Translation Risk in the Baltics and other matters on Eastern Europe

by Claus Vistesen

cross-posted from Alpha Sources

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

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

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

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

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

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

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

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

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

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

Moving on to the Baltics

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

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

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

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

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

• The charts will show three things. Firstly, charts will be presented on the evolution of the external balances in order to show the magnitude of the problem. Secondly, a set of charts will seek to show the overall build up of credit measured as the evolution of the total stock of loans with special focus on the households' contribution. Thirdly and as a direct measure for the potential translation risk associated with an unwind of the fixed exchange rate regimes in the Baltics charts will be presented which compares the denomination of loans with the denomination of deposits in financial institutions. In this way it is important to note that we are not comparing the stock of loans with the stock of deposits according to a criterion of how much the latter can cover the former in absolute terms but, as it were, solely with a focus on cross-currency denomination.
  

• The charts, which will be presented without many words, denotes what you could call a static analysis of the issue of translation risk. The point is that the charts solely show stocks and not flows. It is thus assumed that in the case of households in particular the cash flows used to service the loans are denominated in local currency (i.e. salaries) as well as it is assumed that households have limited acces to intruments used to hedge cash flows at different points in time.
  

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

Current Account (Estonia, Latvia, and Lithuania)


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

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

(Please click on images for better viewing)

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

Latvia Industrial Output August 2007

According to data released this week by Latvijas Statistika, compared to July 2007, Latvian industrial production in August 2007 increased by 2.6%, according to seasonally adjusted data (seasonal and working day influence is taken into account). Within this total there was a rise of 12.9% in mining and quarrying, 2,4% in manufacturing, and 2.4% in electricity, gas and water supply.

Compared to August 2006, industrial production in August 2007 increased by 3.3% according to seasonally adjusted data. Within this total there was a rise of 1% in manufacturing, 6.2% in mining and quarrying, and 11% in electricity, gas and water.


So year on year manufacturing industry is barely moving, despite general overheating in the economy. This is not good news. Here is the movement in the total index:

And here is the chart for % change year on year. Remember the lions share of the increase is in electricity and other utilities.

Latvia Inflation September 2007

Well, Latvijas Statistika have just published the September inflation number, and the news is not good. Year on year inflation rose to 11.4%, the second highest rate in the EU (Bulgaria's annual inflation rate was 12 percent in August). I have just published an extensive post on the recent Estonia inflation data, and since the issues are essentially the same in both cases, I will simply report the data here.

Firstly here's the chart:



As can be seen, inflation is accelerating, and not reducing. On a year on year basis the big items are food and drink, entertainment, education and housing. As these are year on year data, the housing component may cool considerably as we move forward now, after several months of steady easing, although even on housing the statistics office record a month on month increase of 1.4% from August.

At the same time we have new data which shows that industrial output in August by 2.6% over July, and by 3.3% on a seasonally adjusted basis over August 2006.

Inflation Surge In Estonia Raises Questions About 'Soft Landing'

Estonian inflation surprisingly accelerated in September to reach a new nine-year high, largely on the back of rises in food, housing and services costs. The Estonian Finance Ministry has said it expects Estonia's inflation rate to remain near the current level for the immediate future. The annual rate rose in September to 7.2 percent, which was its highest level since October 1998, and was up from 5.7 percent in August, according to data released by the Estonian statistics office at the end of last week. Month on month, prices rose by 1.1 percent.

The largest increases were registered in food prices (7.8% annual rate), housing (16.1%) and services (hotels, cafes and restaurants, 12%). Here is the monthly inflation chart.

Now the Estonian central bank and Finance Ministry have been insistent in recent months that the Estonian economy remains on course for a ``soft landing'' as the property sector cools and credit growth slows. This outcome is far being a self evident one, however, as this and other recent data which will be reviewed in this note make clear.

Overheating in the Baltics?

What is happening in Estonia may seem to be lacking in any great global significance, given the size of the country and its economy, and its lack of general importance at the global level. But such a conclusion might be over hasty, and premature, as I will try and argue here, given how representative what is happening in Estonia now is of processes at work in many EU10 economies (although not of course all, as the notable exception of Hungary shows).

