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Thursday, May 28, 2009

Devaluation Imminent in the Baltics?

By Claus Vistesen: Copenhagen

Even when liars tell the truth, they are never believed. The liar will lie once, twice, and then perish when he tells the truth.

One thing which is certain at the moment is that the rumour mill is grinding hard and that it is very difficult to get a clear picture of what is going on. It is too cumbersome for me to go into the entire background here (I assume most of you are familiar with the Baltic and CEE situation), but if you want some background try this or this which will give you the opportunity to browse a myriad of articles. The situation is however pretty simple. Ever since it became clear that the Baltics was going to suffer not only a hard landing, but a veritable collapse on the back of the financial crisis one obvious question always was whether these economies could maintain the Euro peg throughout the correction process. So far the peg have held and the countries, as well as the IMF who have been called for aid, have been committed to the peg and thus the future entry in the Eurozone.

But this has come at a price and as international economics 101 tells us, the only way you can correct with a fixed exchange rate and an open external account is through deflation and a very sharp drainage of domestic capacity. And so it has come to pass that particularly in Latvia who has come under the receivership of the IMF the scew has been turned, (and turned and turned) and now the question is how much more can the public and the goverment take. In a recent article in the NYT the situation is well described as the Latvian government scrambles to meet ends on the IMF's pre-condition to continue funding the bailout programme.

One very significant indication that things are near its breaking point came when Central Bank Governor Ilmars Rimsevics launched the idea that, since the liquidity in Lati is being drained in order to keep the peg and because the cuts needed to abide by the IMF rules are immense, public employees might be submitted to receive their pay in "vouchers" in stead of actual Lati. As Edward points out, this is straight out of the vaults of the Argentian crisis' annals. This is one of the things you get with a peg maintained too tightly during a deflationary crisis. It deprives you from liquidity. Now, in some sense this all about the next installment of IMF funds of course and whether Latvia will (can) make the needed budget cuts to please the fund to such an extent that they will continue to slip the bailout checks in the mail.

Essentially, under the peg, the central bank has to buy Lati in the open market to maintain the peg since there is, naturally, a pressure on the peg as everybody want's euros. So, the central bank is forced to drain the economy from liquidity to maintain the peg in an environment where the economy is contracting at about 20% over the year. This is not fun and, as it were, not sustainable given the trajectory of these economies. In this sense devaluation is no cure but a simple prerequisite (and necessity) for the healing process to begin.

Even more significant it appears that the the foreign banks, so important in the Baltic story since they basically provided the liquidity inflows to fund the boom, are beginning to accept the basic point I, and others, have made so often before. This is the point that although a devaluation would entail default on a large batch of Euro denominated loans, this default would come in either case as a result of the utterly horrid contraction. In this sense it was very significant that the SEB Chief Executive Annika Falkengren pointed out;

"In total we would have the same size of credit losses, but (if there is no devaluation) they would be a little more regular and over a longer time frame," SEB Chief Executive Annika Falkengren told Swedish radio. "In the case of a devaluation they would be pretty much instantaneous."

This is important because one prerequisite for the peg to hold was always that the foreign banks explicity backed it since they pretty much finance the majority of the credit needed to hold these economies afloat and particularly so Latvia. Essentially, on the Swedish side of things it appears that they are pretty much treating this as over and done.

According to Dagens Industri' Torbjörn Becker, leader of the Eastern European Institute of the School, a devaluation is likely. "The alternative to a devaluation in Latvia is to wait until the reserve is drained and the economy will disappear into a black hole, " he told the DI. Torbjörn Becker believe that neighbors Estonia and Lithuania follow.

Moreover, the Riksbank just recently bolstered its foreign currency reserve with an amount equal to 100 mill SEK which can be interpreted as a precautionary measure to deal with a potential fallout in the Baltics.

The Executive Board of the Riksbank has decided to restore the level of the foreign currency reserve by borrowing the equivalent of SEK 100 billion. This needs to be done because the Riksbank has lent part of the foreign currency reserve to Swedish banks. We have also increased our commitments to other central banks and international organisations. The Riksbank needs to maintain its readiness to supply the Swedish banks with the liquidity required in foreign currency.

Finally, there is Danske Bank, aka Lars Christensen in the context of the CEE, who warns of a serious event risk in the Baltics in today's daily installment on emerging markets.

The event risk has risen sharply in the Baltic markets and we advise outmost caution. Yesterday, the Swedish central bank Riksbanken said it will increase its currency reserve by SEK 100 bn through a loan from the Swedish debt agency. Investors seem to believe that this is a buffer to deal with potential problems arising from the Baltic crisis.


With worries over the Baltic situation on the rise there is a significant risk of negative spill-over to other markets in CEE. Therefore we see clear downside risk on the CEE currencies and a risk of a sharp sell-off in the CEE fixed income markets in the coming days. We especially see value in buying USD/HUF, but potentially also USD/PLN on an escalation of the Baltic crisis.

Basically, the way I see it is that there is only so much the currency boards can do and in Latvia's case, after having already spent over 500 million euros buying lats, I think we are moving steadily towards the end game. Of course, there is an obvious risk that I will perish further down the road with this one, but then again, so be it. It is imperative that investors and stakeholders entertain the possibility of a multiscale Baltic devaluation and, obviously, a sharp CEE sell off in the wake.

Tuesday, May 26, 2009

The New Orthodoxy Is Upon Us

We seem to be witnessing the arrival of some kind of new financial orthodoxy. The IMF put it like this in the Hungary Standby Loan Report (which by chance I was reading last night):

In emerging market countries with debt overhangs, the “Keynesian” effect of fiscal adjustment is likely to be outweighed by “non-Keynesian” effects related to expectations and credibility. Non- Keynesian effects have to do with the offsetting response of private saving to policy-related changes in public saving. In particular, if fiscal adjustment credibly signals improved public sector solvency, a fiscal contraction could turn out to be expansionary, as private consumption rises based on the view that future tax hikes will be smaller than previously envisaged.
IMF - Hungary, Request for Stand-By Arrangement, November 4, 2008

So from Tallinin, to Riga, to Budapest, to Bucharest, the same sonata on a single note is being played, and the message is cut spending and you will expand. Funny how people are not very convinced about this idea in Berlin, London, or Washington.

Payment By "Voucher" In Latvia?

This sounds like something straight from the Argentine history book. Yesterday someone left this comment on my Latvian Blog:
By the way, latest idea in Latvia is to issue vouchers as a substitute to LVL (thats in case Latvia doesnt get any money from IMF). So if you work in public sector, your salary partly will be paid in vouchers which you can use to buy food. And yes - it would also mean 'stable' LVL, at least on paper. I still don't really understand how it could possibly work in free capitalist economy. But it underlines how strong is the will to keep current LVL rate at any means, even if it means total collapse.

At the time I wasn't sure what to make of this, but then I saw that according to a report in the Latvian newspaper Diena, Central Bank Governor Ilmars Rimsevics visited the town of Liepaja on Friday, and told the astounded journalists assembeled there that: "The level of the expenditure shock we are receiving is so high that we can not cease to maintain this quantity of expenditure. So there is a shortage of funds, and we're forced to look at the different kinds of projects, which can help us provide for the foreseeable future. Taking into account that the money is not budgeted, it can be emitted in vouchers".

Rimsevics also gave an interview to the Russian-language newspaper Telegraf (published this morning) where he says more or less the same thing. Basically, the IMF are threatening to withold the next round of funding if the Latvian government does not move ahead with the agreed wave of budget cuts - which in some areas will be of up to 40%. Latvia received a 7.5 billion-euro bailout from the IMF and the European Commission last December. The agreement required Latvia to limit its budget shortfall to to 5 percent of gross domestic product. Since then, the economic outlook has turned far worse than anticipated and Prime Minister Valdis Dombrovskis's government is seeking approval to run a 7 percent deficit.

At the same time the Latvian central bank keeps having to buy the local currency (the Lat) to support the euro peg - last week the bank bought 6.4 million lati ($12 million), and this was the eighth consecutive week they have had to make such purchases. The longer it takes to reach agreement with the IMF - who are convinced that severe budget cuts will be expansionary in the short term (due to the improved confidence they will produce, see here), the more the bank will need to spend to counter those who are betting they will be forced to devalue.

The bank have now bought about 1.1 billion lati since September 2008, and such interventions have reduced Latvia’s foreign currency reserves by 36.7 percent compared with September last year. The flight to euros is also producing strong liquidity pressure inside the country, and the central bank cut its refinance rate to 4 percent on May 13, the second reduction so far this year, in an attempt to boost borrowing amid a liquidity squeeze and much harsher lending criteria. Basically, in order to keep lati in circulation, interest rates on the Rigibor, the local interbank lending market, have been driven up by 42 percent since 3 February to hit 13.7 percent on May 14 (for six-month loans). And this in an economy which shrank by 18 percent in the first quarter.

As I say at the start, all this - including the vouchers proposal - does now sound incredibly like Argentina, since issuing scrip money is exactly the kind of thing you get pushed into when you try unrealistically to hold a peg. It is the begininning of the end. The same thing, exactly, happened in Argentina, where they ran out of pesos and started to issue Patacónes, Lecops, Créditos, Argentinos and a myriad of other exotic bits and pieces of scrip. I give a bit of background on all this in this post on my Spanish blog, while Bloomberg's Aaron Eglitis has a useful summary of the general Latvian situation here.

