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Sunday, August 19, 2007

Will The Lat Come Under Pressure Again?

Well we all know about the turmoil that is taking place in the financial markets at the moment. Last Friday the Federal Reserve surprised everyone by suddenly lowering the discount rate. This has lead to all sorts of speculation about the future direction of interest rate policy in the major economies. It is now extremely unlikely that the Bank of Japan will now proceed with a quarter point raise later this month, and it is very doubtful in my mind that the ECB will raise in September. It is pretty much a foregone conclusion that the next move by the Federal Reserve will be down, the only outstanding question really is when.

Obviously we need to wait and see how the financial markets respond to the latest move from the Fed, but my feeling is that the so called "credit tightening" isn't over yet (and not by a long stretch), and that even were the "crunch" to come to an end soon the consequences for the real economy are going to be important, since credit - both corporate and private, and possibly even sovereign - will be harder to come by. What this "harder to come by" really means is that you will have to pay more for it, especially if your credit valuation is not of the highest (as was the case with the US sub-prime home purchasers). As I say this will hit at all levels, since the banking sector has clearly had a big shock, and will involve individual, companies and even governments. Just how it will affect them is what we are now waiting to see. But it is important to bear in mind that this impact on new credit will occur regardless of the extent to which central banks lower their base rates, since what has happened is that the lending environment has deteriorated, and this deterioration is likely to influence conditions in new lending (or rollover credit) for years rather than months.

Obviously existing mortgage holders on variable rate mortgages can get some fresh air from any loosening in the base rates, but it is the demand for new mortgages, and activity in the construction sector, and not locally but globally, that we need to be thinking about here. Clearly construction growth can slow, as lenders become more choosy about who - and under what conditions - they lend to. This becomes important for the real economy when we come to consider the importance which construction activity shares have had in economic growth in some major economies - the US, the UK, Spain, Australia etc - since the turn of the century, and the impact which the so-called wealth effect has had on the rate of growth of private consumption in this self same economies. So clearly, in some developed economies, economic growth is now likely to be rather weaker, and for some time to come.

But the "credit crunch" is likely to affect the so called "risk appetite" (that is the willingness to invest in riskier areas or activities) and the place where this is most likely to be felt is in the emerging market area. Those emerging markets which are considered to be most vulnerable will undoubtedly have the hardest time of it, and this brings us directly to the Baltics, who must be considered to be in one of the riskiest situations of all. To quote the Economist's Buttonwood, "WHEN investors get twitchy, developing countries are usually the first to pay the price."

And investors are definitely twitchy right now, as Danske Bank Senior Analyst Lars Christensen commented last Wednesday (pdf link) the markets are beginning to see signs that pressures on the lat are re-emerging. In his research note Christensen argues that while the atmosphere surrounding the Lat calmed down in May,after having experienced significant pressure during February-April period (as reflected in this speech from Latvikas Banka governor Ilmārs Rimšēvičs back in February, which was an irate response to an article in the pages of Diena by the Swedish Economist Morten Hansen, who was arguing that the Lat/euro peg needed to be broken, more on all this in another moment).

Basically Christensen sees this pressure re-emerging, largely for three reasons:

Firstly there is the above mentioned worsening of global credit conditions, which will make it much harder to fund the large current account deficits in Latvia and the other Baltic states. Scandinavian banks naturally are also showing less willingness to fund the Baltic credit boom with global credit conditions worsening and concerns are mounting about the vulnerability of over-leveraged households and investors across the Baltics.

Secondly there are clear signs that the property markets are coming under fairly strong selling pres-sure in all three Baltic states. Christensen suggests that property prices have dropped nearly 10% in Estonia over the last two quarters, while Latvian property prices have declined 5%-8% over the last two months. Meanwhile, Lithuanian property prices are no longer rising. In addition to this he mentions anecdotal evidence that property developers in the Baltics are freezing property projects that have already been initiated.(Latvian Abroad is covering the unwinding of the Latvian property boom here, and here).

Thirdly, there is the fact that the Baltic economies are now clearly slowing. As I argued yesterday, the Estonian economy is now showing very significant signs of a fairly sharp slowdown with the rapid second quarter GDP screech to a halt (only 0.2% growth in the quarter) marking the lowest rate of growth in seven years on a quarter-on-quarter basis.

On the property market angle, Christensen has a separate report (again pdf), and he makes a number of important points here:

Property price statistics are fairly unreliable and hard to compare from country to country in the Baltics, but most sources now point to fairly heavy declines in property prices – at least in the three capital cities. Property prices have dropped most in Estonia’s capital, Tallinn, where official statistics and anecdotal evi-dence indicate that property prices have dropped around 10% this year. Latvia’s capital, Riga, is also ex-periencing falling property prices – down 5-8% over the last couple of months and most indicators suggest-ing an acceleration in the rate of decline.

There are also signs of slowing property prices in Lithuania’s capi-tal, Vilnius, but it is still too early say that property prices are actually declining. There are a number of rea-sons why property prices are now declining in the Baltic States. In our view the primary reason is simple – prices have simply risen far too much relative to fundamentals. Furthermore, a number of negative shocks have hit the Baltic property markets. Most importantly, interest rates have gone up in line with European rates over the last year. Furthermore, the banks have tightened credit standards on the back of rising con-cerns about the large imbalances in all three countries. Hence, it looks like the boom in the Baltic property market is coming to an end. It is very difficult to assess how far property prices in the Baltics could potentially fall, but given the large imbalances in the Baltic economies we think the downturn could be quite severe and long-lasting. It is debatable whether there has been a Baltic property bubble, but there is no doubt in our view that property price growth has been exces-sive, and therefore property prices should be expected to slide further going forward.

So basically, and the bottom line here, the Baltic economies are extremely vulnerable to any sudden turn in investor sentiment. We are in the middle of a major sea change in global sentiment even as I write, so at the end of the day all I can say is, do watch out.

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