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Wednesday, February 25, 2009

Russia's Economy Declines At An 8% Annual Rate In January

Russia’s economy contracted at an annual rate of 8.8 per cent in January, according to the latest statement by the Russian economy minister. This data point, which provides us with the latest confirmation that a very sharp contraction is now taking place in Russia, follows last week's announcement by economic development minister Elvira Nabiullina, economic development minister, that the economy shrank by 2.4 per cent between December and January. Industrial production also fell 16 per cent year-on-year in January, while there was a 17 per cent decline in construction.

It also gives us some indication of the viability of VTB’s Russian GDP Indicator (as posted here) which indicated a year on year rate of contraction of 4 percent in January, down from December’s 1.1 percent decline, and November's 2.1 percent expansion. This is somewhat under the actual reading, but it is an estimate in real time (we got this at the start of February) and it was by far the nearest estimate I have seen. The Russian government is currently forecasting a contraction of only 2.2% for this year, which has to be way, way too optimistic as things presently stand.

In its official estimates, the economy ministry said the global downturn was filtering deeper into the real economy and had begun to weigh heavily on ordinary citizens.

"Among the negative consequences of the deepening crisis, we can now count a notable drop in the population's real income growth (6.7 percent), increasing unemployment and, as a result, falling consumer demand," the ministry said. "The most important reasons for the economic fall of January 2009 is the significant fall in industrial production, the decline in investment activity, a drop in construction and slowing consumer demand."

Among the hardest-hit segments, the ministry cited fertiliser producers, which cut output by 42 percent, while tyre producers reduced their output to almost zero. Car production also fell, by 80 percent, and the ministry cited lack of cheap car loans amid a general decline of personal income and excessive production in 2008. Retail sales and agriculture still remained in positive territory areas which were still growing - at 2.4 percent and 2.6 percent respectively - although they are already down sharply and there is evidently more to come.

Exports fell more than 40 percent to $20.2 billion as the country exported less oil and gas at lower prices, while imports fell by a third to $10.3 billion as a 35 percent rouble devaluation, which continued throughout January, started hitting importers. Consumers of heavy machinery reduced purchases of foreign equipment by 47 percent and food and chemical imports fell by 25 and 29 percent, respectively.

Unemployment Up Sharply

Russia’s unemployment rate rose to 8.1 percent in January, the highest since March 2005. The total number of unemployed rose by 300,000 in the month to 6.1 million people, or 8.1 percent of the working population. This follows an 800,000 rise in December.

Rising unemployment is the “biggest problem” and the “biggest pain” for Russia as it goes through its worst economic crisis in a decade, President Dmitry Medvedev said in an interview on state television on Feb. 15.

The average real (ie inflation adjusted) monthly wage fell an annual 9.1 percent in January to 15,200 rubles ($418.42), the biggest drop since August 1999 when they fell 30.7 percent. Real disposable income fell 6.7 percent.

All of this, of course, has quite serious implications for Russia's public finances, and the budget deficit is now projected to reach 8% of GDP in 2009, according to Nabiullina, who said the figure took into account so-called quasi-budgetary expenditures in the form of subordinated loans to business, which would (in principle) be repaid at a later date. The federal budget for 2009 originally set expenditures at 9.024 trillion rubles ($250 billion at current exchange rates) and revenues at slightly over 10 trillion rubles ($277 billion), but the drop in oil prices has cut the expected income dramatically.

The budget was based on an average oil price of $95 per barrel for the year, but is being recalculated based on a figure of $41 per barrel.

Tuesday, February 24, 2009

Latvia Downgraded To "Junk" By S&P

And the Swedish Krona clearly didn't like the news.

Standard & Poor's Ratings Services today said it had lowered its sovereign credit ratings on the Republic of Latvia to 'BB+/B' from 'BBB-/A-3' and removed the ratings from CreditWatch negative, where they were placed on Nov. 10, 2008. The outlook is negative.......

We believe the necessary process of private sector deleveraging is likely to continue over several years, during which time real incomes will decline, testing Latvia's commitment to both its exchange rate regime and its obligations under the EUR7.5 billion assistance program from the IMF, EU, and other official lenders. The adjustment is made more difficult as external demand for Latvia's key exports continues to decline."

The negative outlook reflects the likelihood of a further downgrade later this year or in 2010 if we believe the government is wavering from its economic agenda in a manner that intensifies currency pressures and risks delays in disbursements from official creditors. If the Latvian financial sector retains access to international markets at reasonable cost, economic prospects brighten on the basis of improved competitiveness, fiscal targets are met, and the near-term prospect for Eurozone entry improves, the ratings could stabilize at the current level.

Standard & Poor's also said it had placed its 'A/A-1' sovereign credit ratings on the Republic of Estonia, and its 'BBB+/A-2' ratings on the Republic of Lithuania, on CreditWatch with negative implications. Which means that both of these may be up for downgrades in the not too distant future.

The IMF are about to withdraw to base camp to observe developments from afar, although it is possible that they have laid out their "conditions" for the incoming government, but since they have no effective "interlocutor" it is not clear whether these conditions are going to be completely acceptable or not at this point. Christoph Rosenberg, IMF mission chief to Latvia, issued the following statement today in Riga:

"The program supported by the IMF, the EU, and other bilateral and multinational donors is meant to sustain policies that will put Latvia back on a sustainable path, not particular political parties or coalitions. As long as appropriate policies are in place, such support will continue.

As IMF Managing Director Dominique Strauss-Kahn has said, the IMF will continue its technical work with the Latvian authorities. The IMF mission currently in Riga for the first review of the program has, jointly with a technical team from the European Commission, made a lot of progress in identifying issues that need to be addressed.

The IMF mission will return to Washington at the end of this week and continue its work with the authorities from there. It will be ready to return to Riga and continue the discussions after a new government has taken office."

While EU Economy and Finance Commissioner Joaquin Almunia seems to be hinting that the EU may be "readying up" intervention. Well, if that isn't what he's doing then I am at a total loss to understand what he is up to.

The European Union could have to bail out a member state in financial trouble but such a move is unlikely, especially among countries in the euro zone, EU economic chief Joaquin Almunia said on Monday.

States such as Hungary and Latvia have received assistance from the EU, and other countries within the 27-member bloc might need a financial support programme, said Almunia, who is European economic and monetary affairs commissioner.

"You can't rule out that a country outside the euro currency might come to need this assistance," he said during an economic conference in Madrid. "We don't think we'll get to this position."

Almunia said euro zone countries were better off and less likely to need EU help. "With the euro zone the position is not the same, either in terms of public debt, foreign debt or the ability to react to this recession," Almunia said.

And the cost of Baltic country CDS not surprisingly shot straight up:

The cost of insuring Latvian sovereign debt for five years rose on Tuesday by more than 30 basis points after Standard & Poor's cut the country's sovereign rating to junk.

Five-year credit default swaps (CDS) for Latvia were quoted at a mid-price of 977.4 basis points, according to CMA DataVision, up from their Monday close of 943.7 bps. Five-year CDS for Lithuania hit a record high of 861.7 bps after the S&P move, compared with Monday's 831 bps. For Estonia, five-year CDS rose to 733 from 730.7 bps.
Below is a chart for Latvia's 10-year Eurobond (quoted yield to maturity) maturing on 5 March 2018, it is now trading some 700 bps in the mid (755 in the bid) over the closest (by maturity) German bund. Apart from noting today's market reaction it is possible to see how the spread, after settling down following the IMF-lead deal, has now opened right up again to the level of the previous October highs.

Moody's Investors Service also said today that it can no longer rule out a Lithuanian currency devaluation, although it was at pains to point out that this was not its central scenario. In the course of its annual ratings review Moody's said the following:

"Even though the net benefits of abandoning the currency board would probably be negative, a devaluation can no longer be ruled out in the current environment, but this is not Moody's central scenario,"

Last week Brown Brothers Harriman & Co. warned that Latvia’s weakening economy might force the government to ease its policy of managing the lats, spurring all three Baltic currencies to break their pegs by mid-year producing a fall of anything up to 50 percent to the euro.

“Latvia stands out as the weakest of the three because its external debt is very high and it’s got a big current-account deficit,” said Win Thin, New York-based senior currency strategist at the oldest privately-owned U.S. bank. “The contagion between the three is so strong that if Latvia broke the others wouldn’t be able to resist.”

Standard and Poor's also issued a more general warning today about the parlous state of many of the Eastern economies. In a report titled "Market Dislocation Exposes Vulnerability Of Eastern European Economies," published yesterday the agency stated that the resilience of Eastern European economies seems to be crumbling under the weight of high foreign currency debt and the potential reprioritization of lending among foreign banks.

"The financial crisis that started to hit developed economies after August 2007 did not immediately affect East European economies," said Jean-Michel Six, Standard & Poor's chief economist for Europe. "In fact, through the first half of 2008 their economic prospects still appeared resilient. But in the second half of 2008, the effects of the crisis started to filter through the region and are now gathering momentum."