Monday, May 25, 2009

Horrid Outlook in Ukraine

By Claus Vistesen: Copenhagen

Not to beat a dead horse or anything, but it seems that Krugman, via Edward, was right after all. This does indeed seem to be a great depression if there ever was one.

(from Bloomberg)

Ukraine’s economy probably shrank as much as 23 percent in the first quarter of the year as the global financial crisis took its toll on the eastern European nation, President Viktor Yushchenko said. “The economic contraction is expected between 20 percent to 23 percent in the first three months of the year,” said Yushchenko today, according to a statement posted on his Web site. “The pace of the decline is one of the fastest in Europe.”

Yushchenko urged the government to review the state budget for this year, which still assumes the economy will expand 0.4 percent, according to the statement. A global recession is compounding problems in eastern European economies, which are being battered by a lack of credit, weakening currencies and plunging demand for their products. Ukraine was forced to turn to the International Monetary Fund with other emerging-market countries, including Hungary and Latvia, to boost its financial system in November.

Ukraine’s economy shrank 8 percent in the fourth quarter, the first contraction since 1999. The state statistics committee is expected to release gross domestic product figures for the first quarter in late June.

Of course, we need confirmation and I would not be surprised if the number reported by the government turned out to be wrong (in either direction!), but the the initial shot across the bow suggests a veritable collapse.

Saturday, May 23, 2009

ZEW CEE Sentiment Index Rebounds

Investor confidence in central and eastern Europe turned positive territory for the first time in 20 months in May according to Sentiment Indicator published by ZEW Center for European Economic Research and Erste Bank. May marked the first positive reading on the index since September 2007. The index - which measures investor and analyst expectations for eastern Europe in the next six months rose to 6 points in May from minus 3.9 in April.

“All sentiment indicators are located in the positive range again,” according to Mariela Borrel, an analyst for ZEW in Mannheim, Germany. The positive outlook “is a novelty since the outbreak of the financial crisis.”

Analysts seem to anticipate that the slower contraction rates being registered in the PMIs and lower interest rates in western Europe will feed through to increased demand for exports from eastern Europe while stimulus efforts in individual eastern countries will further help economic growth.

The six-month business outlook for Romania rose the most, gaining 26.1 points to 11.7 points, following agreement to a 20 billion-euro international loan by the EU and the IMF. Poland also did well, advancing 21.8 points to 20 points, followed by a 20.9-point gain over Hungary’s outlook, which rose to 15.3 points. Overall, the outlook was most positive for the Czech Republic, which added 18.6 points to 24 points.

The valuations of the current economic situation, however, worsened. The CEE indicator declined by 6.4 to minus 60.4 points, while the appraisal of the present state of the Austrian economy feel back by 21.8 to minus 48.9 points.

The Financial Market Survey CEE is a survey carried out by ZEW Mannheim and Erste Group Bank AG Vienna, among financial market experts and has been conducted monthly since May 2007. It offers insights into the experts' assessment of the current economic situation and their expectations for Central and Eastern Europe, Austria and the Eurozone for the next six months concerning the general economic situation, inflation rates, interest rates, exchange rates and stock market indices. The CEE region observed in the survey consists of Bulgaria, Croatia, Czech Republic, Hungary, Poland, Romania, Serbia, Slovakia and Slovenia.

Don't Get Carried Away Now!

As Paul Krugman recently pointed out, one of the central points they made in the latest IMF World Economic Outlook was that recessions caused by financial crises tend to get resolved on the back of export-lead booms, with countries normally emerging from the crisis with a positive trade balance of over 3 percent of GDP. The reason for this is simple, since consumers are so laden-down with debt from the boom period, they are naturally more obsessed with saving than borrowing during the initial crisis aftermath. So much then for the typical crisis, and the typical exit. But musing on this point lead Krugman to an additional, rather disturbing, conclusion: since the present financial crisis is truly global in its reach, the habitual exit route to recovery will only work after we are able to identify another planet to send all those exports to (shades of Startreck IV). The joke may seem a rather exaggerated one, in poor taste even, but behind it there lies a little bit more than a grain of truth.

But not everywhere is gloom and doom at the moment, and on the other side of the world they woke up reeling from different kind of bounce last Monday morning, on learning that India’s outgoing government had been not only been re-elected, but had been thrust back into power on a much more stable basis. And that was not the only pleasant surprise in store for those reading their morning newspapers in London, Madrid or New York, since India's main stock index - the Sensex - shot up as much as 17% during early trading on receiving the news, while the rupee also surged sharply. So just one more time we find ourselves faced with the prospect of living in a rather divided world, where on one side we have growing and deepening pessimism, while on the other we see a burst of optimism, with someone, somewhere, getting a massive dose of that "let a thousand green shoots bloom" kinda feeling. Perhaps we should ask ourselves whether there is any connection?

Well, and to cut the long story short, yes there is, and the connection has a name, and it's called sentiment. Indeed sentiment is precisely why the recent (and highly controversial) US bank stress tests were so important. Their real significance was not for any relevance they may have from a US banking point of view (which was, of course, highly contested), but for the reassurance they can give market participants that there will not be another financial explosion in the United States (as opposed to a protracted recession, and long slow recovery), or put another way, to show the days of "safe haven" investing are now over. Risk is about to make a comeback, and the only question is where?

Which brings us straight back to all that earlier talk of coupling, recoupling, decoupling, and uncoupling which we saw so much of a year or so ago (or to Decoupling 2.0, as the Economist calls it). And to the world as we knew it before the the demise of Lehmann brothers, where commodity prices were booming like there was no tomorrow on the one hand, while credit- and housing-markets markets were steadily melting down in the developed economies on the other, where growth was being clocked up in many emerging economies at ever accelerating rates, while the only "shoots" we could see on the horizon in the US, Europe and Japan were those of burgeoining recessions.

The point to note here is not just that a significant group of investors and their fund managers spent the better part of 2008 busily adapting their behaviour to changed conditions in the US, Europe and Japan, but rather that a very novel set of conditions began to emerge, as the credit crunch worked its way forward and property markets drifted off into stagnation in one OECD economy after another. Just as they were finally announcing closing time in the gardens of the West almost overnight it started "raining money" in one emerging economy after another - as foreign exchange came flooding in, and the really hard problem for governments and central banks to solve seemed to be not how to attract funding, but rather how to avoid receiving an excess of it. Thailand even attained a certain notoriety by imposing capital controls with the explicit objective of discouraging funds not from leaving but from entering the country.

Then suddenly things moved on, and day became night just as quickly as night had become day as one fund flow after another reversed course, and the money disappeared just as quickly as it had arrived. Behind this second credit crunch lay an ongoing wave of emerging-market central bank tightening (during which Banco Central do Brasil deservedly earned its spurs as the Bundesbank of Latin America) with the consequence that one emerging economy after another began to wilt under the twin strain of stringent monetary policy and sharply rising inflation. Thus the boom "peaked" in July (when oil prices were at their highest), and momentum was already disapearing when the hammer blow was finally dealt by the decision to let Lehman Brothers fall in late September. By November all those previous positive expectations were being sharply revised down, with the IMF making an initial cut in its global growth estimate for 2009 - to 2.2 percent from the 3.7 percent projected for 2008. The World Bank went even further, and by early December was projecting that world trade would fall in 2009 for the first time since 1982, with capital flows to developing countries being expected to plunge by around 50 percent. By March 2009 they were estimating that the volume of world trade, which had grown by 9.8 percent in 2006 and by 6.2 percent in 2007, was even likely to fall by 9 percent this year.

Having said this, and while fully recognising that the future is never an exact rerun of the past - and especially not the most recent past - given that emerging economies have been the key engines of global growth over the last five years, is there any really compelling reason for believing they won't continue to be over the next five? Could we not draw the conclusion that what was "unsustainable" was not the solid trend growth which we were observing between 2002 and 2007, but rather the excess pressure and overheating to which the key EM economies were subjected after the summer of 2007? And if that is the case, might it not be that the "planet" we need to find to do all that much needed exporting to isn't so far away after all, but right here on this earth, and directly under our noses, in the shape of a growing band of successful emerging economies.

According to IMF data, the so called BRIC countries actually accounted for nearly half of global growth in 2008 - China alone accounted for a quarter, and Brazil, India and Russia were responsible for another quarter. All-in-all, the emerging and developing countries combined accounted for about two-thirds of global growth (as measured using PPP adjusted exchange rates) . Furthermore, and most significantly, the IMF notes that these economies “account for more than 90 per cent of the rise in consumption of oil products and metals and 80 per cent of the rise in consumption of grains since 2002”.

But behind the recent emerging market phenomenon what we have is not only a newly emerging growth rate differential, since alongside this there is also alarge scale and ongoing currency re-alignment taking place, a realignment driven, as it happens, by those very same growth rate differentials. The consequential rapid and dramatic rise in dollar GDP values (produced by the combination of strong growth and a declining dollar) has meant that a slow but steady convergence in global living standards - at least in the cases of those economies who have been experiencing the strongest acceleration - has been taking place, and at a much more rapid pace than anyone could possibly have dreamed of back in the 1990s, even if the long term strategic importance of this has been masked by the recent collapse in commodity prices and the downward slide in emerging stocks and currencies associated with the post-Lehman risk appetite hangover. Which is why, yet one more time, that simple issue of sentiment is all important, or using the expession popularised by Keynes "animal spirits".

