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Thursday, March 26, 2009

The Latvian Cat Is Out Of The Bag

Reuters this morning:

The International Monetary Fund (IMF) would back a devaluation in Latvia, but the government, central bank and European Commission are against, the prime minister was quoted on Thursday as saying. It was the first clear statement by a policy maker about a differing stance between the IMF and Latvia and its other lenders over the currency, though the Fund has warned that keeping the currency peg during a sharp downturn would be tough. "The International Monetary Fund has no objection to a devaluation of the lat, but the European Commission, Bank of Latvia (central bank) and the government do not support this solution," Baltic news agency BNS quoted Prime Minister Valdis Dombrovskis as telling a meeting of regional journalists.

and Nordea flash comment:

According to Latvian Prime Minister Valdis Dombrovskis the IMF has no objection to a devaluation of LVL. However, he continues that the European commission, Bank of Latvia and the government are against devaluation. IMF's opinion counts as Latvia is asking the fund for a permission to increase the budget deficit to 7% of the GDP from the agreed 5%. Latvian economic contraction has been worse than expected. Getting out of the woods requires that competitiveness must be improved. This can be done by external or internal devaluation. IMF's stance highlights the risk of external devaluation. However, it is not a done deal since the political opposition is very hard. Some 90% of the Latvian loans are in foreign currency and hence external devaluation would affect most Latvian households and companies. Ongoing discussion emphasizes the importance of hedging the Baltic FX risk. If Latvia gives up, speculation that the other Baltic countries follow, increases.

This was always like this, and even though Ambrose Evans Pritchard glossed it all up a bit by talking about secret IMF documents that had been leaked, the information was always freely available in this report of the IMF website:

A change in the peg is strongly opposed by the Latvian authorities and by the EU institutions, and thus would undermine program ownership. The quasicurrency board has been an anchor of macroeconomic stability for more than 15 years, was able to withstand the 1998 Russian crisis, and commands popular and political support. Any change in regime would cause significant economic, social and political disruption.

The authorities and staff examined the merits of alternative exchange rate regimes. A widening of the exchange rate band to ±15 percent (as permitted under ERM2; currently Latvia has unilaterally adopted a ±1 percent band) would result in a larger initial output decline, since adverse balance sheet effects would reduce domestic demand. However, competitiveness would improve more quickly, reducing the current account deficit and fostering a more rapid economic recovery. The case for changing the parity would be stronger if it could be accompanied by immediate euro adoption. Technically, this would address many of the risks described above, and give Latvia deeper access to capital markets. With its negligible public sector debt, the government would also find it easier to borrow in euros on international capital markets. However, the EU authorities have firmly ruled out this option, given its inconsistency with the Maastricht Treaty and the precedents it would set for other potential euro area entrants.

So the only real news that Valdis Dombrovskis seems to be announcing today is that the central bank the Latvian government, the EU Commission, the ECB (and possibly) the Nordic Banks are the explicit villains of the piece.

Personally I am very sorry that we are now coming to what may turn out to be a "disordely" resolution of the four East European pegs, since I think it didn't have to be like this, as I have argued in:

Why The IMF's Decision To Agree A Lavian Bailout Programme Without Devaluation Is A Mistake

Why Latvia Needs To Devalue Soon - A Reply To Christoph Rosenberg

Why You Need Devaluation - An Open Letter To The People Of Estonia

Devaluation, Euro Membership And Loan Defaults - Some Thoughts For My Critics

Basically, if we go back to my last post on toxicity, and look at the causal chain:

Financial Crisis -> Real Economy Crisis -> Political Crisis

we can see that it is the political crisis which ultimately breaks the loop. Without the devaluation Latvia is stuck in a self reinforcing contraction where budget cuts slow the economy further and make necessary further cuts, while all the time more and more toxic assets are created, faster than you can borrow the money to clean them up (you know, the ball of negative energy that feeds on itself).

Update Dombrovskis "Corrects" Himself

According to the latest out of Reuters Riga Latvian Prime Minister Valdis Dombrovskis clarified later this morning (Thursday) that the International Monetary Fund was not currently seeking a devaluation of the lat currency. Speaking to reporters at the talks he is holding with IMF representatives, Dombrovskis said his earlier words were a "historical review" of negotiations last year with the IMF. "The current agreement of an unchanged exchange rate remains in force," he told reporters. Of course, no one doubted it. But still........

Thursday, March 12, 2009

Devaluation, Euro Membership And Loan Defaults - Some Thoughts For My Critics

Joke - How do you know when a country is in crisis? Well, on the buses on the way to work, and in the bars and cafes during the mid morning break, everyone is reading the economy rather than the sports section in the local newspaper.
Several pieces of news out over the last week are relevant to the whole debate we are having about how to drag the Estonian economy (kicking and screaming it would seem) out of its current slump. In the first place the Estonian parliament passed a supplementary 2009 budget at the start of the week, in an attempt to address the ongoing crisis in the economy and the dramatic decline in revenues. The cuts were approved by 61 votes to 35 against in what was also an effective vote of confidence in the present government. So at least it is clear that the majority of Estonia's politicians back the present course, and the degree of public support for the current path is greater than it would seem to be in, say, Latvia. That is, naturally a very positive point.

The supplementary budget lowers the amount of revenues in the annual budget by EUR 615.5 mln and of expenditure by EUR 419.9 mln. According to the revised budget, state revenue this year is now anticipated to be EUR 5,635 mln and expenditures EUR 5,871 mln. Both these numbers are of course conditional on the economic contraction for 2009 only being the forecast one (on which the budget is based) of 9.5%.

The second piece of news is that the Estonian Finance Mininistry have sent an official loan application today to the European Investment Bank, with a request to borrow Eur 550 million for 5 years. And this point is important, since obviously, as I will argue below, Estonia's private sector (households and companies) is now basically very overleveraged (in too much debt) and the government is being forced to step in and assume greater responsibility for the collective debt as the correction continues.

The third relevant piece of news is that the number of unemployed registered with the Estonian Labour Board was up again last week, and reached 50,527, which means 2418 more people signed on with the board during the week, following the 3,019 who joined the list in the previous week. Meanwhile the Estonian Parliament has been having a debate about what kind of labour market reforms the country needs to handle the present crisis. Since one witty soul appropriately baptised me in my most recent post the "excel economist" I would just like to add-in my own little chart-based contribution. People are leaving Estonia. How do I know that, well just take a look at the spike at the end of the time series shown in the grphic below, the volume of income transfers to Estonia (largely worker remittances) has been on the increase ever since the crisis started in 2007, and during the last quarter of 2008 they really spiked up, just (coincidentally?) as the economy spiked sharply downwards.

We don't know too much about the murky topic of out-migration in the Baltics, since no one seems to consider it a particularly pressing issue. In fact, migrant labour flows could be considered to be a leading indicator for a modern (open) economy (in both directions), but surprisingly little attention is paid to the matter. We do have an old "estimate" that around one third of those working abroad are working in Finland, and now somewhat dated reports of young people working in Finland repairing motorway crash barriers for 150 kroon an hour, but that's all we seem to have, anecdotal evidence. Maybe one of the reforms all those very busy parliamentarians could think about agreeing to would be the introduction of a question in the labour force survey about whether or not the interviewee currently has (or has had in the recent past) a family member working abroad.

The sudden apparent deterioration in labour market condidtions is all the more worrying since up to now, and despite the fact that growth in the Estonian economy started to slow early 2007, the labour market did not show signs of any severe impact until Q3 2008. On the contrary, according to official statistics, unemployment continued to decrease and bottomed out at 4.0% in the second quarter of 2008. Since then the unemployment rate has jumped to 6.2% in Q3 followed by 7.6% Q4. Thus we now have the highest rate effective rate since the middle of 2005, and things are only getting started.

According to the statistics office, nearly half of those signing on have become unemployed due to layoffs, closures or bankruptcies. On the other hand total employment has so far help up reasonably well, with the total number of employed persons in the 3rd quarter running at 652,600, only 0.2% less than in the same period a year earlier (656,500).