In particular S&P's singled out the Baltics, Hungary, Romania and Bulgaria as especially vulnerable.

The Baltic states (Estonia, Latvia, and Lithuania), Bulgaria, Hungary, and Romania. For this group the level of economic vulnerability is high. The Baltic states face significant external financing requirements that make them highly vulnerable to a cut-off in capital flows. Each maintains a currency board (except for Latvia), and the pegs to which their currencies are linked remain under heavy pressure, as they have since the middle of last year. Bulgaria's main vulnerability, meanwhile, remains its massive current account deficit. As foreign financing becomes much tighter, the Bulgarian economy is likely to experience a painful period of adjustment in 2009 and 2010, with GDP growing about 1% this year and close to 2% in 2010, and a negative growth scenario cannot be excluded. A similar rationale applies to Hungary, where we expect GDP to decline by 2.5% this year before experiencing a mild recovery of 0.5% in 2010. Romania, once one of the economic high-fliers, is also poised to slow sharply in 2009. After an impressive 7.3% in 2008, we believe GDP growth will plummet to 0.8% this year.

Sunday, February 22, 2009

Let The East Into The Eurozone Now!

“It’s 20 years after Europe was united in 1989 – what a tragedy if you allow Europe to split again.”
Robert Zoellick, World Bank president, in an interview with the Financial Times

(Click On Image To View Video)

World Bank president, Robert Zoellick, made a call this week - in an interview with the Financial Times - for a European Union-led and co-ordinated global support programme for the economies of Central and Eastern Europe. I agree wholeheartedly, and even if I have, reluctantly, to accept the point made last week by our Economy & Finance Commissioner Joaquin Almunia that our pockets, though deep, are certainly not bottomless (and thus it is probably beyond our means right now to rescue the non-EU Eastern states), I still feel we should make good on our responsibilities to those who are EU members, and to do so by opening the doors of the Eurozone to those who wish to join. Since this proposal is fairly radical, the justification that follows will be lengthy.

This is not a view I have arrived at lightly, but looking at the extent of the problem we now have before us, a problem which is growing by the day, and taking into account the fact that the origins of the economic crisis in the East must surely rest (at least in part) in the decision to make euro participation a condition for EU membership for these countries (a possibility which was subsequently withdrawn in the critical moment, when the going started to turn rough), and then assessing the risk to the Western European banking system which would be posed by simply sitting back and watching it all happen, I think this move is not only the least damaging of the policies we can now follow, it is the in effect the only viable path left to us if we are to keep the eurozone as an integral entity together.

If this proposal were accepted a new set of membership criteria would need to be drawn up, of course, but the underlying principle would have to be one of offering the certainty of entry as guaranteed forthwith, for those who chose to accept. Rules were made to be broken, and nothing should be so inflexible - not even the Maastricht eurozone membership criteria - that it cannot be ammended as circumstances dictate. And at this point even the undertaking that this - like the long awaited US Stimulus programme - was on the table, would be sufficient to provide immediate, and much needed relief. Flirting with doing nothing here is, in my opinion, flirting with disaster, both in the East and in the West.

Existing Maastricht Criteria

Convergence criteria (also known as the Maastricht criteria) are the criteria for European Union member states to enter the third stage of European Economic and Monetary Union (EMU) and adopt the euro. The four main criteria are based on Article 121(1) of the European Community Treaty. Those member countries who are to adopt the euro need to meet certain criteria.

1. Inflation rate: No more than 1.5 percentage points higher than the three lowest inflation member states of the EU.

2. Government finance:

Annual government deficit: The ratio of the annual government deficit to gross domestic product (GDP) must not exceed 3% at the end of the preceding fiscal year. If not, it is at least required to reach a level close to 3%. Only exceptional and temporary excesses would be granted for exceptional cases.

Government debt: The ratio of gross government debt to GDP must not exceed 60% at the end of the preceding fiscal year. Even if the target cannot be achieved due to the specific conditions, the ratio must have sufficiently diminished and must be approaching the reference value at a satisfactory pace.

3. Exchange rate: Applicant countries should have joined the exchange-rate mechanism (ERM II) under the European Monetary System (EMS) for 2 consecutive years and should not have devaluated its currency during the period.

4. Long-term interest rates: The nominal long-term interest rate must not be more than two percentage points higher than in the three lowest inflation member states.

The Dimensions Of The Problem

European governments, the European Union and international financial organizations need to act fast on risks stemming form banks’ exposure in the eastern part of the continent to avert an escalation of the credit crisis, Nomura Holdings Inc. said. East European countries are struggling to refinance foreign- currency loans taken out by borrowers during years of prosperity through 2007, when economic growth averaged at more than 5 percent. The International Monetary Fund, which has bailed out Latvia, Hungary, Serbia, Ukraine and Belarus, warned on Jan. 28 that bank losses may widen as “shocks are transmitted between mature and emerging market banking systems.” “Swift action is needed to restore confidence and prevent trouble” to financial and economic stability in the euro region and emerging Europe, said Peter Attard Montalto, an emerging markets economist at Nomura International in London. “Any move should be quick. The situation has begun to decline more rapidly since the end of last year and there is risk that any action may come too late.”

Robert Zoellick is far from being a lone voice in the wilderness about the current level of risk to the coutries in the East, and indeed precisely those EU banks who have been most active in emerging Europe are now busily trying to convince EU regulators, the European Central Bank and Brussels itself to coordinate new measures to counter the impact of the financial crisis confronting the region. The problem in the East certainly now adds a new dimesion to the problems facing us here in Europe, since West European governments are now being simultaneously hit on a number of fronts, and the situation is become more complicated by the day.

In the first place most West European economies are now either in or near recession, and their domestic banking systems are, to either a greater or a lesser extent, struggling. The West European states are thus, by and large, already feeling stress on their own sovereign borrowing capacities. But, with greater or lesser effectiveness, these countries are still able to increase their debt, even if sometimes the surge in borrowing is very dramatic, as in the case of Ireland, which will see gross debt/GDP shooting up from 24.8% in 2007 to a projected 68.2% in 2010 (EU January 2009 Forecast).

The situation in Eastern Europe is very different, and their economies and credit ratings evidently can't support such dramatic increases in their debt levels. Thus, in the case of those countries with a significant home banking presence, like Latvia's Parex, or Hungary's OTP, the support of external organisations (the IMF, the World Bank, the EU) becomes rapidly necessary when the bank concerned starts to have liquidity problems. But as a result of the consequent bailout the debt to GDP ratio starts to rise in a way which then places even subsequent eurozone membership in jeopardy. Latvia's Debt/GDP is, for example set to rise from around 12% of GDP in 2007 to over 55% in 2010. With a 10% plus GDP contraction already in the works for 2009, it is clear that Latvia's debt to GDP will rise beyond the critical 60% level. Hungary's debt/GDP is already above, and rising. If we don't do something soon, these two countries at least are being launched off towards sovereign default.

But the other half of this particular and peculiar coin turns up again in a rather unexpected way, and that is in the form of those West European banks who have subsidiaries in CEE countries, and who find now themselves faced, not with bailouts, but with ever rising default rates. This difficulty evidently and inevitably then works its way back upstream to the parent bank, and to the home state national debt, as the bank almost inevitably needs to seek support from one West European government, or another (in fact Unicredit, which has difficulty getting money from an already cash-strapped Italian government is talking of applying for support from the Austrian government via its Austrian subsidiary).

Austria is, in fact, a very good case in point here, since, as Finance Minister Josef Proell recently indicated, the country had some 230 billion euros of debt outstanding in Eastern Europe, equivalent to around 70 percent of Austria's GDP. The Austrian daily "Der Standard" have also reported the analysts view that a failure rate of 10 percent in Eastern Europe's debt repayments could lead to serious difficulties for Austria's financial sector. And this is no hypothetical "what if" type problem since the European Bank for Reconstruction and Development (EBRD) has estimated Eastern Europe's bad debts could go over 10 percent and could even reach 20 percent in the course of the current crisis. Underlining the mounting concern in Austria, Proell tried last week to convince EU finance ministers to provide 150 billion euros is support to CEE economies as a first step in trying to contain the growing wave of defaults.

The total quantity of debt outstanding is hard to put a precise number on, but the Bank for International Settlements estimated that, as of last September, more than $1.25 trillion had been leant by eurozone banks, and if you add in U.K., Swedish and Swiss bank liabilities the number rises to $1.45 trillion.

Western Europeean banks have a very important market share in the East, ranging from a low of 65 percent in Poland to almost 100 percent in the Czech Republic. This basically means two things, that the region's businesses and consumers are extraordinarily dependent on uninterrupted capital inflows from the West, and that some West European banking systems are extremely sensitive to rising default rates in the East. Of course the problem goes beyond the EU's borders, and while EU bank market shares in the Community of Independent States is rather less significant than in the EU12, due to the still substantial domestic ownership which exists there, exposure to defaults is not unimportant, especially in Ukraine, Kazakhstan and, of course, in Russia itself. Further, there is South East Europe to think about, and countries like Serbia and Croatia.

