Estonian Producer Price Index Continues To Rise

Estonian producer prices rose in July at their fastest annual pace in 9 1/2 years, led by rising food and timber costs, a sign the country's competitiveness is under severe pressure.

According to the latest release from the Estonian Statistics Office producer prices rose in July 2007 at an annual rate of 8.7%, up from an 8.3% rate in June. As can be seen from the chart below, the annual rate of increase has been accelerating continuously over the months:



There is a small piece of good news if we look at the evolution of the index itself, since despite the large year on year increases registered recently the pace of increase seems to be slowing down, as can be seen in the chart below. Indeed over the last two months the annualised rate has been only something like 3.6%.




But this is of little comfort if we look at the export producer price component - export prices rose 0.9 percent in July from June and 9.1 percent from a year earlier, again see chart below - which has clearly been going steadily on its upward path:



Since domestic demand is now evidently slowing substantially, the need to obtain growth from exports is stronger than ever, but with these rates of increase in export prices this is going to be a very difficult matter indeed.

Estonia's economy is struggling to handle the dramatic increase in wage costs the growing labour shortage is causing - wages and salaries were up over 20 percent year-on-year in the first quarter of this year. And companies are cutting jobs, like Boras Waefveri AB, a Swedish textile company, who said in April they will cut at least 800 jobs, or a quarter of the staff, at its plant in Narva, Estonia, due to competition fromlow-cost imports from Asia.

Other companies, such as Elcoteq Network Oyj, a Finnish contract manufacturer for mobile-phone makers such as Nokia Oyj, have attempted to address the problem by cutting production and trying to move over to higher value-added production.

Others again, such as Nolato Telecom, a Swedish contract manufacturer of mobile phone components are simply packing their bags and leaving. Nolato Telecom announced in its second-quarter earnings report last month that it plans to close production at its Tallinn unit in the second half of 2007, but gave no reasons for the move.

If all of this continues the outlook will become grave indeed. This problem needs a much more extensive response, not only from the Estonian government, but from the European Commission itself.

Fitch downgrades Latvia to BBB+

Fitch ratings agency has downgraded Latvia’s foreign currency issuer default rating (IDR) to ‘BBB+’ from ‘A-. It has also downgraded the Latvia's currency IDR to ‘BBB+‘ from A, –‘both of these ratings with a stable outlook. In defence of its decision Fitch argues that the Latvian economy is severely overheating (and who can disagree about that) whilst considering the policy reaction of the Latvian government to be insufficient to restore the economy to a sustainable growth path (again it is hard to disagree, although it would be simply unjust to pour all the blame on the Latvian government here, since there are important structural factors at work which are to some considerable extent beyond the control of the Latvian government”. For a fuller analysis of this see this post, and this one.

At the end of the day it is hard to disagree with Fitch and the downgrade should as such not have come as a surprise, especially since Standard & Poor’s earlier this year also made a similar downgrade, and we are still only waiting to hear from Moody's (who still maintain an A2 investment grade on Latvian sovereign deb). Should Moody's also revise their rating then Latvia would be without a single investment grade rating from a ratings agency, and their would be consequences from this since the ECB have earlier signalled that they are no longer prepared to accept paper from countries in this position as collateral (more on this below).

But there is another issue which arises here, and that is the actual role of credit ratings agencies in protecting both investors from serious financial risk, and citizens of sovereign states from the profligate practices of their political leaders.

This issue has recently been getting some coverage in the case of Italy, where of course public debt has over the last decade spiraled upwards almost out of control (to 107% of GDP) and the European Commission has proved itself to be completely incapable of rising to the challenge which this situation presents in the context of Italy's rapidly ageing population. (For more analysis of the role of the credit agencies in the Italian context see this post).

The ratings agencies question has also been entering particularly muddied waters in recent days due to the insistance of some EU Commissioners and the French President Nicolas Sarkozy on holding an investigation into the role of these self same agencies in the US sub-prime mortgages problem.

Now why am I pointing the finger especially at Nicolas Sarkozy here? Well, according to the Financial Times:

In a letter to Angela Merkel, the German chancellor and acting president of the group of eight industrialised nations, which includes the G7, Mr Sarkozy highlighted his concerns over the weaknesses of the international financial system revealed by the present crisis.

He called for G7 finance ministers to draw up proposals for their meeting in Washington in October to address transparency and risk awareness among market participants and regulators.