Lastly, statistics Estonia reported last week that in January 2009 there was a year on year drop of 29% for exports and 37% for import 37%, meaning that the current account deficit is closing (more on this below). But first let me try to address some of the questions that have come up in the debate about devaluation.

In The Event Of Devaluation What Happpens To Euro Denominated Debts?

Basically this seems to be the big theme in the forefront of everybody's minds, but there seems to be some kind of large misunderstanding here. Essentially we are only talking about two different forms of devaluation (one internal via deflation, and the other external, by changing the exchange rate of the kroon with the euro). I think everyone is agreed that the Estonian economy - due to severe overheating, a massive housing bubble, and rampant inflation, all of which were the effect of faulty monetary and fiscal policy inside Estonia - is now hopelessly uncompetitive by international standards, hence a substantial downward correction in prices is agreed by all parties to be essential.

So the impact of this price downward price adjustment (which should be equal in either case) will be the same on the relative cost of maintaining non kroon loans. Let me put it this way, if you are one of the people in the unfortunate position of having such a loan it will make little difference to you whether your salary is reduced in kroon by 20% and your mortgage payment stays unchanged, or whether your salary in kroon remains unchanged and the currency drops 20% against the euro. Thus most of the argumentation about this topic seems to be highly emotional.

Of course, in both cases there will be loan defaults, but much more than the 20% drop in real salary (since it is unit hourly labour costs that matter here) will be the fall in earnings as the economy enters deep recession and people lose overtime, bonuses, or even their jobs themselves. This is what puts the default rate up, and prolonging the length of the slump long enough for people savings to run out, and for the normal unemployment benefit (of one year's duration) to run out, and people to be forced to try and live on the 59 euros a month social security allowance.

This, in my view, is the strongest argument in favour of the "short sharp shock" of the devaluation route (the so called V shaped recovery), rather than the more protracted "U shaped" one of internal deflation. On the second path you will almost certainly have more unemployment for longer, and with this the risk of loan default will increase. To counterbalance against that is the Estonian's national pride in their currency board, and their desire not to be seen to fail. But sometimes it is a good policy to stand and hold your ground, and others it is the more intelligent policy to retreat, and live to fight another day. All withdrawal is not an act of cowardice, nor is renegotiation a sign of unreliability. To make mistakes is to be human, and I doubt that the word of the United States has been put especially in doubt by the sub prime mortgage fiasco. In market economies "stuff happens", and when it happens normally it is better to take the corrective measures and put the issue behind you.

Of course, there are no guarantees here, and success or failure with devaluation (as with any measure) depends on the rest of the policy mix you put together to accompany the move. I don't think that there is any doubt that Estonia's position is very difficult, so there is no panacea, or easy way out of all this. It would have been better not to get into the mess, but it is a bit late for that now.

What I do think is that devaluation gives you a chance to fight back, and in any even you should feel better fighting, than simply waiting, and sitting and taking it on the cheek. With a current account deficit to reduce and falling government tax revenue there is little the government can do in the way of economic stimulus. Devaluation gives you a kind of indirect stimulus, that is the strongest argument in favour of it. It also places future output on a higher level and thus (arguably) reduces the unemployment and default risk.

Basically 2 years sitting around at home waiting can be very demoralising for anyone, and especially if you are trying to live for the second year on 59 euros a month. I am saying categorically and absolutely clearly here that I see no possibility of any kind of recovery in 2010 (especially given the global environment), and much less so if you just there and wait for it all to happen.

Now, if you devalue, you recover monetary policy, and you then need to keep a tight reign on inflation, but frankly, and again if we look at Hungary, they have devalued 25% and they still only have 3% inflation (and falling) so this may not be such a massive problem. The thing is you need a better monetary policy once the recovery starts, so you don't simply get the inflation again.

But basically, you should be able to foster domestic industries as an alternative to exporst in some things - I know, Estonia is so small it is hard to see how to do this, you obviously need to be very open as an economy, and practice good old Ricardian comparative advantage.So you need to specialise to some extent in new activities, and this is really up to the ministry of industry, or whatever, to formulate projects. Then you need to sell Estonia to some new investors. Price is only part of this, but it is part. Remember, with the present crisis there are plenty of people offering, and few people wanting to invest in new productive activities, but potential investors do exist, and you have to find them. That is the job your politicians should be up to now.

If you have the structure is right, and you can provide a base for some sort of exporting activity, then so much the better when it comes to persuading people to come. So devalution is just a kind of stimulus, it is like a large subsidy to exporters, socialising the costs. It isn't perfect, nothing in this world is, but it is better than nothing. You can keep more people in work this way, and those people create wealth, rather than simply consuming government benefits.

But going back to the loans and the default problem, what about the banks. Well my main point in this regard is that the last thing in the world the banks want to do is to start becoming estate agents, so they are in fact reasonably reluctant to start mass reposessions of property. It is that old story, if you owe them a little money and you can't pay, then you have a problem. But if you owe a lot of money, and you can't pay, they THEY have a problem, and normally they are going to be quite reasonable and down to earth when it comes to finding solutions, which they need as much as you do.

Banks basically prefer to stay in the business of banking, which is what they know about, in the same way that governments really don't want to nationalise banks, even though from time to time they may have to. Governments really don't know that much about running banks, any more than banks know about being estate agents, and holding a lot of property in a country in deep recession is hardly a plus for them, or their international credit rating.

When just a few householders have to throw in the towel and hand their home over to the bank, then banks may try to practise a "hold to maturity" rather than "mark to market" policy, and and profit from any hypothetical rise in property values in the future. But this credit and housing crisis isn't like previous ones in recent history. House prices in boom/bust economies like the Estonian one are unlikely to recover for many many years, and bank balance sheets simply won't let them hold on to dubious assets for such an extended period of time.

Banks want to manage mortgages, not houses, since mortgages pay a stream of income, while houses are only non performing loans, with no income.The same thing has been happening in Spain since the bubble burst, but now banks are swifty moving towards "fire sales" as they can hold out no longer, but even selling at rock bottom prices they are having trouble finding buyers. So what they would really prefer is to keep people in their homes.

This process will also happen in the Baltics, and the best policy for the banks will be to recognise reality, accept their share of the loses, and negotiate with householders while they are still in their homes and still in work, and with the government.Thus I think that those who have the most immediate interest in debt restructuring and devaluation - even though they don't seem to realise it going by their pronouncements - are those very Nordic banks who have been pressing to avoid it. As I say, 100,000 houses with people living in them and working and paying something are worth a lot more than 100,000 empty houses whose owners have long gone to work in Finland (or wherever) and which have been left to rot.

Joining The Eurozone

Now at this point I would like to be clear, I am not arguing for a unilateral devaluation by the Estonian authorities, but rather an acceptance of that as an objective on their part, and a negotiation of such devaluation with the EU authorities (the EU Commission and te ECB). Actually, what is rather to be lamented in this regard is that they themselves are not doing the reposible thing and taking the initiative here.

In fact the Estonian Finance Ministry has estimated that Estonia may well comply with the Maastricht criteria before the end of this year. Prime Minister Andrus Ansip is reported to be considering following the 2006 Lithuanian example and formally requesting an assesment of the fitness of Estonia for Eurozone membership: "We are entitled to request from the European Commission and from the European Central Bank that they would assess the compliance with the Maastricht criteria outside the regular approximation reports cycle," with the Finance Ministry adding that "Although thus far all the countries have adopted the Euro in the beginning of a year, the dates of the transition to the single currency is not so strictly regulated,".

Prime Minister Ansip estimates that Estonia may well comply with the inflation criterion by October, and that an evaluation at that point could lead to Eurozone membership as early as July 2010. Yet one more time I beg to differ.

I differ basically not because I doubt the assertion that Estonia's inflation rate will meet Eurozone criteria later this year, but becuase I doubt the interpretation of how such an application would be considered. You see, complying with the minimal criteria is only a first step in the process, the EU institutions then have to make an evaluation of the sustainability of the path your economy is on, and of the realism of the exchange rate at which you seek to enter, and since Estonia's economy, far from being clearly settled on a sustainable path is right in the middle of a boom-bust correction, and there is widespread agreement that your currency is, as of the present time, pretty overvalued. In have gone into all of this on an earlier occasion in the case of the review of the Slovakian situation, but it is clear that they will be unlikely to be sympathetic to any special pleading about your crisis in Estonia (all of Eastern Europe is in crisis), and (especially over at the ECB) will more than likely take the view that while financial support should be offered the best approach is to let you work out your own "imbalances" before you enter, since experience with those countries who entered in Southern Europe has not exactly been positive, and they may even already be having second thoughts as to whether they made the right decision in giving the go ahead to Slovakia and Slovenia.

