Update on the Potential for Devaluation in Latvia

As I pointed out recently in the context of Latvia and the impending potential for a devaluation there is a distinct risk of falling victim to the sin of crying wolf. Yet, as the plot inevitable thickens I am maintaining, as it were, my cry. There are two significant points to think about in the context of what we might call recent developments. First of all there is the news that the 2009 deficit envisaged in the budget before the Latvian parliament will amount to 9.2% of GDP - significantly higher than the original IMF agreed "limit" of 5%, and even well above the latest negotiating objective of the Dombrovskis government of 7%. Of course, this is just number salad but at the end of the day it is important because it determines whether and under what condition the IMF funded bailout packaged continues. The fact that Latvia reports a deficit of this magnitude almost amounts to throwing in towel in my opinion or at least it means that the playing field is now a different one when it comes to IMF funding. Finally, and in case you think that Latvia has not already cut spending just look at the following estimates for cuts in the public sector:

Taking into account that the budget amendments envisage steep spending cuts, the amendments must be passed immediately, so that the ministries and other government agencies know how much money they will be allotted from the budget this year, stressed the Finance Ministry.

It is planned that the Defense Ministry's budget will be reduced LVL 30.8 million, the budget of the Finance Ministry will be cut LVL 14 million, Interior Ministry - LVL 10.4 million, Education and Science Ministry - LVL 22.1 million, Agriculture Ministry - LVL 20.5 million, Transport Ministry - LVL 109.5 million, Welfare Ministry - LVL 7.2 million, Justice Ministry - LVL 7.4 million, Culture Ministry - LVL 15.9 million, Health Ministry - LVL 39.3 million, and Regional Development and Local Governments Ministry - LVL 10.8 million.

The initial demands would of course represent even deeper cuts and this is the main point in this case; just how much pain can you inflict under a fixed exchange rate before the dam breaks? As it appears, everyone has a breaking point and with e.g. property prices slumping 50% y-o-y in Q1 alone it is not difficult to see the boom-bust nature of Latvia's recent economic performance.

Another and very important part of the picture comes from the fact that it is not only the IMF who is footing the bill in Latvia. Consequently and this is the case for all three Baltic economies the expansion has effectively been characterised by the outsourcing of the financial sector to particularly Nordic banks' subsidiaries and most notably Swedish owned banks. This creates a large dilemma in the context of devaluation since most of the of the credit to corporates and households have been provided in Euros as result of the so-called road map towards Euro entry which was perceived as a fait accomplit. Recently, RGE analyst Mary Stokes explicitly tackles this question in the context of the entire CEE edifice. Mary frames the issue neatly when she says:

The general idea is that these parent banks (as well as the CEE economies in which they operate) are likely to be collectively better off if they all continue to support their Eastern European subsidiaries. The problem, however, is they may not be individually incentivized to do so.

Mary is initially positive in the sense that we won't see a large scale withdrawal of foreign banks from Eastern Europe citing recent evidence in the context of Romania, Hungary and Serbia where foreign banks have pledged to support their subsidiaries despite strong economic head-winds. However, she also makes a very important point when she coins the notion of the asymmetric prisoner's dilemma. What lies behind this term is the idea that because different foreign banks are exposed to a different degree in different parts of Eastern Europe with different economic fundamentals the idea of a common commitment across the board may be difficult. One key ingredient here is of course, as Mary notes via Fitch ratings, that the extent to which banks are exposed relative to their parent companies differ substantially. This is simply to say that while some banks are indeed able to shoulder the inevitable losses which will come in a CEE context, some are threatened on their life [1]. Finally, there is the risk that if one bank decide to give up its support for the subsidiary and thus the domestic economic edifice in its current form, so will other banks do the same. On a macroeconomic level this would of course be tantamount to one economy deciding to devalue which would immediately, one would assume, force others to follow suit.

As you can probably tell by now I am getting closer to the topic at hand. Consequently, I believe that what is now materialising with Latvia as the main venue is exactly this asymmetric prisoner's dilemma that Mary is talking about.

