In Search Of The Bottom - Estonia's Economy Continues To Drift Aimlessly

The Estonian recession continues to deepen, month by month. The most recent evidence comes to us in the form of a decline in both Estonian retail sales and industrial production, which fell in each case for the fifth consecutive month in September, leading us to expect the rate of GDP contraction to accelerate further in Q3.

Retail Sales Fall An Annual 8%

Retail sales, excluding cars and fuel, fell by an annual 8 percent in August, the largest such decline registered since at least 2001. This follows a 6 percent in August. The year on year chart (see below) couldn't be clearer.



Sales were also down month on month (ie with respect to August), this time by a non seasonally adjusted 7%. In fact, on a seasonally adjusted basis retail sales peaked in February 2008, and have been trending down since. We still don't have the seasonally corrected data from Eurostat for September, but looking at the uncorrected data we do have from the Estonian statistics office, it does seem that retail sales were down again in Q3 over Q2.




Thus retail sales turned negative in March and the trend simply continues. The decrease in the retail sales of goods was most influenced by the stores selling manufactured goods where sales decreased by 12% compared to September 2007. Sales in non-specialized stores selling manufactured products and shops selling household goods and appliances, hardware and building materials were the worst hit.

Sales in grocery stores have, as might be expected, been rather more stable, with sales only down 3% . As had been the case in previous months, the decrease in food sales was largely influenced by the rise in food prices and the resulting decline in consumption.



Industrial Output Down 3.8%

Output adjusted for working days decreased an annual 3.8 percent, compared with a revised fall of 3.7 percent in August.

If we look at the seasonally and working day adjusted output index, then we can see that the level of output is now meandering downwards, and we now are way off the highs reached during last October and November. With this in mind we should expect the year-on-year percentage drops to start to decline after December, but it will then become much more interesting to follow the evolution of the absolute levels indicated by the general output index.

The main reason for the decline in output is evidently the lack of demand. The fall in manufacturing output was greatest in food, wood and building materials production. Food output was especially hit by the decrease in consumption resulting from this years large price increases. Although the rate of price increase has decelerated in recent months, food product prices are still up by 12% compared to September 2007.

The other area with big output drops is the manufacturing of wood and wood products, where the drop in sales in both domestic and external markets continues. The Estonian market is influenced by the construction slump, while in the external market Estonian manufactures are having a hard time due to the competitive environment and their own weaknesses in price competitiveness. Compared to September 2007, 22% less sawn timber and 9% less glue-laminated timber were produced. The largest drop (32%) was in the production of building materials which is directly connected with the decline in the construction market.

Some export-oriented industries have been continuing to expand - even in this difficult environment - especially enterprises involved in the manufacture of metal products, chemical products, and electrical machinery. Output was also up in the manufacture of machinery, radio and communication equipment, precision instruments and motor vehicles, since again a lot of the output is for export. The export share is 97% in the manufacture of radio and communication equipment and 91% in the manufacture of precision instruments.

Both Wages and Unemployment Still On The Rise


Wages continued to rise rapidly in the second quarter, up by 15.2%, even if this was the slowest pace of increse in more than two years, while the unemployment rate rose - to 3.1 percent in September - the highest level in more than three years.

Estonia's jobless rate, based on the number of unemployed registered with labor offices, rose to 3.1 percent, the highest since July 2005, from 2.9 percent in August, according to data from the Estonian Labor Market Board. The number of people signed on as seeking a job rose 6.6 percent from the previous month to 20,015. This number is of course, incredibly low by any comparable international standard, and is hard to square with a country in the midst of a very deep rcession (even after all the ritual genuflections towards the labour marekt being a lagged indicator). In order to understand how this situation is possible it is important to take into consideration Estonia's special demography and migration history.



However, it is also true to say that unemployment does normally follow changes in economic output with a time lag, se we should expected it to rise considerably in the coming months and quarters. Indeed the unemployment rate as measured by the Estonian statistics office in quarterly labor surveys is nearer to 4 percent in the second quarter (and the EU harmonised rate which is based on the survey shows 4.2% for September in the Eurostat database), and may rise as high as 10% according to recent estimates from Erkki Raasuke, head of Baltic research for Swedbank AB (not that they have been getting too much right of late, but still).


Despite the fact that unemployment will undoubtedly rise further as the recession deepens, it is the very tighness of the labour market (which is, as I say, in part a product of Estonia's demography) which prevents wage increases slowing down more rapidly, and thus the entire Estonian price system adapting to the slowdown (this phenomenon is often called "sticky wages and prices", and as we can see, the degree of viscosity here is almost treacle like). So Estonia's low earlier fertility fuelled the initial wage craze which along with the credit boom got us to the present point, and now the same lack of strength in depth in the labour market blocks the downward adjustment. In both cases the net by-product is massive pressure on the Kroon-Euro peg as Estonia struggles to find export competitiveness.


Consumer Confidence Falls Again


Unsurprisingly Estonian consumer confidence fell again in October, hitting its lowest level in more than 9 years, a sure sign the that the economy is about to shrink again, as domestic demand continues to search for a bottom. The Tallinn-based Konjunktuuriinstituut consumer confidence index declined to minus 27, its lowest reading since June 1999, and down from minus 22 in September. The institute cited worsening expectations for personal and state finances as the key drivers behind the drop.

And of course, consumer confidence is not only falling in Estonia, it is also falling among potential consumers of Estonian products in all Estonia's export destinations. Indeed general European economic confidence saw its biggest ever fall in October as the global bank crisis generated the bleakest outlook since the early 1990s, at least these are the findings of this months European Commission economic sentiment survey. The survey results give us just one more dramatic illustration of the devastating impact the financial turmoil is having on Europe's real economy. Pessimism has risen dramatically on all fronts - from manufacturers' expectations about exports to consumers' fears about unemployment.

The European Union executive's "economic sentiment" indicator for the 27-country bloc fell by 7.4 points in October to 77.5 points. The latest index reading was the lowest since 1993 and marked the largest month-on-month decline ever recorded.