Large Banks Take The Initiative

Getting near to desperation, some of the largest banks involved - Italy's UniCredit and Banca Intesa, Austria's Raiffeisen International and Erste Group Bank, France's Societe Generale and Belgium's KBC - have launched a common initiative to try to lobby for an EU wide solution to the problem.

UniCredit is the largest lender in Poland and Bulgaria, while Erste is number one in Romania, Slovakia and the Czech Republic, with KBC occupying the position in Hungary, Intesa in Serbia, and Raiffeisen in Russia and Ukraine. Hungary's OTP Bank, emerging Europe's number 5 lender and the largest one in its home country, does not formally belong to the group. On the other hand OTP is actively looking for support.

OTP Bank Nyrt., Hungary’s biggest bank, said it’s in talks over a “role” for the European Bank for Reconstruction and Development, as it announced a 97 percent drop in fourth-quarter profit and “substantial” job cuts. As well as a possible EBRD involvement, OTP may also seek funds from Hungary’s emergency loan package from the International Monetary Fund, the European Union and the World Bank to “better serve the economy,” Chairman and Chief Executive Officer Sandor Csanyi said at a press conference in Budapest today. “There’s a chance the EBRD will assume a role in OTP, but I must stress that we plan no issue of new shares,” he said. OTP “doesn’t need to be saved,” Csanyi added.
Chancellor Angela Merkel, while expressing support for the bank initiative, has stopped short of offering concrete assistance or suggesting measures beyond those which are already in place.

The president of the European Bank for Reconstruction and Development, Thomas Mirow, wrote in the Financial Times this week the bank proposals "deserve full support as a worsening crisis in emerging Europe will threaten Europe as a whole".

The Austrian government has already announced it is trying to raise support for a general European Union initiative to rescue the region’s banking system. The government has set aside 100 billion euros in cash and guarantees to stabilise its banking sector. Next in line in terms of exposure are Italy ($232 billion), Germany ($230 billion) and France ($175 billion).

Unicredit is publicly rather dismissive of the problem (as can be seen from the slide below which from a presentation they gave earlier this week, please click on image to see better), but Italian investors are far from convinced by their arguments, as witnessed by the fact that their stock has plunged 41 percent this year, and by the fact that they were forced to sell 2.98 billion euros in 50 year bonds this week to shore up their Tier I capital after investors only bought about 4.6 million shares, or 0.48 percent, from their most recent rights offer. UniCredit, which said last month it is considering asking for government assistance, has also been disposing of assets to raise money and it plans to pay shareholders their dividends in yet more shares. Nationalisation of banks to supply credit lines to the private sector is one hypothesis currently being studied by Silvio Berlusconi, according to a Financial Times report this morning.

(Click on image for better viewing)
The Austrian proposal includes funds from the European Investment Bank, the European Central Bank and the EU Cohesion Fund. The Austrian government has offered money of its own and has been urging Germany, France, Italy and Belgium as well as the EU itself to contribute. One feature, however, stands out in all of the proposals which have so far been advanced: they are loan based-support. What Soros calls the "tricky question" of fiscal allocation from Europe's richer member states has not so far been raised, but it will be, since it will have to be.

And of course, Austria's concern is far from being altruistic, as Austria's economy and sovereign debt stability depend on finding a solution. It is hardly surprising to learn that credit-default swaps linked to Austrian government debt soared this week - by 39 basis points to a record 225 - on concern the country will need to bail out the domestic banks itself as they report losses and writedowns linked to eastern European investments. Erste, which said last week that full-year profit probably slumped by almost 26 percent, is in talks with the government to get 2.7 billion euros ($3.4 billion) in state aid. RZB has asked for 1.75 billion euros.

The European Central Bank on the other hand, seems reluctant to extend emergency financial help to crisis-hit countries beyond the 16-country eurozone. The ECB did not have “a mandate to be a regional United Nations agency”, Yves Mersch, governor of Luxembourg’s central bank, recently told the Financial Times. Such comments reveal the level of resistance which exists within the ECB’s 22-strong governing council to the idea of offering financial support to countries outside the zone.

The ECB has so far offered loans to Hungary and Poland, but has attached what some consider to be excessively strong conditions on facilities allowing them to borrow up to 5billion and 10billion euros respectively. Mr Mersch, whose views are thought to be widely shared in the ECB, suggested the central bank was worried about setting precedents if it relaxed its stance on helping individual countries. While some euromembers might favour assisting nearby nations, “we must not forget that other people might be sensitive to different countries”.

Who Bails Out The West European Banks In The East?

Governments and EU officials are struggling to formulate a coherent response to the economic and financial turmoil that has started to engulf the eastern part of the old continent. EurActiv presents a round-up of national situations with contributions from its network. Leaders of EU countries from central and eastern Europe will meet on 1 March ahead of an extraordinary summit on the same day with the bloc's other members, it emerged on Thursday (19 January). Polish Prime Minister Donald Tusk has invited his counterparts from the Czech Republic, Slovakia, Slovenia, Romania, Bulgaria, Lithuania, Latvia and Estonia for the talks to ensure the 27-nation meeting on the financial crisis is not dominated by the interests of Western member states. See full Euractiv article on background.

The EU has so far provided emergency balance-of-payments assistance to two of the East European member states in difficulty - Hungary and Latvia, and EU ministers did agree in December to more than double the funding available for such emergency lending to 25 billion euros ( so far Hungary has been allocated 6.5 billion and Latvia 3.1 billion). It is also quite probable that such lending will now have to be extended to the two newest southeast European members, Romania and Bulgaria, since their ballooning current account deficits and dramatic credit crunches mean that they are steadily getting into more and more difficulty.

The core of the problem is that the East European economies enjoyed strong credit driven booms, which fuelled higher than desireable inflation and lead to strong foreign exchange loan borrowing which simply bloated current account deficits. Now capital flows into emerging Europe have dried up as the global financial crisis has raised investors' risk aversion and prompted them to dump emerging market assets, leaving foreign-owned banks as the only source of loans for companies and consumers.

Italy's UniCredit, the biggest lender in emerging Europe, warned at the end of January that there was a clear risk of the global credit crunch gripping the region. UniCredit board member Erich Hampel stated at a Euromoney conference in Vienna that the bank was committed to fund its subsidiaries in the CEE countries and would continue to lend, but at the same time made absolutely clear that in order to do this his bank would need government support, whether from Austria, or Poland, or Italy itself.

Hampel said Bank Austria would decide during the first quarter whether to tap the Austrian government's banking stability package for fresh equity. " he said. "Our budget is under discussion now and clearly assumes growth in lending and in funding to the East. "

And according to a report from the Austrian central bank the fact that a relatively small number of Western European groups - including three Austrian ones - own most of the banks in Central and Eastern Europe means that there is the risk of a "domino effect", implying the crisis would spread quickly from one country to another. "How capital flows into (emerging Europe) will develop depends on the financial strength of the parent groups and of the sister banks, and on whether the parents are willing and able to fund their subsidiaries," the bank's half-yearly Financial Stability Report said. "The risks to refinancing are increased by the danger of a domino effect, because a large part of the foreign capital in many countries comes from a relatively small number of Western European banks," .

"What we see is that the emerging European economies have lost all sources of funding but banking," said Deborah Revoltella, chief economist for central and eastern Europe of UniCredit, the region's biggest lender. The task to carry whole economies through a downturn comes at a time when parent banks already face a double challenge: a likely sharp rise in loan defaults at their eastern subsidiaries and more difficult and expensive refinancing for themselves. "The international banks cannot solve this situation," Revoltella said. "They can do their part, and it's fundamental that they do their part but we have to take care of the other sources of funding which are missing now."
And it isn't only Austria who is worried, since Greek central bank governor George Provopoulos warned Greek banks only last Tuesday against transferring funds from the country's bank package to the Balkans, where they have invested heavily.

Regional Risks

In our view GDP growth is like to be negative in all CEE countries this year. In those countries “least” affected by the crisis (i.e. Poland, the Czech Republic, Slovakia and Slovenia) GDP is like to drop at least 2-5%, while those countries worst affected (i.e. the Baltic States, Bulgaria, Romania and Ukraine) are likely to face double digit declines in GDP. In other words, in terms of expected output lost in the region this is as bad as or even worse than the Asian crisis of 1997-98.
Danskebank - CEE: This Looks Like Meltdown

The problem that the EU has in adressing the situation in the Eastern member states is that what we have on our hands is not only a banking crisis, there is also a strong credit crunch at work, one which is now having a severe impact on the real economies in the region. Most of the economies in the region are already in recession, and those that are not soon will be (I have intersperced a number of relevant graphs throughout this post which should give some general impression of what is happening). Thus these countries are all taking multiple hits at one and the same time.

