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Wednesday, January 28, 2009

Why Latvia Needs To Devalue Soon - A Reply To Christoph Rosenberg

The IMF Senior Regional Representative For Central Europe and the Baltics, Christoph Rosenberg, recently took me to task on RGE Monitor about my Latvian devaluation proposal (as did RGE's own Mary Stokes), and I would like now to take a closer look at some of the points they raise.

In the first place, I would like to say that I obviously regard both Chrisoph and Mary as excellent economists, and I was in no way refering to them when I said that arguing in favour of sticking to the present currency peg constitutes trying to justify “virtually the unjustifiable” according to “the implicit consensus among thinking economists.” I do still hold that the consensus is with me, but that certainly does not mean I regard those who differ from me as "unthinking", and certainly hope I didn't give the impression that I was. And with that little "mea culpa", let combat begin.

And what better way to do this than by looking at Christoph's own arguments, (see below, and I hope I am being fair), although before I actually get into this part, let me "fast forward" to what I see as the three central issues involved: the timing and duration of the correction (that we all agree is needed), the role of Latvia's special demographics, and the distribution of the impact of the eventual debt restructuring between external stakeholders (the EU fiscal structure and the foreign banks) and Latvian state finances.

V Shaped or U Shaped?

As I see it, some of the force of Christoph and Mary's argument lies in the idea that there is little possibility of Latvia being able to succesfully carry out a V shaped correction at the present time due to the hostile global environment, thus it is better (my words not theirs') for Latvia to "mark time" to some extent between now and (say) 2012 (when possibly the external environment will be returning to some sort of normality, again my feeling, not theirs), and I understand the force of this point, I really do, it's just that I don't think Latvia's social fabric will be able to withstand the sort of pressure it is going to be put under (and Edward Harrison has already highlighted this part, as I have in my longer post on the difficulties associated with introducing generalised wage reductions). The IMF report on the Stand-By Arrangement stresses time and again that political consensus is vital to carrying through the proposed "fixed-peg correction", and yet it seems as if we are already running into difficulties on this front.

Also, and to try to keep this simple and as non-technical as possible, we are simply dealing here with trade offs, trade offs between the accumulation of bankruptcy and non-performing loans on the one hand, and the attraction of new FDI for manufacturing industry and getting growth through exports moving on the other. The trick is to get the balance right.

Now the U shaped recovery puts greater weight on the former, while the V shape one puts it on the latter, and I think the choice is as simple as that really. But I would also add in a further factor (to be explored a little more below), and this is the cost of waiting (there is always a cost to waiting) in terms of the demographic transition Latvia is living through (I am thinking about both out-migration and the impact of population ageing and Latvia's declining potential labour force). I suspect that part of the difference between us lies in the fact that Christoph and I attach different values to the cost of waiting in the Latvian case, and the roots of this difference lie, at least in part, on the differing theoretical frameworks we are using. To be blunt, I do not live in what I consider to be the rather timeless and abstract world of neo-classical steady-state growth and convergence theory (for all of which we have precious little meaningful empirical evidence across the EU27), but in the real historical time of ageing and shrinking populations, non-linear growth trajectories and windows of opportunity.

Latvia has between now and 2020 to get rich before it gets starts to accumulate so many age-dependency-related on-costs that it may, if it doesn't put in a well-founded spurt now, quite simply never close the gap. So Latvia is living in real historical time, and not an abstract theoretical one, and in the former, if you don't seize the opportunities you are offered with both hands, then you may well simply end up as tyre rubber on the highway of history, enjoying momentary fame only to end up as a historical irrelevance. So although history doesn't simply keep repeating itself in a simple circular (or Poincaréan) fashion, tragedy is always tragedy, whether it is the first, second, third or nth time round.

But perhaps "marking time" isn't really a fair analogy either, since obviously Christoph feels that the time in question can be put to good use - implementing structural reforms, rewriting the bankruptcy law to make debt restructuring easier, reducing wages and prices, etc, etc - but my worry is that all this will take place against a strongly contractionary atmosphere, with strong reductions not only in real GDP but also in nominal GDP - I mean if we are talking about a 5% plus contraction in real GDP, and (let's say, just as an example) a 3% reduction in the general price level, then we are talking about a drop of about 8% in the nominal value of GDP in 2009, and about another very large one in 2010, so let's be clear, these are contractions of a large order of magnitude (not far off the US 1930 - 33 ones) and my most serious doubt is about the ability of the Latvian social consensus to hold together through this, especially if there is no visible improvement in general conditions as a result. You need some sort of carrot, and not just good will.

Wage freezes Are more Palatable than Wage Cuts

Now it may seem strange to adduce arguments from evolutionary psychology (not Evolutionary Psychology, please note) in a debate about macro economic policy, but I do feel that years and years of evolution have left us with a kind of asymmetric bias which means while we definitely (always and everywhere) don't like to see our wages and salaries actually cut, we have much less resistance to them being eaten away by price inflation (again, this is the whole point of Keynes's little tract "How To Pay For The War" - its just that this war is an economic and not a military one). So politically, it is easier in principle to maintain consensus around a devaluation which followed by tight controls on income, than it is to cut people's salaries outright. Another example which illustrates my point here comes from the recent German experience, where real wage deflation was effected over a number of years (1995 - 2005), and export competitiveness restored, by maintaining a wage freeze, and getting people (during the most significant part of this process) to agree to work more hours for the same money. But to do this in Latvia you need to be able to expand output and add jobs, which is why devaluation is, in my opinion, highly desireable. You cannot expect people to work for the same money and longer hours, and agree to the chap working next to them being dispatched off to the employment offices, things just aren't that simple in the real world.

The bicycle is must easier to keep stable if you peddle forwards.

The Demographics Clinch It

So this brings me to the biggest problem I have to the whole U shaped correction idea in the Latvian context. I will readily agree with Christoph when he says that the Latvian labour force is extremely nimble, and indeed it is especially so when it comes to packing its bags and heading off in the direction of the frontier in search of work abroad. In fact it is so nimble that it manages to do this without the Latvian statistical office even noting that the people have gone, that's how nimble they are.

So this is the outcome I really fear most, the one which means that when Latvia does eventually start to recover, this recovery will only take place with a time lag, and in the wake of an expansion in some key West European (and especially Nordic) economies, which will mean that their will be another loss of workforce in the slipstream their take off will create, a loss which can become a very serious drag on future growth, and indeed may well restrict even further the inflation-free level of sustainable growth for the entire Latvian economy. The chart below, which compares the Irish and the Latvian wage distributions comes from an earlier period (and indeed was prepared by the IMF itself), but it does give some idea of the problem, since there is a clear wage slope running across Europe from east to West, and much needed Latvian workers have an unfortunate tendency of trying to climb their way up it.

(please click over image for better viewing)

So the situation envisaged in the "fixed-peg correction" - namely a period of negative economic growth and substantial wage contraction - will probably only produce yet another round of out-migration (although this time, in all probabity, it won't be to Ireland) which will in turn makes the domestic wage correction even more difficult to implement (another kind of 'vicious loop'). It is interesting to note that the IMF were raising this sort of issue with the Latvian authorities during the earlier overheating phase, but the Latvian solution (which prevailed at the time) was really to tolerate higher than desireable wage increases in order to disuade Latvians from leaving. So there is prior evidence that whatever the promises (and even, lets be generous, the good intentions) local governments find it very hard to stand in the path of their voters when these want social improvemnt, and indeed such vulnerability could come from the most compassionate and noble of motives, the problem is these are simply misplaced.

Debt Restructuring A key Problem

Here (see below) is the IMF Structural Roadmap as it appears in the latest report, and as can be seen, there is a heavy emphasis on the legislative changes needed to carry out the debt restructuring, which gives some idea of the important role this played in the decision making process.

• Cabinet of Ministers to adopt decision that reforms controls over budget execution (December 31, 2008).
• Adopt operational guidelines clarifying procedures for provision of emergency liquidity assistance (December 31, 2008).
• National Tripartite Co-operation Council will establish a Committee to Promote Wage Restraint (January 31, 2009).
• Review and, if necessary, revise regulations on emergency liquidity support (January 31, 2009)
• Complete focused examination of the banking system (March 31, 2009).
• Develop comprehensive debt restructuring strategy (April 30, 2009).
• Amend banking laws to give FCMC, BoL and Government powers to restore financial stability in case of systemic crisis (June 30, 2009).
• Adopt an amendment to the Budget and Financial Management law to strengthen financial responsibility, transparency and accountability (June 30, 2009).
• Amend insolvency law to facilitate orderly and efficient debt restructurings (June 30, 2009).