Carry On Trading

But now we have a new factor entering the scene. The US Federal Reserve, along with many of the world's key central banks, has so reduced interest rates that they are now running only marginally above the zero percent "lower bound", and the Fed is far more concerned with boosting money supply growth to fend of deflation than it is with restraining it to combat inflation. Not only that, Chairman Ben Bernanke looks set to commit the bank to maintain rates at the current level for a considerable period of time.

In this situation, and given the extremely limited rates of annual GDP growth we are likely to see in the US and other advanced economies in the coming years, all that liquidity provision is very likely to exit the first world looking for better yield prospects, and where better to go than to to look for it than those "high yield" emerging market economies.

The Federal Reserve could thus easily find itself in the rather unusual situation of underwriting the nascent recovery in emergent economies like India and Brazil , just as Japan pumped massive liquidity straight into countries like New Zealand and Australia during its experiment with quantitative easing between 2001 and 2006. And the mechanisms through which the money will arrive? Well, they are several, but perhaps the best known and easiest to understand of them is the so called carry trade, which basically works as follows.

Stimulus plans and near-zero interest rates in developed economies boost investor confidence in emerging markets and commodity-rich nations whose interest rates are often in double figures. Using dollars, euros and yen these investors then buy instruments denominated in currencies from countries like India, Brazil, Hungary, Indonesia, South Africa, Turkey, Chile and Peru - which collectively rose around 8% from March 20 to April 10, the biggest three-week gain for such trades since at least 1999 . A straightforward and simple carry-trade transaction would run like this: you borrow U.S. dollars at the three-month London interbank offered rate of (say) 1.13% and use the proceeds to simply buy Brazilian real, leaving the proceeds in a bank to earn Brazil’s three-month deposit rate of 10.51%. That would net anannualized 9.38% - under the assumption that the exchange rate between the two currencies remains stable, but the real, of course, is appreciating against the dollar.

Other options which immediately spring to mind are Turkey, where the key interest rate is currently 9.25 percent, Hungary (9.5 percent) or Russia (12 percent). And the cost of borrowing is steadily falling - overnight euro denominated inter-bank loans hit 0.56 percent last week, down from 3.05 percent six months ago after recent moves by the European Central Bank to cut interest rates and pump liquidity into the banking system. The London interbank offered rate, or Libor, for overnight loans in dollars is thus down to 0.22 percent from 0.4 percent in November. And while the ECB provides the liquidity, the EU Commission and the IMF provide the institutional guarantees which - in the cases of countries like Hungary or Romania - mean that even is such lending is not completely free from default risk, they are at least very well hedged.

Indeed Deustche Bank last week specifically recommended buying Hungarian forint denominated assets, and according to the bank the Russian ruble, the Hungarian forint and the Turkish lira are among the trades which offeri investors the best returns over the next two to three months. Deutsche Bank recommends investors sell the euro against the forint on bets the rate difference will help the Hungarian currency gain around 10 percent over the next three months (rising to 260 from around 285 to the euro when they wrote). Investors should also sell the dollar against the Turkish lira and buy the ruble against the dollar-euro basket, according to their recommendations.

And it isn't only Deutsche Bank who are actively promoting the trade at the moment, at the start of April Goldman Sachs also recommended investors to use euros, dollars and yen to buy Mexican pesos, real, rupiah, rand and Russia rubles. John Normand, head of global currency strategy at JPMorgan, is forecasting a strong surge in long term carry trading as the recovery gains traction. Long trading, he says, is decidedly "underweight" at this point. Long carry trade positions held by Japanese margin traders, betting on gains in the higher-yielding currencies, peaked at $60 billion last July, according to Normand. They were liquidated completely by February, and have subsequently increased to around one third of the previous value (or $20 billion). “Only Japanese margin traders and dedicated currency managers appear to have reinstated longs in carry,” Normand says. “Their exposures are only near long-term averages.”

And Barclays joined the pack this week stating that Brazil’s real, South Africa’s rand and Turkey’s lira offer the “largest upside” for investors returning to the carry trade. A global pickup in investor demand for higher-yielding assets and signs the worst of the global recession is over “bode very well for the comeback of the emerging-market carry trade,” according to analyst Anfrea Kiguel in a recent report from New York. In part as a result of the surge in carry activity the US dollar declined beyond $1.40 against the euro on Friday for the first time since January. Evidently the USD may now be headed down a path which is already well-trodden by the Japanese yen.

India on The Up and Up.

But some of these trades are much riskier than others. Many of the countries in Eastern Europe who currently offer the highest yields are also subject to IMF bailout programmes, so they are with good reason called "risky assets". But others look a lot safer. Take India for example. As Reserve Bank of Indian Governor Duvvuri Subbarao stressed only last week, India’s “modest” dependence on exports will certainly help the economy weather the current global recession and even stage a modest recovery later this year. Of course, "modest" is a relative term, since even during the depths of the crisis India managed to maintain a year on year growth rate of 5.3 percent (Q4 2008), and indeed as Duvvuri stresses, apart from the limited export dependence, India's financial system had virtually no exposure to any kind of "toxic asset".

As mentioned above, the rupee rose 4.9 percent this week to 47.125 per dollar in Mumbai, its biggest weekly advance since March 1996, while the Sensex index rallied 14 percent for its biggest weekly gain since 1992.

And, just to add to the collective joy, even as Indian Prime Minister Manmohan Singh began his second term, and stock markets soared, analysts were busy rubbing their hands with enthusiasm at the prospect that the new government might set a record for selling off state assets, and thus begin to address what everyone is agreed is now India's outsanding challenge: reducing the fiscal deficit.

Singh, it seems, could sell-off anything up to $20 billion of state assets over the next five years as he tries to reduce the central govenment budget shortfall which is currently running at more than double the government target - it reached 6 percent of gross domestic product in the year ended March 31, well beyond the 2.5 percent government target. The prospect of a wider budget gap prompted Standard & Poor’s to say in February that India’s spending plans were “not sustainable” and threaten that the country's credit rating could be cut again if finances worsen. But just by raising 100 billion rupees from share sales and initial public offerings in the current financial year would reduce the fiscal deficit by an estimated quarter-point, at the stroke of a pen, as it were. And there is evidently plenty more to come from this department.

As a result of the changed perception that the new Indian government will now - and especially with the elections and the worst of the global crisis behind it - seriously start to address the fiscal deficit situation, both S&P and Moody’s Investors Service, have busied themselves emphasising just how the outcome gives India's government a chance to improve its fiscal situation. The poll result gives the government more “political space” to sell stakes in state-run companies and improve revenue, according to Moody’s senior analyst Aninda Mitra, while S&P’s director of sovereign ratings Takahira Ogawa commented that the result means “there is a possibility for the government to implement various measures to reform for further expansion of the economy and for the fiscal consolidation.”

So off and up we go, towards that ever so virtuous circle of better credit ratings, lower interest rates, rising currency values, and ever higher headline GDP growth, which of course helps bring down the fiscal deficit, which helps improve the credit rateing outlook, which helps... oh, well, you know.

And it isn't only India which is exciting investors at the moment. Brazil's central bank President Henrique Meirelles went so far as to warn this week against an “excess of euphoria” in the currency market, implicitly suggesting the bank may engage in renewed dollar purchases to try to slow down the latest three-month rally in the real. The central bank began buying dollars on May 8, and Meirelles’s latest are evidently upping the level of verbal intervention. The real has now climbed 20.5 percent since March 2, the biggest advance among the six most-traded currencies in Latin America, as prices on the country’s commodity exports rebounded and investor demand for emerging-market assets has grown. The currency is up 14 percent this year, more than any other of the 16 major currencies except for South Africa’s rand, reversing the 33 percent drop in the last five months of 2008.

Carry Me Home

Despite a number of outsanding worries about the emerging economies in Eastern Europe, the general idea that countries like India, Brazil, Turkey, Chile, Peru etc are firmly at the top of the list of the economies where current growth conditions are generally favorable seems essentially sound. Additionally, if this sort of argument has any validity at all it is bound to have implications for what is sure to be one of the key problems we will face during the next global upturn: what to do with the financial architecture which we have inherited from the original Bretton Woods agreement (or Bretton Woods II as some like to call it).

The limitations of the current financial architecture have become only too apparent during the present recession, since with both the Eurozone and the US economies contracting at the same time, the currency see-saw between the dollar and the euro has failed to provide any adequate form of automatic stabiliser. And since Japan's economy is in an even more parlous state -deep in recession, and desperate for exports - having to live with a yen-dollar parity which is at levels not seen since the mid 1990s can hardly be fun. This has lead some analysts to start to talk of a new and enhanced role for China's currency, the yuan, in any architectural reform we may initiate. But obviously, beyond the yuan we should also be thinking about the real and the rupee. However,I would like to suggest the problem we now face is a much broader one than simply deciding which currencies should be in the central bank reserve basket, and it concerns the central issue of how to conduct monetary policy in an age of global capital flows. During the last boom, comparatively small open economies like Iceland and New Zealand were on this receiving end, but this time round we face the truly daunting prospect of having global giants thrust into the same position, while the USD gets pinned to the floor, just as the Japanese yen was previously.

The problem is evidenty a structural one. The euro hit 1:40 to the USD on Friday (at a time when Europe's economies are in deeper recession than the US one is), while - as I said - the Brazilian central bank President felt the need to come out and warn against an “excess of euphoria” in the local currency market following an 18% rise in the real over 3 months. Officially, the euro surged as a result of news that the US might receive a downgrade on its AAA credit rating, but this justification hardly bears examination, given that around half of the eurozone economies could be in the same situation. Obviously currency traders live in a world where the most important thing is to "best guess" what the guy next to you is liable to do next, and in this sense the rumour could have played its part, but the real underlying reason for the sudden shift in parities is the return in sentiment we have been seeing since early May, and the massive and cheap liquidity which is on offer in New York.