And even as confidence deteriorated sharply in key EU economies like Germany, Italy and Spain, the increasingly-worrying outlook for all those previously fast-growing eastern European economies is now hitting business and export opportunities pretty hard, and this is plain from the survey. All three Baltic economies registered another sharp lurch downwards, with Lithuania, as has now become almost traditional, hanging back slightly from the Ocean depths currently being combed by her Estonian and Latvian neighbours.






The Outlook Darkens

And just to add to all these woe's Eastern Europe is currently experiencing what amounts to its biggest credit rating downgrade in at least a decade, adding to evidence that the region far from avoiding the impact of the global credit crisis, may well find itself at the very heart of the next stage.

“We expect the EU and the IMF to announce additional rescue packages for other Central and Eastern European economies in the coming days and weeks. Top of the list are the most imbalanced countries in the region - the Baltic States, Romania and Bulgaria."
Lars Christensen, Danske Bank, Copenhagen

Both Standard & Poor's and Fitch Ratings have responded over the last month to mounting risks from the global credit crunch by downgrading or revising credit rating outlooks to negative for a number of CEE economies including the Baltic states, the Balkans, Hungary and Ukraine. Moody's Investors Service has also revised its outlook to negative for Latvia and downgraded Ukraine.

S&P and Fitch both downgraded long-term sovereign ratings to Latvia and Lithuania on Oct. 27, citing recession risks and the growing need for external financing, while Estonia, had its rating cut by Fitch and outlook revised to negative by S&P. Basically, the crunch is biting in terms of both the cost and the availability of credit. This tightening in credit conditions is not, of course, new in Estonia, and in many ways we could say that the credit conditions should never have been allowed to get so "loose" in the first place. As can be seen from the chart below, the year on year rate of increase in peaked at the end of 2006, and since then the slowdown in Estonian domestic demand has been driven by the slowdown in the availability of credit (strictness off the terms, documentational requirements etc). Evidently, if such criteria had been applied much earlier, and the rate of annual increase never approached 80% all this may well have been a much less dramatic process.







The Estonian central bank said last week revised it's forecast for the economy, which has already made the turn around from being the second-fastest growing one in the EU in 2006, to being one of the most rapidly contracting ones in 2008. According to the bank the Estonian economy may shrink 1.8 percent in whole-year 2008 and 2.2 percent in 2009. As we have noted above the economy sank by 0.8% q-o-q in Q2 and by 1% year on year.



The decrease in GDP in Q2 was mainly a result of weak domestic demand, but the drop in both imports and the rate of increase in the export of goods and services meant that the contribution from external trade was negative. About the only item which maintained some momentum was government spending - buoyed by the tax income from an earier and better epoch. Compared to Q2 2007, total domestic demand was down by 2.8% , largely as a result of adecrease in private consumption and capital investments ( down by 2.0% and 2.5%, respectively).



Private consumption decreased mainly due to the decrease in expenditures on transport and clothing and footwear. The growth of expenditures on food and non-alcoholic beverages decelerated. Capital investments decreased in both the financial and the household sector. Investments in manufacturing industry were almost stationary year on year. At the same time public sector construction investments accelerated.



The decrease in exports and imports since the second half of 2007 which had been noted in Q1 went even further in the 2nd quarter. Compared to the 2nd quarter of the previous year, exports of goods and services decreased by 4.9% and imports by 8.2% (at constant chain-linked prices).




Goods exports were down by 3.2% primarily due to the decrease in exports of refined petroleum products. At the same time, exports of basic metals and electrical machinery (electrical motors and appliances), which significantly influence export movements, increased. Exports of services decreased by 8.9% primarily due to the decrease in exports of services for railway cargo, airway passengers and cargo transport and trade related exports services. The decrease in imports of goods was influenced mainly by the decrease in imports of refined petroleum products and motor vehicles. While imports decreased faster than exports, the deficit of net exports in GDP has increased since the second half of 2007 and amounted to -4.6% of GDP in the 2nd quarter. In the 1st quarter the impact of net exports was -7.1% (so the negative impact slowed vis a vis Q1).

Fiscal Crunch Coming

Basically, as the economy slows, and government income increases even while counter cyclical spending policies add to expenses, the government is moving into tricky fiscal deficit territory. Mindful of this the Estonian government approved on September 25 a draft 2009 budget which attempted to balances overall finances, including local government and the social insurance funds. The budget, which is still to be finally approved by the Estonian parliament, will fall into a deficit and need to be covered from government reserves, according to former Prime Minister Vaehi in a recent interview with the Maaleht newspaper Maaleht.

A deficit of 10 billion krooni would equal 3.5 percent of the expected gross domestic product of 283 billion krooni forecast by finance ministry in August. SEB have forecast a deficit of 1 percent of GDP in Estonia's overall finances next year.

Falling tax revenue has forced the Estonian governemnt of Prime Minister Andrus Ansip to cut spending and seek out new financing in an attempt to maintain a balanced budget, formerly a linchpin of the country's fiscal policies. The Finance Ministry have already forecast the budget will fall into a deficit of 3.1 billion krooni, or 1.2 percent of gross domestic product this year, after running surpluses in each of the last 6 years.



Two Questions In Conclusion

Basically then, it is hard to call the exact impact of trade on Q3 data without having the September trade data in front of us, since although the July and August export numbers are well below the April and May ones, we also need to take into account the accompanying drop in imports (which helps net trade, and thus is GDP positive). On the other hand the general impression you should get from all the data is that we are in for another shocker in Q3. Which leaves us with two questions:

1/ Where do we go from here?
2/ Just how long will it be before we hit generalised price deflation?

Let's take the second one first. Possibly for many people the question will appear to be a ridiculous one, but it isn't. If you look at the CPI index itself (this now becomes much more important than the year on year inflation rates, since what we need to watch for are the price movements from month to month. Now in the rate of increase from one month to another has been slowing, and in September the index was barely up over August (less than 0.5%, following a virtually stationary reading in August over July) so we should not be surprised to see the index hit a ceiling at some point, and then start to come down. Basic economic theory leads us to expect this (on the back of falling commodity and food prices and in a situation where internal capacity is way above the sum of internal and external demand available to the Estonian economy at current prices). Thus there is only one way for prices and wages to go: down. Although people may struggle with all this yet awhile before they accept the inevitable.