I have to say that I am really rather surprised at a numberof the things I found on reading the IMF report in detail. In particular I discovered that the true size of the 2009 annual fiscal deficit is going to be 17.3% and not the "mere" 4.9% that appears in the final budget accounts. This is not a problem of "massaging" (I am not suggesting that) but a by-product of the cost of bank restructuring - which involves recapitalisation and the acquisition of "troubled assets" - and these costs, under the new accounting rules, are classified as held to maturity, and not marked to market in terms of their valuation, nor, under the present convention do such liabilities appear as part of the headline fiscal deficit number.

Nonethless Latvia's gross public debt is now set to rise, and dramatically. It is set to go up from 8.3% of GDP in 2007, to 14.3% in 2008 and to an estimated 46% in 2010. And this is all basically to pay for the bank bailout (which is estimated by the IMF to be likely to cost of $1.868 billon in 2009) and not in order to address issues in the broader economic crisis.

The worrying part of all this is that if we don't get the best case scenario, and find ourselves, for example) not with a U- but with an L- shaped non-recovery, then this debt to GDP (and indeed even the annual fiscal deficit itself) may start to head above the EU 60% and 3% rules in 2011 or 2012, thus putting in jeopardy the IMF's own exit strategy for Latvia of eurozone membership. The IMF themselves go to some length to point out that the best case outcome critically depends on maintaining a political will which (as we are starting to see) may not be so strong as they were lead to believe at the time of making the agreement.

The problem is that Latvia, apart from the internal credit boom, and the consequent housing bust and real economy contraction which follows (and which all three Baltic states "enjoyed" actually stands out from its Baltic peers in that it also became something of an offshore financial centre during the boom years. That is to say, there are shades of the Iceland or UK problem in the Latvian situation. I quote the IMF document:

"Finally, standard debt sustainability analysis may not capture all of Latvia's characteristics, given its dependence on foreign bank borrowing for credit intermediation and its role as an offshore financial centre. First, Latvia's net foreign debt is much lower (around 70 percent of GDP), as it reinvests many of the non-resident deposits in assets overseas. The value and liquidity of these assets then becomes key. Second, much of its foreign borrowing is backed by domestic assets. Thus external debt sustainability will depend on whether these assets recover value and will be able to generate future returns to service the debt."

As I read it, this means that Latvia is a miniture version of Iceland or the UK, and that as well as a macro consumption boom/bust disaster there is a non-domestic-loan recovery problem inside the banking system of some magnitude. As the IMF itself says the value and liquidity of Latvia's overseas assets is one of the "keys" to the problem. The other "key" depends on whether or not domestic assets recover their earlier value, an outcome which given even the internal price deflation strategy proposed by the IMF seems fairly unlikely, at least over the relevant time horizon.

The bank restructuring component is so expensive largely because the Latvian owned Parex bank (assets equivalent to more than 20% of GDP) was taken over by the government following a run on deposits and the consequent need to avoid default on the 775 million euros ($1 billion) of syndicated credits due in 2009. In fact the problems at Parex were one of the main reasons Latvia went to the IMF and EU for financial help in the first place - since in theory the issuers of the syndicated credit had the right to demand repayment of the debt immediately following a change in ownership at the bank, and the government needed the institutional support to be able to renegotiate and rollover the debt.

As a result the Latvian authorities have been able to issue guarantee for the refinancing of isyndicated loans of EUR775 million due in 2009 (EUR275 million in February and EUR500 million in June). The credit ratings agencies, and in particular Fitch, believe that in the current global economic climate a rapid future sale of the bank difficult and that the government will have increasing difficulty in the future refinancing the syndicated loans. Moreover, the risk of further deposit withdrawals from Parex bank, especially by non-residents, will continue despite the effective nationalisation of the bank.

The new Parex chairman Nils Melngailis was quoted recently as saying that the bank's value was anywhere between 2 lats ($3.65), the price the state paid to buy out the two previous owners, and 600 million euros.

If all this is correct, then my guess is that we could even be eventually looking at the possibility of a Latvian sovereign default. I mean, personally speaking, I am pretty sure the medicine the IMF are administering just won't work (for the reasons I am putting forward) and that things will deteriorate. But sovereign default something I would never have imagined before I started digging a bit deeper into the whole situation. And the IMF should seriously be thinking about this. Latvia's level of public debt was previously very low, and then whooosh. Fitch seem to share this view, since they have maintained their negative outlook following last November's downgrade.

Fitch Ratings has today downgraded the Republic ofLatvia's long-term foreign currency Issuer Default Rating (IDR)to 'BBB-' (BBB minus) from 'BBB', Long-term local currency IDRto 'BBB' from 'BBB+' and Country Ceiling to 'A-' (A minus) from'A'. The Short-term foreign currency IDR is affirmed at 'F3'.In addition, Fitch has placed Latvia's sovereign ratings onRating Watch Negative (RWN).

Soon enough Latvia will have to face all the on-costs of pensions, health etc for the growing numbers of old people as the median age rises (see chart above). Claus Vistesen and I are busily trying to "calibrate" things here, since notionally Latvia's median age is a lot younger (41) than that of Japan, Italy or Germany (43). But then, on the other hand, Latvians live on average ten years less. So people stop working earlier, and since the really large health care costs are during the last 5 years of life, and this doesn't change substantially if those involved are between 65 and 70 or between 80 and 85. So there is an ageing "calibration" issue here - one which non of the multilateral agencies involved have yet taken on board as far as I can see. Also we need to move the saving and borrowing age ranges around a bit when we come to think about the life cycle (to adjust for shorter working lives etc).

And this "just where is all the money from the loans going" issue is a much bigger question than simply a Latvian one. The IMF original loan to Hungary, for example, included HUF 600 billion (about 20% of the total loan) to be allocated to bank bailout plans, 50% of which was earmarked for capital injections while the other 50% was to be used for state guarantees for commercial banks. The government later boosted this HUF 300 billion guarantee fund to HUF 1,500 billion, however today it has been announced that more of the IMF loan facility may be used to back loans right up to the 1,500 billion HUF level - which surely gives us an indication of the severity of the problems they are having. But what concerns us here is that as a result of these and other measures Hungarian debt to GDP is now projected to rise (Januarry 2009 EU Commission forecast) from approximately 65% in 2009 to 79% in 2010, and of course there can be downside (or if you prefer, upside) on this. So both Hungary and Latvia look dead set to me to receive further credit downgrades, downgrades which will only serve to materially worsen the situation. And thus there is a considerable danger of a self-perpetuating downward spiral, especially if due to the weighting towards the bank problems the present package of measures simply don't work. People are vastly overestimating the power of longer term structural reforms in the context of such a sharp downturn. All very troubling.

Deflation A Problem?

Also, there is another fundamental reason for devaluation, and that is the ability to regain control over an independent monetary policy, since handling a sharp and sudden deflationary shock may well be much harder with a fixed-wheel lock-in to the ECB benchmark rate. Ben Bernanke himself gave us a good example of how the sort of debt deflation process to which Latvia is going to be subjected works in practice, and why it is so dangerous in a modern economic context) in an early paper he wrote on Japan.

To take an admittedly extreme case, suppose that the borrower’s loan (taken out prior to 1992) was still outstanding in 1999 , and that at loan initiation he had expected a 2.5% annual rate of increase in the GDP deflator and a 5% annual rate of increase in land prices. Then by 1999 the real value of his principal obligation would be 22% higher, and the real value of his collateral some 42% lower, then he anticipated when he took out the loan. These adverse balance-sheet effects would certainly impede the borrower’s access to new credit and hence his ability to consume or make new investments. The lender, faced with a non-performing loan and the associated loss in financial capital, might also find her ability to make new loans to be adversely affected. This example illustrates why one might want to consider indicators other than the current real interest rate—-for example, the cumulative gap between the actual and the expected price level—-in assessing the effects of monetary policy. It also illustrates why zero inflation or mild deflation is potentially more dangerous in the modern environment than it was, say, in the classical gold standard era. The modern economy makes much heavier use of credit, especially longer term. Further, unlike the earlier period, rising prices are the norm and are reflected in nominal-interest-rate setting to a much greater degree. Although deflation was often associated with weak business conditions in the nineteenth century, the evidence favors the view that deflation or even zero inflation is far more dangerous today than it was a hundred years ago.

