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.

Estonian Industrial Output Falls 26.8% In January

It’s a depressing spectacle: on both sides of the Atlantic, policy-makers just keep falling short — and the odds that this slump really will turn into Great Depression II keep rising.

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.

Oh, and Jean-Claude Trichet says that there is no deflation threat in Europe. What’s the weather like on his planet?
Paul Krugman, yesterday

Well Estonia just set a new record this time round, for the sharpest year on year contraction in industrial output seen to date. The Great Depression II is evidently now among us, and it is currently visiting Estonia.

Estonian industrial production fell the most in at least 14 years in January, a further sign that the Baltic economy’s recession may deepen.

Output adjusted for working days dropped an annual 26.8 percent, the most since 1995 when the Tallinn-based statistics office started providing the data, compared with a revised 22.4 percent slump in December, the statistics office said today on its Web site. In the month, output decreased 4.5 percent.

“The contraction of external demand coupled with extremely poor domestic demand dynamics will play a major role in pushing down all economic activities,” Danske Bank A/S said in a note ahead of the report. It forecast a decline of 22.3 percent.

Estonian industrial production fell the most in the 27- member European Union in December as the global credit freeze shut off export demand, exacerbating a slump in consumer spending that began at the start of 2008. Companies including the local unit of Elcoteq Network Oyj, a Finnish electronics manufacturer and Estonia’s biggest exporter, and AS Norma, a seatbelt maker, have been forced to cut jobs and output.

Production of building materials slumped 44 percent in January, the office said. Output of metal products dropped 40 percent and chemicals production fell 38 percent.
Bloomberg

Saving Europe?

By Claus Vistesen: Copenhagen

It appears that many of us have had quite a bit of a weekend these past days. Sitting here in Barcelona’s airport I can look back at some very nice dinners and conversations in the company of friends and colleagues as well as the odd stroll down La Rambla. I can also look back at some nice cultural experiences in the form of trips to the Museum of Contemporary Art to see the exhibitions of Thomas Bayrle, Joan Rabascall, and Cildo Meireles and a visit to the National Museum of Catalonia where I only managed to see but a small bit of its extremely well endowed selection of Catalonian painters not to mention their fascinating display of church frescos and artifacts.

All in all, a most satisfying and enriching weekend for me.

However, perhaps not all would be able to say that I’d imagine; at least not with a straight face. I am of course thinking about the big EU summit on Sunday where the lot of European leaders met to discuss the economic situation, how to deal with it, and ultimately how to avoid the whole thing collapsing under their feet.

One of the many interesting conversations I had here in Barcelona was with a very able economist at one of the universities who, as the first thing, asked me what a credible answer from the European leaders would be in the context of the unfolding mess. After pondering for a minute or two, I answered that; above and beyond everything else I would like to see a common answer to the Eastern European situation and in terms of concrete measures I would call for a de-facto entry of the four currency board economies in the Eurozone (the Baltics and Bulgaria). Then of course and to be picky, a common statement towards the issuance of Eurobonds would not be bad either.

Looking at the various reports from the summit it is difficult to say whether the glass is half full or half empty. In fact, one has to wonder what in fact the grand leaders of our nations decided on, if anything at all?

One the one hand the pre-summit meeting by the Eastern European countries that resulted in a call for a common response to the woes of Eastern Europe was thoroughly thwarted yesterday, but then again on the other hand it does seem that the ERM-2 mechanism and thus potential way into the Eurozone will be eased; at least for some member countries. As the FT reports, the rather bold Hungarian proposal for a €180b aid package to recapitalise the banking systems of the CEE economies as well as to reschedule their foreign debt was rejected. However, what was committed to was a firm grip on the Eastern European crisis on a country by country basis;

“The fragility of the financial systems in several eastern European countries dominated an emergency summit in Brussels. Leaders of the 27-nation bloc committed themselves to “getting the real economy back on track by making the maximum possible use of the single market, which is the engine for recovery”, according to a communiqué.

The summit was called to reaffirm core EU principles, such as avoidance of protectionism and solidarity among richer and less well-off member-states, in the face of a crisis that is putting the bloc’s unity under severe pressure.

(...)