So what about the future of the economy in general? Well, let's take two quotes from the most recent Eesti Pank growth forecast. First, a recognition that they got it wrong in the past:

According to the base scenario of Eesti Pank's 2008 autumn forecast, Estonia's gross domestic product will decline by 1.8% in 2008 and by 2.1% in 2009. So far the economic correction has been more abrupt than expected primarily due to decreasing domestic demand. In addition to the cessation of the rapid real estate market expansion, also private consumption dropped in spring more than forecasted.

and now a forecast which, it seems to me is based on the same faulty methodology that lead the current deline to be "more abrupt" than they expected earlier.

According to Eesti Pank's estimate, the economy should pick up again either at the end of 2009 or at the beginning of 2010. The average economic growth rate of 2010 will be 3%. Private consumption growth should recover in 2010 along with the revival of household confidence, whereas 2009 will be characterised by slowing wage growth and increasing unemployment.

As I say above, I expect wage declines, and not slowing wage growth, but this is beside the point. Household consumption will undoubtedly decline in 2009, but I am not expecting any significant recovery in 2010. And the reasons for this expectation are based on some of the main tenets of economic theory as I understand them. Basically Estonia is in the midst of the transition from being a domestic consumption driven economy to being an export driven one. This, in part, has something to do with the demographic transition which Estonia is currently passing through.

Estonia is, if you like, about to become more like Germany and Japan, and less like the UK, or the US, or France, in terms of a basic typology of economies. And if you look carefully, you will see that the one thing that doesn't recover (ever) in Japan or Germany is household demand. The reason for this is obvious, and it has to do with the demand for credit. Proportionately less people in the age groups which drive the demand for credit increases means that credit (and with it domestic consumer demand) becomes less of a driver of economic growth and exports become proportionately more important. This is why German and Japanese banks have relatively less exposure to their own domestic property booms, but have been carrying losses from housing liabilities elsewhere.

Unfortunately, this is not some strange opinion I have acquired from some distant planet or other. It is based on, and supportable by, fact, and by what is going on right in front of our noses. We are not playing some sophistocated intellectual game here to see who is right and who is wrong. People's livelihoods and those of there children depending on getting a hold on this, and the sooner that the economists over at Eesti Pank (and elsewhere) get the underlying dynamics straight, the better.

Estonia's Trade Deficit Drops In August

I suppose in the midst of all this mess we should be thankful for small mercies. Estonia posted its smallest trade deficit in two and a half years in August, helped by in part by rising exports, and in part by the declining cost of crude oil (which reduced the value of imports).

Estonia's deficit narrowed to 2.7 billion krooni ($220 million), down from a revised 4.3 billion krooni in July, according to data out today from the statistics office.





Exports rose an annual 8 percent and imports fell 6 percent. Thus we could say that August was a comparatively good month, but we should not draw any very extensive conclusions from this about what we may now get to see next in September and October. Really we will need to wait and see the data for next January and February (by which time we could hope things will have settled down a bit) before we can begin any real damage assessment.



Latvian Central Bank Buys More Lati


The Latvian central bank bought about 86 million lati ($150.8 million) in the market last week to support the currency after it weakened to the limit of its trading band, according to data released by the central bank today The lats fell to 0.7098 against the euro for the fourth consecutive week, prompting the bank to buy it. The currency is allowed to rise or fall 1 percent from a midpoint to the euro.

The central bank has bought about 237.5 million lati over the last four weeks. It had foreign currency reserves of about $6 billion at the end of September, which would cover the last five months of imports. This month's bank intervention has reduced reserves by about 7 percent.

Swedbank To Raise Capital

Swedbank have said today (Monday) that they plan to raise more than $1.5 billion in a rights issue at the same time as the Swedish central bank have announced that they are to provide capital for a smaller bank in an attempt to lessen the risk of "serious" systemic disruption. Swedbank, whose shares have slumped lately on worries about mounting credit losses from its Baltic business, thus became the first major Swedish financial firm to shore up its balance sheet during the current crisis.

But the bank was swiftly joined by investment bank Carnegie which said it had been granted a 1 billion Swedish crown ($126 million) bridge loan from the Riksbank pending a government guarantee scheme.

Swedish banks until recently were considered less vulnerable to the global credit crisis: They had little direct exposure to sub-prime mortgages and a more conservative financial profile. But Swedbank's exposure to the Baltics, where it had expanded in the search for stronger growth, has obviously rattled the market, and follows a pattern of banks whose domestic markets did not suffer from a domestic property bubble getting over-exposed in other countries where they did.

Carnegie's capital boost was less than a 10th the one Swedbank are contemplating, but the Riksbank's statement raised the possibility of systemic problems.

"Given the currently prevailing anxiety, the Riksbank has decided to grant
liquidity assistance to Carnegie to reduce the risk of a serious disruption to
the financial system," Riksbank Governor Stefan Ingves said in the statement.

Carnegie was finding it difficult to finance payments and it was suffering from increased collateral requirements in the wake of the financial crisis.

Swedbank said it plans to issue one preference share for every two existing ordinary shares at 48 crowns per share, raising a total of 12.4 billion Crowns. Swedbank said the issue was fully underwritten by investors. The issue will boost the group's Tier 1 capital ratio to 10.5 percent from the present 8.7 percent and its core Tier 1 ratio to 9.2 percent from 7.4.

Swedbank's declared loan losses in the Baltic region were 405 million crowns in the third quarter, against 153 million crowns in the same period a year earlier and 245 million in the second quarter of 2008. Swedbank and its domestic peer SEB have both in recent years expanded in the Baltic region. But as the financial crisis has worsened, and economic prospects for the Baltic countries have grown steadily bleaker, generalised concerns that loan losses at the banks could rise sharply have been mounting.

Sweden Bails Out It's Banking Sector

Well, don't those days when everyone was arguing that the Baltic economies were going to be just fine, since they were such small beer that foreign banks would be only too happy to keep funding them until the cows came home. Well, the cows it seems have just reurned to their sheds.