He said the G7 should join the European Commission in investigating the role played by credit ratings agencies in the crisis, and said that bank involvement in credit markets should also be addressed.

Now obviously, in general terms, there may be little to disagree with here. A nice theoretical discussion of transparency, and the role of the ratings agencies (which could also be extended to the role of the EU Commission and the ECB when it comes to the tricky question of the sovereign debt ratings of some delicate EU member states, including unfortunately the Baltic ones) may well be in order. But, I ask you, is now, precisely now, the moment to be airing all this. Isn't the number one priority for everyone right now to settle the global financial markets down, and to try and pass through this storm without incurring any excess damage?

But no, we need a scapegoat for our problems apparently, and the scapegoat it would seem is to be the ratings agencies, forgetting conveniently in the process that only last week they were being regarded as the last firewall of our collective defence.

So what do you expect, the agencies themselves hit back, at least to cover themselves. On Thursday it was Chris Mahoney, vice chairman of Moody's who responded in kind:

Moody's Investors Service fueled concern that the global credit crisis is worsening by speculating that a hedge fund collapse on the same scale as Long-Term Capital Management LP in 1998 is possible.

Hedge funds face potential losses on collateralized debt obligations, securities packaging bonds, loans and other assets, Chris Mahoney, vice chairman of Moody's, said on a conference call today. The funds are unable to agree on prices to sell riskier assets, causing the market to seize up, Mahoney said.

Then on Friday it was the turn of Fitch:

Latvia's long-term sovereign rating was cut to BBB+ from A- by Fitch Rating Service as government plans to keep the economy from overheating are ``insufficient.''

Now I really don't see that you can expect the ratings agencies to respond in any other way. You suggest you want to criticise them for being insufficiently vigilant, and so naturally they respond by starting to be "extra-vigilant". You can hardly blame them for this.

But as I indicate above, this decision by Fitch also begins to put the ECB in an interesting situation. Let us go back to November 2005, and the ECB decison to only accept bonds with at least a single A- rating from one or more of the main rating agencies as collateral in its financial market activities (and the original article here).

Well technically Latvia still has an A2 rating from Moody's, and this is equivalent to an A- (as has Italy in the case of Moody's), so the ECB will in theory continue to accept Latvian paper, but at this pace it would only seem to be a matter of time before Moody's downgrade too, especially with Sarkozy loading on the pressure. This will, apart from making it much more difficult for the Latvian government to raise credit, effectively take away the guarantee which underpins the present structural distortion in the Latvian economy, put even more distance between Latvia and membership of the euro, and complicate the task of the Latvian government in trying to steer the economy forward. Bottom line: is all of this a good idea. Answer: what you ask for is what you get, so my advice in future is to think first before opening your mouth.

The principal point I want to make here is that while in the normal course of events such downgrades - or the threat of them - may serve a useful purpose by putting pressure on governments to change course, in the current climate these very same downgrades may only serve to provoke the very situation which they are intended to avert, and that is the danger now. Let us remember what Buttonwood wisely, and possibly presciently, said:

As central banks lose authority, might credit-rating agencies play the watchdog role? By acting swiftly to downgrade debt, they would constrain companies (and countries) from borrowing too much. But the agencies tend to lean with the wind, rather than against it. They upgrade debt when the economy is booming and downgrade it when recession strikes. If the central banks do eventually slam on the brakes, therefore, the rating agencies will only exacerbate the downturn. As asset ratings fall, investors will be forced to sell their holdings and credit will be withdrawn from the system. Thanks to the financial markets, central banks now struggle to police the economy. But this may imply that the bust, when it comes, is as hard to control as the boom that preceded it.

Will The Lat Come Under Pressure Again?

Well we all know about the turmoil that is taking place in the financial markets at the moment. Last Friday the Federal Reserve surprised everyone by suddenly lowering the discount rate. This has lead to all sorts of speculation about the future direction of interest rate policy in the major economies. It is now extremely unlikely that the Bank of Japan will now proceed with a quarter point raise later this month, and it is very doubtful in my mind that the ECB will raise in September. It is pretty much a foregone conclusion that the next move by the Federal Reserve will be down, the only outstanding question really is when.

