Everyone is agreed that the drop in domestic demand will help bring inflation down substantially, although some are still only focused on whether or not this will be enough to qualify for adopting the euro by the end of 2010. Unfortunaely much larger questions than this now loom on the agenda. Basically we will now start to follow a new chart for inflation purposes on this blog - the monthly index itself (see below). As can be see the monthly upward march is now quite small - and getting smaller. At some point it will peak, and then start turning down. At that point one of two things can happen (there really aren't too many choices at this point, it would have been better had we never gotten here, but then, to put the best interpretation on things, people were simply deaf): either the kroon-euro peg can be abandoned, or the index will start to march downwards and Estonia will simply fall deeper and deeper into deflation. I think I know which one of these I would prefer (coming off the peg), and neither is going to be easy - either people are going to have to start paying those euro mortgages in a much cheaper currency, or the value of their wages in euros is going to drop as wage deflation savages the whole economy. Which do you prefer, the devil or the deep blue sea?
EU Banks To Take the Hit
The other important detail here is the way in which banks based in other EU countries are going to be asked to get their home governments to step in and fork out to make up for all the inevitable defaults. I am not an avid Swedish bank watcher, but I have been following what has been going on in Austria, and especially the recent government decision to move and help the Austrian banks with state funds, since this move seems to be aimed less at shoring up troubled domestic lending and more at boosting credit and growth in emerging Europe, where Austrian banks dominate and the country could well lose heavily in the coming downturn.
Essentially, what used to be a lucrative grip on the financial markets of central and Eastern Europe - which contributed 42 percent of Austrian bank profits in 2007 - has now been transformed into a strong risk. The situation has even made it relatively more expensive for the Austrian government to borrow - since the spread over 10 year German bund has been sriven up - and has also driven up costs to insure against the seemingly unlikely even of an Austrian sovereign default.
Austrian banks are owed $290 billion by borrowers across the CEE, from Albania to Russia. Its exposure is much higher than that of Italy, Germany and France, and almost on par with what Spain has lent to Latin America, according to the Bank for International Settlements.
Relative to Austria's size, the exposure - roughly equal to its entire gross domestic product - is daunting.
Put another way, should the recent central European hiccup turn into a crisis of Asian or Latin American proportions, with currencies devaluing and debtors defaulting en masse, Austria would be in trouble, and more so than any other western country.
This underlying reality has evidently shaped how the Austrian government is using its 100 billion euro ($129 billion) banking package. The finance ministry last week agreed to boost the capital of Erste Group Bank by 2.7 billion euros, even though the bank, emerging Europe's third-biggest lender, is well-capitalized and funded.
The state money came cheaper and with fewer strings attached than similar deals in Germany or Belgium. There are few rules on how to use the capital - just enough to allow the government to present the measure as boosting domestic credit.
In reality, most of the capital is going to underpin lending in countries including Romania, where Erste owns the biggest bank, or Hungary, where it is number 6.
"That this is about providing credit to Austrian companies is just a pretense," said Matthias Siller, who manages emerging market funds at Baring Asset Management. "This move is a clear commitment to eastern Europe......But this has nothing to do with charity. Those (Austrian) banks are system-relevant banks in central and Eastern Europe, and if they had to withdraw capital from there, this would set off a landslide," he said.
A number of emerging countries in Central and Eastern Europe share the problem of having a gaping hole in their current accounts - one which they currently fill to a considerable extent through the funding that Austrian, Italian, French, Belgian and Swedish parent banks provide. Fears that they were about to choke off this lending simply because the parents themselves had trouble refinancing played a big role when investors dumped Hungarian assets in droves last month.
By tapping their home governments, the banks effectively lean on taxpayers in their home countries for refinancing countries with large current account imbalances - countries which apart from Hungary also include Romania, Bulgaria and the Baltics.
"If there is no EU-wide plan then it will be left to Sweden (in the Baltics) and Austria (on the Balkans) to take care of this," said Lars Christensen, an analyst at Danske Bank. "Obviously you can't have the Austrian government bailing out central and Eastern Europe," he added. "The problem in this situation is a lack of coordination between European Union governments about a stabilization plan for Eastern Europe."
Well, don't feel especially discriminated against in the CEE I would say, since there is no plan for Southern Europe either, and the problems in Italy, Greece and Spain are every bit as large. Indeed I would say that those responsible for policymaking across the CEE would do well to look at what happened to the Spanish economy after the external funding for the Spanish banks was effectively cut off in September 2007, or for that matter to what has happened in the Baltics. Canaries in the coalmine, anyone?
Incidentally, and quite coincidentally, Moody's Investors Service cut Latvia's credit ratings and lowered the outlook for both Lithuania and Estonia to negative, citing the worsening economic slowdown and the global liquidity crisis. Given what I have been saying above, it seems to me they might also like to take a long hard look at their Austrian and Italian sovereign ratings at this point too.