And it seems Lavia is now about to enter a sustained period of price and wage deflation (and thus loan to income inflation) with no monetary and no fiscal tools to attack the problem.

OK, Now for Christoph's points

1/ a devaluation in Latvia would have severe regional contagion effects. I think that on this point we are all in basic agreement. On my view, the EU and the IMF need a coherent common strategy to address the whole situation in the East (at least across those countries who form part of the EU), and I think we are rapidly getting past the point where problems can be dealt with on a piecemeal basis. I mean. clearly some of the points here post date our earlier debate, but part of the foundation of my initial argument was that the whole situation was at risk of becoming so serious that nothing less than a concerted regional initiative would have the credibility and the robustness to work. It may be that outright eurosisation of the entire group maybe the only viable way to go, but I need to argue this separately and substantially, so I will not go into this further here). But, be that as it may, the leading question is that even if eurosiation is to be contemplated, Latvia, Lithuania, Estonia and Bulgaria all need to come of their pegs and lower the parity at which they would enter, and even if the situation in each case is different, the problem is going to be the same, so my underlying point would be better to do this in a cordinated way, and indeed the decision by the Hungarian government to come off their band back in May could be seen as a first step in just this direction.

This is doubly the case since when we talk about regional consequences, we can also talk about the regional effects of a strong devaluation of the UK pound, the Swedish krona, the Russian ruble, the Ukrainian hryvnia, the Czech koruna, the Hungarian forint, and the Polish zloty. Basically the economies in all the aforementioned countries all face a similar problem - domestic demand is down and they need to export, and they are all addressing this by the application of a mixture of devaluation and price deflation, and basically I don't see why the Baltics should be so different, and why we (or at least the IMF, the WB and the EU) don't treat the three Baltic states as one single group here.

3/ Latvia’s preference for the peg is strongly supported by all foreign stakeholders, including the EU and its Nordic neighbors..........it seems unlikely that they will cut their losses and pull out, as Japanese banks did during the Asian crisis. Well, this is certainly the case, but it is not at all clear that these stakeholders could not be brought over to a devaluation strategy. There is currently a lively debate going on in Sweden about just how much responsibility the Swedish government and monetary authorities should accept in the context of what is happening in the Baltics (see here, and here), and more significantly, the Group Of Ten West European banks with most exposure to the CEE economies has started to lobby for an initiative from the ECB and the EU Commission to address the problem of the inevitable bank losses (since I take it we are agreed that the defaults will be no less on the internal deflation approach, and may well, as Krugman suggests, be greater as those who have borrowed in local currency are also forced into default).

4/ A devaluation would not significantly reduce Latvia’s external financing needs. I am not sure about this. Obviously a devaluation which was sharp enough to remove all further worries about future devaluations would take a lot of pressure off the country's reserves. The shrinkage in the CA deficit would also, as you say, help a little, as would the fact that internal saving would start to improve domestic liquidity.

While it would shrink the current account deficit further, private sector roll-over rates might not improve because the higher external debt to GDP ratio would likely result in credit agency downgrades to junk status and trigger the immediate repayment of most syndicated loans. I completely accept this point, but assume that the devaluation strategy would need to be accompanied by a loan restructuring package. Evidently this will be necessary in any event, on the devaluation variant they restructuring will come sooner, but against the difficulties this may present for a Latvian legal framework which is ill equipped to address the problems which will arise can be offset the advantages of getting all the bad news out of the way early.

5/ there are advantages to a U-shaped adjustment via factor price compression over the V-shaped recovery that is often associated with a devaluation.....Christoph makes the entirely valid point that Latvia’s banks (both domestic and foreign owned) and its legal system are at this point quite uprepared for the sort of stress a comprehensive debt restucturing process would put them under. By drawing the process of bankruptcies and nonperforming loan accumulation out a bit, Christoph argues, the authorities may well buy time to improve the country’s insolvency regime, strengthen banks’ capital base and allow private debt restructuring.

Well, this is essentially the same set of issues as in argument 4. There are advantages in drawing out the bankruptcy process, but against these advantages need to be offset the problems posed by reform fatigue, as people are asked to sacrifice over a long period with no visible benefits to see for their effort. And there is no guarantee that the towel won't simply have to be thrown in at the end of the day on the U shaped recession, with a hasty devaluation being carried out, and the U being converted into a UL, with the bounce back only coming much later.

6/ it is questionable whether a devaluation would quickly boost exports, given the global environment and the structure of its exports. Re-orienting the economy towards tradables will require structural reforms which are envisaged in the program. Basically, I think we are back to the "waiting room" approach again here. Export lead growth is not really a credible option at the moment, so the argument goes, given that the external conditions are extremely unfavourable, and that Latvia's economy is dominated by non-tradeables, financial services and construction. All of this is undoubtedly true, but my argument is that you have to start somewhere, and may own view is that it is better to start tomorrow, rather than the day after, and I think the key to breaking the logjam is attracting greenfield site FDI, but to do this you need to get your operating costs down, and the V shape correction achieves this outcome quicker than the U shaped one.

7/ Latvia has a very flexible economy, especially a quite nimble labor market. Really I don't know what to make of this argument, since if this is the case, why was it not more evident during the years of dramatic wage inflation. Wage cuts of up to 25 percent do seem, as Christoph says, large, but so does the tripling of nominal wages between 2001-07 (doubling in real terms), and unless we get to grips with why all that happened in the first place (that is we take a good look at what may be the real Latvian capacity growth rate without inward migration) then I feel I remain unconvinced that we are suddenly about to see a newborn agility in the Latvian labour market. What I see are rather labour market rigidities, and a resistance to change.

Some analysts called for expanding inward migration to alleviate shortages and dampen wage pressures. However, policymakers generally considered that this would have the effect of replacing domestic low-cost workers with imported ones, thereby holding down wages and promoting further emigration. The government argues that rapid wage convergence with western Europe is needed to check emigration. - IMF Staff Report, 2006
Conclusions And Exit Strategy

So where does all this leave us? Well basically that what we have on our hands is one hell of a mess, and that here there are no easy solutions. Did anyone tell you we lived in an imperfect world? Well what is going on in Latvia is surely as good an illustration that you are likely to find that this is the indeed the case. There are no easy, quickfix, policy solutions, and I fully understand Christoph's dilemma, and the difficulty associated with decision taking in this case.

But, while nothing is guaranteed to work, some approaches may turn out to be better placed than others, and it is my considered opinion that the best way of addressing the Latvian problem is by trying to kick-start the economy via devaluation, and to then tackle the wage increase problem by explicitly opening Latvia's frontiers to external migrant labour (as, for example, the Czech Republic have, to some extent, done). Such devaluation, backed by imaginative enough greenfield site support from the government, could attract the FDI, and alongside it the migrants to provide the manpower for unskilled positions, with better educated Latvians being able to get involved in some of the higher value work. If something is not done to break the population vicious circle, and the meltdown in internal demand and property prices as young Latvians seek work elsewhere then the outcome is all too clear, although not for that any less tragic, as Krugman suggests.

Of course, some may wish to object at this point that devaluation has the same effect on wages as wage cuts do, and they would be right, but the point is the overall level of economic activity is greater on the V shaped approach (this was Keynes', and is today Bernanke's, basic insight). Latvian GDP is about to be thrown, from a period of trying to operate above capacity, to one where for an extended period of time it will operate below capacity. This can never be a good solution. On the V shaped recovery scenario the time path of GDP is higher, and the possibility of finding remunerative employment for each and every individual Latvian is to that extent greater. More idle resources will be put to work at a time when there is huge slack in the global system, and energy and material costs are at very low levels. Investment (building factories etc, buying machinery and equipment) simply couldn't be cheaper . Putting the resources to work to make this possible quite simply can't be a bad thing, or so I contend, and certainly not if the alternative may be sitting back and waiting till you have a sovereign default coming crashing in on top of you.

I see plenty of work for Latvian parliamentarians (passing much needed laws etc) in the current proposals but I see comparatively few initiatives which will keep the idle hands of Latvia's valuable human resource base from freezing over.

Let us be clear, of course there is no single clear "cure all" remedy here, but I think we need to say strongly that the earlier attempt to stem the migrant out-flow by being lax on the wage inflation front was to invite disaster (and the disaster of course came), whereas now, excessively compressing wages as the solution will have the impact which was previously feared.

Export Defeatism?

