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Friday, September 7, 2007

Eastern Europe Needs Watching Now

by Claus Vistesen

cross posted from Alpha Sources

If you have followed my writings both here and over at AS you will indeed have noticed an increased interest in the Baltic and CEE economies. As the turmoil in financial markets continue to make investors jittery and as market participants and even some academics in general seem convinced this will continue for the worse it is now time to move the glance towards Eastern Europe. Moving to the general condition of the global economy and markets the actual timing of events is of course impossible to predict. We have seen for other reasons than the financial market debacle in general that growth in both Japan and the Eurozone has slowed rather sharply in Q2 and with lingering issue of subprime mortgage market the US economy does indeed seem set for a prolonged period of sub-trend growth even if it does not turn into a recession. But the drawings of more than a liquidity crunch has been on the blackboard for some time now. The liquidity crunch in itself which prompted larger than usual central bank interventions in the interbank money in August is in and of itself not the problem. In fact, as we can see liquidity dried up rather dramatically again today in the wholesale banking market for Euro and Sterling on the back of next week's funding round where $113 billion of commercial paper requires new funding. The risk as it has been extensively sketched out by so many is of course that credit in general undergoes a structural recession and that standards are tightened all over the board. This would then mean that both sovereign, corporate, as well as household credit (debt) will be subject to tighter loan conditions. In essence, such a repricing or evaluation of standards does not at all seem unreasonable at this point. However, the crucial point is that in this environment the process is likely to occur very fast and with asymmetric effects as risky assets clearly is hit hardest. Also, with 1998 fresh in mind we can also see that such events are likely to overshoot significantly relative to economic fundamentals. In this way, such an abrupt retrenchment would feed into the real economy too and this at a time where it could seem that the tides are turning for other structural reasons. As a very final qualifier before we get to the main issue it is furthermore important to distinguish between credit conditions and general macroeconomic liquidity where the latter seems set to remain abundant relative to previous expectations of a continuous hiking process at the BOJ, ECB and perhaps even the FED. These two factors are likely to work against each other but it seems certain at this point that structural risk aversion and credit tightening is set to continue and perhaps even increase, at least this would be a plausible scenario to build into the general market assumptions.

It is in this environment sketched superficially above that I believe we need to watch the Baltic Economies and Eastern Europe since I do feel that they may end up being at the forefront of what happens next. As an immediate frame of the current discussion we are of course talking about the macroeconomic dynamics surrounding currency crises and what happens when such events loom around the corner. An extensive body of literature has identified the dynamics by which such events unfold. At the heart of the matter is in particular the emerging markets/countries with large negative external balances and those who have been running up the present cycle through aggressively and an often lax as well as unhedged cross-over currency credit expansion. As always, reality deviate from the textbook's stylised facts and on this note I would also like to reiterate the points made in a recent analysis from Danske Bank's Lars Christensen in which he and his fellow colleagues look at emerging markets from the vantage point of safe havens. Clearly, safe havens and emerging markets are not mentioned in the same sentence very often but this is perhaps the point at this exact point in time in the sense that some EMs will weather the coming storm better than others.

Turning to Lars Christensen's immediate conclusion it is not exactly of a controversial nature ...

In conclusion, the credit crunch is spreading to Emerging Markets and there is thus reason to be extra cautious in these markets and focus on strong fundamentals – especially on strong external balances.

As such, the real point I want to emphasize here is the main focus on Eastern Europe and the Baltic countries which emerges as a main point from Christensen's note. As both Edward and I have argued several times (see particular this note by Edward) there is a sound theoretical justification to believe that Eastern Europe is especially vulnerable towards a rapid correction in the current climate. Let me try to explain this.

As a first approximation let us return to that most interesting factoid presented in the recent BIS quarterly review published June 2007 where it was noted how Eastern Europe accounted for a massive 60% of new credit to emerging markets even surpassing East Asia. This, at least at a first glance, should give an indication of the magnitude of the issue. As a derivative issue of this there is also strong evidence to suggest that any sudden and abrupt correction entailing sharp region wide currency depreciations would reveal most sinister balance sheet issues as a very large share of Eastern European households and corporations carry a large chunk of their claimants in foreign currency (most often we are talking Euros and CHF). For a much more comprehensive description of this a recent paper by Danske Bank's Carsten Valgreen (get link from this post) has some very illuminating graphics. For a general and very informative analysis of balance sheet exposure in Europe Edward had two notes a while back which are very much to the point. Add to all this that many countries are pegged to the Euro suggests that the valve through which to correct are not present and thus that any region wide correction will be rather severe.