1/ In the first place they have an economic contraction on their hands, in some cases becuase they are struggling with a steep decline of export demand from western Europe, in others because their externally financed credit boom has now come to a sharp and painful end.

2/. Most countries in the region have some form of foreign currency exposure, although at present this is largely household and corporate rather than sovereign. In a number of countries -notably Hungary, Romania, Bulgaria and the Baltics this is particularly onerous since most of the mortgages were taken out in euros or Swiss Francs, and the default risk is now rising as their economies either deflate (internal devaluation) or their currencies fall as part of the regional sell-off. The danger is that as the bailouts are implemented at local level this exposure is steadily transferred over to the sovereign level, creating a dangerous dynamic which can endanger future eurozone membership. States which default will be unlikely candidate members.

3/. These countries are also suffering the impact of significant asset writedowns, as those assets bought at very high prices during the boom - some at up to six times their book value - now have to be written down, further weighing on earnings and weakening financial and corporate balance sheets.

4/ Finally there is significant contagion risk. The comparatively small number of foreign lenders involved has lead IMF economists and the credit ratings agencies alike to repeatedly warn of how the risk that a seemingly isolated incident in one country may rapidly spread right across the region.

"I don't think it's an exaggeration to say that the whole banking sector and financial system (in the region) rests on the response of parent banks," said Neil Shearing, economist at Capital Economics. "If they withdraw funding it's not very difficult to see how there would be a very severe financial crisis sweeping across the region, and the whole region en masse would have to go to the IMF," he said.

Governments in the region have already taken what measures they can. Most increased deposit guarantees from 20,000 to 50,000 euros following the EU October Paris meeting. Lithuania went further and upped the limit to 100,000 euros, while Slovakia, Slovenia and Hungary all now offer unlimited protection. But this begs the question, who guarantees the government guarantees in the event they are called on.

So the problem has now become a very delicate one, since the banks want to maintain their presence in the region even while almost every factor imaginable is working against them. The latest such factor is the threat of credit downgrades for their core business in Western Europe, and Moody’s Investors Service warned only this week that some of Europe’s largest banks may be downgraded because of loans to eastern Europe, a warning which sent Italy's UniCredit to its lowest level in the Milan stock market in 12 years.

Moody’s argues there will be “continuous downward rating pressure” in the region as a result of worsening asset quality and western banks’ reliance on short-term funding. UniCredit’s Bank Austria subsidiary earned almost half its pretax profit from eastern Europe in 2007, Raiffeisen International Bank-Holding almost 80 percent and Austria’s Erste Group Bank more than 60 percent, according to Moody’s.

“The most risky parts of the western European banks’ businesses are in eastern Europe and when you decide to cut risks, you cut back on the most risky assets first,” Lars Christensen, an analyst at Danske Bank A/S in Copenhagen, said by telephone today. “This could add further risk in the region as the economies there may face large current account deficits if funding from western European banks is withdrawn.”

As a result last Tuesday we saw a surge in the cost of protecting bank bonds from default, lead by Raiffeisen International Bank-Holding and UniCredit. Credit-default swaps on Vienna-based Raiffeisen climbed 26 basis points to a record 369 and those for UniCredit soared 23 basis points to an all-time high of 213, according to data from CMA Datavision in London. Credit-default swaps on Erste increased 24.5 to 307, Paris- based Societe Generale rose 6 to 116 and KBC in Brussels was unchanged at 240, according to CMA prices.

The rising cost of insuring against default by a “peripheral” European government is likely to weigh on the euro, according to Merrill Lynch & Co. “This remains an important background negative for the euro,” Steven Pearson, a strategist in London at Merrill Lynch, wrote in a note today. “European banking-sector exposure to Eastern Europe, often via foreign currency lending, is an additional euro negative story that is gaining air-time.” Emerging market central banks may move away from holding European government bonds in their reserves as widening yield spreads between debt of different euro-zone economies makes bonds more difficult to trade, Pearson said.

So Why Would The Euro Help?

Well, in the first place, four of the Eastern economies - Bulgaria, Latvia, Lithuania and Estonia, are effectively stuck, since their currencies are pegged to the Euro. They are in the unenviable position of being stuck between the proverbial rock and the hard place. They are now faced with US depression type economic slumps, and massive internal wage and price deflation all at the same time. Would Euro membership help? Well lets look at what the IMF said in their most recent report on the stand-by loan arrangement for Latvia.

Accelerated adoption of the euro at a depreciated exchange rate would deliver most of the benefits of widening the bands, but with fewer drawbacks. Unlike all other options for changing the exchange rate, the new (euro-entry) parity would not be subject to speculation.

By providing a stable nominal anchor and removing currency risk, euroization would boost confidence and be associated with less of an output decline than other options.Euroization with EU and ECB concurrence would also help address liquidity strains in the banking system. If Latvian banks could access ECB facilities, then those that are both solvent and hold adequate collateral could access sufficient liquidity. The increase in confidence should dampen concerns of resident depositors and also help stem non resident deposit outflows.

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

Basically, devaluating the Lat and entering the euro directly was the IMF's preferred option for Latvia, "euroization with EU and ECB concurrence" was the second option, and keeping the peg and implementing massive internal deflation only the third. The problem was that the EU, in its wisdom felt euro adoption "would be inconsistent with treaty obligations of member governments" - as would I suppose bailing out Austria and Ireland be "inconsistent with treaty obligations of member governments under the Maastricht Treaty. Go tell it to the marines, is what I say!

And this is not just Latvia, but four entire countries (little ones, but still countries) that are effectively being thrown to the wolves here.

Downward Pressure On Currencies, Upward Pressure On Interest Rates

Nor is the position of those with floating currencies - Poland, Hungary, the Czech Republic and Romania - much better, since their currencies are now coming under substantial pressure, and as a result defaults are growing, defaults which will only work their way back upstream to the Western Countries whose banks will have to stand the losses.

At the same time, the risk of a sharper, 1997 Asian-style adjustment cannot be excluded, given the similarities between Asia before the eruption of the crisis there in 1997 and the situation in emerging Europe. Beyond any considerations about valuation, the FX market may overreact as it did during the Asian or Russian crises in 1997 & 1998. To halt the downward spiral of currency depreciation, a substantial rise in interest rates combined with a tight fiscal policy under an IMF programme could be necessary.
Murat Toprak & Gaelle Blanchard, Societe Generale

Obviously there is now a sense of urgency here, and the warning signs are everywhere, for those who know how to read them. According to Zbigniew Chlebowski, the chairman for the Polish ruling party’s parliamentary group speaking in an interview earlier this week, the Polish government has been in official talks with the European Central Bank over joining the pre-euro exchange-rate mechanism “for several days.” So consultations are getting to be fast and furious.

And Hungarian, Polish and Czech government debt, which has been among the highest rated in emerging markets, is now being downgraded by bondholders. Investors are currently demanding 20 basis points more yield to own Hungary’s bonds than similar-maturity Brazilian debt, which is rated four levels lower by Moody’s Investors Service, according JPMorgan bond indexes. The risk of Poland defaulting is currently running at about the same as Serbia, ranked six levels lower by Standard & Poor’s, based on credit-default swap prices, while Czech 10-year bonds yield the most compared with German bunds since 2001.

“Everybody is running for the door,” said Lars Christensen, head of emerging-market strategy at Danske Bank A/S in Copenhagen. “The markets have decided the central and eastern European region is the subprime area of Europe.”

The currencies of these currenciies are tumbling on investor concern the region’s economies are among the most vulnerable to the global credit crisis. Poland’s zloty has fallen 35 percent against the euro since August, the forint - which has fallen around 13% since the start of the year, and about 25% since last August -weakened to a record low of 309.71 this week. At the same time the Koruna hit the lowest level since 2005.

(Chart above - Polish Zloty vs Euro)

The zloty has risen - against the previous trend - by 3.2 percent this week, following a decision by the Finance Ministry to enter the market (on Wednesday) and started selling euros from European Union funds for zlotys. Prime Minister Donald Tusk said yesterday the currency must be defended “at any cost.” The Czech central bank stated it regards the buying and selling currencies to manage the koruna as an “exceptional” tool that it’s resisted using since 2002, with the implication that it may not be able to resist much longer, although interest rate hikes (as practised in Hungary) seem to be the more likely approach in the Czech Republic. Such gains as have been obtained for the zloty are likely to be short lived (intervention is a tool of desperation, not of strength, and rarely has any lasting effect) and they can hardly exhaust EU funding they badly need to spend on stimulus type projects in the face of the downturn defending the indefensible, as Russia has been learning to its cost in another context.

“It [currency intervention ]is for us an exceptional tool at our disposal,” Tomas Holub, head of its monetary policy department, said in a telephone interview today. “Of course it’s one of the potential tools, but so far no decision has been taken in this direction.”

