cross posted from Alpha Sources
As a part of my general assessment of the current financial market turmoil which has lead me to conclude that especially Eastern Europe should be carefully watched Lithuania in particular has commanded a lot of attention here at Alpha.Sources. Of course, my general attention directed towards Eastern Europe has been shared by my colleague Edward Hugh who is shadowing the day-to-day economic development in the Baltic and CEE economies on the following three blogs; Baltic Economy Watch, Eastern Europe Economy Watch and Latvia Economy Watch. This is then to say that if you want to do a bit of catch-up as it were on what is actually going on the links provided above should provide you with plenty of ammunition. In general and as we home in on today's topic, the Baltic economies are interesting for three main reasons ...
- All three countries have pegged their exchange rates to the Euro. Apart from being a simple fact we need to understand the perfect logic in this regime since these countries are shaping up to become a full fledged member of the Eurozone. Ironically of course this may now seem to be one of those events subject to eternal postponement as inflation remains at very high levels well above the comfort level for Trichet and his cabal in Frankfurt. The situation is well epitomized in the following headline carried this morning in Bloomberg; Baltic Inflation Leaves Slovakia as Only Viable Euro Candidate. Another aspect which is then intimately tied to the choice of a pegged exchange rate regime in the Baltic economies relates to the potential risk of a sudden abrupt unschackling of the exchange regime as a result of the inability to maintain the peg. Many events can course such a process and as the US economy seems set for sub-trend growth and as the financial market turmoil muddles along the risk is increasing given the rather unsustainable growth path of the Baltic economies. In this note I will focus on Lithuania. I will predominantly try to treat two topics. Firstly I will try to quantity the recent build up of credit in Lithuania in the current (very expansory) cycle and secondly I shall look at the balance sheet exposure towards a potential correction of the exchange rate.
- The second reason why the Baltic economies is interesting is quite simply derived from the fact that all three countries seem to have been somewhat on the forefront of the overall credit expansion in Eastern Europe. At this point I would not try to give any kind of explanation to illuminate this but my intuition suggests that perhaps the very nature of the Baltic economies' institutional environment, of which the currency peg and subsequent expectation of Euro membership is certainly an important factor, as well as the relative proximity to the competitive Nordic economies have created a solid base for the recent economic expansion.
- The third stylised fact attached to the interest of the Baltic economies is quite simply their difference. In this way we could as a rough and ready approximation group the Baltic economies according to potential risk relative to the current environment. As the most exposed economy Latvia seems to hold this ill favored position as the build up of credit and subsequent inflation has been somewhat more severe in this country. Secondly, we have Lithuania which I shall examine today where it seems as if growth is not as sizzling as in Latvia. Lastly, we have Estonia then and although the expansion indeed has not passed Estonia in its wake Estonia has not seen such a rapid exodus of workers as its neighbours and this together with other factors (see below) may render Estonia to be able to weather the storm just a wee bit more effectively than its Baltic counterparts should push come to shove. For a more thorough assessment of Estonia I recommend this GEM note authored by Edward Hugh and Aapo Markkanen. Clearly, this juxtaposition is not by any means exhaustive but it should act as a fair initial guidance line for the economic situation in the Baltics.
As a first approximation to the topic in question let us look at the evolution of total amounts of outstanding loans to households and non-financial corporation since October 2004 (monthly data). As a qualifying note the notice of (non-cumulative) might seem a bit odd but it originates from the fact that the data set includes loans with between 1-5 year maturity which means of course that, given the time span in question, non linear overlappings will be present as a result of the term structure of the data set.
Putting methodological issues aside we can easily see the extent of the expansion as it took off especially in the middle of 2005. In order to substantiate the figure above we can see from the two figures below that particularly loans to households have seen a steady increase through what seems clearly to be housing loans (+5 year maturity) and consumer credit loans.
A hefty and steady increase of credit to households and non-financial corporations does of course not indicate that ill tidings are in store for the economy. However, as is so often the case we need to consider the overall quantity as well as the subsequent effects on wages and inflation. In this way as it has been noted several times (see links above) Lithuania now finds itself with a rather large and growing current account deficit as well as it is almost certain that labour productivity has been wholly unable to follow the increase in wage costs which has then eroded the external competitiveness and thus probability for an endogenous correction of the external balance. It is in this context and with what seems to be an evolving state of uncertainty in financial markets that the next aspect of this analysis becomes important.
Consequently, what really matters in Lithuania's situation is the hypothetical risk associated with a potential run on the currency and subsequent testing of the peg (for a general assessment of this issue in Eastern Europe see this piece from the WSJ). In order to illuminate and gauge this risk we will look a bit more closely at the denomination of all those loans which have been provided to Lithuanian households and corporations. This will in turn be compared to the overall currency denomination of residents' deposits in order to essentially create a proxy for the risk associated with a sudden appreciation of the book value of loans outstanding relative to a depreciation of the deposits and essentially income cash flow used to service these loans*. The following two graphs seek to shed light on exactly this aspect. The first shows overall denomination of loans whereas the second shows denomination of resident deposits. What we are obviously looking for is a mismatch which might lead to an increased risk as a result of a sudden appreciation of the Euro with respect to the Litas.
As we can see quite obviously from a comparison of the graphs above the potential exposure is rather large. However, we should note that whereas the relative ratio of deposits remain the same over the time period in question the ratio of Euro denominated loans to Litas denominated loans has declined steadily from around March 2006. This does not however mean that the exposure has evaporated and there seems indeed to be notable balance sheet issues present in the situation of run on the Litas peg. As a general qualifier we of course have no idea regarding the extent of currency hedging and thus how many of these positions are backed in the derivative markets. In the perfect world it would clearly have been optimal to gauge especially households' currency exposure in order to assess the potential for very rapid contaigon to the real economy.
As a final note it is of course most relevant to actually gauge the risk of a breakdown of the peg which could lead to the balance sheet issues sketched somewhat above. Given the small size of Lithuania and indeed the Baltic economies in general it would seem as if ample opportunities would exist for a potential bailout; surely the ECB would be able to cover the Lithuanian balance sheet. But then we also move in muddy territory since there would be no precedent for such a move (right?) and at the end of the day the future prospect of Euro membership does not work as a pull process from the point of view of the ECB but rather as a push process from the point of view of outside economies. All in all, the peg might very well remain for some time but given the obvious unsustainability of the current growth rate relative to deteriorating capacity constraints on the labour market I am looking into the future with some anxiety.
* At some point I will provide a comprehensive list of literature regarding currency crises and balance sheet issues.