My own view, which is pretty much the same as that held by Wolfgang Munchau, is that the countries of the East are playing a self defeating game at the present time, and that Collective Action On The Crisis Is Our Best Hope. What would be a better idea would be for you all to emphasise what you have in common at this point, rather than clinging to what differentiates you one from the other.

Paul Krugman, writing in the New York Times from Madrid (where he was meeting with Prime Minister Zapatero today) had this to say:

In the past, Spain would have sought improved competitiveness by devaluing its currency. But now it’s on the euro — and the only way forward seems to be a grinding process of wage cuts. This process would have been difficult in the best of times; it will be almost inconceivably painful if, as seems all too likely, the European economy as a whole is depressed and tending toward deflation for years to come. Does all this mean that Europe was wrong to let itself become so tightly integrated? Does it mean, in particular, that the creation of the euro was a mistake? Maybe. But Europe can still prove the skeptics wrong, if its politicians start showing more leadership. Will they?
Current Account Deficit

Well, now let's take a brief look at the current account deficit issue. The first problem Estonia has is that she has been running one.

And the second problem is that now that the capital flows which were supporting it have dried up, you need to get rid of it. Which isn't as easy as it sounds. The ideal way to straighten out a current account balance is to increase exports and reduce imports at one and the same time.

Now, if we look at the deficit over the last few years (see chart below), we can see that only a part is produced by the goods and services trade deficit.

That is because another part (structurally) of the deficit comes from the negative impact of income flows (these are basically composed of interest on loans and dividends on equities).

And why does Estonia have these negative income flows, well in part as a result of all those bank flows which paid for the loans that so many Estonians were contracting, and in part they are produced by income earned on Foreign Direct Investment. The point is FDI is good, but if you are a borrowing economy, rather than a saving one, then you accumulate over time an imbalance between the investments you make in other countries and the investments others make in your country. The upshot of this is that you accumulate a structural deficit under the income account of your Balance of Payments current account, and this is exactly what has happened to Estonia (see chart below).

So basically, not only does Estonia need to start exporting to create economic growth, it also needs to do more exporting to pay down the debt (hence addressing the structural weakness in the account) and to start accumulating a greater external FDI stock, which among other things can generate income to help you pay for your old age. One of the features of generalised economic corrections like the ones we are suffering from is that we tend to suffer from what Keynes called the Paradox of Thrift. Paul Krugman puts the situation like this (in a US setting, but Estonia'ssituation is not that different, structurally speaking)

I don’t know who else has made this point, but it’s quite clear that we’re in serious paradox of thrift territory here. Or perhaps more accurately, we’re in a paradox of debt.

Consumers are pulling back because they’ve realized that they’re too far in debt. The economy is shrinking in large part because consumers are pulling back. And the result, almost surely, is to leave household balance sheets worse than ever. I can’t do this accurately until the Federal Reserve’s flow of funds data have been updated, but almost without question the ratio of household debt to personal income has been rising, not falling, as consumers try to save more.

And guess what, while I don't have the data to hand, I bet you all the tea there is in China that the ratio of household debt to personal income will also have been rising as the economy contracts, even as Estonian consumers try to save rather than borrow. That is, the faster you try to save, the less you really do manage to save as your income contracts, and here is just another reason why you need exports. I'm afraid that those who say "speculations about devaluing of the kroon are irresponsible as no one in Estonia would gain anything from such a move", simply don't understand what they are talking about. (Well that makes two Baltic central bank governors who don't agree with me).

One of the reasons, of course, that it seems so difficult for people to contemplate increasing exports as a way out of this crisis is that the economy has been completely distorted by the construction, financial services and real estate boom. Just one indication of this can be found in the share of construction activity in the whole economy (see chart below). As we can see in the chart, the construction share in Estonian GDP climbed steadily after 2005. This share now needs to drop back again towards its historic average. This correction has started, but there is still a long way to go, and meanwhile the economy contracts and contracts.

So, summing up, and in the words of the IMF:

The recession is sharply reducing Estonia’s imbalances. The external current
account deficit nearly halved between 2007 and 2008, largely due to a
demand-driven compression of imports
but also helped by a drop in income
outflows, reflecting the fall in profits to foreign-owned companies and banks.
Exports continued to grow modestly despite an appreciation of the real exchange
rate, owing to an improvement in terms of trade and a recovery of oil transit
trade with Russia. (my emphasis).

Q4 2008 GDP

So what is happening to the Estonian Economy? Well lets look at the latest GDP data. Now, according to the preliminary estimates from Statistics Estonia output in the Estonian economy dropped by 9.4 percent during the 4th quarter of 2008 (on a year on year basis). This is a huge drop, unprecedented in Estonia since the upheavals of the very early nineties, during the transition from a planned to a market economy. This, however, is not that surprising, since the recession in all highly developed economies is currently more serious than anything seen since the 1930s, and the Baltic correction is one of the most dramatic among these. Compared to the third quarter, the seasonally and working-day adjusted GDP was down by 4.3%, while fourth quarter GDP was even below Q3 at current prices for the first time since 1995 (down by 4.7% - that is GDP was down in what we economists call nominal, as well as real terms. this is quite a significant development to which we will return in the coming months and quarters).

So, following year on year real GDP growth rates which were fluctuating in the 11-12 percent range for six consecutive quarters between mid 2005 and the end of 2006, we now have a strong and sustained contraction (which has now, according to Eurostat seasonally corrected quarterly data lasted for 5 quarters, with no end to the pain in sight). This is why we refer to a boom-bust process, since the normal (garden-variety) recession lasts only 2 quarters.

In 1997, when Estonia went through its last comparable cycle, overheating driven growth lasted for around 5 quarters, and was then followed by several quarters of negative growth, starting in Q4 1998. GDP hit a low point with a 1.6 percent decrease in GDP in Q3 1999, and growth was positive again in Q4 1999, and by Q1 2000 was up at an annual 8.4% rate.

Today nobody is expecting such a rapid recovery as the two crises are very different. In the first place, while during the 1997/98 crisis the downturn only really involved emerging markets, and especially in the Estonian context Russia, the current crisis is more of a depression than a recession and is a global one. West European countries, which were the main export markets for Estonian products by the late nineties, contributed to Estonia's rapid recovery with their own momentum. This year few expect Europe's economies to expand this year, and large question marks still hang over 2010. Further, the Estonian economy had a lot more in the way of sector transition driven easily achievable catch up growth in front of it, now this element will be much less favourable, since Estonia will really need to find substantial productivity and competitiveness improvements in existing activities, and even from abandoning some parts of the higher value sectors (like construction and real estate) which had been fuelling the earlier growth. So nothing here is going to be easy, and certainly nothing like as easy in 1999. The two moments just do not bear serious comparison.

If we look at the Q4 data, the fall in GDP was largely produced by a drop in domestic demand (which fell year on year by 14.8%).

Domestic demand is basically composed of three elements, households’ final consumption expenditures (HFCE), gross fixed capital formation (GFCF) and government spending. HFCE was down year on year by 10.4% in Q4.

Total government consumption expenditure (including transfers) was up 3.5%.

And GCFC (which basically means investment in one form or another) was down by 24% year on year.

So apart from the increase in government spending, the only bright spot in Q4 GDP came from the net trade effect, since this was a by product of the fact that imports fell (11.9%) by more than exorts (3.2%). The drop in imports was driven by a fall in machinery, equipment and motor vehicle imports. Which means simply that both investment and private consumption (or living standards) are falling.