In fact all three Baltic economies show clear signs of overheating, despite the fact that assessing the extent of the overheating in the Estonian case was initially complicated by an overly negative preliminary Q2 2007 GDP relase, which cited figures that were subsequently revised substantially upwards. I have addressed some of these questions in this post, and Claus had dealt with the external balance sheet position in this note here.


Slowing Down Nicely?

When we come to look at the details we can quickly appreciate that the Estonian economy certainly does show some clear signs of slowing, as can be seen from the GDP quarterly growth rates:



Also, and according to data from Statistics Estonia, industrial production increased in August 2007 when compared to August 2006 by only 4.4%, a pace which which was slightly down from the annual 5.2% increase recorded in July, and indeed the year on year rate of output growth has been slowing now since April, as can be seen from the chart.



But other data show if not a completely different picture, at least a more qualified one. If we look at retail sales for example, and again according to Statistics Estonia, we find that in August 2007 retail sales were up 13% year on year over August 2006. This rate is actually down on those registered earlier in the year, but it is still very high.


Actually, compared to July 2007, the level of retail sales in August was more or less stationary:



And again if we look at the monthly annual change figures, the rate of increase is clearly slowing.

Wage Push Inflation?

One big part of the underlying isssue here is undoubtedly strong wage-cost push inflation, of the old school kind. If we look at the quarterly chart we can see that though the rate of annual increase in wages and salaries has fallen back somewhat in the second quarter from the first, it is still very substantial:

Now if we move on to look at producer prices, which is where all the "cost-push" inflation shows up, we can see that these have been rising steadily over the last 18 months, and while they may well now have peaked in terms of the rate of increase, the pace is showing no real sign, up to now, of having eased off to any substantial extent.



The situation is even more problematic if we come to look at the rate of producer price increases in the export sector:



The reason this situation is so problematic is the impact that this sustained inflation on producer prices is bound to have on Estonia's ability to export, especially given that the kroon is effectively pegged to the euro, so prices cannot adjust via a downward movement in the currency.

We can perhaps get a point of comparison if we take a look at what has been happening in Hungary. The Hungarian economy has certainly been undergoing a "correction" since the autumn of last year, internal demand is down very sharply, and while domestic inflation remains stubbornly high - though not as high as Estonia's - export prices show a completely, and much more desirable pattern, since wage deflation has been very significant in Humgary.

Here is the chart for month-on-month changes in domestic sales prices and export prices in Hungary:

and below are the equivalent year on year changes. What we can observe is that there is now a very strong disinflationary process at work in Hungary, a disinflationary process which has yet to be seen in Estonia, or for that matter in the Baltics generally.



Now I think I need to be clear here, since I am certainly not recommending the kind of strong wage deflation they are having in Hungary as a preferred recipe for the Baltics. I am simply trying to suggest that this problem exists, and must eventually be addressed, either by coming off the peg, or by other means. There are even doubts in the Baltic acses that wage deflation as such could be operated, given that omnipresent danger of increased outward migration is bound to make wages and prices more "sticky" than in the Hungarian case (where among other things out-migration has not been present to any significant extent, at least to date it hasn't).

What I am suggesting is that there may well be other ways available to address the problem, even if they do involve "unconventional tools" and "out of the box" thinking. One of these unconventional measures would certainly be a flexibilising of the labour market through a significant and substantial opening to international migrant labour. In order to work this opening would have to be large scale, and should not simply be confined to skilled worker categories. At the end of the day, it is a question of which you prefer, to be flayed alive by systematic wage deflation (and all the problems of out migration that this might produce) or a rapid transition to a modern multi-cultural society. There are not many other options to play around with here I think. And time is pressing.

Now, returning to what I said above, the reason why all of this producer price inflation is so problematic for Estonia is the corrosive impact that it has on Estonia's ability to export its way out of difficulty. This impact is evident enough if we take a look at the recent evolution of the external balance in goods and services for Estonia:

Not a pretty picture, is it? And again, the dimension of this problem becomes even clearer when we come to look at this deficit as a share of GDP:

Well, according to Eesti Pank (Estonia's National Bank, see link above):

The average goods and services export growth rate has been fast, although the situation varies by groups of goods and by markets. Although the growth rate of merchandise exports slowed considerably at the end of 2006 and at the beginning of 2007, we are mainly speaking about the so-called transit goods. When we leave aside transit and the subcontracting sector, there are no reasons to assume the competitive ability of other sectors has substantially declined.

