according to Kaspars Jansons, head of money markets at Parex Banka. The three-month RIGIBOR, Latvia's interbank lending market, rose to 13.5 percent, the highest since November 1998 when Russia defaulted on its debt, and up nearly 20 percent from 11.18 percent on Nov. 14. Janson is quoted by Bloomberg as saying "There is a lack of credit lines in between banks......Banks are not really trading with each other." He also said that a need for lati has driven some banks to raise deposit rates to as high as 10 percent for lati-denominated accounts.

Friday, November 14, 2008

Estonia's Recession Deepens As Latvian Finances Struggle To Find Air

Estonia's economy shrank again in the third quarter - by an annual 3.3 percent, thus clocking up the second-worst performance (after Latvia) in the 27 nation European Union, and offering us plenty of signs that the country's worst economic recession since 1994 is set to deepen. The contraction fulfils the basic technical criterion of recession since it follows a 1.1 percent fall in the second quarter according to data released by the statistics office yesterday (Thursday).

With the global market crisis and credit crunch weighing on the world's leading economies, and especially with Germany - the eurozone's largest economy and principal economic powerhouse itself entering recession, the prospects for any export driven recovery have definitely now faded off into the distance. Estonia and Latvia now lead the Eastern European slowdown, following repeated warnings over the past year of about the risks of an economic "hard landing'', warnings which were not unfortunately headed due to hopes that the eurozone itself would hold out against the US downturn (the United States is still not technically in recession) and that Scandinavian Banks would have little trouble funding growing forex debts (these banks are themselves now seeking support from the Swedish government). As I said, Estonia's economy is contracting the second fastest, since Latvia's economy shrank 4.2 percent in the third quarter, and currently has the worst growth rate in the EU.

``The effect of the financial crisis on the real economies of our main trading partners remained modest in the third quarter but will definitely increase,'' according to Martin Lindpere, an economist at the Estonian central bank. ``External demand is therefore expected to weaken in the coming quarters, and unfortunately, the contraction of the Estonian economy will accelerate.''

The central bank forecast suggests the Estonian economy may shrink between 1.8 percent and 2.7 percent this year, and between 2.1 percent and 4.5 percent next year. Really there is a high degree of uncertainty attached to next years forecast, since nobody is really sure at this point how bad things can get, either inside or outside the Baltics (Russia's economy is unwinding fast even as I write), or when exactly recovery will commence.

Quarter on quarter the economy contracted by 1%, following a revised 1.1% contraction in the second quarter.

All the signs are that the contraction may even accelerate in the fourth quarter. Estonian industrial output, which dropped 3.8 percent in September, has fallen in six of the seven months up to September, and looks almost certain to contract further in October-December . Likewise retail sales which have also been down for six of the past seven reported months.

More Trouble On The Way As The Currency Pegs Come Under Pressure

Lithuania, Latvia and Estonia mayall need to devalue their currencies over the next year as they seek to stave off a recession, according to a recent report from Bank of America Corp. With inflation still running at around three times the average rate across the 15-nation euro region and a slump in domestic demand that looks like it will be very hard to turn around amid the need to export may leave the Baltic states with little alternative but to abandon their currency pegs in the second half, on the view of David Hauner, a Bank of America strategist based in London.

``They will keep the pegs at the current exchange rates well into 2009, but reset the rates to devalue against the euro later, when markets have calmed,'' b Hauner said.

The Lithuanian litas and Estonian kroon have been little changed over the past three months based on their currency board systems that peg them to the euro at fixed rates. The Latvian lat is allowed to rise or fall 1 percent from a midpoint to the euro. The countries also participate in the European Union's exchange-rate mechanism, under which central banks must keep currencies within a 15 percent trading band against the euro.

Andres Sutt, deputy governor of the Estonian central bank, said the kroon's peg
to the euro will remain unchanged and that a devaluation would ``lack any
economic rationale.''
"The competitiveness of Estonian exporters has remained good; wage growth, inflation and loan growth have declined very rapidly, as has the current account deficit, lowering Estonia's dependence on external financing,'' Sutt said "The finances of banks operating here are also strong. All this characterizes the flexibility of the Estonian economy and its ability to adjust.''

In fact Estonia and Latvia continue to run a goods trade deficit, making it impossible to drive headline GDP growth from exports. Latvia's central bank Governor Ilmars Rimsevics also said ecently that "devaluation is an absolutely unrealistic scenario,'' while the Lithuanian central bank Governor Reinoldijus Sarkinas was cited by the Baltic News Service on August 19 as saying that the exchange-rate system "shouldn't change at all.''

Nonetheless the economic rationale for devaluation becomes more compelling by the day, as the Baltic countries if they are one day to enter the euro will need to do so at a much lower partity than the current one to be able to get growth in the longer term.

There are obviously two principal drawbacks to devaluation against the euro, the first of these is that foreign exchange debts will suddenly rise, and this is why the Baltic countries will undoubtedly need EU aid in sorting out the mess. Secondly there will be a delay in euro membership. Countries aiming to adopt the euro must spend at least two years in the Exchange Rate Mechanism, or ERM-2, to demonstrate the stability of their currency. Lithuania and Estonia began participating in the system in 2004, the same year they entered the European Union. Latvia joined a year later. If the Baltic countries devalue then the clock will need to be reset, but then again, eurozone entry with the economies in an economic slump (rather than a mere recession) does not seem to be an attractive proposition either. These economies will need time to get things straight again, so the delay in euro entry does not seem to be an inordinately large obstacle, in and of itself.

Lithuania's ambition to be among the first countries in eastern Europe to adopt the common currency was thwarted in May 2006 as inflation accelerated. Estonia and Latvia were also forced to delay the changeover, and of course it has been this whole process of delay that put the spanner in the works and has lead to the whole boom bust cycle taking the form it has, as euro membership ebbed off into the distance.

``If your real exchange rate is overvalued, there are two options: either devalue, or accept a recession to make inflation fall relative to the trading partners,'' Hauner said. ``So the Baltics have the choice between a deep
recession or postponing euro-zone accession. I think they will choose the latter.''