The Credit Driven Expansion Is Over

During boom times the main supports for Estonia's extremely distorted economic growth were the excessively low interest rates available on euro denominated loans (which effectively fuelled the housing bubble) and strong capital inflows, which made possible the rapid increase in the volume of home loans and loans to building developers. During the current downturn as financial regulation is tightened, what Estonia can expect are higher interest rates, an end to real estate as a GDP growth driver and a decline in borrowing.

During the boom time, the inflow of foreign capital, largely through foreign owners of local banks, seemed never ending. Bank liabilities to non-residents (as a share of total assets) rose from the 31-34% range in 2000-2003 to over 50% by 2007/08. Bank liabilities to Estonian residents as a % of GDP increased from 40% at the start of the century to over 60% in 2007/08, while liabilities to non-residents shot up from 20% to 70% of GDP over the same period.

The share of locally owned banks in Estonia is marginal. Only the Baltic Investments Trust is locally owned and this accounts for under 1% of the total market. As of June 2008, 72% of Estonian banking assets were owned by two Swedish banks, Swedbank and SEB, with Swedbank alone holding a more than a 50% share. The ratio of total bank assets to GDP increased from 60 percent to more than 130 percent in the period of 2000-2008, while the share of loans in these assets increased from 58 percent to 76 percent over the same period. On a quick calculation basis, this means that the banks have an exposure to lonas of about 97% of GDP (and rising as GDP contracts, this is the paradox of thrift point, and especially as nominal GDP falls - as Estonia enters negative price deflation this percentage is set to shoot up, as nominal GDP falls more quickly than real GDP - this is yet one more reason why devaluation is a better option - you take some of the sting out of the growing burden of debt).

Home loans and loans to the real estate sector made up 59 per cent of the total loan portfolio of the banks at the end of 2007, compared to 25 percent in 2000, which shows the enormous increase in Swedish bank exposire to Estonian real estate. Net savings (deposits less loans) of private individuals to GDP changed from around a positive 8 percent in 2000 to minus 26 percent in 2008, i.e. households moved from being net savers to becoming net borrowers, and they are now about to go all the way back upstream again, which is why .... well, you know, exports are about to become so vital.

As can be seen from all the above, the Estonian economy is now heavily dependent on the standing and good will of the Nordic banks. The IMF, the Estonian Central Bank, the EU and other stakeholders arguethat the financial standing of the Nordic banks operating in Estonia should be strong enough to cope with both the global financial crisis and the risks related to Estonia's contracting economy. This may, or may not, prove to be the case. If their only exposure was to Estonia then probably they would be right, but what is happening in Estonia forms part of a broader regional picture, and needs to be seen in that light.

But, anyway, this is beside the point. Even were the banks to view favourably future loan applications from Estonian citizens, those very same citizens would be unlikely to be seeking the loans in the first place. As we are seeing, Estonians will be more inclined to save than to borrow in the coming years, and especially given that the Estonian property market has now decisively turned, which means there will be no more juicy increases in house prices to continually tempt them back to the lending counter, nor rising home equity from which to extract that "something extra" with which to buy that nice new car.

Finally, The Impact Of The Property Crash.

Before closing I would like to return to one rather contested (and possibly ill advised) point I made in my previous post. At the start of the post I said:

"At the same time it is estimated that nearly 250,000 Estonians are currently living in homes whose market value is insufficient to cover the outstanding mortgage loans which their owners have taken out, making "exposure risk" a growing problem for the country's banks. During the boom, house sale transactions were commonly financed with a 90% loan to value (LtV) ratio. This is a very dubious practice at the best of time, but in the face of a sharp fall in both house values and wages it becomes well nigh disastrous."

Now, I do say here "it is estimated" and indeed the estimated came from an Estonian journalist (writing in the newspaper Postimees on 27/02) even if the methodology used to make the "estimate" - calculating that between 2006-2008 there were 100 000 households who bought real estate, and then multiplying by the average household size of 2,5 persons, to get a grand toal of 250 000 Estonians). The truth of the matter is that no one really knows how many Estonians have negative equity in their homes at this point in time, other than the fact that the number is large and rising.

What we do know is that property prices in Estonia’s residential real estate market continued to sfall in 2008 (and especially in Talinn and Parnu), after starting to fall in the last quarter of 2007. In fact, i Tallinn the average price of 2-room apartments was down by 17.2% at the end of Q3 2008 from a year earlier. Taking inflation into account, the average price drop was more like 25.3% in real terms. In a broader context, Estonia's 2008 price falls were among the highest seen globally, and were in sharp contrast to the enormous annual price increases we were seeing in the not very distant past, when annual rates peak at an annual price increase of 77.5% in Q1 2006. Record breakers on the way up, and on the way down. Is this, I ask you, a nice way to live?

Demand for properties in Tallinn, for example, reached an all time high in 2006, with the average price of 2 room flats rising by an average of 27% annually from 2001 to 2005 with the rate peaking in 2006, when prices rose by more than 50% year on year.

The average price of a 3-room apartment in Tallinn was down 11.5% - to EKK20,800 (€1,328) per sq. m. - during the year to end-Q3 2008, and down 18.4% from the peak level of EEK25,500 (€1,629) per sq. m. in Q2 2007. In Parnu average prices plunged by around 30% to end-Q3 2008 from a year earlier.

The volume of real estate transactions also continues to fall, after reaching EEK39.8 billion in 2008, down from EEK57.6 billion in 2007 and EEK73.8 billion in 2006. The number of transactions in 2008 was 50,528, up slightly compared with 49,464 transactions in 2007 but well down on the 60,208 transactions registered in 2006.

And along with the decline in notarial contracts the number of building permits has also fallen. Permits for only 4,301 dwellings were filed in the first three quarters of 2008, significantly down compared with the 7,795 permits issued in 2007.

So really we have seen a huge bubble here with the average price of 2-room flats in Tallinn up by 448.7% from 2000 to 2007, in Tartu by 431.5% and in Parnu by 440%. And almost the entire population is affected, since owner-occupancy rates have risen strongly, and are up from 85% in 2002, to 96% in 2004. Estonia's rental market shrank from 12% of households (with 9% privately renting and 3% in social rents) in 2002, to just 4% in 2004.

And the house price boom was supported by a massive expansion of the mortgage market, with an average rate of annual increase of 62% yearly between 2002 and 2006. Outstanding housing loans grew from EEK4.5 billion (€286 million) in 2000 to EEK88 (€5.6) billion in 2007 and EEK 97 (€6.2) billion in 2008; or if you prefer from 4.7% of GDP in 2000, to 37% in 2007. Even more to the point, at the peak of the boom, banks were willing to provide loans with a maximum lending period of 30 years on a loan-to-value ratio of 100%.

Monetary Policy Always Flawed

One cause of Estonia's inflated boom has undoubtedly come from the pronounced tendency of the Estonian people to favour the pegging of the kroon, first to the deutschemark in 1992 and then to the euro in 2001. Initially the peg lead to lower inflation and lower interest rates. Mortgage interest rates fell from over 10% during the late-1990s, to below 4% between 2004 and 2006, while inflation fell from 89% in 1992 to 8.2% in 1998. Between 2002 and 2006, inflation was permanently below the 5% mark (with an annual average of 3.3%).

However pegging is always a problematic strategy, and so it has been in the Estonian case. Follwoing the decision to peg to the euro, interest rates in Estonia have basically followed the key policy rate set by the ECB. Hence when the ECB began to raise key rates in mid-2005, mortgage rates also increased in Estonia. ECB base rates were gradually raised in 25 basis point steps, from 2% in October 2005 to 4% in May 2007, and again to 4.25% in July 2008.

Clearly these rates were lower than warranted by Estonia’s inflation. Yet Estonia's monetary authorities remained relatively powerless because the kroon’s peg to the euro means the central bank could not raise interest rates further, and even if they did, this would only accelerate the preference for euro loans, with the majority of those borrowing sublimely unaware of the risks they were assuming in taking out unhedged foreign currency loans.