Let us begin first with the simple and ominous sign that lending conditions in the Latvian interbank market have become increasingly tight recently. I already pointed to this in my previous post (see link above) where I noted how the Latvian central bank, through its currency board, has already spent over 500 million euros buying lats. Last week in particular was tough as Bloomberg reports how the central bank had to buy 95.4 million lati ($190.6 million) in order to protect the Lati from moving below its trading limit where it is only allowed to move 1% either way against the Euro (from a mid point). According to Bloomberg, such purchases have already caused the foreign exchange reserve to shrink by 38% between September 08 and april 09 alone.

Latvia’s overnight lending rate rose to a record today because of a shortage of lati on the market after central bank purchases of the currency and Treasury bill sales, said Andris Larins, an analyst at Nordea AB. Asking rates on the overnight Rigibor, the interbank lending market, rose to 14.2 percent after the central bank bought 95.4 million lati ($191.5 million) to support the currency last week. Treasury bill sales and higher interest rates on money the central bank charges to borrow also contributed, Larins said.

As can be seen the effect from these operations are very as they have driven the interbank rate to its highest in more than 10 years as the central bank purchases are sucking up liquidity from the market. The main message here is that the shorter term rates are converging to the annual rate (click image for better viewing).

Especially, it is important to pay attention to the fact that the overnight rate has skyrocketed and even surpassed the annual rate. The overnight rate has risen 1352 basis points since the 21st of May and it indicates verly clearly how much stress and uncertainty which is building up in the market. Essentially this is the effect Bear Stearns/Lehmann had on the Libor back in the days where global interbank markets were freezing over. Moreover, I have from reliable sources that some banks are quoting overnight rates as high as 20% which suggests that things are moving fast at the moment.

But why all this fuss now then?

Well, it is worth remembering that it already began last week and as I pointed out above the larger than expected announced budget deficit cast serious doubt over the potential for future IMF funding. However, a more prominent reason is certainly that the Swedish banks and Swedish discourse in general have begun to turn strongly towards devaluation in Latvia as a sure thing. Last week, the Riksbank strengthened its foreign currency reserve with 100 million SEK, but more importantly SEB Chief Executive Annika Falkengren noted how the level of defaults would essentially be the same regardless of whether Latvia devalued or corrected through internal price deflation. This kind of message from a Swedish bank executive is not without importance since it is, for a large part, Sweden that have financed the Baltic expansion through the heavy exposure of many Swedish banks in the Baltic economies. Up until now however, popular belief has held that since most of the loans having been offered by foreign banks were in Euros these banks would strongly reject devaluation as it would effective eat up a large part of their balance sheet in one sweep. However, as many of us have pointed out these defaults would come anyway as a result of the sharp and essentially brutal deflationary correction. It is exactly this recognition which seems to have trickled down to Swedish bank officials.

As a consequence of this and, arguably, a host of other things Bengt Dennis, a former Swedish central bank governor and an adviser to the Latvian government was quoted this weekend of saying that a Latvian devaluation is a done deal. The only question would be when and how.

Bengt Dennis, the former Swedish central bank governor and an adviser to the Latvian government on how to cope with the economic crisis, said the Baltic country will need to devalue its currency. “No one knows if there will be a devaluation tomorrow or in a few months -- the timeframe is always uncertain -- but we have moved beyond the question of whether there will be a devaluation and should instead focus on how it will be carried out,” Dennis told Swedish state television SVT last night.

This is of course pretty uequivocal and indicates quite strongly how the end game is near. In essence, it is very obvious I think that the sentiment in Sweden has turned from one in which the desire to wait out the storm and take the losses gradually to one where there is a demand for closure and immediate quantification of the losses. This is significant since the longer markets believe that Swedish banks no longer explicity support the peg, the closer we move towards a devaluation.