Of course, the impact spreads far beyond Delhi and Rio. Turkey’s lira is also well up - and has now advanced 10 percent over the last three months - while South Africa’s rand is up 22 percent, making it the best performing emerging-market currency during the same period.

All good "carry" punts these, with Turkey’s benchmark interest rate standing at 9.25 percent, and Brazil’s rate of 10.25 percent. Even the ruble is up sharply, just as Russia's economy struggles to handle the rapidly growing loan default rates. The currency climbed to a four-month high against the dollar on Friday, making for its longest run of weekly gains in almost two years, hitting 31.0887 per dollar at one point, its strongest level since Jan. 12. The ruble was up 3.2 percent on the week - closing with its sixth weekly advance and extending its longest rally since September 2007 - and has risen 16 percent since the end of January. Russia's central bank has cut base interest rates twice since April 24 in an attempt to revive the economy, but the refinancing rate is still 12 percent - well above rates in the EU, the U.S., Japan and even quite attractive in comparison with those on offer in other emerging markets. The basic point here is that carry trade players can leverage interest rate differentials and benefit from the changes in currency valuation that these very trades (along with those made by other participants) produce. So all of this is truly win-win for those who play the game, until, that is, it isn't.

Not all of this is preoccupying - far from it, since the issues arising are in many ways related to the problem I started this article with: namely, who it is who will run the trade and current account deficits and do the necessary consuming, to make all those export-lead recoveries (even in China, please note) possible. Evidently the core problem generated during the last business cycle was associated with the size of the imbalances it threw up, and the impact on liquidity and asset prices that these imbalances had. If I am right in the analysis presented here, then we are all on the point of generating a further, and certainly much larger, set of such imbalances as we let the process rip in the uncordinated and unrestrained fashion we are doing. As you set the problem up, so it will fall. Floating Brazil and India is a very attractive and very desireable proposition. Consumers in those countries can certainly take on and sustain more leveraging. The two countries can even to some extent support external deficits as they develop. But they need to do this in a balanced way, an they do not need distortions. The world does not need more Latvias, Estonias, Irelands or Spains (let alone Icelands, and let alone of the size of a Brazil or an India). So policy decisions are now urgently needed to impose measures and structures which help avoid a repeat of the same in what is now a very imminent future. And despite all the talk of reform, very little has been done in practice. Talk of "tax havens" and the like sounds nice, and is attractive to voters, but all this is on the margin of things. What we need is global architectural reform, and policy coordination at the central bank, and bank regulation level, not to stop the capital flows, but to find a more sophistocated way of managing them.

Wednesday, May 20, 2009

Is Hungary Set To Become The New Iceland?

Iceland, why on earth Iceland? Well, the issue I have in mind concerns the independence and viability of central bank monetary policy (especially in a small open economy like Hungary's) and the role interest rates, and investor sentiment, and yield differentials, and oh yes, I almost forgot, that notorious vehicle so beloved by investors the "carry trade" in producing a situation where financial dynamics get really out of hand.

In a visionary paper given at the International Conference of Commercial Bank Economists (held in Madrid, July 2007) - entitled The Global Financial Accelerator and the role of International Credit Agencies - the Danish economist Carsten Valgreen argued the following:
The choice major countries have made in the classical trilemma: ie, Free movements of capital and floating exchange rates – has left room for independent monetary policy. But will it continue to be so? This is not as obvious as it may seem. Legally central banks have monopolies on the issuance of money in a territory. However, as international capital flows are freed, as assets are becoming easier to use as collateral for creating new money and as money is inherently intangible, monetary transactions with important implications for the real economy in a territory can increasingly take place beyond the control of the central bank. This implies that central banks are losing control over monetary conditions in a broad sense. The new thing – this paper will argue – is that we are increasingly starting to see the loss of monetary control in economies with stable non-inflationary monetary policies. This is especially the case in small open advanced – or semi-advanced – economies. And it is happening in fixed exchange rate regimes and floating regimes alike.
Interestingly enough, Valgreen chose as his paradigmatic examples of central bank loss of control over monetary policy the cases of Iceland and Latvia. Equally today we could add the name of Hungary to our list. As Valgreen argued (and this remember, before the sub prime blow-out):
It is no accident that the two examples are small open economies with liberalised financial markets. Being small makes the global financial markets matter more. A country such as Iceland will be the first to notice that the agenda for monetary policy has changed, as the current and capital accounts are naturally very large and important for the economy. However, this is more of a reason to study its experiences carefully, as they might show something of what is in store for larger economies over the next decade.
So the issue really is, does the Hungarian National Bank continue to control monetary policy in any meaningful sense, or is it reduced to responding to events elsewhere? And does the Hungarian government have any effective tool left with which to fight this crisis? But getting ahead of ourselves and going too far into all this, let's step back a bit, and take a longer look at the Hungarian economy, just to set the scene.

The IMF and the EU Agree To A Larger Deficit

The International Monetary Fund and the European Union has now approved Hungary's request for a larger budget deficit this year, thus giving the government marginally more room for manoeuvre in the face of the very severe contraction in GDP. The government is now going to be authorised to aim for a 3.9 percent of gross domestic product shortfall, as compared with the earlier 2.9 percent objective, according to Finance Minister Peter Oszko. The government have also revised their forecasts, and expects the Hungarian economy to shrink by 6.7 percent this year, the most since 1991, a revision from the earlier 6 percent forecast. Hungary was the first EU member to arrange a 20 billion IMF-led bailout last year, lining up 20 billion euros in a bid to avert a default after investment and credit to eastern Europe dried up. The country then pledged to keep its budget deficit under control to qualify for the loan.

The question is, is this good news or bad news? Evidently the decision not to strangle the government budget is welcome (we are in danger of a contraction that feed on itself here, since with external demand at very low levels, applying 9.5% interest rates and fiscal tightening means the economy can simply fall into a downward spiral). But in the braoder context the news is not good. The IMF and the EU have cut Hungary some more slack simply because the ferocity of the slump in output is worse then any previously imagined, and things are now going to get worse, not better. Which made it rather strange to read in Bloomberg this morning that Finance Minister Peter Oszko has announced the government is to consider selling foreign-currency denominated bonds this year in order to take advantage of rising investor confidence. We are on very dangerous gound indeed here gentlemen! I mean, whatever happened to once bitten twice shy. According to Bloomberg:
Foreign-currency borrowing, along with slower growth, a wider budget deficit and higher government debt than elsewhere in eastern Europeraised concern about Hungary’s ability to repay its debt lastyear......IMF and EU officials this week approved Hungary’s plan torun a wider budget deficit this year and next than earlier targeted....
So what exactly has changed? According to the latest data growth is now even slower than before (or rather the contraction is sharper), the budget deficit and gross government debt are both pointing up again, and the only (vaguely) "good" news is that living standards are falling so fast that the trade balance is improving, and with it the current account deficit. But the government debt dynamics are not the same as the external trade one, and things are getting worse, not better, which makes you wonder what all the optimisim is about? In their recent stress testing exercise the Hungarian Government Debt Management Agency suggested the debt path was sustainable (see much more below on this), but in order to offer this assurance they assumed an average growth rate of GDP of 3% 2013 - 2020 even in their worst case scenario! . My estimate is a much more sobre one, and that is, with declining and ageing population to think about - the Hungarian ecenomy will be lucky to average 1% growth over the above time horizon (more justification on this below). So as far as I can see Hungary's public debt dynamics are still set on a clearly unsustainable path.

Then you need to take into account how you have a 9.5% central bank benchmark interest rate going into a 6% percent plus GDPcontraction (with inflation around 3%), so what are people thinking about? This policy mix doesn't work, and it won't. If you lower the interest rates to support the economy, the forint crashes, and with it the balance sheet of all those households still holding CHF denominated mortgages in their portfolio. Hungary is clearly caught between the proverbial rock and the hard place.

And what's more, this policy mix is leading to all sorts of distortions. Hence the reference in the title of this post to Iceland, since Iceland's problems precisely got out of hand, due to the "juiciness" of the trade their domestic interest rate yield differential offered. Viz a recent Deustche Bank report which specifically recommended buying HUF denominated assets, due to the yield differential.
Currency deals that profit from the difference in interest rates globally are returning to favor on speculation the worst of the creditcrisis may be over, spurring investors to buy eastern European assets,Deutsche Bank AG said.The Russian ruble, Hungarian forint and Turkish lira offer investorsthe best returns in the next two to three months thanks to the highestrates in the region, said Angus Halkett, a strategist at Deutsche Bankin London.The so-called carry trade, in which investors borrow in currencieswith low interest rates to buy higher-yielding assets, helped theforint and lira surge to record highs last year before the collapse of Lehman Brothers Holdings Inc. prompted investors to sell riskier assets.
Perhaps people should reflect a little more on the significance of those final few words: "before the collapse of Lehman Brothers Holdings Inc. prompted investors to sell riskier assets".