Sweden has become the latest European country to take steps to stabilise its financial system by guaranteeing up to $205bn of new bank borrowing and creating a fund to take direct stakes in banks.

Stockholm had insisted there were few problems in its banking sector, but on Monday it was forced to match the stabilisation measures of other European governments and respond to fears its lenders might not escape the global financial crisis unscathed.

In particular there were worries a sharp correction in the economies of the Baltic nations of Latvia, Estonia and Lithuania could undermine its banks, which control two-thirds of lending in the three former Soviet states. Fears about this exposure were one reason share prices of Swedbank and SEB almost halved this year.

The new package involves a pledge to guarantee up to $205bn (€150bn, £120bn) of new medium-term bank borrowing and a separate SKr15bn ($2bn, €1.5bn, £1.2bn) fund that can be used to buy preference shares in any bank that needs a capital boost. As part of the legislation, which will go before parliament next week, the government will also assume the powers to take over banks.

This shoring-up of Sweden's banks could be thought of as an initial protection against any break in the Baltic pegs since as John Hempton points out in a detailed analysis of the situation:

If the Lati doesn't devalue its only because people (i.e. Swedbank) are prepared to continue to fund it. This is not pretty at all. All in Hansa owes Swedbank over 30 billion Swedish Kroner – all denominated in Euro and which can't be paid. The equity capital of Hansa (roughly 7 billion Swedish Kroner) is also going to default.

And there is always Claus Vistesen's most recent examination of the whole position if you are in the mood for a longer read.

And, oh yes, there is also the news that the Latvian central bank bought 24.8 million lati ($47.3 million) in the market last week to support the national currency after it weakened to the limit of its trading band, according to a statement by the bank.

The lats weakened to 0.7098 against the euro for the third consecutive week, prompting the bank to buy the currency to keep it within its trading band. The lats is allowed to move 1 percent on either side of a midpoint against the euro. The central bank has now bought about 151.5 million lati over the last three weeks to support the currency

The Baltic States May Soon Follow Hungary Into IMF Receivership

Well, the Icelandic authorities seem to have bitten the bullet, and after some coming and going agreed to accept assistance from the IMF. An IMF mission is on the island preparing a plan which will then be put to the Icelandic government (protocols here are important). Under negotiation are the terms of any possible loan. According to Einar Karl Haraldsson (a political adviser to the Icelandic government) the plan is expected to be finalized in the next few days, after which the government will have to decide whether to accept the aid and the terms under which it is being offered.

Meantime a growing number of countries now seem to be at risk of following Iceland and Hungary into the arms of the IMF, with the Baltic republics of Estonia, Latvia and Lithuania now looking particularly vulnerable, according to a warning from the International Monetary Fund itself yesterday.

Dominique Strauss-Kahn, managing director of the IMF, which was formally approached yesterday for assistance by Hungary as well as Iceland, said: "The fallout for most banking systems in emerging and developing economies has been limited so far but signs of stress are growing, " Strauss-Kahn said some banks in eastern Europe have become increasingly exposed to struggling property markets, having raised funds on international money markets in the same way as the ill-fated Icelandic banks.

For the time being the various national governments are denying the possibility, with Edgars Vaikulis, spokesman for Prime Minister Ivars Godmanis, being quoted in Bloomberg as saying "There is no reason to speak of threats to the Latvian financial system......Latvia's situation is different from some of the eurozone members.''

I'm sure that the latter statement is true, even if not in the sense that Vaikulis meant. Nonetheless the Latvian government has taken the step of raising guarantees on all bank deposits to 50,000 euros ($68,225), in line with an earlier decision by European Union finance ministers.

In my view the threat to the Baltic financial systems is real, as is the threat to the Bulgarian and Romanian ones. Action, of some form or another needs to be taken, and soon. Latvia and Estonia are now in deep recessions, and Lithuania, while still clinging on to growth, can't be far behind. Basically it is hard to see any revival in domestic demand in the immediate future, which means these countries now need to live from exports. But with the very high inflation they have had it is hard to see how they can restore competitiveness while retaining their currency pegs to the euro. The IMF will almost certainly insist on a currency float as a condition of rescue, and if you look at the speeches of Lorenzo Bini Smaghi and Jürgen Stark over the last year, it is clear that thinking at the ECB runs along pretty much the same lines. So better get it over and done with now I would say, and take advantage of the shelter offered in the arms of the IMF. Indeed the more I look at what is happening, the more it would appear that a division of labour was agreed to in Paris last weekend, with the EU institutional structure sorting out the mess in Ireland and the South of Europe, and the IMF taking care of all that broken crockery out there in the EU10.

In what is likely to become a sign of the times Hungary's MKB Bank announced that yesterday that it is going to stop providing euro- and Swiss franc-denominated loans until further notice. In defence of its decision MKB said the huge volatility registered in the value of forint in recent weeks, and especially the strong depreciation at the end of last week, make the outlook on the currency extermely uncertain. Most other Hungarian banks are expected to follow MKB's lead. This practice of bringing an end to the extremely dangerous practice of offering foreign exchange denominated loans in countries running large external deficits is now likely to come to a screeching halt all across the CEE and CIS economies, and bit by bit the IMF will have to be brought in to offer support during the transition back to reality.

For a full and thorough analysis of the current threat to the Baltic economies, see this whopping post this morning from Claus Vistesen.

The CEE and the Baltics - Moving Towards the Center of the Storm?

by Claus Vistesen: Lausanne

As I peer out my window over towards the Alps and the northern entrance to Le Vallé du Rhône I can't help asking myself whether some of those experiments which are habitually conducted a mere 40 kilometers from my current habitat haven't gone terribly wrong? With every passing day getting I find it more and more difficult to avoid associating all those worthy attempts to uncover that illusive Hick's Particle with the all-encompassing black hole into which our financial markets seem to be getting sucked with a disturbing velocity, despite the numerous efforts by the global financial authorities to invent some sort of monetary equivalent to "anti-matter".