EU Readying-Up Aid

The Baltic States now have some hard decisions to take, but the EU and the IMF are there ready to support. The European Commission hopes to come to a decision on providing financial support for Latvia "fairly soon", according to European Commission spokesman Jonathan Todd.

``We've been in close touch with the Latvian authorities for the past week and those contacts are continuing. We hope to be able to adopt a decision fairly soon,'' Todd told journalists at a Brussels press conference today.

Latvian authorities also themselves reported on Wednesday that they were in talks with the European Commission about possible financial assistance following the decision to take over Parex Banka AS, Latvia's second-biggest bank, as liquidity tightened and depositors withdrew funds. Following the nationalisation Latvia added about 200 million lati ($357.8 million) in liquidity to Parex to shore up its finances.

``We don't need the money now,'' said Edgars Vaikulis, a spokesman for Prime Minister Ivars Godmanis, yesterday. ``We are just in consultations,'' he said. Turning to the International Monetary Fund for support in the future was also a possibility, he said.

Latvia's 26 banks lost about 461 million lati, or about 4.6 percent of their total deposits, during October, according to a statement from Latvia's Financial and Capital Markets Commission. Latvia would prefer to turn to the commission and not the IMF, according to Karlis Leiskalns, head of the Latvian Parliament's budget and financial committee, speaking on Latvijas Radio this week.

``I can't say that Latvia won't go to the IMF for help,'' he said. ``The IMF will come with conditions, and one of the basic conditions will be to cut the social budget. I'm completely against taking from the IMF, unless the state becomes bankrupt.''

More Credit Agency Downgrades In The Works

Moody's Investors Service have announced that they may cut their ratings on Latvijas Krajbanka AS and Norvik Banka, citing concerns about the Latvian lenders' asset quality due to the worsening recession in the Baltic country. Moody's have assigned a negative outlook to both banks' D- bank financial strength ratings and Krajbanka's Ba2 long-term deposit rating and Norvik Banka's Ba3 long-term deposit ratings.

``The economic downturn, which is already under way, is now likely to be more acute than previously anticipated and thus have a negative impact'' on both banks' asset quality ``in the near future,'' Moody's said.

Earlier in the week Fitch cut Latvian debt to the lowest investment- grade rating of BBB- and signaled it may reduce again to the category of high-risk, high-yield or junk.

``In the absence of substantial and timely international financial support, Latvia faces the likelihood of a severe financial and economic crisis and a further downgrade of its ratings,'' Eral Yilmaz, associate director for Fitch's sovereigns group in London, said in a statement.

Monday, November 10, 2008

Massive Foreign Reserves Outflow Puts Russia's Ruble Trading Band Under Threat

Russia's currency reserves, the third-biggest in the world, are falling steadily as tumbling oil prices and an exodus of capital are piling the pressure on the central bank and government policymakers to accept a devaluation in the ruble. Oil prices which are now down 60% from their july peak, slowing economic growth and increasing investor concern are steadily draining Russia's foreign exchange reserves, which fell 19 percent (to $484.6 billion) in the 12 weeks through Oct. 31. This is down from $598.1 billion in the week before the invasion of Southern Ossetia.

Russia had been using the reserves to try and contain the upward movement in the ruble was thought to present a threat to the competitiveness of exports. But resistance is now becoming increasingly difficult in the fact of a 13 percent drop against the dollar since August 1.

Bank Rossii began managing the ruble's exchange rate in February 2005 against a
currency basket comprised of about 55 percent dollars and 45 percent euros.
Policy makers let it trade within a fixed range in mid-May. Since then, it has
dropped 2.1 percent against the basket to 30.4020. Though the central bank
doesn't reveal the limits of the band, BNP Paribas considers 30.40 to be its
weaker end.
Evidently the main responsibility for the drop in the ruble has been a change in the relative values of the currencies in the basket, with the euro falling significantly against the dollar.

The central bank sold a record $40 billion in October, according to Moscow-based Trust Investment Bank, while Troika Dialog, the country's oldest investment bank, have warned that the currency may fall by as much as 30 percent in the event of a devaluation.

The logic behind any impending devaluation would not be too hard to find either. Try looking at the inflation bonfire which has been allowed to rage in Russia over the last eighteen months.

Inflation Drops Back In October, But Is Still At 14.2%

Russia's inflation rate fell to 14.2 percent, the lowest in seven months, in September as grain, legumes and gasoline prices all decreased. The rate dropped from 15 percent in September, according to data from the Moscow- based Federal Statistics Service. Prices were up 0.9 percent on the month, after rising 0.8 percent in September.

Bank Rossii, Russia's central bank, may have to increase the "flexibility'' of the ruble exchange rate, and this will involve a "certain tendency toward weakening'' according to bank Chairman Sergey Ignatiev speaking on state television Vesti-24 last week.

Russia may "gradually'' widen the trading band if the current account falls into a deficit next year, according to Arkady Dvorkovich, an economic adviser to President Dmitry Medvedev, recently.

And Russia's current account, the widest measure of flows in goods and services, seems now to be inexorably headed toward just thatdeficit. Russia's trade surplus narrowed to $16.4 billion in September, from $18.5 billion in August, according to the latest data from Bank Rossii .

Russia's benchmark 30-year government bond has fallen substantially in 2008, pushing the yield to an almost seven-year high of 12.55 percent as of Oct. 27. So far this year, the RTS Index has lost 64 percent, and is headed for its worst performance since 1998.

And Corporate Lending Piles Up And Up

VTB Group, Russia's second-biggest lender, has lent 377 billion rubles ($14 billion) to Russian companies since the beginning of September. The state-run bank provided 120 billion rubles worth of loans in September, 229 billion rubles in October and 28 billion rubles in the first week of November. Most of the money was leant by VTB (94 billion rubles) to metals companies. This was followed by 33 billion rubles for the power industry and 32 billion rubles for retail companies. The bank increased its corporate loan portfolio to 667 billion rubles in the first 10 months of 2008, from 363 billion rubles in the same period last year, according to the bank. The bank has also increased its retail loan portfolio by 183 billion rubles, a 97 percent increase from the first 10 months of 2007.