Clear signs of such sentiment comes from the publication of the Riksbank's Financial Stability Report out today where it is estimated how Swedish banks will lose as much as SEK 170 billion during 2009 and 2010 on loan losses. Now, it is impossible to say whether these estimates implicitly include a Latvian devaluation or not, but one thing is certain; the estimates have the Baltics written all over them and, if anything, the downside looms as a direct function of the potentially worsening situation in the Baltics. Add to this that the Swedish economy in general have endured an absolutely horrendous 6 months across Q4-08 and Q1-09 and it is not difficult to see from where the impetus to pull the plug in the Baltics could come from. Recent figures for GDP indicate how national output fell 6.5% over the year in Q1-09 which compares to an annual drop of 4.9% in Q4-08.

To add to the pressure it also appears that the political tensions in Latvia is growing.

In the first instance there is of course the expected and almost obligatory refutation of the Dennis' comments about the almost certainty of a devaluation.

I hereby announce that an opinion by Bengt Dennis, member of the High Level Advisors Working Group to the Government of Latvia, which he expressed today to the Bloomberg news agency about an inevitable devaluation of the Latvian national currency – lats – is not true, and should be evaluated as expert’s personal, individual opinion which has nothing to do with issues concerned in the first sitting of the High Level Working Group, as well as with the position of the Government of Latvia on overcoming the economic crisis.

This is of course all well and good, but the question is whether we can take this for granted as the "official" position. For starters, Bloomberg (linked above) quotes Justice minister Mareks Seglins for calling a debate about the potential gains and losses relative to a currency devaluation. This would indeed be something new in a Latvian context as a debate about the Lati's Euro peg hitherto has been stifled completely by the official backing of the Lati's value against the Euro. As people closer to the Baltic situation than me have pointed out, this may a specific attempt to stir up things by Seglins since his party are bound to lose local elections come Saturday and may thus lose the majority in parliament.

A Done Deal Then?

Not quite, but it is impossible not to notice that some significant cracks have emerged. I think it is particularly important that Swedish stakeholders in the Baltic debacle now seem to favor "throwing in the towel" through a devaluation as it is assumed that it would amount to same thing, in the end, as trying to keep things together. Of course, no one other than Latvia herself can choose to devalue but the signs from Sweden are very important in the sense that the Swedish banks are paramount in keeping the economic edifice together. Moreover, there is the IMF where we do not yet know whether bailout funding will continue with the new estimate of 2009 budget deficit. My guess is that the IMF won't stand for it but then again, it would be wise to cut some slack if they have an interest in keeping the peg (which I am not it really wants).

I will end as I did last time with a general warning. At this point rumours will drive the discourse as much as real economic fundamentals and political decions. However, it is difficult to deny that a devaluation in Latvia seems to be moving closer.

---

[1] - Incidentally and for all the complaints about me focusing too much on the similarities between the CEE here is an example of differences. This is to say that when it comes to a high degree of event risk there are of course notable assymmetries. What I would like however to point out is that when it comes to the fundamentals and the underlying problems/courses of the crisis the Eastern European countries are, in many cases, strikingly similar.

Devaluation Imminent in the Baltics?

By Claus Vistesen: Copenhagen

Even when liars tell the truth, they are never believed. The liar will lie once, twice, and then perish when he tells the truth.

One thing which is certain at the moment is that the rumour mill is grinding hard and that it is very difficult to get a clear picture of what is going on. It is too cumbersome for me to go into the entire background here (I assume most of you are familiar with the Baltic and CEE situation), but if you want some background try this or this which will give you the opportunity to browse a myriad of articles. The situation is however pretty simple. Ever since it became clear that the Baltics was going to suffer not only a hard landing, but a veritable collapse on the back of the financial crisis one obvious question always was whether these economies could maintain the Euro peg throughout the correction process. So far the peg have held and the countries, as well as the IMF who have been called for aid, have been committed to the peg and thus the future entry in the Eurozone.