But while the current crisis is pretty much a generalised global one, if there is one region where the crisis is making its presence more acutely than elsewhere, that place is Eastern Europe, and among the ranks of the regional casualties high on the list come the three Baltics countries, Estonia, Latvia and Lithuania. That this is the case should not really strike us as so strange. On many occasions since the credit crisis went global back in the summer of 2007 many analysts (including yours truly) have been flagging the risk of a hard landing in Eastern Europe. This unfortunate situation has now by and large materialised and the only question which really arises is how hard is "hard" going to be? A couple of recent tentative signs suggest that the big eye of the credit crunch, not unlike Sauron with his glance toward Frodo et al., is fixing Eastern Europe fast in its gaze.

In terms of Russia, we have already witnessed the speed with which financial markets have turned the tide for the erstwhile high powered economy. Now that oil is dipping into negative on an annual basis, the screw may just get turned a little more.

In Ukraine, the market for the state's sovereign debt almost collapsed during the past week as credit default swaps (insurance against loses on debt) rose almost 40% to 1700 basis points as rumours mounted on an early election as well as the government made steps to take over one of the country's big banks. Furthermore and as could be expected the Hryvnia took another beating. A similar situation seems be unfolding in Hungary where prominent government and central officials were dipatched spent part of their Friday trying to avoid a rout on the Forint in the spot markets. Meanwhile, and as a natural bed-fellow to this the stock market, and especially financials, were pumelled. In many ways, the Hungarian predicament resembles more and more a tragedy in the making which is also why the IMF is moving in to calm things down as well as attempt to bring the boat back on course.

The situation in Ukraine and Hungary is important. It highlights the flipside of de-pegging from the Euro (and in the case of the Hryvnia, the USD) in the expectation that subsequent appreciation will help quell inflation. Such a strategy perhaps seemed clever at the time (personally, I always had my doubt), but now as the tide turns downside risk is substantial. From a macroeconomic point of view this is extremely significant. a major part of Eastern Europe's expansion has been supplied by foreign credit and more importantly with loans denominated in foreign currency (mostly Swiss and Euro loans in Hungary and Ukraine). It does not take much of an economist to see the potential abyss of downside risk in the form of translation exposure. As Edward puts it in a recent note;

Basically, the crossover we need to be thinking about in macroeconomic terms is the one between the Swiss Franc and the Hungarian Forint, given the exposure of Hungarian households to Swiss Franc denominated mortgages, and the impact on internal demand which is to be expected if the current dramatic decline continues.

To cap it all off, the significant increase in stress levels of Eastern Europe aslo appears to be sending tremors towards Austria where the banking sector is highly involved as intermediary for swiss denominated consumer and housing finance.


And in the Baltics?

While things are likely about to get very interesting in Eastern Europe the recent tumultous events in financial markets seem to have spared the Baltics from the worst repercussions. This only goes for the more theatrical "Iceland type" events however. If we look at the real economy it is evident that a sharp correction has now begun, something which was confirmed as the data from Q1 2008 rolled in. If we take a look at the most important data pieces, the Baltics have now almost entered a collective recession (even if Lihuania is performing above par).

Both in Estonia and Latvia output contracted for the second consecutive quarter in the second quarter while output in Lithuania stayed surprisingly strong. On the inflation front it finally seems that the pressure is abating somewhat even if of course this is a process that works with considerable rigidities relative to the decline in output. In this way, the Baltics still find themselves in a situation of stagflation.

One very interesting development in this regard however is the evolution of labour costs. If we look at the development up until Q1 2008 the y-o-y increase was one of 7-10% per quarter, but that changed strikingly in Q2. As such, in Estonia and Latvia quarterly labour costs fell to 2.9% and 2.4% respectively Lithuania entered wage deflation. It is still too early to gauge a trend here but it is obvious that for the Baltic economies to correct while simultaneously maintaining a fixed exchange rate regime the correction mechanism would fall entirely on the domestic sector's ability to become more competitive.

And this is now becoming more than a passing preoccupation.

In this way, and while the external deficits have been reduced (mainly due to a sharp drop in imports) the imbalances are still very much present, not least because a negative income balance remains to keep the balance in red. As I have argued before this can only go on until it can't, which is a cryptic way of saying that something at some point has got to give. Unfortunately for the Baltics, the watchdogs of global credit markets (the rating agencies) have begun to seriously turn their scent on to the contradictory fundamentals of these three economies.

Last week, the Baltics's sovereign ratings were consequently collectively downgraded by Fitch Ratings which followed an earlier decision by Moodys to lower the region to negative. The reason cited will not surprise regular observers of these economies (indeed readers of this blog's eastern europe installments). Head of sovereings in Europe Edward Parker from Fitch consequently noted that the worse than expected correction in financial markets coupled with the vulnerable macroeconomic enviroment as the main reasons for the downgrade. More specifically, the mixture of external deficits funded to a large extent by inflows of credit (e.g. some 30% for Lithuania) supplied by foreign banks lies at the root of the decision and incidentally, as it were, also at the root of the macroeconomic vulnerabilities of the Baltic economies.[1]

In this context it is interesting to initially peruse the graphs plotting cross currency exposure and overall leverage (Latvia data only for households).

The point conveyed by the graphs above is one of the main reasons for an increasing risk of a more than traditional adverse outcome from this crisis. It is thus important to understand that the Baltics are still dependent on inflows of foreign credit even as the economy slows and that this shows up, in part, through the substantially higher leverage in foreign currency relative to the total leverage ratio. Especially the extra graphs in the Lithuanian case is interesting in that it shows how the marginal increase in total leverage from 2003 and onwards almost exclusively can be attributed to an increase in leverage of foreign currency loans relative to foreign denominated demand deposits.

This is of course where things begin to get interesting because if we look at the companies supplying the credit to the Baltics, they are increasingly looking to get sucked down into the maelstroem that has fit financial markets. Most prominently is of course the Swedish bank Swedbank which perhaps has the biggest exposure to Baltic markets (through Hansabank). Analysts have persistently been voicing warnings on Swedbank's aggressive lending policy in the Baltics, but if we look at activity in Q2 Swedbank continued to expand credit to the Baltics. And this is not a mere problem of a Swedish bank potentially having to retreat from a growth market gone sour. No, this has the potential to become a full blown macro catastrophe in which the Swedish Riksbank will be faced with the rather odd dilemma of having to bail out a domestic bank, in part, in order to allow the relatively benigh unwinding of macroeconomic imbalances in the Baltics.