Russian Services Contract In October

Russia's service industries contracted in October for the first time in more than seven years as the effects of the financial crisis spread into the real economy. VTB Bank Europe's Purchasing Managers' Index of growth in services fell to 47.4 from 55.5 in September. A figure below 50 shows a contraction.

If we put this chart alongside the October manufacturing PMI one, it is clear that something significant happened in October. If things continue this way we are heading straight for recession I would say.

Update Tuesday 11 November 2008

The ruble fell this morning by the most in at least a month against the central bank's dollar-euro basket and stocks fell back as traders speculate policy makers are allowing the currency to weaken. The Micex Stock Exchange halted trading for an hour after the benchmark index sank almost 10 percent. The Russian currency extended its 16 percent drop since August 1 following the statement by central bank Chairman Sergey Ignatiev (see above) that under current conditions the ruble may have a ``certain tendency toward weakening.''

The ruble declined 1 percent to 30.6879 versus the basket as of 1:30 p.m. in Moscow. Against the dollar, it was at 27.3040 having earlier slid by as much as 1.3 percent to 27.3975. It was 1 percent weaker against the euro at 34.8484 per euro.

In other news Fitch Ratings yesterday followed Standard & Poor's and lowered the outlook for Russia's credit rating to negative, while Bank Rossii today set a limit of 10 billion rubles ($366 million) on the amount of so-called currency swaps it offered. The swaps allow traders to bet on the exchange rate without having to sell rubles. The central bank started curbing swaps on Oct. 20 in theory to deter "speculators".

Among the falling stocks were those of OAO Sberbank, which dropped sharply after Vedomosti reported that Russia's largest savings bank had suffered a record $3 billion of withdrawals from retail accounts in October. Sberbank, which is the biggest holder of ruble deposits, fell 3.2 rubles, or 10 percent, to 27.63 rubles on the Micex Stock Exchange. Retail clients of Russia's biggest bank withdrew 80 billion rubles ($3 billion) in October, a record amount for a single month, Vedomosti reported, citing an unidentified person familiar with the bank's accounts. Central bank Chairman Sergey Ignatiev estimated yesterday said net private capital outflows reached $50 billion in October.

Friday, November 7, 2008

Latvia's Economy Contracts By 4.2% in Q3 As Moody's Downgrades The Credit Rating

Latvia's economy shrank an annual 4.2 percent in the third quarter, the fastest drop since at least 1994, according to today's flash estimate from the Riga-based statistics office (Friday). This follows a 0.1% year on year expansion in the second quarter.

We do not have quarter on quarter statistics at this point, but if we apply the minus 4.2% calculation over last years Q3 2007 constant price number, then what we get is 2.147 billion Lati, and a GDP graph which looks like this:

Which may have little analytic value (since the data is not seasonally corrected), but does enable us to form a pretty rough and ready visual impression of what is going on, where the annual contraction data remains rather abstract. The economy definitely peaked and started to enter contraction mode after the summer of 2007, and now we need to keep watching and waiting to see just how far it is we go.

The statistics office will release constant price and seasonally adjusted data for the third quarter on Dec. 9. The last time Latvia's economy contracted on a year on year basis (by 2.2 percent) was in 1994, according to data from the Latvian central bank.

Coincidentally Moody's Investors Service today downgraded Latvia's credit rating to A3 from A2, the third-lowest investment grade level, citing a worsening global liquidity crunch and economic slowdown.Moody's warned today that tighter global liquidity could affect some of Latvia's 26 banks, many of whom rely on syndicated loans to finance operations.

``The global liquidity crisis will probably cause a shock to the Latvian banking system, which will reverberate throughout the rest of the economy,'' Kenneth Orchard, a senior analyst at Moody's, said before the report. ``Unless there are major improvements in the European syndicated loan market by early 2009, the government and central bank will be forced to take remedial action.''

Thursday, November 6, 2008

The Czech Central Bank Slashes Rates As Manufacturing Contracts And Exports Wane

The Czech central bank slashed its benchmark interest rate more than expected this morning as a growing credit crunch slows down borrowing and a decline in external demand hits exports and industrial output. Manufacturing output in the Czech Republic contracted for the seventh month in a row in October, and the purchasing managers index (PMI) hit an all-time low of 41.2, just above the revised euro zone figure of 41.1, giving us some idea of just how interconnected Czech and Eurozone activity are.

Sharp Rate Reduction

The Prague-based Ceska Narodni Banka reduced the two-week repurchase rate by three-quarters of a percentage point to 2.75 percent, its lowest level since June 2007. The size of the cut is the largest since at least 2004.

The koruna fell to 24.953 per euro immediately after the decision, and this was its lowest level since Oct. 27. It was trading at 24.868 at 12:37 p.m. in Prague, compared with 24.550 late yesterday. The koruna has risen 11 percent against the euro over the last 12 months, and obviously Czech exporters have been feeling the pinch. This was the second time this year the bank has lowered rates (there was a quarter point reduction in August) as economic growth in both the CR and its key trading partners has fallen back rapidly.

Exports Weaken In September

Czech exports exceeded imports by 10.9 billion koruna ($581 million) in September, well short of the 14 billion-koruna surplus many economist had been expecting. On a working day adjusted (but not price corrected) basis exports were down 1.2% year on year in September (the third month of y-o-y decline, there were 3 working days more in September 2008 than there were in September 2007), while imports were up 6.5%.

Without the working day correction exports at current prices grew by 5.1% and imports by 6.8%, year-on-year. Month on month, seasonally adjusted exports were up by 1.8% over August and imports by 9.8%.

Year-on-year, exports and imports at current prices were up by 5.1% and 6.8% respectively. Imports grew faster than exports for the first time since February 2008. External trade turnover amounting to CZK 436.6 billion was the second highest (after April) in this year. September 2008 was by three working days longer than September 2007. Due to appreciation of the koruna external trade grew more rapidly in euros (exports +18.3%, imports +20.3%) and US dollars (exports +22.4%, imports +24.5%) than in korunas.