But this has come at a price and as international economics 101 tells us, the only way you can correct with a fixed exchange rate and an open external account is through deflation and a very sharp drainage of domestic capacity. And so it has come to pass that particularly in Latvia who has come under the receivership of the IMF the scew has been turned, (and turned and turned) and now the question is how much more can the public and the goverment take. In a recent article in the NYT the situation is well described as the Latvian government scrambles to meet ends on the IMF's pre-condition to continue funding the bailout programme.

One very significant indication that things are near its breaking point came when Central Bank Governor Ilmars Rimsevics launched the idea that, since the liquidity in Lati is being drained in order to keep the peg and because the cuts needed to abide by the IMF rules are immense, public employees might be submitted to receive their pay in "vouchers" in stead of actual Lati. As Edward points out, this is straight out of the vaults of the Argentian crisis' annals. This is one of the things you get with a peg maintained too tightly during a deflationary crisis. It deprives you from liquidity. Now, in some sense this all about the next installment of IMF funds of course and whether Latvia will (can) make the needed budget cuts to please the fund to such an extent that they will continue to slip the bailout checks in the mail.

Essentially, under the peg, the central bank has to buy Lati in the open market to maintain the peg since there is, naturally, a pressure on the peg as everybody want's euros. So, the central bank is forced to drain the economy from liquidity to maintain the peg in an environment where the economy is contracting at about 20% over the year. This is not fun and, as it were, not sustainable given the trajectory of these economies. In this sense devaluation is no cure but a simple prerequisite (and necessity) for the healing process to begin.

Even more significant it appears that the the foreign banks, so important in the Baltic story since they basically provided the liquidity inflows to fund the boom, are beginning to accept the basic point I, and others, have made so often before. This is the point that although a devaluation would entail default on a large batch of Euro denominated loans, this default would come in either case as a result of the utterly horrid contraction. In this sense it was very significant that the SEB Chief Executive Annika Falkengren pointed out;

"In total we would have the same size of credit losses, but (if there is no devaluation) they would be a little more regular and over a longer time frame," SEB Chief Executive Annika Falkengren told Swedish radio. "In the case of a devaluation they would be pretty much instantaneous."

This is important because one prerequisite for the peg to hold was always that the foreign banks explicity backed it since they pretty much finance the majority of the credit needed to hold these economies afloat and particularly so Latvia. Essentially, on the Swedish side of things it appears that they are pretty much treating this as over and done.

According to Dagens Industri' Torbjörn Becker, leader of the Eastern European Institute of the School, a devaluation is likely. "The alternative to a devaluation in Latvia is to wait until the reserve is drained and the economy will disappear into a black hole, " he told the DI. Torbjörn Becker believe that neighbors Estonia and Lithuania follow.

Moreover, the Riksbank just recently bolstered its foreign currency reserve with an amount equal to 100 mill SEK which can be interpreted as a precautionary measure to deal with a potential fallout in the Baltics.

The Executive Board of the Riksbank has decided to restore the level of the foreign currency reserve by borrowing the equivalent of SEK 100 billion. This needs to be done because the Riksbank has lent part of the foreign currency reserve to Swedish banks. We have also increased our commitments to other central banks and international organisations. The Riksbank needs to maintain its readiness to supply the Swedish banks with the liquidity required in foreign currency.

Finally, there is Danske Bank, aka Lars Christensen in the context of the CEE, who warns of a serious event risk in the Baltics in today's daily installment on emerging markets.

The event risk has risen sharply in the Baltic markets and we advise outmost caution. Yesterday, the Swedish central bank Riksbanken said it will increase its currency reserve by SEK 100 bn through a loan from the Swedish debt agency. Investors seem to believe that this is a buffer to deal with potential problems arising from the Baltic crisis.

(...)

With worries over the Baltic situation on the rise there is a significant risk of negative spill-over to other markets in CEE. Therefore we see clear downside risk on the CEE currencies and a risk of a sharp sell-off in the CEE fixed income markets in the coming days. We especially see value in buying USD/HUF, but potentially also USD/PLN on an escalation of the Baltic crisis.