It is extremely important in this regard to be aware of the narrative that Swedbank and the rest of the short term credit providers effectively are the only ones keeping the boat afloat. The logic, as brilliantly detailed by John Hempton here, goes as follows. The credit needed on a flow basis to sustain the Baltics' external deficit is being supplied by foreign banks and mostly through loans denominated in Euros (this last thing being very important). Consequently, this presents Swedbank et al. with a rather delicate problem. For the Baltic currencies (or one of them) not to devalue they need funding and more importantly, they need funding on their way down into whatever abyss that may now have opened. Now, as my colleague Edward pointed out in another context it is not the most pleasant of dilemmas to be confronted with the choice of having your throat slit with the stanley knife or the chainsaw. However, this may the situation which now confronts Swedbank, the Baltics, as well as potentially the Swedish Riksbank in the current situation which increasingly resembles some of Kafka's best creations. Hempton makes it very clear when he says;

If the Lati doesn't devalue its only because people (i.e. Swedbank) are prepared to continue to fund it. This is not pretty at all. All in Hansa owes Swedbank over 30 billion Swedish Kroner – all denominated in Euro and which can't be paid. The equity capital of Hansa (roughly 7 billion Swedish Kroner) is also going to default.

The juicy point here is of course the presence of massive translation risk which would arise as the liabilities (denominated in Euros) multiplied in value relative to the asset side.[2] More importantly, this would not only potentially crash Swedbank but also potentially the Baltic economies, and this is something we should attempt to avoid.

However, it is not easy to see where to go from here. One fascinating correlation between micro and macro data is epitomized in the graphs below which shows the evolution in the total stock of loans broken up on currency denomination.

First of all, it is very interesting to peruse the graphs shown above in connection with the graphs plotting cross currency and overall leverage (Latvia data only for households). In my opinion these graphs, taken together, resemble the epitomy of the kind of risk the Baltics face. As such, it is not only a case of devleveraging which, given the multiples, would be bad enough; it is also about the crisis that would emerge if the pegs were abandoned to restore competitivness. However, whether to keep the pegs or not may not be entirely up the Baltic economies themselves. Rather we can easily imagine a situation in which the decision of whether to keep the pegs would reside within the halls of a Swedish bank and perhaps even ultimately the Swedish Riksbank.

How does this compute then?

One way to approach the answer is to look at the total evolution of loan stocks (accounted on a flow basis. One striking feature is that the growth of loans denominated in Euros continue to markedly outpace loans denominated in local currency. This is a well known story in the Baltics and one which I have discussed several times [3], but the key point here is that as the economic edifice now visibly crumbles credit flows continue to enter the Baltic economies. Given the rapid deteriration of the real economy this seems rather contradictorary. However, it is is not, and it essentially means two things.

First of all, it means that whoever is doing the credit service increasingly is throwing good (and presumably scare) money after bad money. From a standard profit maximizing point of view this would seem and odd behavior unless of course there is more to the story than meets the eye. This brings us to the second point and was detailed above in the context of Swedbank et al. and their exposure in foreign currency (with receivables in domestic currency). Ultimately, the situation in the Baltics surrounding the pegs is beginning to resemble more and more like the attempt to cling on to something which is becoming more and more unsustainable by the day. Obviously, the foreign banks could stick it out, but the question is whether they can afford it.

In fact, I believe the only scenario which we, with certainty, can say will not continue is the current one in which lending is expanded on a linerging basis. As such, we need de-leveraging and we are going to get it one way or the other. The only question is whether it will be through Swedbank et al. closing the tap or through a move by Baltic authorities to loosen the peg (in which case Swedbank would be in grave trouble). The alternative would of course be a significant bout of internal deflation which we, with the incoming wage cost data, may already be seeing. The problem with this process though is that it takes time at the same time as it is politically unacceptable. I would seriously question in this regard the usefulness of continuing to look toward the future for potential Euro membership. At some point it should dawn on market participants and politicians alike that this is very unlikely to materialize.

Finally, we may ask the question of whether it is enough? I don't think so and while it still may end up being part of the correction I think that the extent to which these economies need to shore up their competiveness will also include a tweak of the currency peg [4].

Where do We Go From Here?

At the current juncture in financial market the answer to such a question is bound to riddled with uncertainty. In Lithuania, the people just elected a new parliament and while people may be more worried about the immediate need to secure stable gas deliveries from Russia and winter approaches, it is difficult to see how the attention on the crisis can anything but increase as we move forward. In this respect, and as an aside, Lithuania does seem to somewhat different from its northern bretheren in that the leverage ratios and debt multiples are not as high as in neither Estonia nor Latvia. Obviously, this may ultimately come down to comparing one ugly duckling with a slightly less ugly duckling.

As regards Latvia, Alf Vanags and Morten Hansen recently published a detailed analysis on the future path of the Latvian economy faced with the incoming financial crisis and potential global recession. Their conclusion is rather dire with respect to the potential loss of output between and now and 2010. As the authors make painfully clear, this fact obviously brings into the question the whole idea of convergence towards the illusive EU15 living standards not to speak of the convergence towards their own steady state which we really don't anything about at this point.

I would tend to apply the same analysis to Estonia even if Estonia seems to benefit from a stronger external environment and in particular with the economy's strong affiliation with the Finnish economy.

Ultimately however the immediate challenge for the Baltics at this point in time is damage control and more specifically how to wrigle themselves out of the current vice of dependence on credit inflows at the same time as the economy needs to restore competiveness. So far, the show goes on with Swedbank in particular continuing to supply the credit. However, if the recession rolls in, in a manner predicted by most analysts the ensuing squeeze of consumers may make it difficult for Swedbank not to sustain massive losses, not to mention what would happen with the peg and households and companies' liabilities.