This is what is known as the "carry" trade, and it works like this. Stimulus plans and near-zero interest rates in developed economies boost investor confidence in emerging markets and commodity-rich nations with interest rates which are often in double figures.Using dollars, euros and yen these investors then buy instruments denominated in currencies from countries like Brazil, Hungary,Indonesia, South Africa, New Zealand and Australia which collectively rosee around 8% from March 20 to April 10, the biggest three-week gain since atleast 1999 for such carry trades, according to data compiled by Bloomberg . A straightforward carry-trade transaction would be to borrow U.S. dollars at the three-month London interbank offered rate of 1.13% and use the proceeds to buy Brazilian real and earn Brazil’s three-month deposit rate of 10.51%. That would net anannualized 9.38% - as long as both currencies remain stable, but the real, of course, is appreciating. Now all of this can present a big problem for a number of CEE economies, because:

Turkey’s key interest rate is 9.25 percent, Hungary’s is 9.5 percent and Russia’s 12 percent. The cost of borrowing in euros overnightbetween banks reached 0.56 percent yesterday from 3.05 percent sixmonths ago as the European Central Bank began cutting interest rates and pledges of international aid allayed concern the global slowdownwould worsen. The London interbank offered rate, or Libor, forovernight loans in dollars fell to 0.22 percent from 0.4 percent inNovember as the U.S. government and the Federal Reserve spent, lentorcommitted $12.8 trillion to stem the longest recession since the1930s.

So basically, "Big Ben's" US bailout is fuelling specualtion on Hungarian debt!

And don't miss this point from the Bloomberg article:
Deutsche Bank recommends investors sell the euro against the forint on bets the rate difference will help the Hungarian currency gain 10 percent to 260 per euro in two to three months from 286.55 today. Investors should also sell the dollar against the lira and buy the ruble against the dollar-euro basket, the bank said.
And it isn't only Deutsche Bank, Goldman Sachs recommended on April 3 that investors use euros, dollars and yen to buy Mexican pesos, real, rupiah, rand and Russia rubles.

We can see some of this impact in the German ZEW investor sentiment index. As can be seen, something interesting is happening somewhere, even if it is not immediately evident where. As Solow would have said, "I can see evidence for improved investor sentiment everywhere, except in the real economies".

So, come on everyone, off you go to Monte Carlo, and place your bets. But meanwhile, remember, in Hungary at least, the most notable phenomena are the growing unemployment and the way the bad loans pile up, even as the Hungarian economy tanks! Basically, the all the evidence now points to the fact that IMF and the EU urgently need a rethink about how they are going about things, but this is beyond the scope of the present post.

"Hungarian lenders face an increase in non-performing loans, which will contribute to “substantially deteriorating” profits for the country’s financial system, central bank Vice President Julia Kiraly said. The whole banking system, which is stable with adequate liquidity, may end up with “negative profit” this year and some lenders need to strengthen their capacity to resist shocks, Kiraly said at a conference in Budapest today."

The Fundamentals, All The Fundamentals, And Only The Fundamentals

Horrid GDP Data

The decision to widen the deficit allowance slightly is not that surprising when you take into account that Hungary's gross domestic product dropped by 5.8% year on year in the first quarter of 2009. The figure was announced by the statistics office last Friday and followed a decline of 2.6% in the last three months of 2008.

Quarter on quarter there was a 2.3% GDP decline, (down from 1.5% contraction in the fourth quarter) which means the economy was shrinking at a 9.2 percent annualised rate, quite sharp, but far from being one of the worst cases in the EU. What makes the Hungarian recession rather different is the way it has been lingering in the air since the initial "correction" in 2006, and is now becoming protracted since this was the fourth consecutive quarter when quarter on quarter growth was negative, and it is hardly likely to be the last.

Household consumption is in continuos decline (see retail sales data below), real wages are falling, and the lack of internal and external demand growth means that investment remains weak. Further, this dynamic is not likely to change rapidly. Exports have plunged - even though since imports have slumped even further we have the ironic detail that net trade is still mildly positive for GDP. However, with interest rates at such a high level and fiscal policy being continually tightened there is little chance of a 'V' shaped recovery in Hungary, and the recession has all the hallmarks of becoming an 'L' shaped" one.

Even the agricultural sector due to the high base effect of last years bumper harvest. So basically, it's back and back in time we go at the moment.

Retail Sales In Continuous Decline

Hungarian retail sales fell for the 25th consecutive month in February as rising unemployment falling wages and a generally deepening recession sapped consumer spending. Retail sales were down an annual 3.2 percent following a 2.8 percent decline in January, according to national statistics office data. Prime Minister Gordon Bajnai, who replaced Ferenc Gyurcsany last month as differences over how to handle the recession boiled over, has indicated he plans to raise the value-added tax as the recession cuts into budget revenue. This will surely push sales down even lower, and household consumption is now expected to decline by as much as 8 percent this year, according to the most recent government estimates.

Consumers started finding themselves with less to spend following the introduction of the government austerity programme in 2006 which raised taxes and utility prices.

Unemployment On the Up and Up

Hungary's jobless rate rose to 9.7% in March, up sharply from the 8% level recorded in December. Hungary's unemployment rate has been howevering continuously in the 7%-8% range for more or les 4 years now, so the current spike (with the prospect of more to come) suggests something important has changed. Between Q4 2008 and Q1 2009, unemployment claims rose by 66,000.

Of the country’s 402,800 registered unemployed, 42.5 percent have been out of work for at least a year, now. The number of Hungarians employed averaged 3.76 million in the first quarter, compared with 3.88 million in the previous three months. It is hard to see a resurgence in the number of Hungarian's employed, even after this recession is past and forgotten, since the working age population is falling steadily, and has been for some time now.

Alongside the increase in unemployment the activity rate has declined even more rapidly. Of the 117,000 laid off during the last quarter some 40,000 chose to remain inactive rather than looking for employment elsewhere. Hungary's already languishing job market received a major blow from the global economic crisis in the form of layoffs and bankruptcies, meanwhile, companies may have been more cautious in hiring new staffers. These job market trends were only to be expected, however downsizing is on a higher scale compared with forecasts. Hungary's economy is in a state of deep recession, with predictable consequences for employment, real wages, and demand.

One consequence of the sharpnesss of the recession has been that Hungarian aggregate wages are falling much more rapidly than anticipated, and this, in turn, has put a major dent in the new government's fiscal adjustment plans. The Finance Ministry had originally anticipated an additional HUF 50 billion in tax revenue. However, the new unemployment figures suggest that the decrease in wage costs may surpass the government's most recent 2% forecast. In a worst-case scenario, the drop in aggregate earnings may be as high as 4%, with a HUF 100 billion-HUF 150 billion negative impact on the budget.

Exports Continue To Fall

Hungary posted a foreign trade surplus of EUR 492.8 million in March, the largest in the past decade, according to the Central Statistics Office (KSH). Still exports were down by nearly 20% year on year, and the improved balance was the result of imports falling even more - by over 23%.

In fact Hungary's exports came in at EUR 5,173 million in March - an 18.2% year on year decline, a considerably slower rate of decline than that registered a month ago (-29.7%). Imports came in at EUR 4,680 million , a staggering 23.4% drop, following a plunge of 32.3% in February.

The gap between export and import growth (5.2 percentage points) has not been as wide as this this wide September 2007 (5.9 percentage points). The March balance shows a record high, a surplus of EUR 492.8 million, which compares with a surplus of EUR 213.9 million in March last year. Exports in the first quarter as a whole amounted to EUR 13,843 million, a decline of 26.3% in annual terms. Imports in Q1 amounted to EUR 13,233 million, down 28.5% year on year. Hungary's Q1 foreign trade balance showed a surplus of EUR 609.3 million, another record, which compares with a surplus of EUR 282.1 million for the same period of 2008.

And Industrial Output Slumps

With exports slumping in this way it is not surprising to find that Hungary's industrial production dropped by 19.6% in March, according to working day adjusted data. Over the first quarter Hungarian industrial output declined by 22.3% year on year, but - although it rose 4.3% month on month, according to data adjusted for calender and working day changes.

And activity in Hungary's manufacturing sector continued to contract in April according to the PMI reading, although the pace of contraction is now down slightly from January's all-time low.

The headline manufacturing PMI stood at a seasonally adjusted 40.4 in April, up slightly from the 39.5 registered in March, according to the release from the Hungarian association of logistics. This was the seventh consecutive month of contraction, following the all-time low of 38.5 hit in January. The Hungarian government currently forecasts that GDP will contract by as much as 6% this year as the German economy, Hungary's chief export market, also faces a similar decline in GDP. Hungarian manufacturing output contracted even more in April than in March, to 37.1 from 37.6. The export index showed a further decline to 35.6 from 36.5 in March. The only positive development came from the new orders index which showed a marginal increase to 37.5 from a reading of 35.0 in March.

Only Inflation Rebounds

Hungary’s inflation rate unexpectedly rose in April for the first time in 11 months, after a weaker forint made imports more expensive, with prices of fuel, medicine, clothing and new cars leading the rise. The annual rate was 3.4 percent, rising from 2.9 percent in March to what is its highest level so far this year. Core inflation, which filters out food and energy prices, was 3.2 percent on the year and 0.5 percent on the month. The annual rate had returned to the central bank’s 3 percent target in February for the first time in more than two years.

The prices of consumer durables, including cars, rose 1.4 percent in a month, while fuel costs climbed 2.9 percent and medicines by 1.9 percent. The price of clothing increased 3.7 percent, the statistics office said. With Hungary’s recession damping demand, consumer prices are set to increase “only moderately,” according to the central bank. Policy makers now expect the inflation rate to average 3.7 percent this year and 2.8 percent next year. The bank raised its estimate from an earlier forecast of between 3.1 percent and 3.4 percent for 2009 and 1.5 to 1.9 percent for 2010.