Basically, the way I see it is that there is only so much the currency boards can do and in Latvia's case, after having already spent over 500 million euros buying lats, I think we are moving steadily towards the end game. Of course, there is an obvious risk that I will perish further down the road with this one, but then again, so be it. It is imperative that investors and stakeholders entertain the possibility of a multiscale Baltic devaluation and, obviously, a sharp CEE sell off in the wake.

Danske Bank Warn On The Baltics

Danske Bank has issued the following advice to investors:

The event risk has risen sharply in the Baltic markets and we advise utmost caution. Yesterday, the Swedish central bank Riksbanken said it will increase its currency reserve by SEK 100 bn through a loan from the Swedish debt agency. Investors seem to believe that this is a buffer to deal with potential problems arising from the Baltic crisis.

No comment.

The krona fell for a third day after the Riksbank announced the loan, and declined more than any of the 16 most-traded currencies against the dollar and the euro. Stefan Ingves, central bank governor, said in the statement that the financial crisis may be “prolonged”. Since the start of the financial crisis, Sweden has spent 100 billion kronor on swap agreements with Iceland, Estonia and Latvia and on dollar injections into Swedend's financial system.

Swedish banks have claims in Latvia, Lithuania and Estonia amounting to about $75 billion, according to ING Groep NV, with SEB, Swedbank and Nordea accounting for 53 percent of Latvia’s lending market. Sweden’s central bank raised the amount of euros available for the Latvian central bank to swap for lats to 500 million euros ($670 million) at the start of May. Latvia’s central bank first entered the swap agreement with both its Swedish and Danish counterparts to borrow as much as 500 million euros for lats last December. The Riksbank was to provide 375 million euros and the Danish central bank the remainder.

Latvia has already spent over 500 million euros buying lats this year to support the currency.

Earlier this week the New York Times Economix Blog said the following:

The jury is still out on whether Latvia can do what it takes to rebalance its budget and qualify for the bailout money it received from the International Monetary Fund and the European Union. Take a look at this analysis of Latvia’s situation from Danske Bank, which has consistently offered hard-headed – that is, pessimistic – views of the Baltic nations of Latvia, Lithuania and Estonia. (The bank was also far ahead in calling the disaster in Iceland.)

The most interesting aspect of the story, from a global perspective, was the notion that a default — even by a small country — could trigger a cascade of bad news at a time when the financial situation appears to be easing.

Let us just all hope that this last mentioned "notion" remains just that, "an interesting notion".

Meanwhile, Swedish media seem to be treating the devaluation as almost a "fait accompli" - those of you who don't speak Swedish can try putting this and this through your Google translator if you are interested.

Payment By "Voucher" In Latvia?

This sounds like something straight from the Argentine history book. Yesterday someone left this comment on my Latvian Blog:

By the way, latest idea in Latvia is to issue vouchers as a substitute to LVL (thats in case Latvia doesnt get any money from IMF). So if you work in public sector, your salary partly will be paid in vouchers which you can use to buy food. And yes - it would also mean 'stable' LVL, at least on paper. I still don't really understand how it could possibly work in free capitalist economy. But it underlines how strong is the will to keep current LVL rate at any means, even if it means total collapse.

At the time I wasn't sure what to make of this, but then I saw that according to a report in the Latvian newspaper Diena, Central Bank Governor Ilmars Rimsevics visited the town of Liepaja on Friday, and told the astounded journalists assembeled there that: "The level of the expenditure shock we are receiving is so high that we can not cease to maintain this quantity of expenditure. So there is a shortage of funds, and we're forced to look at the different kinds of projects, which can help us provide for the foreseeable future. Taking into account that the money is not budgeted, it can be emitted in vouchers".

Rimsevics also gave an interview to the Russian-language newspaper Telegraf (published this morning) where he says more or less the same thing. Basically, the IMF are threatening to withold the next round of funding if the Latvian government does not move ahead with the agreed wave of budget cuts - which in some areas will be of up to 40%. Latvia received a 7.5 billion-euro bailout from the IMF and the European Commission last December. The agreement required Latvia to limit its budget shortfall to to 5 percent of gross domestic product. Since then, the economic outlook has turned far worse than anticipated and Prime Minister Valdis Dombrovskis's government is seeking approval to run a 7 percent deficit.

