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Tuesday, October 16, 2007

Translation Risk in the Baltics and other matters on Eastern Europe

by Claus Vistesen

cross-posted from Alpha Sources

Work is piling on my desk at the moment and I fear that events might even overtake my efforts to keep up with them but here is to trying. Basically and if this was not clear back in the beginning of September it should now be readily clear everybody that Baltic and CEE economies now need serious watching and attention. As my regular readers will know I have been slowly and steadily chipping away together with my colleague Edward Hugh. My own catalogue of posts on the subject can be found here and you might also want to check the following three blogs; Baltic Economy Watch, Eastern Europe Economy Watch and Latvia Economy Watch. Also, the group blog Global.Economy.Matters has been the venue lately of some very interesting posts on the issue at hand. In fact, Edward's recent entry over at GEM offers an excellent introdution to the issues in Eastern Europe as they have been dealt with and indeed described regularly in the past months here at this blog. As such and in order not to repeat myself, I reproduce a key quote by Edward below which sums up the current situation quite well and also allows me to get down to business in this post ...

Basically the principal outstanding issues confronting the EU10 countries are threefold:

1/. Labour capacity constraints (which are normally a by product of long-term low fertility and large scale recent migration flows) are producing significant wage inflation and strong overheating.

2/. A structural dependence on external financing - which is in part a by-product of the effect of low levels of internal saving, and which is another factor which separates the EU 10 from those like India or China who are benefiting from a typical demographic dividend driven catch up, is leading to large current account deficits, and potentially high levels of financial instability.

3/. A loss of control over domestic monetary policy due to eurozone convergence processes which - with or without the presence of formal pegs - make gradual downward adjustment in currency values as a alternative to strong wage deflation virtually impossible. This issue is compounded by the likely private "balance sheet consequences" of any sustained downward movement in the domestic currency given the widespread use of mortgages which are not denominated in the local currency.

Now the worrying part about all three of these is that they are not simply cyclical in character. As such they are not problems which will "self correct" as a result of a recessionary slowdown, whether this be of the "soft-" or "hard-landing" variety.

And business, as it were, in this post is basically an extension of the analysis I did a couple of weeks ago regarding the balance sheet exposure of (primarily) Lithuanian households towards a potential rattling of the pegs to the Euro carried by a currency board. To put it more directly, this post will deal with aspects of the topic at hand which ties up to point 2 and 3 above.

In order to frame the discussion a bit before we move into the data I want to emphasize that the risk of a rapid currency unwind somewhere in Eastern Europe is most emphatically not some kind of odd suggestion. The risk is very real indeed! You just need to take a brief look at what has happened the past weeks to see how things are now set in motion towards what seems to be an inevitable loosening of the tight strings attached between the Eurozone and the pegging and also floating currencies in Eastern Europe. Exhibit one is found in two recent publications from the World Bank and the IMF in which specifically Eastern Europe is singled out as a cluster of countries where the economic development as epitomized by the three points above have put these economies in a situation where not only the general macroeconomic environment is in risk of taking a serious blow. However, this is also a situation where the process of convergence with the Eurozone countries as well as of course the final carrot of Eurozone membership have become events subject to eternal postponement for the majority of the countries in the region. Now, this raises obvious questions surrounding political reactions and while I can understand the overall political and economic dynamics which are now set in motion I also need to emphasize why these countries should not be handed the stick at this point since this would not help at all. Yet, this is an issue for another post. What I am really getting at here, and this would be exhibit two, is quite simply the fact that people which in this case mean policy makers and opinion makers at the ECB as well as of course investors seem to be positioning themselves for a collapse of the de-facto fixed exchange rate regime which ties together the Eurozone and most of the CEE and Baltic economies. A notable example of this would then be Danske Bank's Lars Christensen who is also shadowing the unfolding events in Eastern Europe and who recently suggested in a note that the ECB might be growing rather un fond of the close ties to the economies in Eastern Europe with respect to the fixed exchange rate relationships.

The increasing and clear signs of overheating in a number of Central and Eastern European countries – especially the Baltic States and South East Europe – are drawing attention not only from the financial markets, but also from international institutions. Recently the IMF has warned of the dangers of overheating in the CEE and the World Bank has on numerous occasions raised the same concerns. Now the ECB is also stepping up the rhetoric. At a conference earlier this week ECB officials expressed their concern about the in-creasing imbalances in the Central and Eastern European economies.

Now, some of my readers with a special interest in ECB affairs will recognize that Christensen is a keen ECB watcher by his mentioning of a recent conference on Eastern Europe which indeed produced some rather spectacular contributions related to the economic situation in Eastern Europe. The most cited speech from this conference is consequently one held by Lorenzo Bini Smaghi who is a member of the executive board about the risks which pertain to the process of convergence in Eastern Europe. Of course, mentions of the currency pegs were not made explicitly but as Christensen also homes in on, Bini Smaghi did note that there is a clear tradeoff between keeping the pegs and continuing the process of convergence. I will devote more time later to discuss this speech as well as another one along the same lines made by another member of the executive board Jürgen Stark but for now and in connection with the immediate topic at hand we need to understand that the scene is now effectively set for an (potential) economic correction triggered by either/or both an unwind of one of the pegs and an 'attack' one of the floaters.