The end point of all this clearly appears to envision a fiscal response; at least as a part of the solution. What is critical for the Baltics at this point is consequently that the currenct economic downturn is managed in such a way to minimize the risk of a collapse of the financial system as foreign banks shut down operations. Whether this entails the maintaining of the Euro peg is a difficult question to answer. One thing is pretty certain however and this is that the kind of wage and price deflation needed to correct the imbalance would be a disaster for any political leadership.

Of the three economies Latvia clearly seems to be the most vulnerable to a rout, and given the proximity of the economies sudden unexpected events in one country could easily spread to the others. Here is to hoping that it does not come to that.

---

[1] - Sometimes things actually fit together.

[2] - Here the asset side would be both deposits as well as future cash flows which would be in domestic currency (for households). For Swedbank itself, main point Hempton highlights is simply the fact that Hansabank would become an immensely heavy ball and chain since the whole thing would have to be written down with the devaluation itself.

[3] - See for example Christoph Rosenberg's brilliant piece on drivers of FX loans in Eastern Europe. As per reference to my own analysis (limited to Lithuania though) Rosenberg finds that lower interest rates on Euro loans as well as the fact that these economies effectively has outsourced the developmentment of their financial system to foreign banks are strong explanatory factors.

[4] - One thing which could provide relief here would be a slump of the Euro which would allow the CEE economies to restore competitiveness at the same time as maintaining the peg to the Euro. However, I think this is rather unlikely because it would imply a level of the Euro which would be in accordance with either the US' need to correct nor the ECB's inflation focus.

Latvian Inflation Stays Stubbornly High In September

Latvia's inflation fell for the fourth month straight in September, and was down to 14.9 percent. Monthly inflation over August was at 1.1 percent, due largely to a jump in textile and education prices.



Latvia has had the European Union's highest annual inflation rate for more than a year now, a starnge trophy to obtain, this one. Inflation peaked at 17.7 percent in May, and has since been slowing steadily.

Latvia's economy posted 10.5 percent growth in gross domestic product in 2007, following 11.9 percent growth in 2006. Since that time Lativia's economy has turned sharply downward, with GDP expanding only 0.2 percent during the first six months of 2008 - down from 10.2 percent over the same period in 2007.

And the future seems to be even more bleak with the IMF forecasting that Latvia's gross domestic product will decrease 0.9% in 2008. Only Ireland and Estonia are forecast to see their GDP contract by more than Latvia – by 1.8% and 1.5%, respectively. The IMF also expects that Latvia's GDP will shrink another 2.2% next year.

The IMF also expect inflation to remain high in Latvia. According to IMF estimates, annual inflation in Latvia could reach 15.3% this year, 10.6% in 2009 and 6.7% in 2007. On the other hand, they expect the current account deficit to decrease to 15.1% of GDP this year and 8.3% in 2009.

Latvia needs to cut spending in next year's budget to avoid rising loan costs as turmoil in financial markets drives up borrowing rates, central bank Governor Ilmars Rimsevics said in Dienas Bizness.

``The global financial crisis has strongly dried up the flow of money: borrowing
abroad for a reasonable price has become practically impossible,'' Rimsevics
wrote in an Ed-op piece for the Riga-based newspaper.

The central bank forecasts growth between zero and 0.5 percent next year, which would widen the budget gap to as much as 4 percent. Rimsevics also said that Latvia may end next year with a fiscal deficit of 5.5 percent of GDP, in an interview with Leta newswire today. A shortfall that size would be ``unacceptable" he said accusing the Latvian government of having given up trying'' to cut spending. As can be easily imagined, Rimsevics song, when coupled with an IMF forecast of an 8.3% CA deficit for 2009, will be like sweet music to the ears of the global investment community at this point.

It is thus hardly surprising that Fitch Ratings recently cut Latvia's credit rating to BBB from BBB+, the second lowest investment grade, citing a deterioration of the European economy.

Estonia's Inflation Comes Down (slightly) As Unemployment Rises (a bit)

Estonia's inflation rate fell in September to the lowest level this year as fuel and food prices declined. The rate declined to 10.5 percent, the lowest since December 2007, from 11 percent in August, according to the latest data from the statistics office in the capital Tallinn. Month on month prices were up 0.6 percent, mainly because of rising alcohol and tobacco prices after an excise tax increase in July.



Lower fuel costs cut transport prices by 1.3 percent in the month for an annual increase of 12.1 percent. Food prices eased 0.3 percent from August to cut the annual gain to 13.9 percent. Alcohol and tobacco prices rose 7 percent in the month, gaining 26.7 percent on the year.


Unemployment Edges Up


Estonia's registered unemployment rate rose to the highest level in more than three years in September as Estonia's recession continued to deepen. The jobless rate, based on the number of unemployed registered with labor offices, rose to 3.1 percent, the highest since July 2005, from 2.9 percent in August, According to the Estonian Labor Market Board. The number of people signed on as seeking a job rose 6.6 percent from the previous month to 20,015, it added.

Lower consumer spending and weaker industrial output pushed Estonia into a recession in the second quarter as gross domestic product shrank for two quarters following the onset of a sharp credit crunch. Unemployment, which usually follows changes in economic output with a time lag, is expected to rise considerably from current levels.


The unemployment rate as measured by the Estonian statistics office in quarterly labor surveys, may rise as much as 10 percent by the end of 2009 from a 16-year low of 4 percent in the second quarter, according to estimates from Erkki Raasuke, head of Baltic operations for Swedbank AB.

Latvian Credit Downgraded As Retail Sales Continue Their Decline

As reported in this post, on Friday Fitch Rating Service announced they were cutting long-term sovereign ratings for Estonia, Latvia and Lithuania, citing worsening financial conditions in Europe. Latvia's long-term foreign-currency Issuer Default Rating was cut to BBB from BBB+. The outlooks were kept negative.