At the same time the Latvian central bank keeps having to buy the local currency (the Lat) to support the euro peg - last week the bank bought 6.4 million lati ($12 million), and this was the eighth consecutive week they have had to make such purchases. The longer it takes to reach agreement with the IMF - who are convinced that severe budget cuts will be expansionary in the short term (due to the improved confidence they will produce, see here), the more the bank will need to spend to counter those who are betting they will be forced to devalue.

The bank have now bought about 1.1 billion lati since September 2008, and such interventions have reduced Latvia’s foreign currency reserves by 36.7 percent compared with September last year. The flight to euros is also producing strong liquidity pressure inside the country, and the central bank cut its refinance rate to 4 percent on May 13, the second reduction so far this year, in an attempt to boost borrowing amid a liquidity squeeze and much harsher lending criteria. Basically, in order to keep lati in circulation, interest rates on the Rigibor, the local interbank lending market, have been driven up by 42 percent since 3 February to hit 13.7 percent on May 14 (for six-month loans). And this in an economy which shrank by 18 percent in the first quarter.

As I say at the start, all this - including the vouchers proposal - does now sound incredibly like Argentina, since issuing scrip money is exactly the kind of thing you get pushed into when you try unrealistically to hold a peg. It is the begininning of the end. The same thing, exactly, happened in Argentina, where they ran out of pesos and started to issue Patacónes, Lecops, Créditos, Argentinos and a myriad of other exotic bits and pieces of scrip. I give a bit of background on all this in this post on my Spanish blog, while Bloomberg's Aaron Eglitis has a useful summary of the general Latvian situation here.

SEB Accept Krugman's and My Point.

Currency devaluation in the Baltics would not lead to bigger loan losses for Swedish banks, the losses would simply come more quickly and be harder to deal with, according to SEB Chief Executive Annika Falkengren speaking in a radio interview on Saturday.

"In total we would have the same size of credit losses, but (if there is no devaluation) they would be a little more regular and over a longer time frame," SEB Chief Executive Annika Falkengren told Swedish radio. "In the case of a devaluation they would be pretty much instantaneous."

Now what was it Krugman and I were saying that everyone jumped down our throats for:

I’ve been saying this for a couple of weeks, but Edward Hugh has the goods.

Hugh puts his finger, in particular, on one gaping hole in the logic of the opponents of devaluation. We can’t devalue, they say, because the Latvian private sector has a lot of debts in euros, and a devaluation would make it very hard for borrowers to service those debts. As Hugh points out, the proposed alternative — sharp wage cuts, and basically a major domestic deflation — will also make it hard to service those debts. In fact, I’d be a bit more specific than Hugh: other things equal, a nominal devaluation and a real depreciation achieved through deflation should have exactly the same effect on debt service (unless some of the debt is in lats rather than euros, in which case devaluation would do less damage.)

Ms Falkengren has a very peculiar way of looking at things when it comes to analogies:

However, Falkengren said that devaluation without long term policies to get economies back on track was not a good option. "It's like peeing in your pants. It feels good, but only for a very short time," she said.

But essentially she is right, devaluation is not a solution, only a route to solutions. Long term structural reform is needed either way.

Estonian GDP Shrinks By An Annual 15.6% In The First Three Months Of 2009

Well, the best thing that can be said about this is that it wasn't as bad as the 18% contraction recorded in Latvia.

Estonia’s economy contracted the most in at least 15 years in the first quarter, making it the second-worst performance in the European Union. Behind the number lay a sharp fall in consumer spending and a plunge in industrial output. GDP was down by an annual 15.6 percent, the sharpest drop since at least the first quarter of 1994, according to the flash estimate from the statistics office. The fall follows a 9.7 percent drop in the last three months of last year.