Flagging Retail Sales

And if we want additional evidence on the domestic slowdown in the Czech Reoublic then we need look no further than August retail sales, which fell the most in six years as inflation damped consumer spending and two fewer working days than a year ago cut shopping hours. Inflation adjusted sales (excluding automotive sales) were down 2.6 percent, compared with a 3.4 percent increase in July, according to data from the Czech Statistical Office earlier this week. Working day adjusted sales were down 0.3 percent.

Hungarian Industry Takes A Pounding As The Global Storm Clouds Gather

Hungarian manufacturing continued to contract in October following a shocking performance in September, while exports drop sharply in the midst of a looming global manufacturing recession. All of which indicates that the real economy impacts of the recent financial turbulence is now about to make its presence felt. I think we are in for a real shocker in Hungary.

October PMI Down

Hungary's manufacturing industry contracted sharply in October, according to the latest PMI reading, which fell 5.2 points to hit 44.7 in October - a historic low, and 0.8 points below the previous worst reading registered in October 1998, according to the latest data from the Hungarian Association of Logistics, Purchasing and Inventory Management (HALPIM).

Sharp Industrial Output Contraction In September

Hungarian industrial production dropped the most in more than 16 years in September as the global financial crisis hit the economy and slowing growth in western Europe curbed demand for exports. Production was down 5.3 percent from a year earlier on a working day adjusted basis, following a 1.2 percent drop in August. This was the rapidest annual decline since August 1992, according to the national statistics office (based on preliminary data).

Output was down a seasonally and working day adjusted Output 2.4 percent month on month.

Output also fell for a fourth month for the first time since 1992 as the euro region, which buys 57 percent of Hungarian exports, looks set to enter its first recession since the launch of the single currency and crimped demand for Hungarian assembled products like Audi cars and Nokia phones. The economy of the 15 countries contracted in the second quarter for the first time since the common currency's creation, and it is a pretty sure bet it continued to contract in the third one.

“Preliminary September industrial production data was yet another stark reminder that Hungary is feeling the pain from the global slowdown. Although output “only" fell by 0.7% y-o-y according to unadjusted data (versus the huge, 5.9% drop seen in August), working day adjusted figures showed a much darker picture: on a workday-adjusted basis, output fell by a whopping 5.3% versus the 1.2% decrease observed during the last summer month. The month-on-month figure was just as dreadful, exhibiting a precipitous, 2.4% fall (contrasting the 0.8% pick-up seen during the preceding month)."
György Barta, CIB Bank, Budapest

“Headline GDP growth in Q4 could be well below zero even including the beneficial impact of farming. In light of the most recent data, the -1.0% GDP forecast of the 2009 budget draft seems at the very optimistic end of the possibilities as the joint effects of the fiscal and monetary shocks aggravate the growing problems of the real economy."
Gábor Ambrus, 4Cast, London

Hungary's export-driven economy is expected to contract by 1 percent next year as a result of the global economic decline, according to the latest government estimates, although as Gabor Ambrus notes, even this number now looks pretty optimistic. If things continue like this, a contraction of GDP in the 3 to 5% range would not surprise me. The crisis, which recently forced the country to line up 20 billion euros ($26.1 billion) in emergency loans, have now long since dashed hopes for a recovery from 2007's 1.1 percent growth rate, already the slowest growth in 14 years.

August Exports Drop Year On Year

The national statistics office confirmed during the week (Wednesday) that Hungary posted a trade deficit in August - running at a revised EUR 76.1 million (down from the prelim EUR 103.7 million). The January-August balance was a EUR 24.8 million surplus (as compared with a prelimary EUR 2 million surplus), and this compares positively with the deficit of EUR 457.2 m clocked up in the same period of 2007.

Exports in August 2008 totalled EUR 5,366.3 m (vs. prelim EUR 5,378.3 m), down 0.9% year on year, compared to a growth of 8.2% in July. The export volume growth of 4.2% in July turned into a decline of 6.8%, a far cry from the year to date average of a 7.7% increase. Negative export growth had not been seen in Hungary for five years.

Imports stood at EUR 5,442.4 million, revised up by nearly EUR 40 m from the preliminary estimate. The 12 month running total was also revised from the preliminary -1.9% to -2.6%. Imports were up in July at 12.4% year on year as record oil prices boosted the total. In volume terms Hungarian imports plunged 8.5% year on year in August as compared with a 8.3% increase in July.

The JP Morgan Global Manufacturing Index Plummets Too

The October manufacturing contraction in Hungary really forms part of a much larger global picture, since the current dramatic events in Hungary have, above all, a global backdrop, one which the current dependce of the Hungarian economy on exports only serves to highlight.

Manufacturing output fell in October in one country after another, and indeed the latest JP Morgan Global PMI report really does makes for quite depressing reading.

The world manufacturing sector suffered its sharpest contraction in survey history during October, as the ongoing retrenchment of global demand and further deepening of the credit market crisis negatively impacted on the trends in output, new orders and employment. The JPMorgan Global Manufacturing PMI posted 41.0, its lowest reading since data were first compiled in January 1998 and a level below the no-change mark of 50.0 for the fifth month in a row.

Output, total new orders and new export orders all contracted at the fastest rates in the survey history in October. With the exception of India, which again bucked the global trend, all of the national manufacturing surveys posted declines in output and new orders. The impact of the downshift in global market conditions also had a far-reaching effect on international trade volumes. Although new export orders fell at a slower rate than total new business, all of the national manufacturing sectors covered by the survey (including India) saw a reduction in new export orders.

"October manufacturing PMI data reinforce the stark retrenchment that the sector is currently facing, with production, total new business and new export orders all falling at record rates. The latest Output Index reading is consistent with a fall in global IP of almost 8%. The only positive from the surveys was a decline in input prices for the first time since August 2003."
David Hensley, Director of Global Economics Coordination at JPMorgan

Economies across the Eurozone are being affected. In Italy manufacturing activity contracted at the fastest rate in at least 11 years in October according to the latest Markit/ADACI PMI survey out yesterday (Monday). The Markit Purchasing Managers Index fell to 39.7, its lowest since the series began in 1997, down from 44.4 in September. The Italian manufacturing PMI has now not been above the 50 mark separating growth from contraction since February and the latest data showed activity falling at an accelerating pace as demand shrank while jobs were shed at the fastest rate in the history of the survey.