One factor which will influence future inflation is the new government's decision to raise the main value-added tax rate to 25 percent from 20 percent, as of July 1 in an attempt to offset declines in state revenue and narrow the budget gap. Raising the rate of consumption tax is deeply problematic in the sort of double-bind situation which Hungary faces. Germany raised VAT by 3 percentage points on 1st January 2007, and look what happened to consumption (see chart below) in December 2006, and then subsequently. This is doubly relevant to the Hungarian case since the Hungarian economy is more than likely set on the German path of becoming an export dependent economy. Weakening domestic consumption further could well prove to be a "lethal dose".

Magyar Nemzeti Bank policy makers expect the annual inflation rate to be “near” their 3 percent goal “on the monetary policy horizon” of five to eight months, they said on May 8.

“The NBH would clearly like to cut interest rates, which at 9.5% look far to high for an economy that will contract by 5-6% this year, but this is more dependent on global financial stability and declining risk aversion than the latest CPI release." Nigel Rendell, Royal Bank of Canada

And So The NBH Keeps Rates On Hold

Hungarian monetary policy makers left the benchmark interest rate unchanged at their April meeting for a third month as concern over the forint’s decline outweighed the outlook for slowing inflation and growth. The Magyar Nemzeti Bank kept the two-week deposit rate at 9.5 percent.
Policy makers didn’t consider cutting the interest rate in March based on stability concerns (according to the minutes) and even rejected a proposal, backed by Governor Andreas Simor and his two deputies, to raise the key rate to 10.5 percent. In April the rate-setting Monetary Council considered the recession, the outlook for inflation and economic stability when setting the key rate. The annual inflation rate may be near the bank’s 3 percent target on the 18-month monetary policy horizon, according to the statement.

Much Ado About Debt

Zsuzsa Mosolygó and Lajos Deli, of the Hungarian Government Debt Management Agency recently published what they call " a first a simple model to analyze the impact of the international credit line on debt ratio trends as well as to demonstrate the importance of calibrating reasonable values for decisive macroeconomic parameters".

Read stress tests.

Below you will find the chart showing their basic assumptions, and giving the outcomes for the various scenarios. The whole idea of the process was to show that Hungarian debt to GDP will not necessarily rise in the future as some analysts had been predicting. I don't want to go into all of this in too much, but if you click on the chart and take a look at the assmptions for GDP growth (which is actually the key parameter), you will find that on both the basic and the pessimistic scenarios average growth of 3% is assumed (this is impossible to attain on my view), while the "optimistic" scenario even assumes 4% (incredible). Remember these are average growth rates and over seven years (2013 - 2020). This is like selling Spanish property pre 2007 with a splendid photo of the sun and the beach.

And this comes from two apparently serious analysts, analysts who are supposed to be committed to taking a serious stab at putting the country's longer term finances on a stable footing. All they actually acheive is offering a confirmation of the worst fears of those of us who feel that the debt dynamics in Hungary are totally unstable in the mid term, and illustrate just how out of balance most of Eastern Europe now is as we move forward.

They justify their decision in the following way:

Market analysts tend to assume in their debt models a 2% economic growth for the
Hungarian economy. The National Bank of Hungary estimates currently a 2%
potential GDP growth rate, however, it does not mean necessarily the long-term
economic growth. A few years ago the estimates were higher and it seems to be
possible that adequate reforms to encourage employment would result in a 3-4% or
even higher potential GDP growth rate.

(Please Click On Image For Better Viewing)

In fact the objective of the study was not to seriously stress test Hungarian debt dynamics, but to try to argue that those analysts arguing for unsustainable dynamics have it wrong. The end product isn't very convincing. Not surprsingly the debt to GDP ratio diminishes gradually after 2009 both in the “optimistic" and “basic" version. The authors even underline that debt development does not appear to be unsustainable under very pessimistic macroeconomic conditions, either. In the “pessimistic" scenario debt ratio peaks at about 80% in 2020 and descends slowly afterwards (which is due to the assumed 6% interest rates). Of course, "pessimistic" here means Hungarian GDP rising by 3% a year every year from 2013 to 2020. To put this in perspective, using current Hungarian government forecasts average GDP in the ten years up to 2010 is something like 1.8% per annum. And this has been a pretty good decade by Hungarian standards (see chart for long term growth).

In fact, with a declining and ageing workforce, together with decline domestic consumption (see retail sales chart above), even a 1% per annum growth rate may be optimistic. In any event we won't see 3%, and nothing produced by the Hungarian government to date substantiates the claim that longer term debt is NOT on an unsustainable path. "To sleep, perchance to dream-ay, there's the rub."

Tuesday, May 19, 2009

The Russian Government Forecasts A Possible 8% GDP Contraction For 2009

Of course, with all these large negative numbers going the rounds at the moment, we are all in danger of going rapidly dizzy, but some pieces of data still have the power to shock, like this morning's announcement from Russia's Economy Minister Elvira Nabiullina that the economy may shrink as much as 8 percent this year.

“The specific contraction numbers could be 4 percent or 6 percent or 8 percent,”
Nabiullina said in an interview with Bloomberg Television in Moscow today.
“We’re doing various calculations, pessimistic and optimistic. We believe much
depends on how efficient we are.”
So the Russian Government is still going through the scenarios, and the ministry now promises to submit new growth forecasts by the end of the month, but it is worth bearing in mind that, as recently as last January, the most probable estimate stood at 2.2 percent. And the Economy Ministry aren't the only ones with the excel sheets and calculators out - Alfa Bank, Russia's largest private bank, Goldman Sachs, Citigroup and the International Monetary Fund have all revised their 2009 growth forecasts down recently, and Alfa this week cut its outlook to minus 5.7 percent from an earlier anticipated drop of 3 percent. Nabiullina's deputy, Andrei Klepach, recently described the International Monetary Fund’s estimate for a 6 percent annual drop as “realistic.”

Sharp Fall In Q1 GDP

Russia's Q1 gross domestic product slumped back by an incredible 23 percent from the last three months of 2008, according to the latest (non seasonally corrected) preliminary data from the Federal Statistics Service.

“The big dip in industrial production jumps in your face,” said Tatiana Orlova,
a Moscow-based economist with ING Groep NV, who plans to lower her forecast for
a 2.7 percent contraction this year. “The government should be worried. It’s
very easy to come up with headlines announcing bailout measures, but the
situation shows that you have to adjust them. It’s hard to do these things

Yet despite the very bad first quarter numbers, and the pessimism which currently emanates from the Economy Ministry, a number of recent data points have been rather better (in the sense of less bad) than those were were seeing in January and February.

Both the PMIs and the GDP indicator were registering improvement, although the March Index of key economic activities - at minus 12.4% - was not that far off the February low of minus 12.6%, while April's fall in industrial output was the worst to date.

Russian retail sales also fell again in March - at an annual 4 percent rate - registering their biggest decrease since September 1999.

Services PMI Shows Contraction Weakening

Russia's VTB Bank services industries PMI came in at 44.4 last month, compared with 43.9 in March, suggesting some slight improvement in condition from one month to the next.

“The sector’s performance is still under pressure from the deteriorating business conditions on the back of weakening demand,” Svetlana Aslanova, an analyst at VTB Capital, said in the report.

While the index declined for the seventh consecutive month, the rebound from December’s record drop of 36.4 continued, with the rate of decline in new orders easing for the third consecutive month after registering a record contraction in January.

And inflationary pressures are weakening, with prices charged by companies declining for the first time since VTB started compiling the survey as providers competed by offering lower tariffs and discounts, the bank. In addition input prices advanced at the slowest pace on record.

And The Contraction Softens In April

VTB Bank manufacturing PMI continued to signal that the sector remained in a strong downturn in April, although, as elsewhere, the rate of decline slowed again (for the fourth straight month) hitting the almost respectable level of 43.4 (in comparison with what is being seen elsewhere). This was the highest level in six months, although (in terms of historical comparisons) the latest results provide further evidence that the sector is experiencing a longer and more pronounced contraction than that seen during the financial crisis of 1998. At that time the PMI spent seven successive months in negative territory. In comparison the current run already extends to nine months - and we are still far from the end of the process - and in addition the rate of contraction has been much more pronounced.

According to VTB the largest component of the headline PMI – new orders – showed a weaker rate of decline in April. The rate of contraction in new business has now moderated continuously since hitting a survey record in December. However, new export business declined at a faster rate in April compared to March, suggesting that while the Russian administration's stimulus plan may be having some impact, the devaluation of the ruble is yet to make any real impact, possibly due to the hefty rate of continuing internal price inflation and also due to the sorry state of international trade.

Worthy of note is the fact that a number of survey respondents linked lower output levels to payment problems at clients as credit conditions remain challenging.

Average input costs continued to increase in April, although at a weaker rate than that seen in the previous two months. Energy prices and exchange rate fluctuations were reported by firms to have increased costs, but this was partly offset by pressure on suppliers to discount rates as underlying demand remained weak. VTB reported that competitive pressure in the manufacturing sector was evident in April as firms cut output prices for the fifth time in six months. Manufacturers also continued to cut back their workforces in April, and employment in the manufacturing sector has now fallen continuously since May 2008, and the rate of job shedding remained marked despite easing for the third month running.

And The GDP Indicator Reflects The PMIs

Thus it is hardly surprising to find that the VTB Capital GDP Indicator showed the Russian economy contracting for the fifth month in a row in April, although again at a weaker rate. The indicator showed the economy contacting 4.7 percent year-on-year in April, after shrinking by a record low of 5.4 percent in March.