I say that Estonia's monetary authorities remained relatively powerless, but relatively here does not mean completely, since more could surely have been done on both the fiscal and the monetary side to avert the present tragedy. The fiscal authorities could have paid more heed to the warnings from the IMF and the credit ratings agencies that a higher level of budget surplus was urgently needed to drain all the excess demand which was violently overheating the system. The central bank (you know those people who now blithely say that "speculations about devaluing of the kroon are irresponsible as no one in Estonia would gain anything from such a move") could have issued very strict instructions to the banks about the income multipliers on loans, loan to value percentages, and documentation needed, and this, as we saw later, would surely have has an effect. And above all, both the central bank and the fiscal authorities could have taken a much less tolerant attitude to the sharp wage inflation which broke out in the second half of 2006. It is not so much a matter of having no policy remedies available, as a lack of the necessary will to look for the tools and find them. All of this is far more reminiscent of what we are unfortunately all too accustomed to seeing in country's with "currency corridors" like Ukraine or even Russia itself than it is of the sort of modern new dynamic and free market economic model we were all lead to believe Estonia had firmly set its path on.

Housing Oversupply And Declining Construction Activity

So what we have before us is a huge housing overhang, a seriously endebted population, and an economy which was dependent on construction and real estate which will now need to "reinvent" itself. It wasn't always like this. Following the break-up of the Soviet Union in 1991, housing construction entered dramatic deceleration and between 1996 and 2001 less than 1,000 dwellings were added to the dwelling stock annually - not even enough to meet "normal" demand. After 2001, housing construction really took off, and in 2007, around 7,200 units were added to the dwelling stock, up from the 5,100 units built in 2006.

This massive increase in dwelling completions has now transformed a housing shortage situation to substantial oversupply one, pushing house prices down in the process. Another 4,282 new dwelling units were completed within the first three quarters of 2008. Although less than the 4,911 completions which were registered in the same period in 2007, these, in a market which is already "oversold" have only added more pressure on an already bloated 645,400 dwelling stock. Maybe it is worth someone remebering at this point that Estonia's population is actually falling. So, as buildings output drops by 25% year on year in Q4 (see chart below) maybe the time has come to ask when will the level of output ever start to rise again? And in the meantime, what will Estonia live from in the meantime? Anyone ready now to have second thoughts about exports?

Saturday, March 7, 2009

Why You Need Devaluation - An Open Letter To The People Of Estonia

The macroeconomic data coming out of Estonia in recent weeks are truly shocking even in the context of the ten percent annual drop in GDP for 2009 that most observers are now forecasting. Perhaps the most evocative number of all is not the 27% year on year drop in industrial output registered in January, but the announcement this week that Estonia’s registered unemployment rate rose to a record 7.4 percent during the first week in March, with a total of 47,774 job-seekers registering with the unemployment offices, up 3,019 in a week. Of course, for many outsiders these are not large numbers, but then Estonia is not a large country. Still this was the highest number since the Labor Market Board started disemminating data in 1993 (although not as measured by Eurostat, which uses a different methodology). The level was up from 7.1 percent at the end of February and 6 percent in January, although the important thing is not the volume of unemployment, but the rate of its increase.

At the same time it is estimated that nearly 250,000 Estonians are currently living in homes whose market value is insufficient to cover the outstanding mortgage loans which their owners have taken out, making "exposure risk" a growing problem for the country's banks. During the boom, house sale transactions were commonly financed with a 90% loan to value (LtV) ratio. This is a very dubious practice at the best of time, but in the face of a sharp fall in both house values and wages it becomes well nigh disastrous.

Once boasting one of Europe's fastest-growing real estate markets, property prices in Estonia fell by a whopping 23% in 2008 (following an 18% increase in 2007) according to data in the latest edition of the Royal Institution of Chartered Surveyors European Housing Review. The RICS tracked 2008 year-on-year house price inflation in 18 West and East European countries, and found that Estonia's fall was the most substantial in the entire group.

Take, for example, a 50 sq metre apartment bought in the spring of 2007 for a price of around EEK 1.3 mln. This apartment is currently worth around EEK 790,000, but the outstanding loan balance is of the order of EEK 1.1 mln. Should the once proud owners of that lovely appartment now find themselves among those unfortunate enough to be queueing up outside the offices of the Estonian Labour Board and need to sell it, then even assuming they could find a buyer they would not only lose their home, but they would still end up owing the bank EEK 300,000 under Estonia's "full recourse" lending laws (which are of course very different from those operating in the United States). With an average net monthly salary in the region of EEK 10,000 this means that the unfortunate ex-property owners would in all probability end up with a debt worth more than two years their total income.

Of course, in this climate buyers are likely to be scarce, and it is more probable that the banks themselves end up with a substantial direct interest in Estonia's property market. And this would only add to the problem they are already having with overdue loans, which are rising and reached 3.6 percent of total credit in January, according to the most recent data from the central bank which now forecasts bad loans will hit 6 percent before the year is out. Of course, as is by now well know, more than 95 percent of Estonian banking assets are held by Nordic banks, and despite the fact that the banks don't cease to reassure us that their Baltic operations form a “key part” of their business and that they have a “long-term commitment” to Estonia, this doesn't stop them getting downgrades. Swedebank, for example, had its credit rating cut to A1 from Aa3 by Moody’s Investors Service last month, citing the risk of a “substantial increase in impairments” (read loan defaults and deteriorating asset quality) from the bank's Baltic operations.

Meantime output and employment simply keep on falling, with Estonia's industrial production dropping by the most in at least 14 years in January - 26.8 percent year on year, the most since 1995 (following a 22.4 percent slump in December).

Of course, as output drops and people are sent home to remain inactive, the one thing Estonia does have at the moment is a lot of loan offers. Thus the central bank recently announced that they will be able to borrow as much as 10 billion Swedish kroner against Estonian krooni from their Swedish counterpart in an attempt to boost confidence in Estonia's financial markets. As Riksbank Governor Stefan Ingves said in the statement “The financial systems in Estonia and Sweden are closely linked”. But what Estonia needs is not more loans, and more debt, and people lying around idle, it needs work, and output, and exports to pay off all that debt which has been accumulated. And it is just at this central point that the current solutions are being tested and found wanting.

The Price and Wage Correction Is Too Slow

In order to understand what is wrong with the path on which Estonia has set itself we need to bear fully in mind that the problem is that the country (or its households) have become excessively indebted in relation to the economy's competitiveness, and the consequent ability to pay. Estonia has a current account deficit, and this does not help things, but Estonia's problem is not, in the longer run, a simple balance of payments and financial crisis one (against which external loans can of course help), but a problem of competitiveness and the ability to pay off debt.

And even despite the recent sharp fall - almost all of which is produced by a fall in imports and a reduction in living standards - Estonia's current account deficit was still running at slightly over 9 percent of gross domestic product in 2008 (following the 18.1 percent shortfall achieved in 2007).

Estonian central bank data show an estimated current account defict for last December of 943 million kroons, down from a revised 1.87 billion kroons for November, and from around 3.5 billion kroons in December 2007, but since exports were down 6% year on year in December, it is obvious that the reason for the contraction in the deficit is the 17% drop in imports. Ouch!

Now, as I say, basically the problem here is to restore competitiveness and, although not everyone will be prepared to agree with me, I would argue that the only solution for Estonia is to export its way out of trouble. Given the problems the banking system is having and is about to have, it would be sheer fantasy-land (and very foolish) to imagine we are going to see a return at any point in the forseeable future to consumer credit driven growth (we are talking everywhere about more, not less, regulation), so as Estonians work hard (once they finally get a job again) to pay off their debts and try to save for their increasingly uncertain old age, the only really valid way to try to go for growth is by exporting. Saying that this is not possible, well... this is simply defeatism before you start, and I don't imagine the Estonian character that way somehow, not after so many years of fighting to gain a hard won independence.

So if you want to export, you have one benchmark to work againt - Germany. And if we look at the chart below, we will see the extent of the competitveness gap which has opened up since 1999. Now Reel Effective Exchange Rates (REERs) are a nice measure of competitiveness, since REERs attempt to assess a country's price or cost competitiveness relative to its principal competitors in international markets. Since changes in cost and price competitiveness depend not only on exchange rate movements but also on cost and price trends the specific REERs used by Eurostat for its Sustainable Development Indicators have been deflated by nominal unit labour costs (total economy) against a panel of 36 countries (= EU27 + 9 other industrial countries: Australia, Canada, United States, Japan, Norway, New Zealand, Mexico, Switzerland, and Turkey). Double export weights are used to calculate REERs, reflecting not only competition in the home markets of the various competitors, but also competition in export markets elsewhere. A rise in the index means a loss of competitiveness, and as we can see Estonia's index has risen sharply against Germany's in recent years.