“More, of course, will be done, but on a case-by-case basis, not as a single category. In the new member states there are different situations,” José Manuel Barroso, European Commission president, told reporters after the summit.

(...)

“We help countries in need and we will do so further, particularly through international institutions,” Angela Merkel, Germany’s chancellor, told reporters.

“But I see a very different situation in different countries. We cannot compare Slovakia and Slovenia with Hungary,” she said, referring to two countries to some extent sheltered from the financial crisis by being members of the eurozone.”

Together with last week’s pledge by the World Bank and the European Investment Bank to lend up 24.5 billion Euros to troubled banks in Eastern Europe we are definitely moving somewhere. Yet, to play the role as scrooge for a minute I am note completely happy. In particular, I am not so fond about the narrative on heterogeneity among Eastern European economies and the need to discriminate between CE economies. Lately, this has emerged as the main discourse surrounding the measures taken to shore up the economies of Eastern Europe. Both the Economist’s leader and subsequent briefing highlighted this view as well as did the FT’s Thursday in depth analysis of the Eastern European malice. Far be it from me to disagree with the principle in this, but I cannot help but feel that pointing towards heterogeneity amongst the CEE is rather like pointing towards heterogeneity in the context of critical patients on an intensive ward. Surely, one patient may be closer to the brink than another but common to all of them is that they are in pretty bad shape. I would especially push this point in relation to macroeconomics where we know how contagion, much unlike the situation for patients in intensive care [1], can easily spread from one patient to another. In this vein, I agree with the remarks from the Polish envoy that the Eastern European problem, as a whole, should worry the EU. Oddly enough, German chancellor Angela Merkel was the European leader most ardently pushing the argument that a case-by-case orientation is the best solution. I find this odd because this was, presumably, the same Merkel quoted in Thursday's FT saying that she favored a global initiative on bonds to answer the growing need for many governments to issue more debt that normal. Clearly, there seems to be room for Euro bonds in this narrative and one would think that this kind of grand vision would exclude the kind of short sightetness shown in the context of Eastern Europe.

In relation to the nitty gritty details of potential measures and, as it were, things I actually agree with Eurogroup chairman Jean-Claude Juncker noted how entry requirements into the ERM-2 might be loosened. As clockwork, Bulgaria opted to enter the ERM-2 subject to a shorter time span than the traditional 2 years.

In my opinion this is an important initial step and what I would subsequently like to see is a swift entry of the four currency board economies into ERM-2.

Back to the Drawing Board then?

Despite the good intentions which it seems there were aplenty I still think the concreteness of the measures was too timid. Basically, there is a big difference between arranging a summit to quibble over the Czech Republic’s criticism of France’s proposed bailout package for auto makers and a full scale rescue plan for the European periphery. Now, that it seems that the former is taken care off, I hope that the latter will get the full and deserved attention.

Markets seem to agree somewhat with this sentiment.

Both Eastern European currencies and stocks have tumbled in trading today on the back of what has to be considered as anything but new measures (except for the ERM-2 initiative). From all analysts with eyes fixed on the issues the message is that markets are disappointed with the initial stab at dealing with the situation.

“The forint weakened 2.7 percent after EU leaders yesterday vetoed an appeal by Hungary for 180 billion euros ($228 billion) of loans for eastern European countries. Their currencies have tumbled this year as worries about the region’s economic region amid the global financial crisis have spread.

“Markets are somewhat disappointed, taking the lack of news from the EU as an indication that the EU may not have grasped the magnitude of the problem yet,” said Christian Keller, a foreign- exchange strategist in London at Barclays Capital. “We cautioned our investors on Friday not to position for a sustained recovery” in the region’s currencies even if a package had been approved.

(...)

Eastern European stocks dropped to the lowest in 5 1/2 years and Hungary’s forint fell the most in a month after European Union leaders rejected pleas for a region-wide aid package.

OTP Bank Nyrt., Hungary’s biggest bank, lost 5.4 percent to the lowest since 2001 after Morgan Stanley lowered its price estimate. Komercni Banka AS, Societe Generale SA’s Czech unit, slid 4.4 percent. The forint dropped as much as 2.6 percent, the most since Jan. 30, leading currency declines.