Other recent indicators from Italy have also been far from encouraging, with October business confidence hit its lowest point since September 1993, when the economy seized up after Italy was rocketed out of the European Exchange Rate Mechanism a year earlier.

Germany's manufacturing sector contracted in October at the fastest pace in seven years as incoming orders and output experienced their sharpest declines in more than 12 years. The headline index in the Markit Purchasing Managers Index for what is Europe's biggest economy fell in October to 42.9 from 47.4 the previous month, well below the 50 mark that separates growth from contraction.

The French manufacturing purchasing managers index was revised down to a series low 40.6 in October, down from both the 'flash' estimate of 40.8 and September's 43.0 figure, Markit Economics said in a press release issued on Monday.

Disaggregating the figures, the output component fell to an all-time low of 37.8 from September's 41.7 level, while new orders slipped all the way to a series low of 34.9 for the month, down 2.6 points from September's 37.5 level. Purchase quantities and new export orders also saw some new record lows in October, falling to 33.7 and 38.5 respectively.

Spain's manufacturing sector continued to shrink at a record pace in October - possibly the fastest among all those included in the JPMorgan index - with both output and new orders contracting and employers shedding jobs at a near record pace, according to the latest Markit Economics Purchasing Managers Index published yesterday (Monday). The Markit PMI for Spain dropped to 34.6 in October, the lowest reading registered by any eurozone economy since the series began in February 1998 and down from the already rapid 38.3 point contraction in September. As we can see, according to this indicator Spanish manufacturing has now been weakening steadily since the start of 2006.

Central and Eastern Europe

Apart from the Hungarian decline, output also contracted elsewhere in the CEE. In Poland the ABN Amro Purchasing Managers Index fell for the sixth month running to 43.7 (down from September's 44.9) a record low and well below the neutral reading of 50, according to Markit Economics yesterday. In the Czech Republic, manufacturing output contracted for the seventh month in a row, and the index hit an all-time low of 41.2, just above the revised euro zone figure of 41.1. As the Eurozone itself contracts, these economies which are heavily dependent for exports to the zone will be buffeted, especially now that forex loans for their domestic housing markets have all but dried up.

US Manufacturing

The US manufacturing PMI dropped back to 38.9 in October from 43.5 in September, indicating a significantly faster rate of decline in manufacturing when comparing October to September. It appears that US manufacturing is experiencing significant demand destruction as a result of recent events. October's reading is the lowest level for the US PMI since September 1982 when it registered 38.8 percent. On the other hand inflationary pressures are evaporating rapidly, and the Prices Index fell to 37, the lowest level since December 2001 when it registered 33.2 percent. Export orders also contracted for the first time in 70 months.


China's PMI dropped to lows not previously seen in October, confirming that the economy of the so-called factory of the world is now decelerating along with everyone else. Two international surveys measuring the PMI independently corroborated the evidence of a cooling Chinese industrial economy.

According to a survey complied by securities firm CLSA, China's PMI fell to 45.2 in October, its third consecutive drop, from 47.7 in September, as new orders and exports, as well as pricing power, were squeezed by the global financial crisis.

"The very sharp fall in the October PMI confirms that China is more integrated into the global economy than ever. Chinese manufacturers are seeing their order books cut, both at home and abroad, as the world economy falls into recession," said Eric Fishwick, CLSA's head of economic research, in a report released Monday. "Costs are falling but so are output prices. The coming 12 months will be difficult ones for manufacturers, China included."

The government-backed China Federation of Logistics purchasing managers' index - published on 1 November - also showed a strong contraction, falling to 44.6 in October, the lowest level since the data began in 2005, from 51.2 in September

Russian manufacturing contracted in October at the slowest pace in over two and a half years as the global financial crisis cut demand, according to the latest reading on VTB Bank Europe's Purchasing Managers' Index, which fell to 46.4 from 49.8 in September. This was the third consecutive month in which Russian industry has been contracting.

Business conditions in the Brazilian manufacturing worsened in October for the first time since June 2006. The headline seasonally adjusted Banco Real Purchasing Managers’ Index (PMI) posted 45.7, down from 50.4 in September, pointing to a sharp contraction -the fastest in the survey history in fact. The PMI was driven down by accelerated declines in output and new orders, as well as falls in employment and stocks of purchases.

Even in India the seasonally adjusted ABN Amro India Manufacturing Purchasing Managers’ Index dropped steeply in October, falling to a record low of 52.2, down from a reading of 57.3 in September suggesting another sharp deceleration in growth, even if Indian industry managed to keep expanding. The biggest fall was in the new orders sub-index, which dropped to 54.4 in October from 62.6 in September. Perhaps the saving grace in the Indian survey is that most firms said demand remained strong in domestic markets, while it had been international orders which had waned. This can also be seen from the new export orders sub-index, which contracted to 49.7 for the first time in the history of the series. That fits in with the latest data showing that Indian year on year export growth slowed to 10.4% in September. Thus the Indian expansion is still hanging on in there, by its fingernails, but it is hanging on in.

Tuesday, November 4, 2008

Hungarian Business and Consumer Sentiment Fall Sharply In October

Well, you don't need to be especially adept at reading tealeaves to know which way things are about to move now on the Hungarian economy front. But just in case any of you did have some last, lingering doubts, the latest edition of the GKI sentiment index should have wiped them smartly away. In fact the GKI economic sentiment index declined in October to a record low as the financial crisis made businesses and consumers "dramatically more pessimistic'' (according to the institute) about Hungary's growth outlook.

The overall index fell to minus 25, the lowest since measuring began in 1996, from minus 17.9 in September. Business confidence declined to minus 14.8 from minus 9.3, also a record.

``Businesses of every kind and consumers became dramatically more pessimistic about the outlook of the Hungarian economy as the international and domestic financial environment deteriorated by the day...... The industrial confidence index fell ``significantly'' on the predictions for orders, specifically for exports, while the estimate for industrial production ``visibly deteriorated. Expectations for employment also fell significantly.