One of the biggest obstacles facing countries like Latvia at the present time (of course Latvia is far from being unique, Latvia is simply the "canary in the coalmine") is a kind of passive defeatism about exports. Of course, Christoph is completely right, the global environment coundn't be more unfavourable, but there really is plenty to be done, so why not keep warm during those long dark winters doing some of it. The EU Commission points out the problem in its latest forecast:

Exports are still dominated by commodity products and re exports, with only limited evidence of moving up the technology ladder. Hence, export revenues are exposed to volatile global commodity price developments (mainly prices of wood and metals). Furthermore, unfavourable real exchange rate developments (based e.g. on unit wage costs in manufacturing) had a negative effect on the external competitiveness of the economy. However, a recovery of exports in the first part of 2007 was driven by manufactured goods which stood at odds not only with the above described problems of the supply side, but also with the reportedly very low increase in manufacturing output in the same period. The overall conclusion on progress in strengthening the supply side is therefore mixed, but it can be concluded that the current domestic cost developments pose serious challenges to producers of tradeable goods and services. EU Commission, January 2009 Latvia Forecast

Finally Christoph has one additional point which really serves as a conclusion and a monument to all this, and that is the idea that Latvia has a clear exit strategy from its currency predicament: euro adoption.

As Christoph says, the Latvian authorities are determined to work to meet the Maastricht criteria in 2012. Certainly entering the euro zone will not do away - at a click of the finger - with the hard lifting necessary to address the competitiveness and high external debt problems (as he suggests in his avoiding the Portuguese trap article, and I go through in my Portugal Sustains post here). But it would offer support to a struggling Latvia and help bring back investor confidence. The point is, at which exchange rate should Latvia enter ERM2? Indeed, it is now apparent - if you read the IMF staff report on the standby arrangement, on their website, that they favoured an expansion of the band to 15% (which basically means 15% devaluation) and it was the EU itself who objected and pushed to retain the peg (see appendix below). It is not difficult to see the problems a Latvian devaluation might face in the light of the Parex related issues without direct euroisation (or EU fiscal support), but the thrust of my argument here has been that these difficulties (credit rating downgrades, sovereign default vulnerability) are going to come anyway. Indeed Latvia had its foreign-credit rating cut to Baa1 by Moodys on January 7 2009, the second such downgrade in three months, with the agency citing increased risks of a prolonged economic decline (read L shaped recession).

“The downgrade reflects the further intensification of the economic adjustment in Latvia since October 2008,” said Kenneth Orchard, an analyst with Moody’s, in the statement. “The economic downturn is now expected to be deeper and more prolonged than previously assumed.” The risk of a “disorderly correction” to economic imbalances remains even after securing the 7.5 billion-euro ($10.2 billion) international aid package. “Government borrowing will rise significantly over the next few years to smooth the adjustment and prevent a major economic crisis,”

Basically, the EU objected to the IMF proposal for emergency eurozone membership on the grounds that this would sat a precedent in other cases. But I really do feel that the Commission (and the ECB presumeably) are being ridiculously pig-headed here. We have an emergency on our hands, and exceptional measures are called for.

It is impossible for me to go here into all the issues involved in collective membership of the eurozone for the EU12 states that are not already in, but let me just say we need a substantial rethink allround, involving:

a) Issuing EU bonds to collectively fund bank bailouts across the Union (East and West)
b) Collective membership of the eurozone for those EU member states who want it
c) A new Lisbon Strategy and Stability and Growth Pact code involving much stricter conditions and stronger Commission powers and sanctions.

c) is the necessary and prior condition for giving consideration to (a) and (b) and not the other way round.

Finally, thank you, one and all, who have struggled forward and reached this point. In particular thank you for being so patient with my verbal largesse. I am trying to contain it, I really am.

Appendix: Extracts From IMF Staff Report On Latvian Request for Stand-By Arrangement

The authorities and staff examined the merits of alternative exchange rate regimes. A widening of the exchange rate band to ±15 percent (as permitted under ERM2; currently Latvia has unilaterally adopted a ±1 percent band) would result in a larger initial output decline, since adverse balance sheet effects would reduce domestic demand. However, competitiveness would improve more quickly, reducing the current account deficit and fostering a more rapid economic recovery. The case for changing the parity would be stronger if it could be accompanied by immediate euro adoption. Technically, this would address many of the risks described above, and give Latvia deeper access to capital markets. With its negligible public sector debt, the government would also find it easier to borrow in euros on international capital markets. However, the EU authorities have firmly ruled out this option, given its inconsistency with the Maastricht Treaty and the precedents it would set for other potential euro area entrants.

The main advantage of widening the bands is that it should eventually deliver a faster economic recovery. Although growth would be depressed in the short run by balance-sheet effects (see below), the economy might then bounce back more sharply, and a Vshaped recovery would likely start in 2010. This reflects a faster improvement in competitiveness since high pass-through (reflecting Latvia’s openness to trade and liberalized movement of labor within the European Union) would be dampened by the negative output gap. Enhanced competitiveness would also reduce the current account deficit more quickly. This would come mainly from import compression, with a relatively slow response of Latvia’s underdeveloped export sector, especially as the external environment is not as supportive as in previous devaluation-induced recoveries as Argentina, Russia or East Asia.

However, balance-sheet effects would cause a sharp drop in domestic demand. The net foreign currency exposure of Latvia’s private sector is around 70 percent of GDP, with the corporate sector’s foreign currency open position roughly double that of the household sector’s. A 15 percent devaluation against the euro would increase private sector net foreign currency exposure by 11 percent of GDP, two thirds in the corporate sector and one third in the household sector. Mismatches between owners of foreign currency assets and liabilities suggest that devaluation may cause substantial redistribution effects. Private consumption would fall by around 6 percentage points due to negative wealth effect as net foreign debt increases, house prices decline, debt service costs increase, and consumer confidence deteriorates. Experience of other countries suggests that a devaluation of this magnitude would lead to a 5 percentage point decline in private sector investment.

Euroization with EU and ECB concurrence would also help address liquidity strains in the banking system. If Latvian banks could access ECB facilities, then those that are both solvent and hold adequate collateral could access sufficient liquidity. The increase in confidence should dampen concerns of resident depositors and also help stem non resident deposit outflows.

However, this policy option would not address solvency concerns and has been ruled out by the European authorities. If combined with a large upfront devaluation, there would be an immediate deterioration in private-sector solvency, which could slow recovery. Privatesector debt restructuring would likely be necessary. Finally, the European Union strongly objects to accelerated euro adoption, as this would be inconsistent with treaty obligations of member governments, so this option is infeasible.

Sunday, January 25, 2009

How Near Is The Czech Economy To Recession?

The highly open Czech economy is set to slow down considerably, affected by the deteriorating outlook for its main trading partners. Although GDP growth was still solid in Q3 2008, both exports and imports growth slowed significantly. The global crisis is expected to adversely impact the real economy particularly from the fourth quarter of 2008. Overall, GDP is expected to have grown by 4.2% in 2008 with a strong contribution from the external balance.
EU Commission Forecast January 2009

Analysts and followers of the Czech economy are basically agreed on two things at the moment: that the Czech is slowing (and rapidly), and that the dependence on car exports is a real achilles heal at a time when a generalised credit crunch means that the financing which is needed for people to make car purchases often quite simply isn't there. Beyond this point opinions differ. Some expect the slowdown to end in nothing more than a year of sub par growth, with a bounce-back recovery in H2 2009 (this is the view, for example, of Pasquale Diana at Morgan Stanley). Others take a more pessimistic view - like Danskebank's Lars Christensen - and fear that not only may we see a substantial slowdown (bordering possibly on outright contraction) throughout the whole of 2009. but also that strong deflationary forces are at work, forces which may well lead the Czech National Bank to become one of the first European central banks (hand in hand possibly with the BoE) to get into the tricky area of trying to operate monetary policy near the zero bound. Personally, after a long hard stare at the detailed macro data, I am in the latter camp, and to answer the question I pose in the title of this post, I think the Czech economy is very near to its first quarter of contraction, indeed we may even have seen contraction in Q4 2008. If we didn't it will be a very close call, since the not only has the trade impact been negative, and industrial output dropped like a stone, but domestic consumer demand - as reflected in retail sales - also seems to have been falling.

And the outlook for domestic demand certainly does not look any too positive, if the most recent consumer confidence readings are anything to go by, since these have been falling strongly since the summer, and surely suggest strong weakness in household consumption right across the first half of 2009, at the very least.

Industrial Output Falls Like A Stone

Czech industrial production fell in November at the fastest rate since at least 2000, dropping by 17.4 percent year on year, following a decline of 7.6 percent in October.