After intervention the only real tool left is interest rate policy, and fear of further currency falls is now acting as a serious brake on monetary policy as the pace of economic contraction gathers speed in one country after another. “A lowering of interest rates at the current levels of the exchange rate is completely out of the debate,” Deputy Governor Miroslav Singer told E15 newspaper earlier this week. “The question is whether to raise, and by how much.”

Really the suggestion that all these countries simply traipse off to the IMF (one after the other) in search of help is shameful. There is simply no other word for it, shameful. As Oscar Wilde put it, losing one child may be an accident, but losing all your children, now that has to be negligence! Let them in, and let them in now, before the whole house of cards collapses on top of each and every one of us.


This article is the second in a series of five I am in the process of writing on ways forward with Europe's financial and economic crisis.

The first was Why We Need EU Bonds.

Subsequent articles will deal with:

a) The need for Quantitative Easing In The Eurozone
b) What might a new Stability and Growth Pact look like?
c) Why as well as rewriting the banking regulations we also need to do something about Europe's demographic imbalances.

Update: The Danskebank View

With which I wholeheartedly agree.

This week the crisis in the CEE markets has intensified dramatically after the publication of a number of reports putting a negative focus on Western European banks’ exposure to the overly leveraged CEE economies. The crisis is clearly developing in an explosive fashion and there is a very clear risk of an Asian crisis style meltdown. The economies in the region are already in free fall, and at least one country – Ukraine – is dangerously close to sovereign default. Rapidly rising concerns have led policy makers across Europe to call for immediate action to avoid a dangerous collapse that potentially could spill into the euro zone. However, policy makers seem very divided on what to do in the current situation.

Earlier this week Lithuanian Prime Minister Andrius Kubilius called for coordinated action from the EU to try to solve the problems in CEE. Later in the week the World Bank’s president Robert Zoellick echoed Kubilius’ cry for help.

However, the EU Commission does not seem very excited about a coordinated effort to avoid meltdown. Rather Joaquín Almunia, EU monetary affairs commissioner, this week said that he would prefer a country-by-country approach to crisis management. In our view, a country-by-country approach to crisis management entails a number of risks, as there is a strong potential for contagion from one CEE country to another due to the significant integration in the financial sector across the region. Therefore, we think that there is urgent need for a more coordinated effort to stabilise the situation– otherwise this crisis will drag out and uncertainty remain elevated for an extended period.

Wednesday, February 18, 2009

Ukraine GDP Down 20% Year on Year In January

Well, Paul Krugman certainly got it right on this one, the Great Depression may now reasonably be considered to have arrived in Ukraine. Ukraine's GDP declined 20 percent in January year-on-year, according to Valeriy Lytvytsky chief advisor to the chairman of the National Bank of Ukraine. "The decline in GDP in January was about 20 percent according to my reckoning. It's the biggest drop ever. It's a bad start," he said. According to Lytvytsky the construction and industry sectors have been the hardest hit by the economic crisis.

The Statistics Office don't produce detailed information on the month by month movements in GDP, but using the raw data they do provide I have calculated the monthly growth rates, and have produced the chart below, which gives a pretty clear idea of what has been happening.

Industrial output fell in January for the sixth month in a row, with a 16.1 percent decline between January and December 2008. This was the biggest decrease since January 1994, when there was an 18.6 percent drop. Industrial production in January was 34.1 percent down on January 2008. The year-on-year decline in construction also increased ten-fold, hitting 57.6 percent, Lytvytsky said.

"At the start of last year there was one sector in recession - construction. All the rest were in positive territory. Now only one economic sector is growing - agriculture - with growth of 0.5 percent, within the margin of error. All the other basic industries, which account for about 80 percent of GDP, are contracting."
Valeriy Lytvytsky

Unfortunately this may well be the last month for which I can do this kind of calculation and comparison, since the State Statistics Committee will not be publishing monthly GDP results (as in the past), starting this January and (ironically) as a result of the move to harmonise Ukraine methodology with international-standard, quarterly reporting. I say ironically, since in this case we will be trading short term insight for longer term precision. However, the office will continue publishing monthly results for individual economic sectors like agriculture, industry, construction and transportation, so we maywell be able to invent some kind of "proxy", just to keep an eye on what is happening in more or less real time.

Monday, February 9, 2009

Russia Heading Towards The Abyss?

“A significant amount, if not all, of the speculative attacks on the ruble are funded by the central bank itself,” said Vladimir Osakovsky, Moscow-based economist for UniCredit

The underlying dynamics of the current ruble devaluation are provoking more than a little consternation in Russia at the moment. In the forefront of the debate are data from Bank Rossii (the central bank) which show they lent 7.7 trillion rubles ($214 billion) in overnight and seven-day loans (secured with bonds or other collateral) in just 16 trading days last month - this was about double the 4.8 trillion rubles provided via so-called repurchase auctions in December. Over the same period the ruble lost 18 percent against the dollar. The question is, is there a connection here?

Russia's banking authorities now certainly seem to think there is and Kommersant reported (Friday) that policy makers planned to reduce bank loans in an attempt to limit bets on the ongoing ruble devaluation. As a result the ruble remained safely within the target band all day Friday, and there was no need for any kind of intervention.

The decision follows several days of severe criticism over the way in which Russian banks appeared to be using the loans being made available to them. Oleg Vyugin, former deputy central banker and currently chairman of MDM Bank has suggested that Russia's banks have now accumulated about $40bn in hard currency deposited for their clients on accounts with the central bank and another $40bn on accounts held with foreign banks.

Policy makers lifted the rate on overnight and seven-day loans obtained through the auctions by 1 percentage point to 11 percent this week, the highest since at least November 2007. Banks used “almost all” the money from loan auctions to bet against the ruble, Natalia Orlova chief economist at Alfa, Russia’s largest non-government bank, said. Policy makers “have basically fueled the speculation on the ruble themselves.....The market is intent on testing the central bank’s ability to spend reserves and they’re going to really have to tighten liquidity, or something, if they want to have a hope against that.”

Saturday, February 7, 2009

Italy Needs EU Bonds And It Needs Them Now!

You see, this isn’t a brainstorming session — it’s a collision of fundamentally incompatible world views.
Paul Krugman

As a wise man recently said, failure to act effectively risks turning this slump into a catastrophe. Yet there’s a sense, watching the process so far, of low energy. What’s going on?
Paul Krugman
First, focus all attention on reversing the collapse in demand now, rather than on the global architecture. Second, employ overwhelming force. The time for “shock and awe” in economic policymaking is now.
Martin Wolf

OK, I think no regular reader of this blog could seriously suggest I have much sympathy for the sort of views you normally find being propagated by Italy's Finance Minister Guilio Tremonti, but when he starts to send out the kind of red warning light danger signals that he has been doing over recent days, then I think we should all be taking note, and when the republic is in danger, then its all hands to the pumps, regardless of who is sounding the alert. This is not a brainstorming session, it is a real flesh and blood crisis.

Perhaps few of you will have noticed it, but our erstwhile logician has been getting extremely nervous in recent days, and most notably chose his visit to Davos to indicate that he personally would look extraordinarily favourably on any move to inititiate the creation of EU bonds (for a brief explanation of why these are important, see Wolfgang Munchau's argument in favour of such bonds here. (Or the longer version here)

Italy's Finance Minister Giulio Tremonti has said he favoured the issuance of government debt by the European Union. "Now my feeling -- I am speaking of a political issue not an economic issue -- is ... now we need a union bond," Tremonti said at the World Economic Forum in Davos. Countries in the euro zone currently issue sovereign debt in their own name, rather than regionally. Bond traders concerned about the mounting public debt of Italy, Greece and Ireland have pushed down the value of their government bonds, sparking speculation they might be driven out of the euro zone.

Now why would he be arguing this? Well the state of Italy's own banking sector would be one part of the explanation, and the fact that the Italian government is in no position to mount a rescue operation on its own given the size of its existing debt to GDP commitment, would be another. In particular, and as I have been arguing, Unicredit - and its Eastern Europe exposure - is a huge worry.

Indeed the situation is now so delicate, that according to this Reuters report last week, Unicredit really doesn't know which government to turn to. The Italian one perhaps, or the Polish one, or "it could consider doing it in Austria".

Italian bank UniCredit is considering requesting state support in Italy and Poland, a source close to the bank told Reuters on Thursday. "The bank does not exclude possible state support in Italy and Poland," the source said on condition of anonymity. In an extract of an interview to be published in Germany's Handelsblatt newspaper on Friday, UniCredit Chief Executive Alessandro Profumo said the bank could consider "state support as insurance against unpredictable events." If the bank does seek state aid, it could consider doing it in Austria, for example, he added.