"The April PMI surveys suggest that stocks of finished goods were back to
their long-run trend, and according to the GDP Indicator the pace of economic
contraction already slowed in April", VTB Capital senior economist Aleksandra
Yevtifyeva said in the report. "The most encouraging trend in the recent survey
is the moderation in unemployment growth in the manufacturing and services
sectors........This might lead to some stabilisation in consumption which has
shown an increasingly rapid decline in the past two months............Costs are
increasing at a lower rate, while prices charged are falling. The latter is
particularly important for the services sector, which recorded a drop in prices
for the first time in the past seven years".

Inflation Falls Back

Russia’s inflation rate fell more than expected in April, dropping to 13.2 percent after rising in March to 14 percent, and consumer-price growth slowed to 0.7 percent in the month, the Federal Statistics Service said yesterday, compared with 1.3 percent in March. Food price growth slowed to 0.6 percent in the month from 1.7 percent in March, according to the statement. In the year the rate eased to 14.5 percent from 23 percent in April 2008.

Allowing The Central Bank To Cut Rates

Russia’s central bank cut its main interest rates for the second time in less than a month last week. The bank cut its rates for the first time since 2007 on April 24. Bank Rossii lowered its refinancing rate to 12 percent from 12.5 percent and adjusted the repurchase rate charged on central bank loans to 11 percent from 11.5 percent.

The reduction is only the second since it made two increases in the refinancing rate and four in the repo during last autumn's financial crisis. Borrowing costs were increased to arrest a 30 percent drop in the currency since August, spurred by falling oil prices after investors pulled money out of ruble- denominated assets.

Bank Rossii has also said it plans to raise the mandatory reserve requirements for banks by a half-point every month between May 1 and Aug. 1. The requirement currently stands at 0.5 percent for reserves held in rubles and 0.5 percent for bank’s foreign currency reserves. The move seems to signal that the central bank is gradually phasing out the aggressive reserve requirement easing steps it implemented last October in order to relieve banks of ammunition to bet on the ruble’s devaluation. Along with the rate cuts, this suggests that the central bank is confident that inflation will slow.

“Probably for the first time in our new history, we’ll be
better than our official target” of 13 percent inflation, First Deputy Chairman
Alexei Ulyukayev said in an interview yesterday. As inflation slows, possibly to
11 percent, “we can talk about the continuation of cutting the policy rate.”

Ulyukayev also suggested it was “probable” the bank would cut the key rates by a total of 1.5 percentage points this year.

Industrial Output Slides At Record Annual Pace In April

Russian industrial production fell at a record pace in April. Output dropped an annual 16.9 percent, the sixth consecutive decline and the biggest since the Federal Statistics Service moved to a new methodology in 2003, compared with a 13.7 percent annual drop in March. Production fell 8.1 percent from March, when it was up by 11.1 percent on February.

“The situation in manufacturing didn’t improve at all,” said Vladimir
Tikhomirov, the chief economist at Moscow’s UralSib Financial Corp., before the
report. “Companies were still under a big strain to try to attract capital and
were diverting a lot of their investment money to repaying current debt.
Investment programs had to be postponed.”

Manufacturing output was down by an annual 25.1 percent in April, up from the 20.5 percent drop registered in March. Cement and brick output fell 34.7 percent and 39.9 percent respectively in April while production of trucks and vans fell 68.1 percent. Car production fell through the floor - dropping an annual 55.9 percent.

Mixed Signals All Round

Despite some positive indications in April (or should I say, some less negative ones) the April industrial output number is a shocker, and especially the strong fall from March (although this may well not be working day corrected, and remember there was Easter in the middle). This continuing decline in manufacturing is sure to hit employment, and Ford began talks this week with the union at its plant near St. Petersburg to cut the workweek to four days to avoid overproduction, citing an anticipated 47 percent 2009 slump in what is now Europe’s second-biggest car market.

In a further sign the contraction may have picked up speed again, Russian producer prices fell by an annual 4.1 percent in April after falling 2.8 percent in March, according to the Federal Statistics Service in Moscow said today, although prices actually rose 2.4 percent from March. This was the fifth consecutive month of year on year price reduction.

Obviously a lot now depends on the evolution in oil prices, and Urals crude, Russia’s principal oil export blend, shot up 6.2 percent in April to $49.61 a barrel. However many analysts are question just how sustainable this surge in prices will prove to be given the very large current global capacity overhang.

Th ruble jumped to its strongest level in four months against the dollar today (Tuesday) as oil rose above $60 a barrel in New York trading. Some analysts, however, pointed to the fact that banks were also buying local currency to repay state loans and make tax payments. Russian banks need to pay back about 181 billion rubles ($5.7 billion) in unsecured loans plus interest by tomorrow, and 408 billion rubles in taxes must be paid by the end of May, according to Evgeniy Nadorshin, senior economist at Moscow’s Trust Investment Bank in a research note. Banks gained access to unsecured loans from the central bank in November as the government sought to bolster liquidity in the financial sector. Lenders have till tomorrow till tomorrow to repay the loans plus yield issued in auctions on April 13, Feb. 16 and on Nov. 17, according to Nadorshin.

Another possible reason for the firming of the ruble was pointed to by Deutsche Bank analysts in a recent research note: the juicy picking to be had from carry - juicy as long as the ruble doesn't change course - given the high yield differential offered by Bank Rossii rates:

Currency deals that profit from the difference in interest rates globally are returning to favor on speculation the worst of the credit crisis may be over, spurring investors to buy eastern European assets, Deutsche Bank AG said. The Russian ruble, Hungarian forint and Turkish lira offer investors the best returns in the next two to three months thanks to the highest rates in the region, said Angus Halkett, a strategist at Deutsche Bank in London.

What this points to is the danger of "lock-in" here. The risk that the Russian central bank may not be able to reduce rates even as the economy contracts and inflation falls, since lowering beyond a certain threshold will almost certainly produce another bout of devaluation, and with it the danger of more conversion of rubles into dollars and general capital flight. This could be called "being stuck up a gum tree".

Whatever the reasons - and high central bank interest rates will be one of them - the ruble has now clawed back some 13 percent of its 35 percent devaluation against the dollar in the six months preceding the end of January.

The Putin rescue programme does not seem to have worked as envisaged , and according to President Dmitry Medvedev (who may well have his own axes to grind) $9 billion slate of state guarantees “failed” to kick-start lending to strategic companies. The World Bank warned in their March report that a “silent tsunami” of bad debt still threatens to stall a recovery in the world’s largest energy-exporting economy, and as a growing number of companies default on loans, the government may need to provide as much as $50 billion for bank bailouts, more than twice the amount pledged to banks in this year’s budget, according to estimates by analysts from UniCredit's Russian unit.

Finally, one of the reasons for the disparity between the more positive movement in the GDP indicator and the deterioration in general operating conditions may well be that the former does not include the key construction industry. Billionaire Mikhail Prokhorov, Russia’s richest man, said Russian property developers may suffer more as the country slides into the worst economic slowdown in a decade. “The crisis hasn’t hit developers in full yet,” Prokhorov told reporters in Yelets, Russia, on May 15. “The worst is yet to come.”

Sunday, May 17, 2009

Slovakia Takes The Biscuit - GDP Drops 11.2% In Three Months

I've been trying to draw attention to what is happening to Slovakian GDP for some months now, since I felt the consensus has been missing something (see this post, and this one). The Economist, for example, has been arguing some sort of version of Baltic and Hungarian exceptionalism in Eastern Europe, and even pointing to Slovakia as a positive example to be followed.

“Most other countries in the region are faring much better, though….Like Slovenia, which joined two years ago, Slovakia can enjoy the full protection of rich Europe’s currency union, rather than just the indirect benefit of being due to join it some day.”
This example is far from isolated, yet, as I have already indicated in this post, the April EU sentiment indicator showed that business and consumer confidence in Slovakia was doing rather worse than the even that in the Baltics, so something relatively unpleasant was obviously happening.

And now we know for sure that it was, since according to last Friday's flash data release from the national stats office Slovakia's economy contracted by 5.4 percent year on year during the first three months of 2009. By way of comparison we could note that the economy expanded by 8.7 percent year on year in the first quarter of 2008. The latest results simply confirm what most Slovak economy watchers, the central bank, the European Commission and others already knew: the country is set to enter recession and remain there throughout 2009.

While the sharpness of the contraction in the first three months is pretty eyebrow raising, it does not come as a total shock, since in its revised GDP estimate released on April 7, the National Bank of Slovakia had already forecast that Slovakia’s economy would contract by 2.4 percent over the course of 2009. At the end of 2008 the bank was projecting growth of 2.1 percent for 2009, so the turnround is pretty sharp. And while the local stats office haven't yet given us a seasonally adjusted quarterly figure for the contraction, last Friday's Eurostat EU GDP release gave the figure of 11.2% for Slovakia q-o-q (which may well not be seasonally corrected, so I am evidently not suggesting they were dropping at a 44.8% rate in the quarter, which would obviously be ridiculous).

Total employment is also also down, falling in the first quarter of 2009 by 0.4 percent year-on-year, so that at the end of March there were 2,199,900 persons employed, according to the stats office.

In presenting the data, František Palko, state secretary of the Economy Ministry, argued that a year-on-year drop in GDP by as much as 5 percent had been expected in the first quarter due to impacts of the Russian gas crisis - which affected Slovakia at the beginning of the year - and the decline in external demand for Slovakia's products.