Obviously we need to wait and see how the financial markets respond to the latest move from the Fed, but my feeling is that the so called "credit tightening" isn't over yet (and not by a long stretch), and that even were the "crunch" to come to an end soon the consequences for the real economy are going to be important, since credit - both corporate and private, and possibly even sovereign - will be harder to come by. What this "harder to come by" really means is that you will have to pay more for it, especially if your credit valuation is not of the highest (as was the case with the US sub-prime home purchasers). As I say this will hit at all levels, since the banking sector has clearly had a big shock, and will involve individual, companies and even governments. Just how it will affect them is what we are now waiting to see. But it is important to bear in mind that this impact on new credit will occur regardless of the extent to which central banks lower their base rates, since what has happened is that the lending environment has deteriorated, and this deterioration is likely to influence conditions in new lending (or rollover credit) for years rather than months.

Obviously existing mortgage holders on variable rate mortgages can get some fresh air from any loosening in the base rates, but it is the demand for new mortgages, and activity in the construction sector, and not locally but globally, that we need to be thinking about here. Clearly construction growth can slow, as lenders become more choosy about who - and under what conditions - they lend to. This becomes important for the real economy when we come to consider the importance which construction activity shares have had in economic growth in some major economies - the US, the UK, Spain, Australia etc - since the turn of the century, and the impact which the so-called wealth effect has had on the rate of growth of private consumption in this self same economies. So clearly, in some developed economies, economic growth is now likely to be rather weaker, and for some time to come.

But the "credit crunch" is likely to affect the so called "risk appetite" (that is the willingness to invest in riskier areas or activities) and the place where this is most likely to be felt is in the emerging market area. Those emerging markets which are considered to be most vulnerable will undoubtedly have the hardest time of it, and this brings us directly to the Baltics, who must be considered to be in one of the riskiest situations of all. To quote the Economist's Buttonwood, "WHEN investors get twitchy, developing countries are usually the first to pay the price."

And investors are definitely twitchy right now, as Danske Bank Senior Analyst Lars Christensen commented last Wednesday (pdf link) the markets are beginning to see signs that pressures on the lat are re-emerging. In his research note Christensen argues that while the atmosphere surrounding the Lat calmed down in May,after having experienced significant pressure during February-April period (as reflected in this speech from Latvikas Banka governor Ilmārs Rimšēvičs back in February, which was an irate response to an article in the pages of Diena by the Swedish Economist Morten Hansen, who was arguing that the Lat/euro peg needed to be broken, more on all this in another moment).

Basically Christensen sees this pressure re-emerging, largely for three reasons:

Firstly there is the above mentioned worsening of global credit conditions, which will make it much harder to fund the large current account deficits in Latvia and the other Baltic states. Scandinavian banks naturally are also showing less willingness to fund the Baltic credit boom with global credit conditions worsening and concerns are mounting about the vulnerability of over-leveraged households and investors across the Baltics.

Secondly there are clear signs that the property markets are coming under fairly strong selling pres-sure in all three Baltic states. Christensen suggests that property prices have dropped nearly 10% in Estonia over the last two quarters, while Latvian property prices have declined 5%-8% over the last two months. Meanwhile, Lithuanian property prices are no longer rising. In addition to this he mentions anecdotal evidence that property developers in the Baltics are freezing property projects that have already been initiated.(Latvian Abroad is covering the unwinding of the Latvian property boom here, and here).

Thirdly, there is the fact that the Baltic economies are now clearly slowing. As I argued yesterday, the Estonian economy is now showing very significant signs of a fairly sharp slowdown with the rapid second quarter GDP screech to a halt (only 0.2% growth in the quarter) marking the lowest rate of growth in seven years on a quarter-on-quarter basis.

On the property market angle, Christensen has a separate report (again pdf), and he makes a number of important points here:

Property price statistics are fairly unreliable and hard to compare from country to country in the Baltics, but most sources now point to fairly heavy declines in property prices – at least in the three capital cities. Property prices have dropped most in Estonia’s capital, Tallinn, where official statistics and anecdotal evi-dence indicate that property prices have dropped around 10% this year. Latvia’s capital, Riga, is also ex-periencing falling property prices – down 5-8% over the last couple of months and most indicators suggest-ing an acceleration in the rate of decline.