Well, just in case anyone thinks that the comparison with Germany is not an appropriate one in Estonia's case, here (see below) is the equivalent chart for Finland, which shows an equally strong loss, and let us remember that the worst year in this sense (2008) is still not included, since Eurostat have not processed the data yet.

And of course, I am only looking at eurozone comparisons here, we won't enter at this point into the embarassing fact that Sweden and the UK have both devalued sharply in rcent months, as have Eastern EU rivals, Romania, Poland, Hungary and the Czech Republic, as well as non EU rivals like Ukraine and Russia. Really hanging on to the peg blindly in these circumstances is not only foolish, it is ridiculous, and I hardly see how following a ridiculous policy (which for sure won't work) is going to enhance your credibility, which is what the decision not to devalue was all about in the first place. It won't even shield the Nordic banks from the slew of incoming defaults.

Now, "plan A" is supposed to involve a very sharp downward adjustment in prices and wages, something of the order of 20% during 2009 and 2010. (Incidentally, talk of a V shaped recovery is misleading here, since the V shaped recovery only comes with a one-off devaluation, say getting the 20% out of the way all at once, and doing it over two years can only bring a U shaped process, as you simply spin the same thing out over two years, think about it, the issue isn't that hard to see). Anyway, over two years it is, so how are we getting on? Well up to December last year (which is the latest data we have) not very well, since average hourly wages (the key number here) were still up 9.9% in the last quarter of last year, and so this is really another 10% or so to add to the 20% we were just talking about above (based on the 2007 REER). True, hourly wages did peak in Q2 at 78.26 kroon, and were down to 75.58 kroon in Q4 (or by 3.4% in six months), but this was only really taking back some of the excess from H1 2008, and the real hard work is still to come.

But if we move away from wages and take a look at prices, we find the situation is not much better, since while Estonia’s inflation rate fell in February to its lowest level in more than three and a half years it was still running at an annual rate of 3.4%. We need to see average price declines in the region of 10% in both 2009 and 2010, and not only am I not convinced we are going to see that, none of the major bank analysts or multilateral organisations are currently forecasting anything like this. Or are we going to run our correction from now till 2015 (and have something which looks more like an L-shaped correction)?

Of course, as many will point out, the price index has been falling in recent months (see chart below), but the question is: is it falling fast enough?

What we really need to think about here is not the general index, however, but the so called "core" index (the one that excludes volatile items like energy, food, alchohol and tobacco). Now as we can see in the chart below this index has stabilised, and has even started falling slightly, but if we keep in mind the rule of thumb idea of a 20% decline, and note that the core level peaked at 118.37 in December, then for the correction to have any hope of working we would need to be looking at a reading in the region of 95 come December 2010.

And the situation may be even more complicated than we imagine, since the Eurozone itself may fall into deflation, and if so every percentage point drop in the Eurozone index will need to be matched by an extra percentage point drop in the Estonian one. Unfortunately your leaders and advisers are a long way from explaining this harsh reality to you.

But there is reason to fear that this may actually be what happens, since if we look at Eurozone headline HICP inflation on an annualised basis, we will find that it fell more than expected in January - to 1.1 per cent, according to Eurostat data - down quite dramatically from the peak of 2.7 per cent hit in March last year. This was the lowest level we have seen since July 1999, and a sharp drop from the 1.6 percent rate registered in December. On a month-to-month basis, prices were down 0.8 percent. The "core" inflation rate - that is consumer inflation without the volatile elements of food, energy, alcohol and tobacco - we find it still stood at 1.6%, since the biggest impact on headline inflation comes from the decline in food and energy costs. But if we look at the monthly movement in the core index, we find that it dropped by a very large 1.3% (see chart below).

Now if we come to look at the core inflation rate over the last six months, we find that the index has only risen 0.1% (or an annual rate of 0.2%). This gives us a much more accurate reading on where inflation actually is at this point in time, and where it is headed. The chart below shows the six month lagged annualised rate for the last twelve months, and the sharp drop in January is evident. If things continue like this, then the eurozone as a whole is headed straight into deflation, for sure.

Retail Sales Dropping Sharply

Basically, to get economic growth, and thus to be able to pay down debts, you need one of three things: an increase in government demand, and increase in export demand, or an increase in private domestic demand. Now the first two of these are categorically excluded in the present situation (especially since the government is cutting, and not increasing, public spending as part of the crisis response package (the so called "plan A" strategy). However, private domestic demand is falling like a stone at the moment. According to the latest data from Statistics Estonia, retail sales were down 10% year on year in January (at constant prices).

As we can see in the chart below, Estonian retail sales peaked in February 2008, since which time they have been steadily falling.

So what are the chances that domestic demand can make a recovery? Well, according to some, quite substantial. According to a recent report from UBS bank on Eastern Europe Lending:

We retain our firm view that convergence is a ‘sure thing’ for those economies already in the EU – it is just a question of time before levels of GDP per capital approach those of the established members. If convergence is perhaps a thirty or forty year process, the most advanced are perhaps half way through (Poland introduced its free market reforms on 1 January 1990). The uncomfortable period we are entering is one where local growth goes from above-trend to sharply below. It may well take a number of years before nominal GDP (in Euro) recovers the levels of summer 2008, but we believe markets can be forward-looking when outcomes are predictable.

So the issue is convergence, and the justification for "plan A" is essentially based on this idea, as UBS analysts

Why does convergence matter so much? Because equity markets – and therefore companies – are essentially about growth. And convergence drives excess growth. The new EU members offer legal systems becoming increasingly like those in old EU states, with labour productivity comparable and labour costs a fraction of those back home – particularly following recent currency declines. Margins on banking products are typically higher than in ‘old’ Europe and levels of penetration much lower.

These arguments were a staple of a thousand corporate presentations through the good times and we suspect will be little mentioned except where necessary over the next twelve or eighteen months. But we believe them to remain essential to an understanding of likely outcomes in the region: they raise the bar for all stakeholders faced with a challenge of whether to prioritise the long-term or the immediate. It is an active debate what the Ukraine will look like several years hence; we believe it is not for the EU members: they will look more like the old EU states, in form and substance.
So we are putting all our money on the "convergence" bet, but just how realistic is this? Unfortunately, not very, since one key argument it simply fails to take into account is the effect of demographic processes. Basically, the whole of Eastern Europe has one large and little discussed problem, birth rates fell dramatically, but life expectancy did not rise: Latvia and Estonia are not only (along with Slovakia) the EU countries with the lowest per capita income, they are also those with the lowest life expectancy. Male life expectancy in Estonia is just 67.16, and for Latvia it is 66.68, compared to 76.11 for Germany, and 77.13 for Italy. Let's not beat about the bush here, this means that each adult working male can contribute roughly ten years work less to paying down the country's debts, and of course, extending the working age to 70 (25% of the Japanese population still work at 75) impossible. This is why the whole idea of "convergence" is a non-starter. And again, you don't need to be an economics PhD from MIT to see this.

In the real world Estonia's population is currently shrinking, which, with fertility around the 1.4 Tfr range is hardly surprising.

The birthrate has been rising (slightlly) in recent years, but as Afoe's Doug Muir explains in this post here, this is more than likely going to unwind during the recession.

Interesting Fact #1: birthrates tend to drop during recessions, and the drop tends to correlate with both the severity of the recession and the speed of its onset. The current recession is looking to be a bad one, and it happened pretty quickly, so we can reasonably expect a sharp drop in birth rates. Makes sense, right? Babies are expensive; more to the point, babies limit your options. They make it harder to move to a different city, change careers, stop working for a while. When times are hard and uncertain, babies become a luxury. For individuals and families, a recession is a good time to put childbearing on hold.