The 15.6% year on year was significantly above the consensus forecast for a drop of 12.8 % and even above more "realistic" forecasts like the Danskebank 14.6% guesstimate, and will obviously have implications for all sorts of things, but in particular for the government budget deficit forecast.

The latest round of GDP numbers from all three Baltic states - Lithuanian contracted by 12.6% and Latvian by 18% - all indicate extreme weakness in the respective economies.

Today's number obviously lends support to the idea that Estonia's economy might decline by more than 15% in 2009. A lot depends on what the next quarter looks like. If the slowdown accelerates the final annual number might be even worse.

According to the statistics office release, output was broadly down for the majority of economic activities, but the steepest decreases were in manufacturing, construction and the retail trade. Weak external demand added to lack of internal price competitiveness meant exports were a further drag on manufacturing performance. Industrial output fell by more 25% year on year in each of the first three months and retail sales have now been falling for 11 consecutive months. Exports plunged 29 percent in January and 25 percent in February.

The weakness of the GDP number means the budget situation will inevitably have deteriorated further, which means that if the deficit target of 3% of GDP is to be maintained the Estonian government will need to respond with even more painful cuts in spending. In general, the performance does not change the outlook for Estonia to fulfil the Maastricht criteria this year, but it does mean that sticking to the criteria is getting to be a harder task with every passing day.

The Agony Continues - Latvian GDP Falls By 18% (Updated)

Latvia's economy shrank by nearly a fifth (year on year) in the first quarter, according to the latest flash estimate from the national statistics office. Obviously this is a dreadful state of affairs, and illustrates just how difficult the country's chosen adjustment path is proving to be.

Gross domestic product fell 18% year-on-year, and Statistics Latvia reported that the decline was broad-based, with manufacturing down 22%, retail trade down 25% and hotel and restaurant services output 34% lower from a year earlier. "The economic situation is of course very serious," Latvian Prime Minister Valdis Dombrovskis reportedly told a press conference in Stockholm, and who could disagree.

GDP fell by an annual 10.3% in the fourth quarter of 2008, while the economy contracted over the whole of 2008 by 4.6% following 10% growth in 2007. This is evidently what is meant by the expression "boom-bust".

The latest GDP numbers from Latvia suggest that the actual situation is in fact worse than the already pretty gloomy expectations. In many ways the “worst case” scenario for the medium term outlook for Latvia has now become a reality. Taking into account further tightening on the fiscal front the downturn could become even more pronounced in the coming quarters.

The weaknesses in the economy seem to be pretty broadly. The decline in both the manufacturing and the service sectors continued in Q1. The export sector has been contracting steadily, due both to slack global demand and uncompetitive domestic prices.

Industrial output was down by 23.4% in March, according to working day adjusted data from the statistics office. Manufacturing fell by 26.6%, electricity and gas supply by 14.1%, while mining and quarrying activity actually increased of 25%. The strongest reductions in industrial output were in textiles - down by 59.2%, in the manufacture of motor vehicles, trailers and semi-trailers – down by 52.9%, and in the manufacture of machinery and equipment - down by 47.2%.






Foreign trade has been dropping, and in March 2009 total trade turnover at current prices was 700.6 mln lats, up 8.3% (or 53.7 mln lats) on February, but down 29.7% (or 296.3 mln lats) on March 2008. Exports reached a low in January, and have climbed slightly since then.

Over the whole quarter trade was down by 32.7% (or 963.9 mln lats) over the first quarter of 2008. Exports fell by 26.0%, while imports were down year on year by a whopping 36.5%.

70.8% of Latvia’s March exports went European Union countries, and another 15.1% went to CIS countries. The principal export partners were Estonia (13.3% of total export), Lithuania (13.0%), Germany (10.2%), Russia (8.7%) and Sweden (7.2%). Since all five of these main trade partners are themselves in strong recessions at this point the outlook for improved exports (even were Latvia competitively priced) is not exactly promising at this point.