EU leaders vetoed an appeal by Hungary for 180 billion euros ($228 billion) of loans for eastern European countries, bowing to German concerns that it would put too much pressure on budget deficits in western Europe as the economy slumps. Hungary, Ukraine, Belarus, Latvia and Serbia have already been allocated more $35 billion from the International Monetary Fund to stave off defaults and prop up ailing banks.

“The failure of yesterday’s summit to provide any fresh thinking about Eastern Europe’s crisis means that investors are faced this week with the prospect of ‘more of the same’,” David Lubin, chief emerging-market economist at Citigroup Inc. in London.

Investors are exiting eastern Europe on concern that companies and consumers will be unable to repay foreign-currency debt as plunging exchange rates increase borrowing costs. East Europe has six of the 10 worst-performing currencies against the dollar this year. Equity benchmarks in Romania, Ukraine, the Czech Republic and Bulgaria are among the world’s 10 biggest losers, according to major stock indexes tracked by Bloomberg. “

Ultimately, a much more systemic perspective is needed here and we need to realize that a case by case approach does not work. This does not mean that the CE economies are not different; it merely means that the EU and the Eurozone need to see this as an integral part of the fight to keep the economic edifice from crumbling entirely. In his daily column, Macro Man opinions that EU leaders have pooh-poohed a blanket bailout for Eastern European economies; (with the USD subsequently sucking up all the safe-haven flows). I agree, but they will get another chance to save Europe and let us hope that they will come to realize the severity of the situation. In my last post I asked whether we are moving closer to a common European answer. This weekend brought the initial first steps, but or now, it is back to the drawing board.

---

[1] – One would certainly hope so at least.

Latvia Downgraded To "Junk" By S&P

And the Swedish Krona clearly didn't like the news.

Standard & Poor's Ratings Services today said it had lowered its sovereign credit ratings on the Republic of Latvia to 'BB+/B' from 'BBB-/A-3' and removed the ratings from CreditWatch negative, where they were placed on Nov. 10, 2008. The outlook is negative.......

We believe the necessary process of private sector deleveraging is likely to continue over several years, during which time real incomes will decline, testing Latvia's commitment to both its exchange rate regime and its obligations under the EUR7.5 billion assistance program from the IMF, EU, and other official lenders. The adjustment is made more difficult as external demand for Latvia's key exports continues to decline."

The negative outlook reflects the likelihood of a further downgrade later this year or in 2010 if we believe the government is wavering from its economic agenda in a manner that intensifies currency pressures and risks delays in disbursements from official creditors. If the Latvian financial sector retains access to international markets at reasonable cost, economic prospects brighten on the basis of improved competitiveness, fiscal targets are met, and the near-term prospect for Eurozone entry improves, the ratings could stabilize at the current level.

Standard & Poor's also said it had placed its 'A/A-1' sovereign credit ratings on the Republic of Estonia, and its 'BBB+/A-2' ratings on the Republic of Lithuania, on CreditWatch with negative implications. Which means that both of these may be up for downgrades in the not too distant future.

The IMF are about to withdraw to base camp to observe developments from afar, although it is possible that they have laid out their "conditions" for the incoming government, but since they have no effective "interlocutor" it is not clear whether these conditions are going to be completely acceptable or not at this point. Christoph Rosenberg, IMF mission chief to Latvia, issued the following statement today in Riga:

"The program supported by the IMF, the EU, and other bilateral and multinational donors is meant to sustain policies that will put Latvia back on a sustainable path, not particular political parties or coalitions. As long as appropriate policies are in place, such support will continue.

As IMF Managing Director Dominique Strauss-Kahn has said, the IMF will continue its technical work with the Latvian authorities. The IMF mission currently in Riga for the first review of the program has, jointly with a technical team from the European Commission, made a lot of progress in identifying issues that need to be addressed.

The IMF mission will return to Washington at the end of this week and continue its work with the authorities from there. It will be ready to return to Riga and continue the discussions after a new government has taken office."

While EU Economy and Finance Commissioner Joaquin Almunia seems to be hinting that the EU may be "readying up" intervention. Well, if that isn't what he's doing then I am at a total loss to understand what he is up to.