Interesting Fact #2: all across Communist Eastern Europe, birth rates declined slowly through the 1970s and ’80s… and then crashed after 1990, dropping to very low levels and staying there through most of the decade. In some countries they bounced back a bit, in others not, but in almost all cases there’s a big “birth gap” from about 1991 until at least 1997, and often later.

Put these two facts together, and there’s a problem.

Indeed Statistics Latvia have already reported a 25% year-on-year drop in births in January 2009 (from 2310 in Jan 2008 to 1860 in Jan 2009), and looking at the Estonian Statistics we find that in January 2008 there were 1493 births and in January 2009 there were 1232. Again about a 20% drop year on year. Of course, one month's data don't prove anything, but since, as Doug points out, this is what the theory predicts, we should all be taking it seriously, and it should be taken into consideration when we talk about which kind of "correction" we want. It is no good saving the stream of external funding coming into your banks if you "meltdown" your population as you do it.

Unfortunately I haven't noticed one single European leader who is seeing fit to even mention this issue - or the other, pending, one that when the recovery does come, if the Baltic countries are still stuck struggling with their pegs, the additional haemorrage out will be in young people looking for money to send home to their ageing and impoverished relatives, thus giving the whole demographic thing another turn of the screw.

The future already looks bleak enough in human capital terms, as this recent report from Statistics Estonia makes evident:

According to the Statistics Estonia, at the beginning of academic year 2008/2009, 154,481 pupils were acquiring general education, 27,239 vocational education and 68,399 students were acquiring higher education. The decrease in the total number of pupils is influenced by the number of pupils acquiring general education, which has decreased during the last decade. The decrease in the number of pupils in general education is related to the decrease in the number of births, which began at the end of the 80s and lasted till the end of the 90s. At the end of the 90s more than 220,000 pupils were acquiring general education, thus the number of pupils in general education has decreased by about a third during the last decade. In academic year 2008/2009, 147,519 full-time and 6,962 part-time pupils were acquiring general education. In autumn 2008, 12,426 children started school, which is over a third less than ten years ago.

So Is There A "Plan B"?

Well, of course there is, and everyone, no matter which side of the argument they are on, knows only too well what this is: devaluation. Of course of devaluation of the Baltic/Latvian pegs contains implied sovereign liabilities, and these need to be thought about. You cannoy do this alone, but you are members of the EU and you can ask for help with the process. But if you don't start to ask for the help, then naturally you aren't going to get it.

Technically the pegs can be maintained. The question which faces Estonians is quite simply which alternative – keeping or changing the peg – implies the greatest cost. The main stakeholder here is the EU, and you should be leveraging that for all you are worth. The capital erosion for Western European lenders would not be insignificant if you (and others) simply sink.

Naturally small open European economies like Latvia and Estonia can only hope to gain very minimal monetary autonomy outside currency board type arrangements, so the only realistic exit strategy is devaluation and Eurozone membership, as I explain in this post (and this one).

Of course this change in EU policy won't arrive tomorrow (but it might come next week, or the week after). It's just that you have to push for it. Stopping work and going home (as unemployed) while your country borrows more and more money is not going to bring the future you all so badly want. There is another path, choose it!

Wednesday, March 4, 2009

How Not To Manage Eastern Europe's Financial Crisis (Part 1)

"Saying that the situation is the same for all central and eastern European states, I don't see that......you cannot compare the dire situation in Hungary with that of other countries."
Angela Merkel, Brussels, Sunday

"Happy families are all alike; every unhappy family is unhappy in its own way"

In Europe, leaders rejected pleas for a comprehensive rescue plan for troubled East European economies, promising instead to provide “case-by-case” support. That means a slow dribble of funds, with no chance of reversing the downward spiral.
Paul Krugman

Bank regulators from Bulgaria, the Czech Republic, Poland, Romania and Slovakia met today and issued a joint statement, ostensibly to reduce the some of the impact of what they term "alarmist comments" from the Austrian government about how the regional banking system is now in such a precarious state that it requires urgent action at EU level to prevent meltdown. The Austrian government are, of course, concerned about the impact of any meltdown on their own banking system. The result of this "reassuring statement" can be seen in the chart below (10 years, HUF vs Euro).

Within minutes of the joint statement Hungary's currency plummeted to an all-time low against the euro and to a 6.5-yr low versus the US dollar. In fact the HUF rapidly depreciated to 312 per euro from 307.50 before climbing back in later trading to 310. And the reason for this swift reaction? Hungary was not invited to join the statement. As the forint plunged, Hungary 's banking regulator hurriedly signed up to the statement, blaming the original omission on a communications mess-up, but the damage was already done.

“Each of the CEE Member States has its own specific economic and financial situation and these countries do not constitute a homogenous region. It is thus important first to distinguish between the EU Member States and the non-EU countries and also to clarify issues specific to particular countries or particular banking groups."

Well this just takes us back to Tolstoy, each of them have their own specific problems, but the underlying reality is that they all face problems, and are vulnerable, each in their own way.

Hungary's economic fundamentals are clearly much weaker than those to be found in the Czech Republic and Poland as things stand, but what about Bulgaria and Romania? And the Czech Republic and Poland are about to have a pretty hard time of it as a result of their export dependence on the West, and Poland has the unwinding of the zloty options scandal still to hit the front pages. So there is plenty of food for thought here before throwing Hungary to the wolves. A default in Hungary could very easily lead to contagion elsewhere, and then the impact in the West is very hard to foresee. We should not be playing round with lighted matches right next to our fireworks stock. "Hey, it's dark in here" and then "boom".

Yesterday it was Latvia's turn, and the cost of protecting against a Latvian default (Latvia is the first European Union member priced at so- called distressed levels) rose to a record following the announcement that the unemployement level rose from 8.3% in December to 9.5% in January, the highest level in nearly nine years. In fact credit-default swaps linked to Latvia increased nine basis points to an all-time high of 1,109 basis points, according to CMA Datavision in London. The cost is above the 1,000 level, breached last week, that investors consider distressed, and is now about 270 basis points above contracts linked to Lithuania, the next-highest EU member.

So two countries are being systematically detached here - Latvia and Hungary - and statements by EU leaders are unwittingly aiding and abetting the process. But we should all remember, after they have eaten Latvia and Hungary for breakfast, the financial markets will undoubtedly chew on other luckless countries over lunch (Romania's Q4 GDP data was out today, and it was a shocker, and S&P have already said they are "closely monitoring" the situation), before perhaps moving on to bigger game for supper.

And we should remember here, no one is too big to fall, and I have already been warning about the gravity of Germany's situation, with a rapidly ageing population, a hefty bank bailout of its own to swallow, and total export dependence for GDP growth. Final data from Markit economics out today showed that Germany's composite PMI fell to 36.3 in February from 38.0 in January. That was the lowest level registered since the series began in January 1998. And it means that the German economy - which is highly interlocked with the whole of Eastern Europe (Austria holds the finance and Germany the industrial exposure) - is certainly contracting more rapidly in the first quarter of this year than it was in the last quarter of 2008, and may well contract in whole year 2009 by something in the order of 5%. So maybe someone over there in Germany should be reading the poem you will see below aloud to "our Angela" right now (Oh, and if you don't speak German, you can find a translation here).

Als die Nazis die Kommunisten holten,
habe ich geschwiegen;
ich war ja kein Kommunist.
Als sie die Sozialdemokraten einsperrten,
habe ich geschwiegen;
ich war ja kein Sozialdemokrat.

Als sie die Gewerkschafter holten,
habe ich nicht protestiert;
ich war ja kein Gewerkschafter.

Als sie die Juden holten,
habe ich geschwiegen;
ich war ja kein Jude.

Als sie mich holten,
gab es keinen mehr, der protestieren konnte.

What Last Weekend's EU Summit Did And Did Not Achieve

Well reading the press on Monday morning it would have been fairly easy to reach the conclusion that nothing really happened yesterday in Brussels, and that a great opportunity was lost. The latter may finally be true, but the former most certainly is not.

