by Claus Vistesen
As my regular readers will know a part of my analysis on
Eastern Europe and the Baltics has been to look at the Eastern European edifice through the lens of Lithuania.
Last time I did that I showed an update in terms of the labour market as well as I did a more thorough analysis of Lithuania's external position. At this point I probably should move in with a lot of updated graphs on the labour market and economic activity. However, I won't since we have not gotten a lot of new data and what we have got confirms what we already knows. Inflation continued its upward increase in the first months of 2008 where the HICP index touched nearly 12% y-o-y. This is not at all good news. As we can currently observe across a wide range of Eastern European countries inflation is lingering even as economic growth slows down considerably. Meanwhile of course Lithuania's capacity to work its way out of this seems quite shaky since unemployment is at all times low which means that the structural pressures for wage increases and productivity eroding inflation is now a fundamental part of the economic structure. A combination of rapid economic growth as per expected on the basis of the convergence hypothesis and a structurally broken population pyramid and net outward migration is now taking its visible toll.
Provisional estimates for Q1 GDP suggests that Lithuania expanded at 8% y-o-y which is still way too fast given the underlying capacity constraints. Official authorities in Lithuania narrate this as if the economy is on track towards a soft landing. I can only hope they are right but I am not confident. Signs of a slowdown are beginning to emerge ever so slightly in the labour market where unemployment has risen a tad going into 2008. Obviously, as Lithuania slows further this development should increase. As ever though, the risk is of a rapid reversal of economic conditions loom on the horizon in the context of the global financial and now also food crisis thundering along with all the increased risks that such events bring with it in the context of a small emerging market such as Lithuania.
What risks we should watch out for is what I will investigate further here.
Better late than never an old adage goes. In this way,
IMF's recent World Economic Outlook as well as its
Global Financial Stability Report comes with a timely warning in the context of the current financial and food/energy related crisis (the latter point which I will deal with later and where you, in the meantime, could do a lot worse than read
Macro Man's recent tale of the 800 lb gorilla). As per usual, IMF's center piece publications are littered with information but the part of it I most noticeably latched on to was
the chapter about emerging markets and their resilience. More specifically, I took note of the part dealing with the resilience of the CEE and Baltic economies' external position. Now, this story has already been
well summarised by RGE's Mary Stokes in her excellent investigation of foreign banks' presence and exposure to the Eastern European markets and thus, by derivative, Eastern's Europe dependence on credit inflows to finance external borrowing (often done in foreign currency just to make it a bit more complicated). Since I have also sketched this situation many times before I am going to quote myself from
a previous note in which the stylised facts are laid out ...
The past years' expansion and subsequent build-up of large negative external positions in the Baltics have mainly been driven by consumer and mortgage credit supplied by foreign (most notably Scandinavian) banks and credit institutions. In this way, the Baltic economies are very dependent on this link not only to keep the external position from not correcting too quickly which would happen if the foreign banks suddenly closed shop and retreated their fangs but also in order to keep and restore confidence in their economies and most importantly the currency boards tying their currencies to the Euro. Quite simply, the Baltics need these banks to now follow them down into whatever the current slowdown will bring. Will the banks be ready for this?
Especially, the last question is important to be aware off and essentially this is also at the heart of the inquiry Mary and IMF are making. In the context of Lithuania the dependence on foreign loans reveals itself on two accounts. Firstly, we have the composition of the external balance where we can see how the liabilities (i.e. the break up of the negative net investment position) is made up disproportionately much of bank loans compared to the more traditional components of portfolio flows and direct investments. Secondly, we have also seen how, as a result of the pegged Litas to the Euro, many of these loans are denominated in Euros. This is about
balance sheet risks then in the context of translation risk which basically arise in connection with loans denominated in Euros and cash-flow/deposits where an overweight is in Litas. Obviously, this works well as long as the peg holds but in light of the discussion sketched above the risk is of course that the foreign banks suddenly retreat and/or that the Lithuanian currency is subjected to a pressure to depreciate as the external position becomes unsustainable. Quite clearly, any kind of market moves here would require the ECB to shield the peg since the currency board itself cannot be expected to keep the peg if the unwind really begins.
The main question I am asking here is what actually provided the build-up of foreign denominated loans in the first place and what the main driver is? Well, we are finally getting to the visual part of this note. As the first set of of graphs we have the formal illustration of what translation risk potentially means. Note that the graphs are updated with the latter part of 2007, a rather important point for the rest of the analysis (click on the pictures for better viewing).