Certainly this decline is evident, since Slovak industrial output fell 22.9 percent in the first three months of the year, led unsurprisingly by the car industry, which had previously been the growth motor. In fact Slovak industrial output contracted at a slower inter-annual pace in March following a record plunge in February since European government incentives helped with car production and the electronics industry continued to expand. Output was down an annual 18 percent, making March the sixth consecutive month when production has contracted, a figure which compares with the revised 25.6 percent decline in February. Car production was down 30.1 percent year on year, compared with a 44 percent drop in the previous month.

The lions share of the fall in industrial output was due to a fall in demand for exports - Slovakia is a small, trade-dependent economy, and March exports decreased by 20,1 % compared with March 2008. Imports were down even more, by 23,1 %, and as a result the trade balance was in surplus (EUR 81,9 million). Over the first three months, as compared with the corresponding period last year, total goods exports were down by 28,6 % and total goods imports by 28,2 %. The quarterly trade balance registered a deficit of EUR 51,2 million (up by EUR 45,6 million compared with the same period in 2008).

Inflation Heading To Zero

The net result of the collapse in demand is an increase in the output gap and strong downward price pressure - in particular since as a member of the eurozone Slovakia no longer has its own currency to devalue. So it is hardly surprising to find the country's EU harmonized annual inflation rate falling back to 1.4 percent in April, its lowest level since August 2007, and down from 1.8 percent in March. Month on month, prices fell by 0.1 percent following a 0.3 percent decline in March.

Indeed Slovakia is on the threshold of negative year on year inflation since consumer price indexes (both the general index and the core one) have actually been flat now since the start of the year (see chart below).

Waning demand is also leading companies to cut back on their workforces, pushing the March unemployment rate to 10.33 percent, the highest in almost three years. The rate, which is the highest since June 2006, was up from from 9.72 percent in February, according to the Bratislava based National Labor Office. The number of unemployed available for work in the country of 5.4 million people increased to 273,779 from 257,564. The unemployment rate has now been rising steadily from a record-low of 7.36 percent achieved in August last year. The EU harmonised rate published by Eurostat was up at 10.5% in March, from 10% in February.

Despite all the talk of Slovakia having a "fexible" labour market, 7.36% is still a very high rate of employment to run when the economy is experiencing a massive boom, so it will be very interesting to see the actual rate of downward movement in wages (and prices) as the recession moves forward (another kind of "stress testing").

Pressure On Public Finances

Slovakia’s central budget deficit widened to 347.4 million euros at the end of April as the economic slowdown cut into tax revenue, according to the Finance Ministry. Revenue for the first four months of the year was 3.32 billion euros, lower than expenditure which amounted to 3.67 billion euros. The shortfall compares with a 204.6 million-euro difference in March and a surplus of 257 million euros at the end of April 2008. Slovakia originally targeted a central government budget deficit of 1 billion euros in 2009, or a shortfall of 2.1 percent of gross domestic product.

The Finance Ministry now estimates tax revenue will be about 1 billion euros short of the original projection, which was based on an expectation for GDP growth of 2.4 percent this year. The central bank now forecasts the economy will shrink 2.4 percent.

In 2008, the general government deficit increased to around 2.25% of GDP. The better-than expected budget outcome was the result of a number of the revenue-increasing measures (e.g. broadening of the corporate and personal income tax base, increase in the maximum ceiling on social contributions), which offset the revenue shortfall due to the deteriorating economic situation.

The 2009 general government deficit is forecast by the EU Commission to increase to 4.75% of GDP. On the revenue side, the anti-crisis packages include measures such as a temporary increase in the tax-free part of income from €3,435 to €4,027, an in-work benefit for low-income employees (negative income tax), as well as a decrease in social contributions for mandatorily insured self-employed. On the expenditure side, the bulk of the measures with budgetary impact are related to the subsidies for R&D activities, for programmes aiming at increasing energy efficiency and supporting existing or newly established SMEs as well as for the Slovak cargo and railway company.

The EU Commission expect the general government deficit to rise to 5½% of GDP in 2010, with the debt-to-GDP ratio increasing from 27.5% of GDP in 2008 to some 36% in 2010. Despite the deficit in excess of 3% of GDP, gross public debt is still very low, and ratings agency Standard & Poors were generally pretty positive in their most recent Slovakia outlook. They did however see two significant challenges lying ahead for Slovakia.

1) Firstly the rather obvious point that here is an increasing risk to the economy from Slovakia's high exposure to the auto sector.

2) And secondly, the rather more important point that since conversion to the euro was undertaken when the Slovak Koruna was trading at a short term peak - the government were using currency appreciation to soak up inflation and stay withing the Maastricht euro limits (see this post here) - Slovak exports are now somewhat penalised compared with those coming from some of their neighbours (the Czech Republic, Poland and Hungary) - in terms of competitiveness, since while they were also using currency appreciation as an anti inflation posture during the height of the commodities surge, they have since been able to "correct" and allow their currencies to devalue. Personally I can't stress too strongly how important an issue I think this is.

The Slovak economy is very open, and indeed has become impressively more so in recent years. It is in fact the third most open economy in the EU after Luxembourg and Malta, according to Eurostat data (in the sense of a “small open economy”). In terms of trade in goods, Slovakia is even the most open economy in the EU. This situation in part reflects the country's small size - Slovak GDP represents only 0.6% of eurozone GDP, or some 2.4% of German GDP. Given Slovakia is so small and so open, a high proportion of domestic demand will now be met by imports from “cheaper” neighbours (notably Hungary and Poland). So Slovakian growth will have to rely more on investments in productive capacity and exports.

As I said above in this sense a shift in emphaisis is called for, since the economy is incredibly vulnerable to the automotive sector, and this in a situation where European car sales have slumpled, is, as weak can see, a lethal flaw. In fact the situation has been made worse by the recent wave of government-backed incentives, since they have only exacerbated the slump in demand for luxury models - like the Cayenne, the Audi Q7 and the Volkswagen-brand Touareg SUVs - which are over-represented in the Slovak sector ((in contrast, theCzech car industry is strongly profiting from car scrapping subsidies). These subsidies together with accompanying environmental incentives have shifted Europe’s shrinking car demand toward smaller and more fuel-efficient models, and hence global No.1 luxury carmaker Bayerische Motoren Werke AG’s registrations dropped by almost one-third in April (to 55,633) even as the German market as a whole expanded 19 percent. Daimler recorded a 26 percent sales decline to 60,214 cars, led by its Mercedes luxury brand.

The Slovak government has been having some success in diversifying the economy, for instance by attracting Sony and Samsung production facilities. Production of cars was down 30.1 percent in March, while output in the electronics industry rose an annual 50.3 percent.

More worryingly, the amount of foreign-investment pledged to Slovakia slumped 92 percent in the first quarter of the year as the global slowdown prompted companies to delay expansion. The only two projects brokered by the state SARIO investment agency in the first three months represent a total investment of 8 million euros, with the potential to create 220 jobs, according to spokeswoman Jana Murinova. In the same period last year, the agency negotiated nine projects worth 103 million euros and creating 1,455 jobs.

Slovakia adopted the euro last January, is now feeling the pressure of price competitiveness from neighbours who have retained an autonomous capacity to devalue their currency as investors as scale back expansion plans during the slowdown. During 2008 Slovakia attracted investment projects worth 538 million euros, less than a half of the 2007 total of 1.28 billion euros.

The Slovak case raises important questions, not least about the rigid application of the Maastricht criteria in a situation where they may not only have lost much of their original relevance, but even where they may lead to distortions - as in the Slovak case - which may mean a painful period of internal wage and price deflation is necessary to overcome the loss of competitiveness produced by entering the common currency at an unrealistically high parity .

Slovakia may now face a difficult period (like Portugal - see this post) of internal price adjustment having entered the euro at too high a rate. The openness of the economy will require more price and wage flexibility. Slovakia joined EMU with a relative strong exchange rate. Currencies of neighbouring countries have been depreciating significantly against the euro. So we are seeing strong deflationary pressures, and average industrial wages fell an annual 0.6 percent in March, following a 1.9 percent fall in February. In nominal terms, average monthly wages rose to 718 euros from 687 euros in February. However, for now these are nowhere near on the same scale as, for example, the impact of the drop in sterling on Ireland.

On a side issue Slovakia issued a 2 billion euro, 2015-dated bond yesterday at 170 basis points over mid swaps. So this can give you some idea what new eurozone members can expect in the future, somewhere up there in the spreads with Greece and Ireland. Slovakia is rated A1 by Moody's Investors Service, A+ by Standard & Poor's Corp. and A+ by Fitch Ratings.

So, while Hungary is still the worst performer among CEE EU member economies the two recent members of the Eurozone - Slovenia and Slovakia - are doing worse than anyone would have imagined, and this should lead to some serious questions being asked in Brussels and Frankfurt. Why is it that, for example, participants in a crisis racked economy like Latvia (whose economy is contracting at an 18% annual rate, and whose bankers and politicians are moving heaven and earth to try to scrape through the qualifying hurdle for eurozone membership) are still feeling better than many economic agents in the Eastern two countries who have actually managed to access the zone according to the latest reading of the EU Economic Sentiment Index. Eurozone membership is not a one way street, far from it. So what are the benefits, and what are the dangers, and how do we optimise the membership process?


Portugal Sustains - what are the lessons of Portugal's membership of the Eurozone (12 January 2009)

Slovakia’s Euro Membership Bid (April 21 2008)

Let The East Into The Eurozone Now! (22 February 2009)