This fall is very substantial and it is clear that the Czech authorities urgently need to revise their growth forecasts in the light of this and other recent data, indeed some analysts - Radomir Jac at Generali PPF Asset Management in Prague , for example - are already arguing the drop may well mean the economy already started to contract in the fourth quarter. Others are more cautious. Still, one thing is common across all the analyses, we are talking about cars, cars, and ever less cars.

The collapse in activity across the region in 4Q08 looks truly extraordinary, and was correctly flagged by the PMI surveys, which sank to all-time lows. Trade data and industrial output and, to a lesser extent, retail sales all show a significant loss of momentum towards year-end. Much of this is due to weaker external demand, in particular in the auto sector, which is the region’s most important export. Car sales in the EU have weakened further, and several carmakers have announced a cut in their production plans for 2009. In the Czech Republic, Hyundai said that it plans to move to a four-day workweek and pay workers 70% of their salaries for a period of 1-3 months; Skoda also downgraded its production plans massively for 2009 (from 700k cars to 570k).
Pasquale Diana, Morgan Stanley

The Czech Republic has arguably the most stable economy in central Europe, but at a time when the world is being buffeted by financial crisis, there is no chance it will escape being hit next year. First in the line of fire will be the automotive sector which, with almost 1m cars manufactured this year, is responsible for about 10 per cent of the economy. Almost all are exported to western Europe, where new car sales have plunged in the final months of the year.
Jan Cienski, Financial Times

And the situation is almost sure to get worse, since the Czech Purchasing Managers' Index fell to 32.7 in December, from 37.8 in November, which indicates a very substantial fall in industrial output again in December.

Thus we can expect Q4 industrial output to be a strongly negative factor, and indeed this only marks a steepening of a trend we have been seeing since Q1 2008, if we look at the quarterly chart for movements in manufacturing output below.

Exports Fall And The Trade Balance Deteriorates

The fall in industrial output is basically a reflection of the ongoing deterioration in the CR's performance in external trade, and the drop indemand for exports. The monthly goods trade deficit was CZK 474 million in November, down from the very large CZK3.95 billion deficit registerd in October, but well below the CZK 12 billion surplus clocked up in November 2007.

Exports were down 18% year-on-year in the month compared with a 10.7% fall in October. The statistics office report said the decline in exports was the highest in the entire history of the Czech Republic. Imports declined 13.2% compared with a 5.9% drop in October. Total imports slipped to CZK 195.2 billion from CZK 221.4 billion.

Retail Sales Also Head South

In November, seasonally adjusted retail sales in retail trade (excluding cars) decreased by 0.3% month-on-month (at constant prices) and fell by 0.7%, year-on-year. As far as the automotive sector goes, seasonally adjusted sales were 3.4% down, m-o-m, and 5.1%. Sales were also down 0.7% month on month in October.

Koruna Continues To Fall

With all this negative data it is hardly surprising that the Czech koruna has been weaking significantly of late, and it depreciated again last week, losing as much as 1 percent on Friday alone (hitting 28.255 against the euro at one point, the weakest since July 2007) and 2.1 percent on the week.

Consumer Prices Already Falling

Consumer prices in the Czech Republic were down again in December, and fell by 0.3% when compared with November. Year-on-year consumer prices were up by 3.6 % in December (down from 4.4 % in November), while the whole year average was 6.3 % in 2008.

As is to be expected the month-on-month drop in consumer prices was lead by the fall in automotive fuel - 95 octane petrol hit its lowest level since March 2002, while food and non-alcoholic beverages were mainly down, with pronounced falls in the prices of flour, milk, butter, citrus fruit and sugar (by 6.7 %, 1.7 %, 2.7 %, 8.6 % and 1.9 %, respectively). But prices drop were far more general, and in the health sector, for example, medical products dropped by 0.5 %. Prices of goods in general decreased by 0.5 %, while prices of services increased by 0.1 %.

But what is perhaps more interesting is the way in which the "core" EU HICP index (ie excluding food, alchohol, tobacco and energy) has now been falling since August, and I do not expect to see an increase in this index in 2009, which means we should see negative core inflation in the CR in 2009.

Industrial producer prices are also falling, and were down by an annual 1.5% in November. The most significant price decreases were observed in ‘coke, refined petroleum products’ (-19.0%), ‘basic metals, fabricated metal products’ (-2.1%) and ‘chemicals, chemical products and man-made fibres’ (-3.8%). Prices of ‘food products, beverages and tobacco’ fell by 0.5%.

The big issue now is what will happen to inflation expectations? The strongest defence against the arrival of deflation is the expectation of inflation to come. To date these expectations have held up, but they could well turn negative at some point, and if this were to occur it would have a very significant impact on consumer behaviour (since evidently it is more interesting to delay that whimsical purchase till tomorrow, when the thing will be cheaper). If expectations do turn significantly negative, then it could turn out to be very hard work indeed getting them back into positive territory. Which is why I suspect the CNB will be pretty proactive, possibly more proactive than many are anticipating.

Moving Towards The Zero Bound At The CNB?

The Czech National Bank, whose next policy-setting meeting is scheduled for 5 February, have been cutting their benchmark borrowing rate pretty aggresively since last October, taking it down to 2.25 percent at its last meeting in December.

The drop of industrial output is “really considerable,” central bank board member Robert Holman said on Patria.cz. The bank’s “pessimistic” forecast scenario is starting to be fulfilled, he said.

The latest central bank forecast cut the outlook for 2009 economic growth to 2.9 percent, although the bank had an alternative (pessimistic) scenario which foresaw growth of 0.5 percent this year.

Today’s industrial production numbers and the outlook for inflation to drop to just above 1% in January should make the Czech central bank (CNB) even more dovish. We now expect a cut of at least 75bp at the next CNB board meeting in February. Furthermore, we would not rule out that CNB could be the first European central bank (maybe with the Bank of England) to go to (near) zero per cent interest rates. Therefore, we also recommend buying EUR/CZK at current levels.
Lars Christensen and Stanislava Pravdova, Danskebank

So far, January’s economic data published support our view that the CNB’s Bank Board Members are ready to continue easing, following the 150bp cut in policy rates in 2H08 to 2.25%. However, yesterday’s data have led us to review our previous forecast of a 50bp cut in the CNB’s policy rates, and we now believe a 75-100bp cut is likely to be discussed at the February meeting. Furthermore, we do not exclude the possibility that the CNB’s main policy rate could breach its all-time low (which was 1.75% in 2Q-3Q05) in February.
Jaromir Sindel, CitiGroup Global Markets

I am with Lars Christensen and Jaromir Sindel here, I think the CNB will move, and move pretty decisively to try to block the path to looming price deflation, and I guess a 75 bp cut (and possibly more) is looking very probable, with further cuts following inswift succession. Evidently the key piece of data will be the January manufacturing PMI, and in the short term I expect the PMI and not the actual output data (which obviously come later) to be dictating policy decisions. The statist office releases simply serve to calibrate the PMIs (post hoc) in this type of situation.

So What Is The Outlook For Czech GDP Growth in 2009?

Well, in trying to determine the future path of Czech GDP, the first thing we need to bear in mind - looking at the GDP chart above - is that the economy has been losing momentum since late 2006, that is the "stellar" catch-up growth component has been waning, and for some time. The second thing we need to bear in mind is that this is not necessarily a bad thing, since it means that the CR's economy (unlike many others across the CEE) is certainly not on a boom bust cycle. The slowdown in quarter on quarter growth is also evident in the chart below. In fact in Q3 2008, Czech GDP grew by 1.0% in comparison to Q2 2008 and by 4.7% in comparison to Q3 2007.

What is interesting is that the weaker growth we can see in the chart has been largely a by-product of slowing private consumption growth (see my earlier post here, and this one here), which leaves us with the possibility that the Czech Republic economy - following along the path already charted by Germany, Japan, Italy and Hungary - may now be in the process of becoming an export dependent one. (Perhaps it sounds strange to talk about Italy as export dependent given its very weak growth, but this weak growth is in fact the outcome of continuing very poor export performance, since domestic demand has now been weak for more years than I personally care to remember). In fact final domestic consumption was still up by 2.7% in Q3 2008, and represented a contribution of 1.9 p.p. to GDP growth. Final consumption was particularly influenced by a year on year increase in household expenditure by 2.5% , while government expenditure grew by 3.7%. Fiscal stimulus should hold the government component steady, but I would expect the household one to drop back, and especially as we start to see job losses from the industrial contraction.