The move by Fitch follows an earlier decision by Moody's Investors Service to lower its Latvia outlook to negative. The outlook change affects Latvia's A2 foreign currency and local currency debt rating. The outlook on the Aa1 country ceiling for foreign currency bonds was kept at stable. Moody's A2 rating is five levels above investment grade. Kenneth Orchard, senior analyst at Moody's wrote in the statement: "Although it is not Moody's central scenario, Latvia's economy is vulnerable to a sharp reduction in foreign capital inflows.''

Latvia has low levels of government debt and no foreign bonds maturing for over five years, so there is little serious danger to Latvia's public sector funding. On the other hand Latvian interest rates to households and companies are expected to rise and the number of non-performing loans to grow as a by-product of the ratings changes and the global financial market turmoil which lead to them.

``Credit is becoming more difficult to access, and if you can access it, it will be in smaller sums and at a higher interest rate,'' Janis Brazovskis, vice-chairman of the Latvian Financial and Capital Market Commission, speaking in an interview on Latvijas Neatkariga Televizija's program 900 Seconds.

According to Brazovkis, interest rates will rise by between 0.5 and 2 percentage points for Latvian borrowers. Overdue loan payments may rise to 2 percent of total credits from the current 0.7 percent. Brazovkis stressed that Latvia's exposure to the U.S. financial system was "extremely minimal,'' and that Latvian lenders did not invest in "toxic financial instruments,''. This is undoubtedly true, but on the other hand I have never actually seen anyone suggest that Latvia's problems were a by-product of poor quality investments made in the US - in other words this would simply seem to be yet another one of those famous "red herrings". Latvian lenders also did not buy toxic instruments, since they were effectively selling them - to eg Swedish investors. Latvia, like the US, the UK and Spain, has a current account deficit, and it is the current account deficit countries who were effectively issuing the toxic instruments to finance their external borrowing at rates which were below the real level of the risk being assumed. If lending practices in Latvia were not lax (which is the normal argument directed towards the United States), then I simply do not understand the chart below - which shows bank lending going off a cliff once documentation and lending rules we tightened up in the spring of 2007.




So the problem is, it seems to me, that the people who bought instruments issued by the Latvian banking system (or who created instruments elsewhere to then inject funds into Latvian banks) are the ones who have the problems, and they are unlikely to be so forthcoming in the future, which is why credit will remain tight in Latvia (about this Brazovkis is undoubtedly right) and interest rates may well rise. Which is just one more reason why we should not expect any imminent revival in Latvia's flagging retail sales (see below) - and by imminent I do mean over the next few years. This recession is in for the long haul.

Retail Sales Continue To Decline



Month on month seasonally adjusted retail sales (at constant prices) were down by 1.2% In August. Compared to August 2007, and according to working-day adjusted data, at constant prices, total retail sales decreased by 8.9%.





The largest volume decreases were in food products – down by 10.3%.

Fitch Cuts Baltic Long Term Rating As Estonia's Industrial Output and Retail Sales Continues To Slide

Fitch Rating Service has today cut long-term sovereign ratings for the Baltic countries of Estonia, Latvia and Lithuania, citing worsening financial conditions in Europe. Estonian and Lithuanian long-term foreign-currency Issuer Default Ratings were reduced to A- from A, while Latva's rating was cut to BBB from BBB+. Outlooks were kept negative.

``The downgrade of the Baltic states reflects the risk that the deterioration in the European economic and financial environment will impose a more costly macroeconomic adjustment in the Baltic countries, given their large bank-financed current account deficits,'' Edward Parker, head of emerging Europe sovereigns at Fitch says in the accompanying statement.

All three Baltic economies are in the global top 10 of those with the largest gap between outstanding bank credit and bank deposits relative to both gross domestic product and total bank credit, Fitch said. Gross external financing requirements plus short-term external debt will be at around 400 percent of end- 2008 foreign exchange reserves in Latvia, 350 percent in Estonia and 250 percent in Lithuania, the highest ratios in emerging Europe.

Industrial Output Onwards and Downwards


Meanwhile in Estonia the whole real economy continues to meander along its steady downward course. According to Statistics Estonia, industrial output was down 2.6% in August when compared to August 2007. Month on month outpot was up 1.6% on a seasonally adjusted basis.

Manufacturing output was down 2% year on year. According to the statistics office statemet The main reason for the decline was the decrease in orders, both on the external and internal markets.




The decrease in manufacturing was mainly influenced by food production, and wood and building materials. The decrease in the manufacturing of food is obviously affected by the large price increases and by the decrease in consumption which follows. Compared to August 2007, 20% less beer, 15% less soft drinks and 10% less meat products were produced. Although the rate of price increases has eased back in recent months, food product prices increased 17% in August year on year.

As in previous months, production increased in August primarily in the export-oriented branches of industry — in the manufacture of metal products, chemical products, electrical machinery etc. Output was also up in the manufacture of machinery, precision instruments and motor vehicles, sectors where there is a sjgnificant export share. The share of exports was 89% in the manufacture of motor vehicles and 93% in the manufacture of precision instruments.

And if we look at the longer term evolution in the working day and seasonally adjusted output index, It is clear that output levels hit a maximum in the first two or three months of this year, since which time they have been moving gradually downwards. In the present climate we are unlikely to see any change in this trend anytime soon.





Retail Sales Also Continue Their Decline


According to Statistics Estonia, retail sales of goods of retail trade enterprises were down 6% in August over August 2007 at constant prices. Compared to July 2008, retail sales decreased by 4% in August at constant prices.



In August, retail sales ran to a total of 4.8 billion kroons. In grocery stores rsales were down by 3% compared with August of the previous year. The decrease in sales was significantly influenced by a rapid growth in the prices of food products (and of course this decline in sales then fed back into industrial output). Retail sales in stores selling manufactured goods decreased by 9% compared with the same month of the previous year. Compared to August of the previous year, retail sales decreased in most economic activities except mail order sale, which increased 24% during the year. The main reason for the increase in the mail order sale was the low reference base of the previous year. Mail order sales do not significantly influence the retail sales in retail trade enterprises, because the share of this activity is very small: it was only 2% in August 2008. The retail sales of stores selling household goods and appliances, hardware and building materials suffered the greatest decrease (15%) as compared to the previous year.