UniCredit SpA is considering asking for government capital amid the credit crunch, Chief Executive Officer Alessandro Profumo said. “State support as insurance for unforeseeable events” is conceivable, Profumo told Handelsblatt newspaper in an interview at the World Economic Forum in Davos, Switzerland. A UniCredit official confirmed the comments to Bloomberg. Italy’s top bankers met with central bank Governor Mario Draghi last week to discuss the financial crisis, which has caused bankruptcies and government bailouts across the world, while stocks have plunged and credit markets have seized up. UniCredit and some of its rivals have tumbled in Milan since the start of 2008 amid concern about the strength of their finances.
Bloomberg 29 January 2009

The announcement that Unicredit was seeking state aid came on the same day that the bank admitted that investors had placed orders for only 0.5 percent of the shares they were offering in a rights issue. The bank received orders for a mere 14.3 million euros of stock out of a total of 3 billion euros, and the plan was to sell leftover stock in the form of convertible bonds, but even this hit a snag, as

The shares were offered at 3.083 euros apiece, or over twice what they were trading for in Milan at the time (around 1.408 euros). Shareholders, including Allianz SE and the Central Bank of Libya, are among those who agreed to buy the convertible bonds, according to the bank offer document. Shares of UniCredit have dropped 54 percent since October, when the rights offering was announced, amid concern the capital raising won’t be sufficient. But even the bonds issue is running into trouble, since Il Sole 24 Ore reported that Unicredit may raise only 2.5 billion euros rather than the full 3 billion euros because because investor Fondazione CariVerona, which holds a 5 percent stake in the bank, reportedly hasn’t received approval from the government to buy the securities, however, the reason they have not received approval may well be that they have not yet applied since the Italian Treasury, in what is a rather unusual step, said on Thursday announced that they had yet to receive a request from CariVerona to sign up for the bond issue. All this suggests, of course, that Tremonti's warning about an imminent bailout could be a piece of brinksmanship, designed to presssure CariVerona to stop playing "positioning" games and come up with the money, but irrespective of whether or not this is the case, some sort of rescue operation for Unicredit surely cannot be far away at this point.

And the fact that Bulgaria's Finance Minister Plamen Oresharski was running around last week assuring everyone that Bulgaria's banks have not asked for state rescue aid so far, and that the government is not worried about the banking system's health for now, is hardly helping to calm already troubled nerves. About 80 percent of the 29 commercial banks operating in Bulgaria are foreign-owned, with the biggest lenders being run by Italy's UniCredit, Hungary's OTP Bank, Greece's National Bank of Greece and Austria's Raiffeisen.

And only today Tremonti has warned that the announcement of more EU bank bailouts is imminent, and maybe as early as this weekend.

European governments may have to bail out more banks as soon as “this weekend,” Italian Finance Minister Giulio Tremonti said today. “So far in Europe there have been more than 30 bank bailouts and I can’t rule out that there will be more this week- end,” Tremonti said, speaking at a press conference after today’s Cabinet meeting in Rome.

So how should we address this danger, imminent or otherwise? At this point in time I have four proposals:

a) The creation of EU bonds
b) The introduction of quantitative easing by the ECB (quantitative easing is the monetary policy which is currently being applied in both the US and Japan, and probably soon in the UK too).
c) Letting those members of the East who want to join the eurozone immediately do so.
d) A new "pact" - one which would be much, much stronger than the old Stability and Growth Pact - to be signed by all countries who enter the EU bond system, a pact which gives direct fiscal remedies to Brussels in the event of non-compliance together with a substantial dose of effective control over the economies of individual countries - since nothing, Mr Sr. Tremonti, ever comes completely for free.

Obviously all of this is quite radical, and indeed fraught with danger, but these are hardly normal times. In all of this (d) is obviously the most important part, as any protection given to EU member economies by the Union must be credible and serious. So no country could or should be forced in, but it should also be pointed out to those who chose sovereignty and remaining on the fringes to participation that they would run an enormous risk. Since almost all EU economies seem vulnerable at this point, anyone staying outside could rapidly see themselves exposed to the risk of forced default, since lack of protection is simply an invitation to attack. Letting ourselves get picked off one by one is not an appetising prospect (Latvia, Hungary, Greece, Austria, Italy, Spain, Ireland, the UK, Romania, Bulgaria.........).

Clearly those who wish to remain "dissenters" should have the liberty to do so, but they should bear well in mind that should they do so they could very easily end up in a group - possibly lead by Diego Armando Maradona - together with Yulia Timoshenko (Ukraine), Cristina Fernadez (Argentina), Rafael Correa (Ecuador) and (possibly) whoever is the new prime minister in Iceland, bankrupt, and without the aid of international financial support to help deal with their mess.

Perhaps readers may think I am being rather shrill here, and perhaps at this point Tremonti (for whom I have no afinity, elective or otherwise, see linked post above) is only playing brinksmanship, but if he isn't, and Unicredit is about to need bailing out, then push does quickly come to shove, since the EU leaders agreed on October 12 in Paris to bail out systemic banks, and Unicredit is a systemic bank. So will will need to know how they plan to stand by their commitment, and if they don't, well then everyone of us stands exposed, since credibility rapidly falls towards zero.

Maybe this is a false alarm situation, and Unicredit will not need bailing out this weekend, or the next one, but one day it will, and one day Spain's huge non performing loan and household debt default problem is going to need sorting out. So I think this is a line in the sand situation, and we are much nearer to having to make up our minds which side of the line we are on than many seem think.

To paraphrase Paul Krugman again, in flirting with the idea of whether the first to default should be Greece, or Hungary, we truly are flirting with disaster.

Monday, February 2, 2009

Central Europe's Manufacturing And Consumers In A State Of Shock

Central Europe's economies continued to contract in January - lead by their manufacturing industries - under the combined weight of a credit crunch and a slump in demand for their exports. My feeling as all three economies - Poland, the Czech Republic and Hungary - are now in recession. Hungary's is clearly the worst case, and events are moving rapidly and negatively there, but the slowdown in the Czech Economy is also very pronounced, and Poland seems finally to be falling into line, following some internal financial chaos back in October. Based on back of the envelope type calculations derived from the PMIs I would say their economies were contracting at the following pace in January.

Q-o-Q Y-o-Y
Hungary -1% -4%

Poland -0.7% -3%

Czech Republic -1% -4%

These are only provisional assessments based on the PMIs and Consumer Confidence Indexes. They will be subject to calibration as we move forward and receive the real data, but all this should give us some general idea of what is happening, something which is badly needed in view of the suddenness of the change.

Hungary PMI

Hungary's manufacturing purchasing manager index (PMI) fell once again to a all-time low of 38.6 in January, down from 40.8 in December, according to the Hungarian Association of Logistics, Purchasing and Inventory Management (HALPIM) today. Any PMI index figure above 50 indicates expansion while a figure below 50 shows contraction in economic activity. The index hasd been above the critical 50 mark for more than three years before it dropped below (to 42.6) in October last year.

The January figure is the lowest recorded since September 1995 and is a further sharp drop from January. The last time the January index was below 50 was in 2005 (48.5) and then in 1997 (49.1), but these contraction were much softer.
“In view of the current situation we can confidently say that the five month negative record of 1998 will be broken. We are facing the gravest crisis of the manufacturing industry in almost 15 years," the HALPIM said.

GKI Confidence Index

Economic sentiment also plunged in January with the GKI index falling to a record. The overall index fell to minus 39.8, the lowest since measuring began in 1996, from minus 36.7 in December. The sub components for business and consumer confidence also fell to new lows.

The outlook for industrial production and orders led a decline in the business confidence index to minus 30.5 from minus 28.2 in December. The outlook for export orders improved “minimally,”. Fifty-eight percent of exports are sold in the euro region, which is in its worst recession since the single currency began trading a decade ago. Concern about future job losses dragged the consumer confidence index to a record of minus 66.1 from minus 60.8 in December.

Polish PMI

Morale in Poland's industrial sector rose for the first time in almost a year in January, but output growth remained mired firmly in negative territory, according to a purchasing managers' index survey published Monday. The survey of 300 industrial companies prepared by Markit for ABN AMRO showed Polish manufacturing PMI increased to 40.3 in January, from 38.3 in December. This is an improvement, but the contraction is still a strong one.

"Though slightly improved from the exceptionally weak December data, the latest survey findings underline the headwinds confronting Polish manufacturers in January. Output, new orders and employment all contracted sharply and, overall, the first batch of 2009 PMI data point to further aggressive rate cuts by the central bank in the first quarter following greater than expected reductions in the main policy rate in both November and December. Inflation concerns have eased despite the falling zloty, as the PMI showedfurther falls in price pressures in manufacturing." - Trevor Balchin, Economist at Markit Economics
Polish Consumer Confidence

Poles have become much more pessimistic about the outlook for their economy in recent months and the Ipsos Consumer Confidence Index fell by 11 points to 84.17. The assessment of the current economic climate suffered the most serious deterioration.