Gross capital formation was down by 2.0% on Q3 2007 and had a negative impact of 0.5 p.p. on GDP growth, although gross fixed capital formation taken alone was up by 4.5% y-o-y; in fact investment in transport equipment and in machinery and equipment was the main source of GFCF growth.

As in earlier quarters, external trade in goods and services was the main source of economic growth in Q3 and contributed by 2.8 p.p. to the GDP increase, despite a considerable fall in y-o-y growth rate of exports (from 13.9% in Q2 to 5.0% in Q3). This was the result of the marked fall in import growth (from 9.7% to 1.6%), hence external trade remained the principal source of GDP growth.

Reflecting Citi’s expectations of a recession in the eurozone, we forecast the trade surplus (both of goods and services) to shrink significantly in 2009 from its surplus of CZK108 billion in 2008 (our estimate).Falling commodity prices are likely to have been behind the improvement in the terms of trade in November, which fell in October. We believe this development has the following implications: the improvement in the terms of trade is likely to cause the foreign trade’s first negative contribution to GDP growth after three and half years, and GDP growth is likely to fall quickly to the levels of real gross domestic income, which was 2% YoY in 3Q08 and much lower than that of GDP growth of 4.3%.
Jaromir Sindel, CitiGroup Global Markets

Employment May Weaken

Employment growth, which has been one of the hallmark features of the Czech expansion, continued to grow in the third quarter and was up by 0.4% q-o-q and 1.9% y-o-y. Labour productivity measured by gross value added per employed person was also up (by 2.3% y-o-y). There were 5.327 million Czechs in employment in Q3 2008, 98,000 more than in Q3 2007. However, there is now some evidence that this favourable situation may now be changing.

Certainly, if we look at the chart below, the substantial drop in unemployment in the CR since 2005 is very impressive, and indeed even though the seasonally adjusted EU harmonised rate ticked up from 4.4% in October to 4.5% in November (the last month for which Eurostat have released data) the change is hardly a dramatic one.

However, if we look at the data from the CR's owb labour office, we find a reasonably sharp increase from November to December (unemployment was up by 32,000, compared with a 7,000 rise in December 2007), and if we look at the situation vis a vis vacancies (see chart below), then it is clear that the deterioration in manufacturing conditions is now affecting the labour market, since the number of vacancies advertised has now fallen from the April 2008 peak of 152,300 to December's low of 91,200 (the lowest number in over 2 years, which is all I have data for).

CA Deficit To Deteriorate, While Fiscal Spending May Increase As The Slowdown Accelerates

The CR does run a current account deficit, but it is actually a fairly moderate one in a regional context, although it is liable to increase in 2009. November’s narrower current account deficit reflects the slightly improved trade balance over October and lower dividend outflows from FDI, which dropped to CZK3.5 billion from October’s CZK12.3 billion. The current account financing requirement has been low but the deficit may have reached 2.8% of GDP in 2008 (up from 1.8% in 2007, and above the IMF estimate of 2.2% GDP).

The EU Commission forecast thatgeneral government deficit will be 1.2% of GDP in 2008. This reflects a much-lower than- expected deficit of 1% of GDP in 2007 and the positive fiscal impact of a variety of revenue and expenditure measures. For 2009, they expect the general government deficit to widen somewhat given the pressure on revenues and expenditure which will result from falling activity, rising unemployment and probable fiscal stimulus measures. Overall, they suggest that the general government deficit will widen to 2.5% of GDP in 2009 but should fall back to 2.3% in 2010 - although this surely reflects their benign slowdown scenario whereby a recivery is expected to arrive in H2 2009. The debt-to-GDP ratio is forecast to rise to above 30% in 2010, from 29.4% in 2008.

Conclusion: Central Europe Is All Recession Bound

This is basically the third in a series of posts, where I have looked at the short term outlook for three key central European economies: Poland (here), Hungary (here) and the CR, and the conclusion is that they are all headed into or near to the contraction zone in 2009. Cetainly Hungary is the worst case scenario, and Poland is struggling with a complex set of forex issues, but even the Czech Republic can not expect to escape unscathed.

Previously, as can be see in this chart for the EU Economic Sentiment index, Poland had been faring rather better its Central European neighbours. But the downward movement in Poland is now evident and pronounced, and in fact the contraction may ultimately be sharper than in the CR.

In their January forecast the EU Commission estimated that GDP growth in the Czech Republic would come in at 1.7% in 2009 and then edge up again to 2.3% in 2010. This now seems very much on the high side to me. I expect Czech GDP to be more or less stationary in 2009, with some downside risk to this estimate given the general problem of economic stability in the region and the very serious contraction which is like to take place in the German economy on which the CR is so dependent. I do not expect a resurgence in domestic demand, and the economy will now more than likely become even more export dependent, which leaves us with the omnipresent question, "exports to where"? On the other hand, at the present time we do are not looking at a "boom-bust" scenario, and the CR economy should fare substantially better than many of those around it.

Friday, January 23, 2009

Russia's Industrial Output, Reserves And Currency All Slump Together

Russian industrial production dropped sharply again in December - by the most since at least 2003. Output was down 10.3 percent following an 8.7 percent fall in November, according to data from the Federal Statistics Service announced yesterday (Thursday) by central Bank Chairman Sergey Ignatiev. Output growth for the year was 2.1 percent, the slowest since at least 1999.

Manufacturing fell an annual 13.2 percent in December, compared with a decline of 10.3 percent in November, as steel-pipe production dropped an annual 35.3 percent and coking coal output plunged 44.2 percent. Truck production plummeted 67.1 percent.

This data is not surprising, and only confirms what we have been seeing in the VTB PMI. The next interesting data appointment will be on 2 February, when we should get to see what happened in January.

Reserves Drop Sharply

Russia’s international reserves fell $30.3 billion last week, the second-biggest drop on record, as the central bank accelerated the rate of the ruble devaluation and sold increasing quantities of foreign currency in an attempt to manage the pace of the decline. Russia’s reserves have now fallen 34 percent from the record high of $598.1 billion in August while the ruble has fallen 29 percent against the dollar over the same period.

Some of last weeks decline can be attributed to the dollar’s 1.5 percent gain against the euro in the week ended January 16, since this means a fall in the dollar value of the other currencies in the reserves. Evgeny Nadorshin, senior economist at Moscow’s Trust Investment Bank, estimates that about $18.3 billion of the drop can be accounted for by central bank interventions last week.

(The reserves are made up of 44 percent euros, 45 percent dollars, 10 percent pounds sterling and 1 percent yen).

The Ruble continued to fall today (Friday) after the central bank announced last night that it was “finished” with its gradual devaluation of the ruble and was going to let “market factors” help determine the level of the currency. The bank set the weakest end of the currency’s trading range against a target basket of dollars and euros at 41 as of today, or 36 per dollar, at a USD of around 1.3 to the euro. Bank Rossii has now widened the currency trading band 20 times since mid-November as it seeks to rebalance Russia's economy amid plunging oil prices and the global financial crisis.

Following yesterdays announcement the ruble fell again this morning, dropping 1.5 percent (to 33.1073 per dollar), extending this weeks decline to 1.8 percent.

“This is an open invitation for speculators to test how quickly the ruble can get to 41,” said Ulrich Leuchtmann, head of currency research in Frankfurt at Commerzbank AG, which ranks itself among the biggest 10 traders of the ruble worldwide. “They wanted to decrease speculative pressures, but now they’ve given the market a good reason to increase them.”

Wednesday, January 21, 2009

Freezing Yourself Out In Lithuania And Latvia

This very short piece of news in Bloomberg this morning is straight to the point, how the hell are you going to export to countries (whenyou now need to live from exports) if those countries are having massive devaluations while you mark time. Oh, I know, the Ukraine and Russia represent only a small fraction of Baltica exports, but they aren't the only ones falling, the Romanian Leu, the Polish Zloty, the Hungarian Forint, the Czech Koruna are all falling, and all these countries are direct rivals for market share in the rest of the EU.

AB Snaige, the only refrigerator maker in the Baltic states, will cut about 300 jobs in its Lithuanian factory, citing lower demand in Russia and Ukraine as both the ruble and hryvnia lose value against Lithuanian litas. Sales in Russia and Ukraine have “stopped” and “there is no evidence these markets will revive” during the first quarter, the Alytus, Lithuania-based company said in a statement to the Vilnius Stock Exchange today. The company employs “more than” 2,300 workers in its two factories in Lithuania and Kaliningrad, Russia, according to its Web page.