Quite simply, translation risk can be measured by the extent to which these two figures are not alike. As we can see the loan composition does not match domestic deposit composition thus making the servicing of the debt vulnerable to potential currency movements. Moreover, these figures tend to underestimate the real translation risk since one thing is deposits another thing is the cash flow itself used to service the loans. In this light, one of the questions that has haunted me a bit lately when I looked at the charts is what exactly drives the fluctuations and general discrepancy between these charts.. One obvious explanation is that, per function of the strong foreign bank presence, the liquidity of the Euro credit market is a lot deeper than the corresponding market for Litas denominated loans. And as we shall see below this seems to correspond to reality since a deeper more liquid market quite simply translates into lower funding costs.
The three graphs above tell an important story about the market for credit in Lithuania and thus I imagine in the Baltics. As can be immediately observed borrowing in Euros is substantially cheaper than borrowing in Litas. Over the sample period in question the average interest rate spread in favor of Euro denominated loans has been 123 basis points (sd: 35 basis points) which should be more than enough to induce a considerable cross-price demand effect. Another interesting observation is that the trend in loan taking now seem to be parting ways with respect to currency denomination. In this way, the volume of outstanding loans denominated in LTL is beginning to decline where as it seems as if steam is still left in the Euro credit flows. Obviously, there may be both stock and flow effects where the latter would be how Litas loans were simply rolled over into Euro loans or, in the context of flows, simply that the amount of Litas loans were falling.
So, what on earth is all this good for?
Well, I think there are two main issues to note. First of all I should thoroughly try to formalize the connection between the interes rate spread and the composition of Litas vs. Euro denominated loans. As can be seen it seems as if the hump of the interest rate spread is indeed reproduced in the graph of the currency composition of the total loan portfolio. In order to investigate this I developed a small rudimentary regression model with the change in the differnce between Litas and Euro loans as a dependent variable and the change in the interest rate spread as an indepedent variable. This produces the following relationship (R-sq = 0.147, F: 6,20 (p; 0.0176).
If you really want the equation just drop me a note in the comments. The formal interpretation of the model is that a 1 basis point increase in the interest rate spread in favor of the Euro translates into a 32 basis point
change in the difference between Euro and Litas denominated loans. E.g. if the interest rate spread widened .25% (25 basis points) in favor of the Euro (i.e. Euro loans got .25% cheaper relative to Litas loans) the change in the difference between Euro and Litas denominated loans would be 8% (800 basis points) in favor of Euro loans. Please note that this is not a very strong model in statistical terms but it does show that a relationship exists.
The second issue which is more pertinent in our present context is just what we can expect from interest rates going forward. Clearly, as Mary shows above (and as is widely detailed in the IMF report) foreign banks are now visibly beginning to wobble. As an appetizer of this we learned recently that
a batch of Swedish banks recently suffered a dent in their Q1 profits on the back of the slowdown in the Baltics. We need to understand that this is just adding further to the perils of these banks since they are obviously already under attack on several other fronts not least in the context of securing financing for their operations in the interbank market. All this points to higher borrowing costs for those Euro denominated loans. Should that be a problem then? Well, not necessarily since as long as the credit market and currency peg is there the denomination of the loan is in fact all about where the low interest rate is. However, as I stressed above Lithuania need those foreign bank loans to finance their external position and if these suddenly dry up because the banks reduce activity and/or borrowing costs rise so much as to make them unattractive we are getting into trouble. In this context I don't see a major move out of Euro denominated loans at this point but that does not mean that the costs of servicing these won't increase. Basically, the banks can do two things. Follow the economy down raising rates and curbing lending or they can write off their losses. In reality it seems as if a process of 'a bit of both' has already begun and now it remains to be seen whether the squeeze becomes so tight elsewhere that some of these banks opt to significantly reduce activity. In this light, Lithuania in itself can hardly bring down any but perhaps a local bank but as Mary warns the contagion risk is not insignificant. Moreover, the issue of the inflows themselves are important since Lithuania, and the rest of the Eastern European gang, has an external deficit to cover. If suddenly, the inflows in the form of foreign bank loans retreat (and they will to some extent) there will be a short fall and since the Litas cannot correct we could see a rather rapid transition from rapid inflation into deflation as this would be the only way to correct the external position.
Ultimately, I am not trying to pull another doom and gloom rabbit out of the hat here. The risks I have pointed to here represent nothing new in the general discourse. What we do need to understand though is that; if the inter-relationship between the foreign banks and Eastern European and Baltic consumers/corporations hitherto was in a honeymoon stage with plenty of mutual benefits for both it is now set to become a
dance macabre (or a tango if you will) and we know that this takes two to tread.