Consumer confidence also dropped, falling to a six-month low of minus 54.0, from minus 42.5 the previous month. Consumer sentiment has in fact been plumming the bottoms since the middle of 2006, when Prime Minister Ferenc Gyurcsany had to raise taxes and cut state subsidies under the impact of a financial crisis which forced him to narrow what was at the time the largest budget deficit in the EU. Since that time the Hungarian economy has effectively been limping forward.

Sentiment In Europe Also Turns Down

European economic confidence saw its biggest ever fall during October as the global bank crisis generated the bleakest business outlook since the early 1990s, according to the findings of this months European Commission economic sentiment survey. The survey results give us just one more dramatic glimpse ino the devastating impact the financial turmoil is having on the real economy. Pessimism across Europe has risen dramatically on all fronts - from manufacturers' expectations about exports to consumers' fears about unemployment.

These gloomy results now make it almost a certainty that the European Central Bank will cut its main interest rate by at least half a percentage point to 3.25 per cent when it meets later this week. The European Union executive's "economic sentiment" indicator for the 27-country bloc fell by 7.4 points in October to 77.5 points. The latest index reading was the lowest since 1993 and marked the largest month-on-month decline ever recorded. Readings were down right across the individual EU economies.

And as the external environment deteriorates, sentiment inside Hungary not unnaturally falls right behind it.

Manufacturing Contracts In October

The most obvious area where the deteriorating export potential is to be found is in industry, and as was to be expected Hungary's manufacturing industry contracted sharply in October, according to the latest manufacturing purchasing manager index (PMI) reading, which dropped 5.2 points to hit 44.7 in October - a historic low, and 0.8 points below the previous worst which was registered in October 1998, according to the latest data from the Hungarian Association of Logistics, Purchasing and Inventory Management (HALPIM), the publisher of the index, has reported on Monday. On these indexes any reading below 50 indicates contraction.

More Budget Details

The Finance Ministry has now made available the latest version of next year's Hungarian budget - which is based on an anticipated 1.0% GDP contraction in 2009. The forecast assumes that wages in the private sector will not grow by more than 1.6% on average during the year, while there is to be no increase in the public sector. The combined result is a 2.6% average decline in real wages. Wage-related austerity measures and an expected 0.6% decrease in employment are projected to lead to a 3.7% contraction in household consumption.

Exports are expected to grow by 3.9% and imports by 2.4% (in both cases revised down from an earlier 4.1%). Based on the above, the government expects the public sector deficit (ESA-95) to come to 2.6% of GDP instead of 2.9%.

Swiss Franc Mortgages Hit Record High In September: The Rise Before The Fall?

Forex borrowing by Hungarian households hit a historic high in September, the month before the crisis, and before the termination or restriction of this practice by a number of significant banks, so this was in all probability one last fond farewell by Hungarians to the practice of local FX borrowing. The monthly statistics of the National Bank of Hungary (NBH) published on Friday also represented, as Portfolio Hungary comments - the calm before the storm in the area of FX loan costs. The average APRC (annual percentage rate charged) on forint loans to households was up, but very slightly slightly overall, while the average APRC on Swiss franc loans remained broadly unchanged compared with August. Next month we will see the result of the substantial (3%) rate hike by the central bank in the middle of the month enter the data.

The seasonally adjusted volume of new loans to companies and households continued to rise in September with both forint and Swiss franc housing loans rising slightly. Also worthy of note was that while the monthly average interest cost of CHF-based household consumer loans remained stationary in September, the value of new loans has risen moderately

Total loans of households rose HUF 296 bn to reach HUF 6,8880 bn in September. But it is important to note that HUF 175 bn of this was the result of the weakening in the forint, and only HUF 121 bn was the result of new transactions, with these being almost exclusively in FX loans. The forint fell by 2% versus the euro, 3.7% against the CHF and 9% against the JPY in September.

As a result of the revaluation effects produced by the forint depreciation the ratio of FX loans to total loans rose hit a record high of 62.3% in September.

Monday, November 3, 2008

In Search Of The Bottom - Estonia's Economy Continues To Drift Aimlessly

The Estonian recession continues to deepen, month by month. The most recent evidence comes to us in the form of a decline in both Estonian retail sales and industrial production, which fell in each case for the fifth consecutive month in September, leading us to expect the rate of GDP contraction to accelerate further in Q3.

Retail Sales Fall An Annual 8%

Retail sales, excluding cars and fuel, fell by an annual 8 percent in August, the largest such decline registered since at least 2001. This follows a 6 percent in August. The year on year chart (see below) couldn't be clearer.

Sales were also down month on month (ie with respect to August), this time by a non seasonally adjusted 7%. In fact, on a seasonally adjusted basis retail sales peaked in February 2008, and have been trending down since. We still don't have the seasonally corrected data from Eurostat for September, but looking at the uncorrected data we do have from the Estonian statistics office, it does seem that retail sales were down again in Q3 over Q2.

Thus retail sales turned negative in March and the trend simply continues. The decrease in the retail sales of goods was most influenced by the stores selling manufactured goods where sales decreased by 12% compared to September 2007. Sales in non-specialized stores selling manufactured products and shops selling household goods and appliances, hardware and building materials were the worst hit.

Sales in grocery stores have, as might be expected, been rather more stable, with sales only down 3% . As had been the case in previous months, the decrease in food sales was largely influenced by the rise in food prices and the resulting decline in consumption.

Industrial Output Down 3.8%

Output adjusted for working days decreased an annual 3.8 percent, compared with a revised fall of 3.7 percent in August.

If we look at the seasonally and working day adjusted output index, then we can see that the level of output is now meandering downwards, and we now are way off the highs reached during last October and November. With this in mind we should expect the year-on-year percentage drops to start to decline after December, but it will then become much more interesting to follow the evolution of the absolute levels indicated by the general output index.

The main reason for the decline in output is evidently the lack of demand. The fall in manufacturing output was greatest in food, wood and building materials production. Food output was especially hit by the decrease in consumption resulting from this years large price increases. Although the rate of price increase has decelerated in recent months, food product prices are still up by 12% compared to September 2007.