(Please click over image for better viewing)

The consumer rating of the current economic climate plummeted by 15 points to hit 69.59. This is one of the lowest levels since Poland joined the European Union. Consumers are worried about the future of the Polish economy, and their worries are linked particularly to the situation on the job market. Currently some 52% of Poles expect unemployment figures to rise over the coming 12 months, while only 6% expect them to fall. This is a radical change, particularly when compared with January 2008, when only 13% expected a rise in unemployment and 39% expected a decline.

The deterioration in consumer sentiment was also to be seen in the ratings for willingness to buy, which in January fell by 8 points to 93.88 (the lowest level for 3 years). In particular expectations regarding the material situation of one's own household deteriorated. Ratings of the current situation in regard to buying durables also weakened somewhat. Nevertheless, consumer appetite is far from dead, and there are more people still considering this a good time for buying than those who disagree.

Czech Republic PMI

Czech industry continued its steep decline in January with the Czech Purchasing Managers' Index falling to dropping below the 50 mark (to 31.5) for the seventh consecutive month. As compared with December (32.7), the PMI was hit by series-record declines in new orders and employment, while deflationary pressure was also evident as both input and output prices continued to fall sharply, according to the report from Markit Economics and ABN Amro. The figure for output rose for the first time since September, to 29.5, indicating a slightly weaker rate of contraction than in December but still the second lowest in the survey's history.

Czech Consumer Confidence

In January 2009, the Czech economic sentiment indicator decreased by 3.2 points m-o-m (it was down by 8.6 points down in December). The business confidence indicator fell by 2.8 points and the consumer confidence indicator dropped 4.8 points. Compared to January 2008, the composite confidence indicator balance was down 30.8 points, the confidence of entrepreneurs is 34.7 points down and the confidence of consumers is down by 15 points. Indicators were thus at their lowest levels in almost ten years.

The survey taken among consumers in January indicates that, compared to December, consumers expect for the next twelve months worsening of the overall economic situation and a slight decrease in their own financial standing. In January, the share of respondents expecting a rise in unemployment increased again. The percentage of respondents planning to save money decreased. The consumer confidence indicator decreased by 4.8 points, m-o-m; it is by 15 points down, y-o-y.

Sunday, February 1, 2009

The Ruble Fall Continues As Unemployment Soars

Russia's current woes can be readily summed up in just one single variable - the value of the ruble - and this value, as we all know, is falling. Almost uncontrollably so.

The bank’s target will be “very quickly” breached without more intervention, said Gaelle Blanchard of Societe Generale SA in London. “Right now the market is convinced it wants to see the ruble lower,” Blanchard said. “As long as the central bank gives these targets, then speculators are going to have something to aim for.”

“The market is testing whether the authorities see this band as something permanent or something that will move,” said Lars Rassmussen, an emerging markets analyst at Danske Bank A/S. “Our view is that they’ll move it because it’s not worth wasting the reserves for a band that is obviously not wide enough.”
First Deputy Prime Minister Igor Shuvalov expressed regret that the general population failed to fully understand the Central Bank’s policy on the ruble’s exchange rate against the dollar/euro basket. The government did let the ruble depreciate, but it did so gradually, providing plenty of time for people to decide which currency to keep their savings in.

In fact the ruble fell sharply again last Friday, and was on the brink of breaching the target trading band, yet one more time, following its biggest monthly depreciation in more than a decade. The ruble was down at one point by as much as 1.4 percent on the day (to 35.59 per dollar), 1.1 percent away from breaking the 36 per dollar limit. The Russian central bank has now expanded its trading range 20 times since mid-November in a series of attempts to defend the currency. These continuing attempts to hold a line have lead the central bank to use up more than a third of its foreign-currency reserves since last August, a period in which the ruble has fallen some 34 percent slide against the dollar.

The ruble has now depreciated by 20 percent since the start of the year - making January already the worst month for the currency since 1998. And there is obviously more to come, with the government now expecting a decline to 36 per dollar following the latest widening in the trading band, according to First Deputy Prime Minister Igor Shuvalov speaking in the State Duma last week. This "managed devaluation" is seen as an attempt to avoid a reapeat of what happened back in 1998, when the ruble fell by as much as 29 percent in a single day. Yet the currency has now lost over 30% against the dollar (and weakened substantially against the euro) since last summer and all this spells disaster for domestic banks and industrial companies, whose debt is denominated in dollars and euros but who depended on rouble-denominated revenues.

One of the principal problems facing those banks and companies who have this mismatch if that they have insufficient foreign exchange liquidity, while other parts of the banking and corporate sector are better positioned. That is the aggregate external position understates the extent of the problem, since the lack of internal confidence makes it hard for those who are under severe stress to find the appropriate lenders. In part as a an attempt at a solution to this problem state owned investment bank Vnesheconombank (VEB) is preparing to issue foreign-currency bonds to be placed among Russian banks with excess of foreign currency and then redistribute the currency raised to those in need of foreign currency liquidity. During the last quarter of 2008 the net increase in foreign currency assets in the corporate sector was over $100 bln. According to the central bank external corporate debt redemptions totaling $120 bln are anticpated during 2009, which indicates a shortfall of only $20 billion, yet according to Interfax the total volume of applications for fx support to VEB from Russian companies is $80 bln. Which suggests that a sizeable chunk of the $100 bln accumulated by Russian corporates at the end of last year was not intended for foreign-currency debt redemptions but was instead a means a protecting free liquidity from falling in value. That is they converted their liquidity into USD and Euro to avoid losses (or make gains) from the devaluation.

Inflation Always Carries A Price

The root of Russia's most recent problems is very evidently all that excess inflation which Russia has seen over the last 18 months (if it hadn't been for the inflation there would have been no devaluation, and hence no issue with forex loans), inflation which has taken badly needed competitiveness from Russia's manufacturing industry at a time when the oil and commodity sectors are in the grips of a severe price slump (which means their contribution to the economy is greatly reduced).

Obviously Russia's situation doesn't make for any easy answers, and even devaluation brings with it the problem of the attendant inflationary uptick from imported goods. Russia's month on month inflation is expected to reach 2.4 percent in January 2009, according to the latest estimates from the Russian Federal State Statistics Service (Rosstat), and the Economy Ministry currently estimates Russia's whole year inflation could be as high as 13 percent in 2009. In fact the annual rate for last December was 13.3% (see chart below), so they seem to anticipate very little change in the situation. In fact they may be unduly pessimistic here, since they are almost certainly underestimating the force of Russia's current economic contraction, and the collapse in internal demand may well bring Russia's inflation down more rapidly than they are expecting.

Monetary Tightening In The Face Of An Economic Slump

Basically the Russian economy is currently suffering the effects of a long term policy of trying to control the currency value at the same time as being "soft" on inflation. This approach evidently hasn't worked out, and it is to be hoped that some lessons for the future may have been learned, but the sorry reality is that those currently responsible for managing Russia's economy are left with only hard policy options at this point, if they wish to avoid another default. Basically, and on top of all the rest, the economy has two added problems (apart, that is, from the drop in oil prices, the internal credit crunch and the slump in domestic demand): the high inflation, and the capital exit.

Russia's reserves are disappearing for a whole variety of reasons at this point. First there are foreign investors who are simply pulling out - investors have removed about $290 billion from Russia sincethe start of August, according to the latest estimates from BNP Paribas. Secondly the Russia central bank has been using reserves to defend the currency. According to the Central Bank last week, Russia's foreign exchange and gold reserves dropped by nearly $10 billion from $396.2bn to $386.5bn in the week to 23 January.Citigroup calculate that the bulk of that fall was the by-product of a strong negative revaluation effect - which may have exceeded $8 billion - and the strengthening of USD vs EUR and GBP probably subtracted $5.5bn and $3.7bn, respectively, from the total in USD. Nonetheless Russia has spent very large quantities of foreign exchange on supporting the ruble since August . According to Kommerant reports Bank Rossii told Russian bankers in a meeting in the middle of the month that their “managed devaluation” of the ruble was over, but as we can see, this is far from being the case. Nikolai Kashcheev, head of economic research at Moscow-based MDM bank, Russia may abandon the ruble's dollar-euro trading band completely and allow the currency to trade freely, with the central bank only intervening to avert serious economic shocks using a so-called “dirty float” mechanism.
“A dirty float would look like it was a free market but the central bank would still have a measure of control,” said Kashcheev, who forecast the ruble may fall 5.9 percent against the dollar if the central bank made the switch this week. “It would be a preferable outcome to the devaluation because what they’re doing at the moment is costing too much in reserves.”

The central bank sold $3.2 billion last Friday alone, and $800 million Thursday, according to MDM Bank estimates. The bank appears to have stayed out of the market between January 23 and 27, the first three days after widening its exchange-rate band.

Other demands on foreign exchange comes from Russian corporates who need to pay off foreign exchange debt, or simply protect their ruble liquidity from the devaluation fall, and from individuals and households who wish to do the same.