Basically as I say, it also matters which currency you are pegged to. One commenter has made this point.

Regarding Latvia, I'm working for industrial company in Latvia, with most customers from Sweden or Russia and latest SEK and ruble rate changes have really eaten up business both for export and import. From SEK/LVL we lose in funny sequence, more you sell - more you lose. Today, here are a lot and a lot of industries closed, closing or planning to close.

Evidently there is a lot of "restructuring" going on, but is it the kind of restructuring Latvia and Lthuania need, I ask you?

Euro To Swedish Krona

Here's the chart of the Euro with the Swedish Krona.

Euro To Russian Ruble

Here's the Euro/Ruble chart:

Euro To Polish Zloty

Finally, here's Latvian industrial output for November, anyone spot the trend?

And incidentally, Latvian exports were down 19.7% between October and November 2008. And incidentally, Latvian exports were down 19.7% between October and November 2008. Oh, I know, I know, not only doesn't Latvia need exports, it doesn't need industry either. Meanwhile, onwards and downwards we go.

The Forex Lending Crunch Means Trouble Is Looming Large In Poland

Poland now looks set to become the latest shoe to drop in the ongoing crisis which is steadily extending its reach from one country top another, right across the whole of Central and Eastern Europe - the latest and possibly the last in the sense that if Poland does role belly side up this will probably be the one which finally does turn the apple cart well and truly over.

Italy's UniCredit, the biggest lender in emerging Europe, said on Wednesday there was a clear risk of the global credit crunch gripping the region and it was up to international banks to help to avert it. UniCredit board member Erich Hampel said in a presentation at the Euromoney conference in Vienna that the bank was committed to fund its subsidiaries in those countries and would continue to lend to consumers and companies. It called on other banks active in the region, the European Union, the International Monetary Fund, other institutions and the countries concerned to launch a joint plan to stem the threat that funds could stop flowing and choke economic growth. "The international financial crisis is questioning future developments and the risk of a credit crunch is clear," said Hampel, who steers most of UniCredit's emerging European units as head of its Bank Austria arm. "A number of interested parties are involved and the support to the region should come from all of them together," Hampel said. "Coordination is essential and a 'Plan for CEE' should be designed."

Eastern Europe is - as Unicredit's Eric Hempel argues in the extended quote above - quite simply falling headlong into a very severe credit crunch, as funding for bank lending steadily dries up. And, unfortunately, as the evidence mounts that Poland is caught in the teeth of this crunch, its real economy falls deeper and deeper into the dreaded pit with each passing day. FT Alphaville's Izabella Kaminska has the forex loan story here (see also see here last Friday). Basically all I have to add are some charts (and some real economy analysis) to add a bit more weight to the point and illustrate more explicitly the speed with which things are now moving forward.

How Important Are Forex Loans In Poland?

Poland’s exposure as to foreign-currency lending has already been extensively documented and analysed on this blog, but just in case there is still anyone out there who holds defiantly onto the view that the extent of such lending in Poland is simply too small and too recent to have any sort of severe impact on the economy, let's take a look at the recent progress in such lending, at least as far as household behaviour goes. As can be seen in the first chart below, since the middle of 2007, the rate of growth in zloty loans has slumped steadily, while forex borrowing has gone up and up, until..... until last November, when the whole thing turned. It now pretty clear that something quite important happened to the Polish banking system back in October - as I attempted to analyse in this post which was written at the time.

The extent of the transition can also be seen from the monthly chart for outstanding household loans, where again zloty loans can be seen to have have virtually stagnated, while forex ones went shooting up and up, till they seem to have hit a something akin to a "dead stop". Nor does the loan "revaluation" argument help us here, since during the period under consideration the zloty has been falling (see chart below) and hence the book value of the capital stock of forex loans should rise, not fall. (I mean, unfortunately, and from a large number of comments I have received on my blogs over the last 18 months, I have to say that this is the part of the story that many of those who have taken out unhedged forex loans in Eastern Europe simply do not "get", it isn't so much the payment stream you need to look at (influenced by the relative interest rates in the two currencies being compared) but at what happens to the capital value - that is what happens to the outstanding sum you owe, as measured in your own local currency, or at least in the currency in which you are paid.

And for those who are interested in how domestic monetary policy works these days (ie how effective central bank interest rate policy is at containing lending in a small or medium sized open economy with access to global finance) it should not come as a surprise to find in the chart below that the uptick in enthusiasm for forex loans really started to gain momentum after the Polish central bank started to raise interest rates, as the short term interest rate differential with Swiss Franc loans simply grew and grew under the impact of monetary tightening.

Systematic Slowdown In Industrial Activity

This application of standard monetary policy by the Polish central bank did have one result, however, and that was that the value of the zloty shot up (in particular here when compared with the euro, which is what really matters for exports), and with it the relative cost of Polish industrial products. And what did this lead to? Well, a steady deterioration in the trade deficit for one thing.

And, of course, an ongoing contraction in industrial output for another. Poland's industrial output continued to fall in December, with statistics office data showing today (Tuesday) that output fell 4.4 percent year-on-year, after dropping 9.2 percent in November. In month-on-month terms, industrial output also fell 3.7 percent, (following a whopping 15.4% drop in November over October) while seasonally adjusted output fell 7.4 percent year-on-year, showing business conditions are quickly deteriorating.

Wage and employment data for December on Monday also suggested companies, in response to falling demand for their products, were starting to lay people off. The pace of wage growth in December was the lowest since 2006.

Business confidence in Poland's industrial sector fell in December to its lowest level since surveys began in June 1998 as plummeting new orders depressed output and employment, according to the latest 300 industrial company survey prepared by Markit Economics for ABN AMRO. The survey also found that the Polish manufacturing purchasing managers index dropped for the seventh consecutive month - to 38.8 from 40.5 in November.

The new business indicators dropped at the fastest rate in survey history, and the new orders index fell to 32.2 in December from 35.6 in November, with new export orders decreasing to 31.4 from 40.1. So we can obviously expect the January result to be even worse.

Previously, as can be see in this chart for the EU Economic Sentiment index, Poland had been faring rather better than some of its Central European neighbours (like Hungary and the Czech Republic). But the downward movement is now evident and pronounced.

This slowdown in industrial output has also been accompanied by a levelling off in construction activity, which has been trending down in year on year terms since the late summer, but which even fell back month on month in November (by 1% over October) for the first time in many months.

In fact if we look at the actual index, rather than the year on year growth numbers, we will see that activity levels have been pretty stagnant for six months or so now.

After the sub-prime crisis banks became more restrictive in their lending policies. It is hard for real estate companies to get loans for their projects. Developers have to delay significant part of their pipeline projects, in most cases till an unspecified date in the future. The significantly tightened lending policies for households will worsen already weak demand for housing. Additionally, the already anemic investment activity should deteriorate further. It should be more and more difficult for real estate developers to sell their projects in the market and this source of money is also drying up.
Polish Equity Market Monitor - Citi Poland - January 2009

Retail sales levels have also flattened out recently, although they have continued to rise slightly in recent months. November 2008 retail sales grewth by just 2.7% year on year confirmed a fast slowdown in domestic consumption following 7.9% growth in October and 11.6% growth in September. While the Penkon consumer confidence indicator is now showing its lowest readings since 2005.

It is most likely that the good times for the retail industry are over. The drivers that fuelled sales and margins of Polish retail companies – rising consumer vdemand and strong Zloty, have disappeared and we do not expect them to return within foreseeable future.
Polish Equity Market Monitor - Citi Poland - January 2009

The Credit Noose Tightens

The core of the East Europe problem is that savings in many parts of the region are not sufficient to underpin growing loan books, thus the banks in the region - which are largely foreign owned - have needed to draw on their parent companies to bolster their balance sheets. When many of the parent banks entered into their own refinancing problems last year as the global financial crisis spiralled out of control, this channel of funding was transformed from being a source of strength into being a source of weakness.

In addition, at the start of last summer the Polish currency soared to record highs against the euro, and many Polish companies took out hedging contracts, effectively betting on further zloty appreciation. Now, as the currency has weakened and weakened, many of these very same companies have found themselves with substantial losses.

The Polish financial watchdog estimated last month that local banks may need to take out as much as $284 million in provisions to cover for client losses on currency options, which currently amount to 155 million zlotys ($49.33 million) among Warsaw-listed companies. And that figure could obviously grow if the zloty continues to weaken.