These three aspects noted above need of course to be held parallel with the more general and often noted characteristics in Eastern Europe (and exposed EMs) of large current account deficits, rapid inflation (especially labour costs), and thus a situation of overheating. In short, the economies in Eastern Europe for the most part all exhibit the characteristics identified in the literature as being at risk when a potential financial crisis looms. However, there is one thing which is missing in this literature and thus one thing which makes the CEE and Baltic economies rather unique. In this way, it is in many ways perfectly 'natural' for small open emerging markets to experience rather 'sizzling' growth rates with subsequent large external balances. This is thus a well-know component of what we in economics tend to call 'catch-up' growth. Of course, we can always talk of different degrees and sustainability of this process but let us leave that question aside for now. In stead, let us think about the most reasonable point that as an economy moves towards a mature state (and, according to Neo-Classical growth theory, a steady state) it also moves through the well-known process of the demographic transition. At this point of course, the theoretical literature does not explicitly try to make this connection but there are however well-known examples of country specific cases where the economic growth has been related to the phases of the DT. Ireland is a well-known case in point proxied by the famous article authored by David Bloom and David E. Canning entitled Global Demographic Change: Dimensions and Economic Significance. In this way and in order to understand what comes next in my line of reasoning you need to accept the fundamental prerequisite that the nature and sustainability of a country's growth performance and composition/path rests, at least in part, depends on the nature of its demographic profile and thus relative position in the process we call the DT.

This theoretical framework of analysis is crucial in order to understand the vulnerability of Eastern Europe and the Baltic Economies faced with the current situation in financial markets and the global economy. In short, these economies have been and are growing (quite naturally) briskly as emerging markets enjoying a growth cycle which by and large started as EU was expanded from 15 to 25 member countries in the beginning to 21th century. However, what we crucially need to understand is that these countries are characterised with a rather unique population structure as a result of a severe collapse of fertility in the beginning of 1990s, a process which has been gravely exacerbated by a high rate of outward net migration. As we can readily see the population structure in itself does not impede a given growth path (well, for large economies I would argue it does) but it does seem to produce fundamental imbalances and asymmetries. In Eastern Europe this is of course best shown in the very rapid rate of inflation epitomized most notably by a very high rate of wage inflation. In so many words, this has two overall implications which feeds into the reason why we should be watching Eastern Europe in particular

  • The recent credit expansion in Eastern Europe and subsequent growth performance has been wholly out of sync with demographic and economic fundamentals. All things equal you can of course always talk about the relative sustainability of credit expansions and high rates of growth but the point I am trying to hammer down here is that in the case of Eastern Europe it has been remarkable to see how the majority of recent global credit expansion has been isolated in a region where credit has been pouring in even as capacity has been thundering down in an alarming tempo. In short, when the crack comes it is likely to be hard.
  • One thing of course is the run-up of credit itself and the subsequent correction which more and more look like it is going to be rather rough. However from a macroeconomic perspective I am also inclined to look a bit further forward. In this sense the real tragedy which might be unfolding is that the potential knock which some countries in Eastern Europe will experience is likely to leave them shaded for quite a while and with the current demographic situation in mind the window of catch up growth might close entirely for some countries. A major downside in this respect is that outward migration will intensify in the wake of a severe economic downturn.

At this point it should of course be readily clear why I agree with Lars Christensen in the overall assessment that Eastern Europe is important. In order to follow more closely what Christensen in fact has to say regarding emerging markets and safe havens I reproduce the pivotal graph from Christensen's piece.

As we can see following the conclusion quoted above Christensen generally notes how investors should shy away from EMs with current account deficits. I would not go this far in the sense that I don't think the world is entirely as red and blue as is suggested even though of course a steady build-up of risk aversion would lead towards the picture painted by the graph above. However, I have a hard time seeing how financing is going to be withdrawn in general from the emerging markets' external deficits. As I have argued extensively Eastern Europe needs ardent watching but to take another example I am not certain that e.g. Turkey will experience anywhere near the same exodus if push really comes to shove. As another case in point I also feel the need to comment on the fact that Japan is mentioned as a potential safe haven which follows quite natural from the fact that Japan has a very healthy external surplus. Yet, Japan is riddled with exceptions from the point of view of textbook theories and while I would also expect Yen appreciation during a process of a flight to safety (or quality perhaps?) we also need to understand that the BOJ is not likely to push up the yield from its current 0.5%. In fact, with the recent near recession growth estimate of Q2 2007 a downside has emerged I think that the BOJ could be looking towards a return to ZIRP; this mind you goes especially if the Yen is subject to a strong appreciation since Japan is still struggling with deflation.

In Summary

Eastern Europe needs close watching from now on. As argued above a number of structural and cyclical factors are now aligning in such a way to render the Eastern European and Baltic economies particular vulnerable and essentially at the forefront of the current market turmoil. A useful proxy for monitoring the CEE economies is to watch the region's currency crosses with the Euro. Here of course especially the Leu (Romania) is interesting since it is floating and as was well expected this has begun to trickle down to investment bank analysis directed towards investors. Not surprisingly, Lars Christensen consequently advised investors yesterday to build up long EUR/RON (Leu) positions in the expectation of further weakness. As a final note, Edward has also been busy building currency charts in order to be able to follow the development closely.

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