As a result of the reserve and inflation pressures Russia’s central bank has little alternative but to maintain a relatively tight monetary stance, and indeed the bank raised two key interest rates for the third time since the start of November last week, with the repo rate for one-day and seven-day loans being raised to 11 from 10 percent. Now I say "relatively tight", since obviously with CPI inflation currently running at over 13%, even 11% interest rates are negative in Russia (by around 2%), and thus Russian policy rates could be considered somewhat accommodative (though not as accommodative as would be desireable given the strength of the hit the economy just took). At the end of the day terms like "tight" and "accomodative" are relative terms, and it all depends what you are dealing with.
The Central Bank does not rule out the possibility of a new wave of the crisis erupting in the banking sector, the bank's Chairman Sergei Ignatyev told the Russian State Duma on Friday. He noted that although such a risk was unlikely in the near term, it was still fairly possible in the foreseeable future. The new wave of crisis may be brought about by a rise in loan defaults, Ignatyev explained. The Central Bank is holding meetings with bankers and keeping a watchful eye on the situation, the official said, adding that the bank was ready for any new developments. He also noted that an increase in certain banks' capitalization might prove necessary.

Russian media are also reporting that the government anti-crisis committee (which is headed by Deputy Prime Minister Shuvalov) is putting together a rescue plan for carmaker OAO GAZ. If confirmed the move that would mark the first custom built financial rescue of an individual company by the government during the current economic crisis. OAO GAZ, which is based in Nizhny Novgorod, may need $1.6 billion in state funds to continue operating. Shuvalov has confirmed that the government plans to offer substantial support to Russian companies. “The list of such companies will be expanded to 2,000,” he said, noting that it would include both companies involved in the technical modernization of the national economy and those in a difficult financial situation. “To save all companies is impossible and unnecessary".

Another company in difficulties is United Co. Rusal, who are set to sell shares in a private placement as they seek to refinance about $16.3 billion of debt, according to billionaire shareholder and company Chairman Viktor Vekselberg speaking in Davos. The Russian company owes $7 billion to foreign banks, about $6.5 billion to domestic lenders and about $2.8 billion to Mikhail Prokhorov’s Onexim Group. Rusal is in “active” talks with creditors. Rusal, which is Russia’s largest aluminum company, will cut output by as much as 10 percent and freeze investment for about three years. Aluminium fell to a five- year low this month, and profit is projected to slump 88 percent to $476 million this year, according to an estimate by ING Groep NV. Aluminum needs to trade at $1,700 a metric ton for Rusal to be able to service its debt and pursue new projects, according to Vekselberg - aluminum for delivery three months forward was 1.2 percent lower at $1,350 a ton as of 12:18 p.m. on Friday on the London Metal Exchange. Rusal was forced to seek a $4.5 billion bailout from state-owned Vnesheconombank in October to refinance loans used to buy 25 percent of OAO Norilsk Nickel, Russia’s biggest metals and mining company.

So far Russia’s indebted companies have been bailed out by the government, but this year they are due to repay an additional US$117bn to foreign creditors. With opportunities to roll over existing debt limited, and the government’s reserves down by US$200bn since August, the chances of continuing rescues by the federal authorities appear greatly reduced. According to the latest central bank data, some US$117bn of debt needs to be repaid this year, with US$52bn owed by banks and US$62bn by corporations. Debt restructuring looms on the horizon.

Unemployment Surges

Evidently the crunch in the financial economy - Russia's base money shrank dramatically (from 4283 bln rub to 3896 bln rub, that's not far short of 10% in a month) between 29 December and 26 January - is having a serious impact on the real economy, and nowhere is that clearer than in the unemployment numbers. As could have been expected Russia’s unemployment rate rose sharply in December (up to 7.7 percent from 6.6 percent in November), its highest level since November 2005, as industrial production shrank the most in ten years. The total number of unemployed reached 5.8 million people, as compared with 5 million in November.

What is most notable is the sharpness of this rise. Alongside the rise in umployment wages have started to fall, and the average monthly wage fell an annual 4.6 percent in December to 17,112 rubles ($517.85), the first contraction since October 1999 when they fell 2.2 percent. Real disposable income fell 11.6 percent, the biggest contraction since August 1999, according to Rostat. So this is how one part of the mechanism works basically. The oil price drops, the ruble devalues, fx loans become unsustainable, new funding dries up, and then the real economy sinks like a stone, and as the unemployment goes up, household and investment demand go down, and economic activity heads on a downward spiral.

GDP Growth Outlook

First Deputy Prime Minister Igor Shuvalov told the State Duma today. “The crisis will continue for three years, of which 2009 will be the most difficult,”

If we now turn to economic forecasts for 2009, Economy Minister Alexei Kudrin said last week that Russia's 2009 GDP growth would be close to zero - a figure which was revised down from the Economy Ministry's earlier 2 percent estimate.

“We must be prepared for further economic decline and a conservative tax and budget policy. Yet we will implement our main programs involving the social protection of the population. The reserves we have built up allow us to be up to that task,” Kudrin stressed.

Current government estimates also project capital flight to be between $100 billion and $110 billion in 2009, while budget revenue will be far below the planned RUB 10.9 billion (approx. $307.9bn). Kudrin's present estimate is RUB 6.5 trillion (approx. $183.6bn), with oil exports expected to generate the bulk of the revenue. He says the federal budget is expected to decline by 40 percent, from a projected $300 billion [10.9 trillion rubles] to about $185 billion [6.5 billion rubles]. Russia’s current budget is based on an average oil price of $70 a barrel, even though Urals crude, the country’s chief export blend, has slumped 69 percent from a July record to $43.72 a barrel. As a result Prime Minister Vladimir Putin has told the Finance Ministry to recalculate the budget, with the Economy Ministry now forecasting oil to trade at an average $41

.“These are the real challenges we face for our economy and the budget system,” Shuvalov said. “If we don’t change our budget targets, and simply replace this lost revenue with money from the reserve funds, the budget deficit will be 6.1 percent of GDP.”

Kudrin is suggesting that Russia will probably spend the bulk of its 7.317 trillion ruble oil-fund reserves to protect the budget, some, “but not all,”. The economic crisis is likely to “peak” this year, and tax revenue may slide by 1 trillion rubles, he added. But Elina Ribakova, Chief Economist at Citibank Russia takes a different view:

“They're planning a large fiscal deficit. Kudrin was mentioning six per cent and our estimate is we could reach ten per cent of GDP, which is most of the reserve fund. So under that scenario yes, we could easily run out of money this year. But I hope that by prudent macroeconomic preemptive policies, we'll not allow that to happen.”

Russia's Reserve Fund now stands at 4.7 trillion rubles ($142.5 billion) and the National Wealth Fund at 2.6 trillion rubles ($79 billion). On February 1 2008 the Finance Ministry divided the former Stabilization Fund into the Reserve Fund, which is intended to cushion the federal budget from a plunge in oil prices, and the National Wealth Fund, designed to help Russia carry out pension reforms.

First Deputy Prime Minister Igor Shuvalov stated that the global financial crisis is expected to last three years, He confirmed the appropriateness of the government’s reserve strategy, noting that the Finance Ministry was under pressure to start using the reserves several months ago. The crisis could be even more severe than was originally thought, he warned. “We are considering a scenario which is already tough enough, but it could get even tougher, with federal and regional budget revenues falling more sharply than we are estimating,” Shuvalov explained.

Unless the oil price recovers soon, Russia's current-account surplus will turn into deficit during 2009 (the Economist Intelligence Unit forecasts that it will equal 4% of GDP), meaning that the country would be forced to subsidise vital imports, including food, out of its already strained dollar holdings. Even if an outright default is likely to be avoided, some debt restructuring moves involving the bulk of Russian debt now seem more or less unavoidable.

As for the outlook for Russian GDP, Kudrin's forecast seems somewhat on the optimistic side, and it is interesting to note that Citgroup have now revised to a 3% contraction in 2009 followed by growth of 1.7% in 2010. They argue (and I agree) that the key change in 2009 GDP is likely to come on the domestic consumption side. Private consumption, which accounts for about 80% of total consumption, now looks set to contract significantly (Citigroup forecast 4.6%), even if the government keeps its originally planned level of current spending.

At the same time investment will also contract (Citigroup suggest by 10%) owing to reduced access to credit and further possible cuts in government capital spending (which accounts for about 10% of total investment growth). The government capital injections (an additional US$40 billion, according to Finance Minister Kudrin, Bloomberg, 22 January) is more liekly to go towards covering bank non performing loan losses rather than supporting new credit.

Even more worryingly Citigroup forecast a 10% contraction in new credit. Furthermore, they argue that the government may well have to cut capital spending owing to the need to accommodate increases in social spending and support for the regional governments. As a result of falling income and investment spending imports will fall (perhaps by 20% in dollar terms), this will be positive for the current account deficit (and to some extent for GDP. A 3% CA defeicit thus seems reasonable assuming no rebound in oil prices.

So, not a rosy picture. Next stop some more real economy data next week, and the manufacturing and services PMIs.