The zloty is currently at its lowest level since the end of 2004 - around 4.306 to the euro. Furthermore, it seems the government’s promise of accelerating the process of euro-adoption - which helped calm the zloty’s decline back in October - is failing to reassure markets. In fact most analysts seem to think that at this point having a 2012 entry target is as good ashaving no target at all.

Euro/PLN Cross - Please Click On Image For Better Viewing

Izabella Kaminska quotes the view of RBC capital, who basically argue that there is no way that the assigned date was ever going to be achievable:

On top of all this, there is no guarantee that Poland will meet the five Maastricht convergence criteria. Holding the PLN stable within the ERM2 bands for two years may prove to be a tall order while the budget deficit, which has been squeezed lower purely as a result of recent strong economic growth, will widen sharply as the economy slows, breeching (SIC) the 3%/GDP limit and disqualifying Poland from Euro entry.
As Izabella says there is a sort of catch-22 at work here: the only way Polish zloty can be saved from further weakening is Eurozone membership, but Eurozone membership becomes ever more distant as the zloty weakens due to the Maastricht criteria. Yet if we look at what has been happening to competitiveness in Poland in recent years (see REER comparison chart with Germany below), it is clear that due to the combined effect of wage inflation and a rising currency, there is some correction still to be made (not comparable with the Baltics or Hungary, but still) if Poland is recover its lost export prowess.

And here's another chart from Citi Poland showing how unit labour costs have steadily risen, and productivity has steadily fallen. The critical crossover point seems to have been somewhere towards the start of 2007. This pattern has been repeated in one CEE country after another, and really lies at the heart of the current economic crisis in the region.

In an attempt to boost liquidity in short-term Swiss franc money markets the National Bank of Poland has set up a currency swap agreement with its Swiss counterpart and the European Central Bank. The agreement will now last until at least the end of April. But while this agreement is obviously providing some relief it is clearly far from solving the problem.

“Today, the SNB, the ECB and the NBP are jointly announcing that they will continue these one-week euro/Swiss franc foreign-exchange swap operations at least until the end of April to support further improvements in the short-term Swiss france money markets,” according to the Polish central bank statement earlier this week.

UniCredit Under Threat?

At the heart of the forex lending (and exposure) in the East lie a small number of major banks whose head offices are to be found in large cities in the core countries of the EU (Western) old guard. Among these, indeed in pride of place here, comes Italy's Unicredit . (See my longer post on Unicredit here). Now it is true to say that Unicredit's Polish subsidiary - Bank Pekao - is relatively immune to the forex lending problem, since it refused to offer mortgages in foreign currencies, and its loan-to-deposit ratio at about 90 percent (compared with an average of about 110 percent for Polish banks generally) is fairly healthy. These features and a capital adequacy ratio of around 11 percent should offer Pekao a reasonable buffer going into the slowdown, but this is not the same thing as an absence of risk, since any serious deterioration in operating conditions inside Poland will affect PLN loan default rates as well as Fx ones, although evidently the banks with fx loan exposure are much worse positioned.

Concern about the position of the entire Unicredit group has been mounting steadily of late, as witness be the latest research report from Moody’s Market Implied Ratings group, which highlighting nagging doubts many observers have over the degree of the bank’s exposure to Central and Eastern Europe. The note, written by analyst Lisa Hintz, suggests UniCredit’s CDS-implied rating of A1 may well be “an overly optimistic signal of the bank’s level of credit risk”.

UniCredit largely avoided the proprietary trading and structured product problems suffered by the other large European banks. However, the financial problems arising from the economic downturn, such as imbalances, could cause deterioration in UniCredit’s loan portfolio, and we do not believe this is reflected in the trading levels of its credit default swaps.

UniCredit’s CDS-implied rating is A1, down three notches from a recent high of Aa1 and one notch below its senior unsecured rating of Aa3. We still see this as an overly optimistic signal of the bank’s level of credit risk, in that it doesn’t capture UniCredit’s comparatively thin level of capitalization and heavy exposure to Central and Eastern Europe. This exposure came after a rapid expansion which has left the bank with an unseasoned loan portfolio.
Loans to Central and Eastern European clients made up 13% of UniCredit’s assets at the end of 2007. These made up an even greater portion of its revenue—21% in the third quarter, and at the top of the list in both cases - see charts below - comes Poland. Fortunately no one is suggesting that the level of loan defaults might be anything like the 60% anticipated in Ukraine (or Russia??, both of which fortunately make up a much smaller part of their portfolio). This CEE activity means UniCredit leads its rivals Austria's Erste Group Bank and Raiffeisen International, France's Societe Generale, Belgium's KBC and Hungary's OTP in terms of both emerging European assets and exposure.

Indeed, UniCredit fell again in Milan today, after the Italian central bank warned yesterday that bank lending is declining and interbank liquidity is insufficient. UniCredit dropped as much 6.5 percent to 1.26 euros, the lowest intraday price since May 13, 1997, and traded at 1.29 euros as of 9:55 a.m. local time. UniCredit shares have now fallen 77 percent since January 2008. The Bank of Italy said yesterday there has been a “significant deterioration” in the general economic scenario and that “lending growth continues to decelerate” because of the high cost of funding for banks. “The situation just seems to keep spiraling in a negative way and if confidence in and among banks doesn’t return there’s no easy way out,” said Giulio Baresani Varini, head of investments at Banca MB SpA in Milan.

Meanwhile UniCredit Bank Austria AG, Austria’s biggest bank, plans to decide whether it will ask for Austrian state aid as part of the national bank bailout programme by the end of March. “We plan to make a decision by the end of the first quarter,” Chief Executive Officer Erich Hampel told journalists in Vienna today. Hampel said in December that Unicredit Bank Austria would need “about 2 billion euros” to increase its Tier 1 ratio, a measure of financial strength, to 9 percent from 7.6 percent at the end of Sept. 30.

But of course it isn't only Unicredit and its subsidiaries who are affected. BRE Bank SA fell to a three-month low on the Warsaw stock exchange this morning, leading Polish banks lower, as loan provisions and losses on derivatives cut into fourth-quarter earnings. The bank - which is a subsidiary of Commerzbank AG - slumped as much as 16.3 zloty, or 10 percent, to hit 146.9 zloty before recovering to 147 zloty at 10:32 a.m. in Warsaw, the lowest level since Oct. 27. The benchmark WIG20 Index was down 3.2 percent and has fallen 8 percent so far this year. The index slumped 48 percent last year, posting its biggest annual decline since its creation in 1994.

Despite 2008 being the worst year in a relatively short history of Polish equity market, with WIG20 down 48% we are not looking for a turnaround in 2009. The performance of the Polish market should still be strongly influenced by global markets which are likely to take some time to recover given the scale of a global macro slowdown not seen since 1945. The illness appears to be very serious and you simply need time to properly recover. We expect the WIG20 index to be down this year by some -10% to -15% (driven largely by expected weak performance of the banking sector).
Polish Equity Market Monitor - Citi Poland - January 2009

So Just What Are The Chances Of A Polish GDP Contraction In 2009?

Well the chances of a contraction of some order in Poland in 2009 are non negligible in my opinion. We are evidently not talking here of something of the order of the Baltics, Romania and Ukraine, or even of the order of Hungary, but still the extent of the slowdown in Poland (or the Czech Republic) should not be underestimated. Average corporate wages rose at their slowest pace in since November 2006 last month, suggesting economic growth is slowing more sharply in the wake of the global financial crisis than many seem to think.

The latest central bank forecast suggested that Poland’s economic growth will slow to 3.7 percent this year from about 5 percent in 2008, but this is very optimistic, and far from everyone agrees. Citi Poland come in with a much lower forecast, and in my opinion a much more reasonable one.

The Polish economy is not immune from global disruptions and an incoming and unavoidable slowdown is already visible. The question is when we will see the recovery. The answer is not easy as so far we have not yet seen the weak GDP numbers which are just around the corner. Looking back at the most recent slowdown during 2000-2003 period we observed 10 consecutive quarters GDP numbers below 2.5% and within that 5 sequential quarters when GDP growth came below 1%. However, this time the most recent 3Q08 GDP number came in at 4.8% so we see a lot of bad macro news ahead of us.

In 2009 we expect GDP growth slowing to 1.4%, driven predominately by deterioration in investment growth as banks started to be very restrictive in lending while corporates are looking for savings and are rather rapidly scaling down investment programs.
Polish Equity Market Monitor - Citi Poland - January 2009

I would go somewhat further. I think it is perfectly possible to see a recession in Poland at some point in 2009, not necessarily a strong one, but a recession just the same.