Moving on to the Baltics

It is thus in this immediate light that I am going to present a slew of graphs below on the Baltics which, as noted picks, up on one of my recent posts on Lithuania which deals with the concept of crossover currency balance sheet exposure or as it has been coined in the literature; translation risk. The following definition is from investopedia.com:

The exchange rate risk associated with companies that deal in foreign currencies or list foreign assets on their balance sheets. The greater the proportion of asset, liability and equity classes denominated in a foreign currency, the greater the translation risk.

Now, the first interesting thing which should be noted in the quote above is of course the notion of how 'companies' are emphasised. Now, I don't have a very broad overview of the literature on this topic but on the back of a superficial glance it seems clear to me that most of the words on this subject has been devoted to the description of companies' exchange rate risk of operating in foreign countries under insecure exchange rate systems and obviously subsequently how this risk can be hedged using derivatives or just by calibrating the denomination of the stock of liquid assets held on the balance sheets. In this way, we need to look at another kind of translation risk and one which is especially important in the case of the Baltic countries and in fact also in many other countries in Eastern Europe. Simply put and as an inbuilt and strongly influential factor in connection to the general economic situation these countries have, as mentioned above, seen a very rapid increase in credit/capital inflows in the past years to cover a ballooning negative external balance helped on its way by boom in domestic demand. The point is moreover that the majority of this credit has been extended to households through loans intermediated by foreign financial institutions and thus in foreign currency (mostly Euros). As an overall point the following point as quoted by a recent report by the World Bank (linked above) is important:

External positions in 2Q 07 in most EU8+2 were financed by FDI. In the Baltic countries they were financed by foreign borrowing through the banking sector. In most countries current account deficits remain largely covered by FDI – fully in the Czech Republic and Poland, in 90% in Bulgaria and 2/3 in Slovakia and Romania. Meanwhile in the Baltic countries, which have the largest imbalances, FDI cover 1/3 of CAD in Latvia and Estonia and slightly more (58%) in Lithuania with banking sector foreign borrowing remaining the primary source of financing.

This last part is rather important for the analysis at hand which basically seeks to present comparable charts for the three Baltic countries according to the following overall analytical principles.

  • The charts will show three things. Firstly, charts will be presented on the evolution of the external balances in order to show the magnitude of the problem. Secondly, a set of charts will seek to show the overall build up of credit measured as the evolution of the total stock of loans with special focus on the households' contribution. Thirdly and as a direct measure for the potential translation risk associated with an unwind of the fixed exchange rate regimes in the Baltics charts will be presented which compares the denomination of loans with the denomination of deposits in financial institutions. In this way it is important to note that we are not comparing the stock of loans with the stock of deposits according to a criterion of how much the latter can cover the former in absolute terms but, as it were, solely with a focus on cross-currency denomination.
  • The charts, which will be presented without many words, denotes what you could call a static analysis of the issue of translation risk. The point is that the charts solely show stocks and not flows. It is thus assumed that in the case of households in particular the cash flows used to service the loans are denominated in local currency (i.e. salaries) as well as it is assumed that households have limited acces to intruments used to hedge cash flows at different points in time.

Now, and if I have been able to hold on to you until this point why don't take a look at the charts. We will begin with the charts showing the evolution of the external balances before moving on to charts showing the evolution of the stock of loans and finally finishing off with charts comparing the denomination of loans with the denomination of deposits in financial institutions. The charts which cuts across all the Baltic countries have been made with the explicit goal that they are comparable. It has not been a complete success but it works.

Current Account (Estonia, Latvia, and Lithuania)

Evolution of total stock of loans (Estonia (million EEK), Latvia, and Lithuania)

Stock of loans and deposits by currency denomination (Estonia, Latvia, and Lithuania)

(Please click on images for better viewing)

As promised I won't say a whole much at this point save of course to point out that the charts above do indicate that a considerable amount of translation risk is present which also conforms with the rather large amount of anecdotal evidence.


TSR said...

Estonia’s success comes from the economic freedom allowed to their business. The ideas of the free market were boldly put into practice and the world is watching the growth of that country. Less than 20 years ago they were in conflict with Russia. The singing revolution inspired Estonia and other countries in the region to protest for their freedom. (There is a great Documentary about Estonia's Singing Revolution: http://singingrevolution.com) It’s an emotional insight to the revolution.

Jim Hass said...

Indeed the Estonian record for economic growth and economic freedom are exceptional, but they are not perfect. In the area "hiring" they rank all the way down at 151 in the latest "Doing business around the world" study by the World Ban. Fraser and the Heritage Foundation have a similar dismal view of Estonian labor law. Real wage rigidity combined with a reversal of money supply growth recalls any previous disasters.