The other area with big output drops is the manufacturing of wood and wood products, where the drop in sales in both domestic and external markets continues. The Estonian market is influenced by the construction slump, while in the external market Estonian manufactures are having a hard time due to the competitive environment and their own weaknesses in price competitiveness. Compared to September 2007, 22% less sawn timber and 9% less glue-laminated timber were produced. The largest drop (32%) was in the production of building materials which is directly connected with the decline in the construction market.

Some export-oriented industries have been continuing to expand - even in this difficult environment - especially enterprises involved in the manufacture of metal products, chemical products, and electrical machinery. Output was also up in the manufacture of machinery, radio and communication equipment, precision instruments and motor vehicles, since again a lot of the output is for export. The export share is 97% in the manufacture of radio and communication equipment and 91% in the manufacture of precision instruments.

Both Wages and Unemployment Still On The Rise

Wages continued to rise rapidly in the second quarter, up by 15.2%, even if this was the slowest pace of increse in more than two years, while the unemployment rate rose - to 3.1 percent in September - the highest level in more than three years.

Estonia's jobless rate, based on the number of unemployed registered with labor offices, rose to 3.1 percent, the highest since July 2005, from 2.9 percent in August, according to data from the Estonian Labor Market Board. The number of people signed on as seeking a job rose 6.6 percent from the previous month to 20,015. This number is of course, incredibly low by any comparable international standard, and is hard to square with a country in the midst of a very deep rcession (even after all the ritual genuflections towards the labour marekt being a lagged indicator). In order to understand how this situation is possible it is important to take into consideration Estonia's special demography and migration history.

However, it is also true to say that unemployment does normally follow changes in economic output with a time lag, se we should expected it to rise considerably in the coming months and quarters. Indeed the unemployment rate as measured by the Estonian statistics office in quarterly labor surveys is nearer to 4 percent in the second quarter (and the EU harmonised rate which is based on the survey shows 4.2% for September in the Eurostat database), and may rise as high as 10% according to recent estimates from Erkki Raasuke, head of Baltic research for Swedbank AB (not that they have been getting too much right of late, but still).

Despite the fact that unemployment will undoubtedly rise further as the recession deepens, it is the very tighness of the labour market (which is, as I say, in part a product of Estonia's demography) which prevents wage increases slowing down more rapidly, and thus the entire Estonian price system adapting to the slowdown (this phenomenon is often called "sticky wages and prices", and as we can see, the degree of viscosity here is almost treacle like). So Estonia's low earlier fertility fuelled the initial wage craze which along with the credit boom got us to the present point, and now the same lack of strength in depth in the labour market blocks the downward adjustment. In both cases the net by-product is massive pressure on the Kroon-Euro peg as Estonia struggles to find export competitiveness.

Consumer Confidence Falls Again

Unsurprisingly Estonian consumer confidence fell again in October, hitting its lowest level in more than 9 years, a sure sign the that the economy is about to shrink again, as domestic demand continues to search for a bottom. The Tallinn-based Konjunktuuriinstituut consumer confidence index declined to minus 27, its lowest reading since June 1999, and down from minus 22 in September. The institute cited worsening expectations for personal and state finances as the key drivers behind the drop.

And of course, consumer confidence is not only falling in Estonia, it is also falling among potential consumers of Estonian products in all Estonia's export destinations. Indeed general European economic confidence saw its biggest ever fall in October as the global bank crisis generated the bleakest outlook since the early 1990s, at least these are the findings of this months European Commission economic sentiment survey. The survey results give us just one more dramatic illustration of the devastating impact the financial turmoil is having on Europe's real economy. Pessimism has risen dramatically on all fronts - from manufacturers' expectations about exports to consumers' fears about unemployment.

The European Union executive's "economic sentiment" indicator for the 27-country bloc fell by 7.4 points in October to 77.5 points. The latest index reading was the lowest since 1993 and marked the largest month-on-month decline ever recorded.

And even as confidence deteriorated sharply in key EU economies like Germany, Italy and Spain, the increasingly-worrying outlook for all those previously fast-growing eastern European economies is now hitting business and export opportunities pretty hard, and this is plain from the survey. All three Baltic economies registered another sharp lurch downwards, with Lithuania, as has now become almost traditional, hanging back slightly from the Ocean depths currently being combed by her Estonian and Latvian neighbours.

The Outlook Darkens

And just to add to all these woe's Eastern Europe is currently experiencing what amounts to its biggest credit rating downgrade in at least a decade, adding to evidence that the region far from avoiding the impact of the global credit crisis, may well find itself at the very heart of the next stage.

“We expect the EU and the IMF to announce additional rescue packages for other Central and Eastern European economies in the coming days and weeks. Top of the list are the most imbalanced countries in the region - the Baltic States, Romania and Bulgaria."
Lars Christensen, Danske Bank, Copenhagen

Both Standard & Poor's and Fitch Ratings have responded over the last month to mounting risks from the global credit crunch by downgrading or revising credit rating outlooks to negative for a number of CEE economies including the Baltic states, the Balkans, Hungary and Ukraine. Moody's Investors Service has also revised its outlook to negative for Latvia and downgraded Ukraine.

S&P and Fitch both downgraded long-term sovereign ratings to Latvia and Lithuania on Oct. 27, citing recession risks and the growing need for external financing, while Estonia, had its rating cut by Fitch and outlook revised to negative by S&P. Basically, the crunch is biting in terms of both the cost and the availability of credit. This tightening in credit conditions is not, of course, new in Estonia, and in many ways we could say that the credit conditions should never have been allowed to get so "loose" in the first place. As can be seen from the chart below, the year on year rate of increase in peaked at the end of 2006, and since then the slowdown in Estonian domestic demand has been driven by the slowdown in the availability of credit (strictness off the terms, documentational requirements etc). Evidently, if such criteria had been applied much earlier, and the rate of annual increase never approached 80% all this may well have been a much less dramatic process.

The Estonian central bank said last week revised it's forecast for the economy, which has already made the turn around from being the second-fastest growing one in the EU in 2006, to being one of the most rapidly contracting ones in 2008. According to the bank the Estonian economy may shrink 1.8 percent in whole-year 2008 and 2.2 percent in 2009. As we have noted above the economy sank by 0.8% q-o-q in Q2 and by 1% year on year.