There are also signs of slowing property prices in Lithuania’s capi-tal, Vilnius, but it is still too early say that property prices are actually declining. There are a number of rea-sons why property prices are now declining in the Baltic States. In our view the primary reason is simple – prices have simply risen far too much relative to fundamentals. Furthermore, a number of negative shocks have hit the Baltic property markets. Most importantly, interest rates have gone up in line with European rates over the last year. Furthermore, the banks have tightened credit standards on the back of rising con-cerns about the large imbalances in all three countries. Hence, it looks like the boom in the Baltic property market is coming to an end. It is very difficult to assess how far property prices in the Baltics could potentially fall, but given the large imbalances in the Baltic economies we think the downturn could be quite severe and long-lasting. It is debatable whether there has been a Baltic property bubble, but there is no doubt in our view that property price growth has been exces-sive, and therefore property prices should be expected to slide further going forward.

So basically, and the bottom line here, the Baltic economies are extremely vulnerable to any sudden turn in investor sentiment. We are in the middle of a major sea change in global sentiment even as I write, so at the end of the day all I can say is, do watch out.

Emerging Markets and Safe Havens

Danske Bank's Lars Christiansen had another research note last week which is of some interest for Latvia's current situation (see this post for his earlier research note). Entitled "Emerging Markets: Looking for the safe haven" (watch out pdf), and published last Thursday, Christiansen accepts that there is a global credit crunch, and that it is now spreading to Emerging Markets (EM), with many of the high-risk EM currencies (the Turkish Lira, the Hungarian Forint, etc) now coming under heavy fire. As to the question what countries may be most at risk, he answers the following:

In a situation where liquidity is tightening there is no doubt that the most liquidity-“hungry” countries are those with large current account deficits and large external debt. In this category we find Turkey, South Africa, Hungary, and Iceland. Furthermore, risks are heightened in the Baltic states, Romania, and Bulgaria.

That would seem to put Eastern Europe pretty generally on the map I would have thought. Chrisiansen seems to accept the arrival of the credit crunch as now a fact:

For the last couple of weeks, we have warned that the global credit crunch could spread to Emerging Markets. This has now clearly happened, but given the major moves in the global credit and equity markets there clearly is potential for even more contagion to Emerging Markets. Therefore, there is also reason to start looking for safe havens within Emerging Markets. Here external funding needs will be the key.

Furthermore:

The credit crunch has triggered a strengthening of the yen and to a lesser extent, the Swiss franc. We would in particular watch the Swiss franc as many households in Central and Eastern Europe have funded their property investments with Swiss franc loans. Hence, if the Swiss franc strengthens further then it could put additional pressures on the CEE markets mostly exposed tothe Swiss franc.

This is really code language for speaking about Hungary (although there may be more) since in Hungary around 80% of the mortgages which have been taken out in recent times have been Swiss Franc denominated (via Austrian banks I should mention, so the Austrian banking sector is also partially at risk, although the Austrian Central Bank think they can withstand the shock if you look at the "Stress Testing the Exposure of Austrian Banks in Central and Eastern Europe" paper presented here.

So here are Danske Banks recommendations. The countries you are told to avoid are in red:



One bright spot - or potential safe haven - does exist in Eastern Europe however: the Czech Republic:

Finally it should be noted that the Czech koruna (CZK) – unlike most other CEE currencies – should be expected to strengthen in the present environment due to unwinding of CZK-funded carry trades. That said, the CZK is fundamentally not undervalued and the Czech central bank should be expected to keep interest rates below the ECB rate – especially if the CZK strengthening accelerates. That will limit the potential for strengthening of the CZK.

In case any of you notice some inconsistency in this view of the Czech Republic, since of course Czechia is also one of the "reds" (though to a much lesser extent than some of the others), I think it needs to be pointed out that other factors beyond the CA deficit need to be taken into account when evaluating the situation (the value content of exports would be one of these, what the deficit is based on would be another - ie are you importing machinery and equipment which can subsequently be used for exports - and the openness of the labour market to immigration would be another - there is of course an acute labour shortage in the Czechia , but they are they are actively attempting to address this and they are even out trying to recruit in Vietnam). Essentially the Czech economy seems to be on pretty solid ground (as may also be the Slovenian one), and you do need islands of tranquility in Oceans of tempest. So some countires will for this very reason prove to be win-win, while others may well, by the same token, prove to be lose-lose. Unfortunately historic reality is seldom just.

I also would be much more cautious than Christiansen is about Russia, political instability is evident, as are labour shortages. We need to see what happens next to oil and other commodity prices before sticking our necks out on Russia I think.