This assessment of the situation seems fairly reasonable when we take into account the impact of accelerating producer price inflation and its impact on competitivity. As we can see from the chart below, both exports and imports "peaked" back in May, and this peak in exports occured despite an extraordinarily favourable environment from an external point of view. This is not what should be happening in the case of a "correction". Domestic demand should, of course, be weakening, but exports should be beginning to play an increasing part in maintaining aggregate demand, otherwise this situation simply shows us that Estonia is moving steadily off into a recession, but since the currency cannot adjust, it is not clear where the actual correction to bring her out of the recession again is to come from here. Unless, of course, the recession produces a very sharp deflation in wages, but isn't that exactly what everyone would mean by a hard landing? (ie a strong recession accompanied by a long and sustained period of wage deflation). As I say in my original post I am simply not clear what kind of vocabulary register is being used by many of the participants here. Indeed, I would venture to say that the people who are using this vocabulary are themselves no more clear than I am.



Labour Shortages The Core of the Problem

Again according to Eesti Pank

In spite of slower economic growth, the number of jobs increased, although more sluggishly than before. In the second quarter of 2007, 1.3% more people worked in Estonia year-on-year. Employment increased to 62.9% of Estonia's workforce and the unemployment level fell to 5%.

This is precisely the problem. Even though the growth rate is slowing, the process of labour market tightening continues. This is due to the fact that there is no inbuilt correction mechanism in the labour market due to the shape of Estonia's population pyramid.

What do I mean by this? Well let's look at some more of those charts. Firstly annual unemployment rates in Estonia:

As we can see, these have been steadily coming down since 2000. Now lets look at the numbers of available unemployed:




As we can see the numbers of people registering as unemplyed and seeking work has dropped steadily since the end of 2000. At the same time the number of people working has steadily risen, as is only to be expected given the strong rate of economic growth.





So it is this path which is not sustainable, especially when we take into account that participation rates have also surged strongly.



As we can see the participation rates for older workers is now quite high by international standards, especially when we consider the compartaively low male life expectancy of around 67. Now if we come to look at youth unemployment:



We can again see that the rate of youth unemployment has been declining steadily since the start of 2005. And it is important to remember that these percentages are on a reducing total youth population as can be seen from this, the last chart in this series, which shows how the 0 to 14 age group - or if you like tomorrows young workers and labour market entrants - has been steadily declining as a proportion of the total population since the early 1990s and it is the impact of this steady reduction that is now about to make itself felt.

So there we have it. I basically don't see how - whether you talk in terms of hard landing or soft landing - the Estonian economy is ever going to "correct" unless this structural issue is addressed.

The macro imbalances we are refering to here are substantial, and as I have tried to argue at some length here, they stem from a virtually unique set of circumstances (historically unique I mean, at the present time the underlying dynamic across all the East European EU member states is remarkably similar, with the possible exception of Hungary). Estonia is facing, at one and the same time, a massive inflow of external funds, and a significant reduction in its potential labour supply after years and years of below replacement fertility. Put another way, demand side factors are increasing rapidly, while supply side capacity not only is unable to keep pace, it is actually shrinking (if we think about the number of people of working age).

So there are two problems to correct here, and they are both large and important. Essentially Estonia needs:

a) more labour supply, both skilled and unskilled
b) a lower rate of inflow of structurally distorting funds, whether these be bank credit, remittances, or even (possibly, this needs investigating further) EU funding for projects which Estonia cannot reasonably expect to carry through in the time horizon outlined, given the capacity constraints.
c) more Foreign Direct Investment to create value creating jobs, especially in manufacturing and services areas with export potential
d) increased spending on education and training projects to upgrade the human capital of the existing population

In this post I have been talking about Estonia, but we could just a well have been speaking about Latvia or Lithuania, about Romania and Bulgaria, and - if nothing is done of an international level to address the problem - in the not too distant future about Poland and Ukraine. If we simply sit back and wait for the crunch to come here, then quite frankly it will, and the end product of all that negligence will be much more significant than many seem to currently appreciate.