The decrease in GDP in Q2 was mainly a result of weak domestic demand, but the drop in both imports and the rate of increase in the export of goods and services meant that the contribution from external trade was negative. About the only item which maintained some momentum was government spending - buoyed by the tax income from an earier and better epoch. Compared to Q2 2007, total domestic demand was down by 2.8% , largely as a result of adecrease in private consumption and capital investments ( down by 2.0% and 2.5%, respectively).

Private consumption decreased mainly due to the decrease in expenditures on transport and clothing and footwear. The growth of expenditures on food and non-alcoholic beverages decelerated. Capital investments decreased in both the financial and the household sector. Investments in manufacturing industry were almost stationary year on year. At the same time public sector construction investments accelerated.

The decrease in exports and imports since the second half of 2007 which had been noted in Q1 went even further in the 2nd quarter. Compared to the 2nd quarter of the previous year, exports of goods and services decreased by 4.9% and imports by 8.2% (at constant chain-linked prices).

Goods exports were down by 3.2% primarily due to the decrease in exports of refined petroleum products. At the same time, exports of basic metals and electrical machinery (electrical motors and appliances), which significantly influence export movements, increased. Exports of services decreased by 8.9% primarily due to the decrease in exports of services for railway cargo, airway passengers and cargo transport and trade related exports services. The decrease in imports of goods was influenced mainly by the decrease in imports of refined petroleum products and motor vehicles. While imports decreased faster than exports, the deficit of net exports in GDP has increased since the second half of 2007 and amounted to -4.6% of GDP in the 2nd quarter. In the 1st quarter the impact of net exports was -7.1% (so the negative impact slowed vis a vis Q1).

Fiscal Crunch Coming

Basically, as the economy slows, and government income increases even while counter cyclical spending policies add to expenses, the government is moving into tricky fiscal deficit territory. Mindful of this the Estonian government approved on September 25 a draft 2009 budget which attempted to balances overall finances, including local government and the social insurance funds. The budget, which is still to be finally approved by the Estonian parliament, will fall into a deficit and need to be covered from government reserves, according to former Prime Minister Vaehi in a recent interview with the Maaleht newspaper Maaleht.

A deficit of 10 billion krooni would equal 3.5 percent of the expected gross domestic product of 283 billion krooni forecast by finance ministry in August. SEB have forecast a deficit of 1 percent of GDP in Estonia's overall finances next year.

Falling tax revenue has forced the Estonian governemnt of Prime Minister Andrus Ansip to cut spending and seek out new financing in an attempt to maintain a balanced budget, formerly a linchpin of the country's fiscal policies. The Finance Ministry have already forecast the budget will fall into a deficit of 3.1 billion krooni, or 1.2 percent of gross domestic product this year, after running surpluses in each of the last 6 years.

Two Questions In Conclusion

Basically then, it is hard to call the exact impact of trade on Q3 data without having the September trade data in front of us, since although the July and August export numbers are well below the April and May ones, we also need to take into account the accompanying drop in imports (which helps net trade, and thus is GDP positive). On the other hand the general impression you should get from all the data is that we are in for another shocker in Q3. Which leaves us with two questions:

1/ Where do we go from here?
2/ Just how long will it be before we hit generalised price deflation?

Let's take the second one first. Possibly for many people the question will appear to be a ridiculous one, but it isn't. If you look at the CPI index itself (this now becomes much more important than the year on year inflation rates, since what we need to watch for are the price movements from month to month. Now in the rate of increase from one month to another has been slowing, and in September the index was barely up over August (less than 0.5%, following a virtually stationary reading in August over July) so we should not be surprised to see the index hit a ceiling at some point, and then start to come down. Basic economic theory leads us to expect this (on the back of falling commodity and food prices and in a situation where internal capacity is way above the sum of internal and external demand available to the Estonian economy at current prices). Thus there is only one way for prices and wages to go: down. Although people may struggle with all this yet awhile before they accept the inevitable.

So what about the future of the economy in general? Well, let's take two quotes from the most recent Eesti Pank growth forecast. First, a recognition that they got it wrong in the past:

According to the base scenario of Eesti Pank's 2008 autumn forecast, Estonia's gross domestic product will decline by 1.8% in 2008 and by 2.1% in 2009. So far the economic correction has been more abrupt than expected primarily due to decreasing domestic demand. In addition to the cessation of the rapid real estate market expansion, also private consumption dropped in spring more than forecasted.

and now a forecast which, it seems to me is based on the same faulty methodology that lead the current deline to be "more abrupt" than they expected earlier.

According to Eesti Pank's estimate, the economy should pick up again either at the end of 2009 or at the beginning of 2010. The average economic growth rate of 2010 will be 3%. Private consumption growth should recover in 2010 along with the revival of household confidence, whereas 2009 will be characterised by slowing wage growth and increasing unemployment.

As I say above, I expect wage declines, and not slowing wage growth, but this is beside the point. Household consumption will undoubtedly decline in 2009, but I am not expecting any significant recovery in 2010. And the reasons for this expectation are based on some of the main tenets of economic theory as I understand them. Basically Estonia is in the midst of the transition from being a domestic consumption driven economy to being an export driven one. This, in part, has something to do with the demographic transition which Estonia is currently passing through.

Estonia is, if you like, about to become more like Germany and Japan, and less like the UK, or the US, or France, in terms of a basic typology of economies. And if you look carefully, you will see that the one thing that doesn't recover (ever) in Japan or Germany is household demand. The reason for this is obvious, and it has to do with the demand for credit. Proportionately less people in the age groups which drive the demand for credit increases means that credit (and with it domestic consumer demand) becomes less of a driver of economic growth and exports become proportionately more important. This is why German and Japanese banks have relatively less exposure to their own domestic property booms, but have been carrying losses from housing liabilities elsewhere.

Unfortunately, this is not some strange opinion I have acquired from some distant planet or other. It is based on, and supportable by, fact, and by what is going on right in front of our noses. We are not playing some sophistocated intellectual game here to see who is right and who is wrong. People's livelihoods and those of there children depending on getting a hold on this, and the sooner that the economists over at Eesti Pank (and elsewhere) get the underlying dynamics straight, the better.