The European Union could have to bail out a member state in financial trouble but such a move is unlikely, especially among countries in the euro zone, EU economic chief Joaquin Almunia said on Monday.

States such as Hungary and Latvia have received assistance from the EU, and other countries within the 27-member bloc might need a financial support programme, said Almunia, who is European economic and monetary affairs commissioner.

"You can't rule out that a country outside the euro currency might come to need this assistance," he said during an economic conference in Madrid. "We don't think we'll get to this position."

Almunia said euro zone countries were better off and less likely to need EU help. "With the euro zone the position is not the same, either in terms of public debt, foreign debt or the ability to react to this recession," Almunia said.

And the cost of Baltic country CDS not surprisingly shot straight up:

The cost of insuring Latvian sovereign debt for five years rose on Tuesday by more than 30 basis points after Standard & Poor's cut the country's sovereign rating to junk.

Five-year credit default swaps (CDS) for Latvia were quoted at a mid-price of 977.4 basis points, according to CMA DataVision, up from their Monday close of 943.7 bps. Five-year CDS for Lithuania hit a record high of 861.7 bps after the S&P move, compared with Monday's 831 bps. For Estonia, five-year CDS rose to 733 from 730.7 bps.

Below is a chart for Latvia's 10-year Eurobond (quoted yield to maturity) maturing on 5 March 2018, it is now trading some 700 bps in the mid (755 in the bid) over the closest (by maturity) German bund. Apart from noting today's market reaction it is possible to see how the spread, after settling down following the IMF-lead deal, has now opened right up again to the level of the previous October highs.



Moody's Investors Service also said today that it can no longer rule out a Lithuanian currency devaluation, although it was at pains to point out that this was not its central scenario. In the course of its annual ratings review Moody's said the following:

"Even though the net benefits of abandoning the currency board would probably be negative, a devaluation can no longer be ruled out in the current environment, but this is not Moody's central scenario,"

Last week Brown Brothers Harriman & Co. warned that Latvia’s weakening economy might force the government to ease its policy of managing the lats, spurring all three Baltic currencies to break their pegs by mid-year producing a fall of anything up to 50 percent to the euro.

“Latvia stands out as the weakest of the three because its external debt is very high and it’s got a big current-account deficit,” said Win Thin, New York-based senior currency strategist at the oldest privately-owned U.S. bank. “The contagion between the three is so strong that if Latvia broke the others wouldn’t be able to resist.”

Standard and Poor's also issued a more general warning today about the parlous state of many of the Eastern economies. In a report titled "Market Dislocation Exposes Vulnerability Of Eastern European Economies," published yesterday the agency stated that the resilience of Eastern European economies seems to be crumbling under the weight of high foreign currency debt and the potential reprioritization of lending among foreign banks.

"The financial crisis that started to hit developed economies after August 2007 did not immediately affect East European economies," said Jean-Michel Six, Standard & Poor's chief economist for Europe. "In fact, through the first half of 2008 their economic prospects still appeared resilient. But in the second half of 2008, the effects of the crisis started to filter through the region and are now gathering momentum."

In particular S&P's singled out the Baltics, Hungary, Romania and Bulgaria as especially vulnerable.

The Baltic states (Estonia, Latvia, and Lithuania), Bulgaria, Hungary, and Romania. For this group the level of economic vulnerability is high. The Baltic states face significant external financing requirements that make them highly vulnerable to a cut-off in capital flows. Each maintains a currency board (except for Latvia), and the pegs to which their currencies are linked remain under heavy pressure, as they have since the middle of last year. Bulgaria's main vulnerability, meanwhile, remains its massive current account deficit. As foreign financing becomes much tighter, the Bulgarian economy is likely to experience a painful period of adjustment in 2009 and 2010, with GDP growing about 1% this year and close to 2% in 2010, and a negative growth scenario cannot be excluded. A similar rationale applies to Hungary, where we expect GDP to decline by 2.5% this year before experiencing a mild recovery of 0.5% in 2010. Romania, once one of the economic high-fliers, is also poised to slow sharply in 2009. After an impressive 7.3% in 2008, we believe GDP growth will plummet to 0.8% this year.