Let's look first at what was not decided on Sunday. The leaders of the 27 member countries in the European Union most certainly did not vote to back a proposal from Hungarian Prime Minister Ferenc Gyurcsany for a 180-billion-euro ($228 billion) aid package for central and eastern Europe. They did not back it because it was not even seriously on the agenda at this point. These people move slowly and we need to talk them throught one step at a time. So what was on the agenda. EU bonds for one, and accelerated euro membership for the East for a second. And once we have the EU bonds firmly in place, then that will be the time to decide how we might use the extra shooting power they will bring us (boosting the ECB balance sheet would be one serious option they should consider, see forthcoming post from me and Claus Vistesen). That is when the emergency blood transfusion Gyurcsany was rooting for might come into play, but on this, as on so many items, the details of how we do what we do as well as the "what we do" will become important, so the moves we do take need to be well thought out, and systematic, they need to get to the roots of the problem, and not simply respond to problems on a piecemeal, reactive basis.

As Paul Krugman puts it "In Europe, leaders rejected pleas for a comprehensive rescue plan for troubled East European economies, promising instead to provide “case-by-case” support. That means a slow dribble of funds, with no chance of reversing the downward spiral." Amen to that!

But let's look at little bit deeper at what has been decided, or if you prefer, at what has been floated, and may be "decided" at the next meet up. Well for one, we have promised not to be protectionist, and for another, The World Bank, The European Bank for Reconstruction and Development (EBRD) and The European Investment Bank (EIB) have launched a two-year plan to lend up to 24.5 billion euros ($31.2 billion) in Central and Eastern Europe. This sounds a bit like trying to drain an Ocean with a teaspoon, and it is, so predictably the financial markets were not too impressed, expecially when they learned that not much of what was promised was going to be new money (as opposed to theacceleration of existing commitments), and especially when we take this sum and compare it with the likely quantities which are needed to "take the bull by the horms". EBRD President Thomas Mirow (who is more likely to give a low side estimate than a high side one) recentlly told the French newspaper Le Figaro that in his view Eastern European banks could need some $150 billion in recapitalisation and $200 billion in refinancing to stave off the risk of a banking failure in the region. At least.

"(It) sounds like a lot of money, but when (commercial) banks have lent Eastern Europe about 1.7 trillion dollars, 25 billion is peanuts," said Nigel Rendell, emerging markets strategist at Royal Bank of Canada in London. "Ultimately we will have to get a much bigger package and a coordinated response from the IMF, the European Union and maybe the G7."

So let's now move on to the positive side of the balance sheet, since as we know our leaders are a slowish bunch when it comes to grasping what is actually going on here, and an even slower group when it comes to acting on that knowledge once it has been acquired. The biggest plus to come out of last weekend's thrash is most definitely the fact that the idea of accelerating membership of the eurozone for the Eastern countries has now started to gain traction, if with no-one else then at least with Luxembourg Prime Minister (and Finance Minister, he is a busy man) Jean-Claude Juncker, aka "Mr Euro", who was quoted by Reuters on his way into the meeting saying he did not expect any early change to accession criteria for the single currency.

"I don't think we can change the accession criteria to the euro overnight. This is not feasible," Juncker told reporters as he arrived for a summit where non-euro eastern countries are due to call for accession procedures to be accelerated after their local currencies have taken a hammering on markets.

While in the news conference following the meeting he said that there was now a consensus that the two-year stability test required for a currency of a country hoping to join the euro zone should be discussed.

"I can understand that there may be a slight question mark over the condition that one needs to be member of the monetary system (ERM2) for two years, we will discuss this calmly," Juncker told a news conference after a meeting of EU leaders.

So something actually went on during the meeting, even if we are largely left guessing about what. Angela Merkel also left a similar impression that movement was taking place. "There are requests to enter ERM 2 faster," Merkel is quoted as saying. "We can have a look at that."

Now I have already spelt out at some length why I think the Eastern Countries should be offered accelerated membership of the eurozone forthwith (see this post) as has Wolfgang Munchau (in this FT article here).

The Economist, in a relatively sensible leader which I have already referred to, divides the Eastern countries into three groups. Firstly there are those countries that are a long way from joining the EU, such as Ukraine, Turkey and Serbia. As the Economist points out, while it would be foolhardy practically and hard-hearted ethically to simply stand back and watch, European institutions are pretty limited in what they can do apart from offereing some timely financial help or some sound institutional advice, and it is entirely appropriate that the main burden of pulling these countries back from the brink should fall on the International Monetary Fund.

Then there are those East and Central European Countries who are themselves members of the Union, and here it is the EU that must take the leading role. A first group of these is constituted by the Baltic trio (Estonia, Latvia and Lithuania) and Bulgaria, who have currencies which are effectively tied to the euro, either through currency boards, or pegged exchange rates. Simply abandoning these pegs without euro support would both bankrupt the large chunks of their economies that have borrowed in euros and deal a huge psychological blow to public confidence in the whole idea of independent statehood. Yet devalue they must (either via internal deflation, or by an outright breaking of the peg) and either road is what Jimmy Cliff would have called a hard one to travel. As the Economist itself suggests, these countries have suffered the most painful part of being in the euro zone—the inability to devalue and regain competitiveness—without getting the most substantial benefits of participation, so although none of them will meet the Maastricht treaty’s criteria for euro entry any time soon (and since they are tiny - the Baltics have a population of barely 7m, and Bulgaria is hardly bigger), letting them directly adopt the euro ought not to set an unwelcome precedent for others and should certainly not damage confidence in the single currency (any more than it already is, that is).

On the other hand unilateral adoption of the euro is a rather more difficult issue for the third group of countries, those who are EU members, are not in the eurozone and have floating exchange rates: the Czech Republic, Hungary, Poland and Romania. None of these is here and now, tomorrow, ready for the tough discipline of a single currency that rules out any future devaluation, and they are large enough collectively (around 80 million) that their premature entry could expose the euro to more turbulence than it already has on its plate. But so could simply leaving the situation as is, since if these economies enter a sharp contraction (more on this in a coming post) then the loan defaults are only going to present similar problems for the eurozone banking system as their currencies slide. The big vulnerability for Western Europe from the Polish, Hungarian and Romanian economies, arises from the large volume of Euro and CHF denominated debt taken on by firms and households, mainly from foreign-owned banks. As the Economist puts it "what once seemed a canny convergence play now looks like a barmy risk, for both the borrowers and the banks, chiefly Italian and Austrian, that lent to them".

So we now have several EU leaders opening the door for the first time to the possibility of fast-track membership of the eurozone. As we have seen German Chancellor Angela Merkel said after the summit that we "could consider" accelerating the candidacy process, French President Nicolas Sarkozy said that "the debate is open", and Luxembourg Prime Minister Jean-Claude Juncker, who heads the Eurogroup of eurozone finance ministers, said he was willing "to calmly discuss" such a possibility. So the debate is open. When will the next meeting be? On Sunday I hope. A week in all this is a very long time for reflection in this hectic world. We need proposals, and concrete ones for how to move forward here. Especially since at the present time all our attentions seem to be focusing on the East, and there is also the South and the West (the UK and Ireland) to think about. Perhaps our leaders will be able to make time from their crowded agendas for a series of mid-week meetings on this topic.

And while the leaders dither, the markets react, and as Bloomberg reports the dollar surges as everyone seeks a safe haven during the coming storm.

The dollar rose to the highest level since April 2006 against the currencies of six major U.S. trading partners.... and .... The euro dropped to a one-week low against the greenback as European Union leaders vetoed Hungary’s proposal for 180 billion euros ($227 billion) of loans to former communist economies in eastern Europe. The Swedish krona fell to a record versus the euro on speculation the Baltic region’s borrowers may default, and the Hungarian forint and Polish zloty tumbled.

The Hungarian forint led eastern European currencies lower today, falling 3.1 percent to 243.86, while Poland’s zloty lost 3 percent to 3.7796. The forint fell to a 6 1/2-year low of 246.32 on Feb. 17 as Moody’s Investors Service said it may cut the ratings of several banks with units in eastern Europe. The zloty touched 3.9151 the next day, the weakest since May 2004.

EU leaders spurned Hungary’s request for aid at a summit in Brussels yesterday. Growth in Poland, the biggest eastern European economy, will slow to 2 percent, the slackest pace since 2002, the European Commission forecasts.