The drop in imports does, of course, mean that the trade deficit has been steadily improving (see chart below), which means that despite the drop in exports, net trade has actually been positive for GDP in the first quarter.

Price Inflation Still Far Too Strong

One of the key points in Latvia's "non-devaluation" strategy is to get the wage and price level down quickly. Since the only relief can come from exports as the global recovery starts to take shape it is important that as much of the internal deflation process should have been carried out by that point. However when we come to the reality it is important to note that progress has been slow, and far from satisfactory. The consumer price level was down in April by 0.4% with respect to March, but compared to April 2008, consumer prices had still increased by 6.2%. Obviously much of this inflation is already inbuilt, but in the absence of independent monetary policy it is obviously clear that the Latvian government should be doing more to speed this up, otherwise all this is going to take an eternity, the pain will be unendurable, and much of the structural damage well nigh permanent. The Latvian economy could look worse than the Florida coast after a hurricane has passed.




The only really bright spot is that the tradeable sector does seem to have responded rather more rapidly than the rest (as theory would predict) and export producer prices are now falling rapidly.

Company finances are strained, as internal demand is weak and financing conditions tough. In addition, the position of the Latvian consumers is difficult, as unemployment has shot up and wage growth has slowed. 2009 is likely to be a very difficult one for Latvia, and the government faces the twin challenge of both keeping the budget deficit within a limit accepted by the IMF in order to receive the rest of the emergency loan, and of breaking the back of the economic contraction which is currently spiralling away out of control.

Households are obviously also having a hard time, and incoming data on the rise of non performing loans in Latvia is becoming preoccupying. NPLs (loans that are more than 90 days overdue) as a proportion of the total rose to 7.8% in March (see chart below), and while this level is still not excessive, it is that rate of increase that causes concern.


Retail Sales In Freefall

Retail trade turnover was down in March by an astonishing 27.3%.

Compared to February sales decreased by 2.6% on a seasonally adjusted basis. Compared to the last quarter of 2008 retail sales decreased by 14.1% in Q1, while compared Q1 2008 there was a 24.5% drop.



Unemployment Also Up Sharply

Obviously one of the factors driving the increase in non-performing loans is the rapid rise in unemployment. In fact, as elsewhere the rate of increase eased in April, but still the rate of unemployment rose to 11% and the numbers unemplyed to over 120,000, according to the latest data from the State Employment Agency.




At the present time the government is working towards a deficit of 7% of GDP, above the 5% initially agreed to with the IMF. According to the Prime Minister discussions with the IMF about allowing a larger deficit are ongoing. Maintaining the deficit within the 5% of GDP limit is turning out to be increasingly difficult as the economy has contracted much more sharply than anyone anticipated.

According to Latvian economy Economy Minister Artis Kampars the economy has now reached the bottom and on the point of recovery. Kampars said this in an interview with LNT television. Asked about the gross domestic product decrease of 18% in the first quarter, Kampars said that it was logical and expected, but the GDP will start increasing later on this year.

He also said that regardless of the significant fall in the GDP, the government is not planning to revise the budget amendments, which are based on a 12% GDP drop.

Basically this whole view could not be farther from the truth, since the worst is yet to come, even if this may not be in terms of ever stronger rates of contraction. 18% is we have to hope "unrepeatable", as a year on year figure, and the contraction in the future may well be slower. But this is not what matters. The hardship of the Latvian people will undoubtedly increase, as will what is called the level of "distress" when it comes to paying loans. I see no recovery on the horizon, and even though the rate of contraction will almost certainly decline, positive growth is a long time away, and it would be a brave person who was willing to forcast any sort of growth in any quarter before we hit 2011.

Worst of all, the government, the European Commission and the IMF seem to have no exit strategy here. Like the Vietnam war, this recession may prove to have been a lot easier to get into than it was to get out of. Hanging on in the hope of a euro entry which may never be possible is no strategy. Those who didn't want to devalue got the Latvian people into all this, now perhaps they can explain to them how to get out, since the answer isn't obvious, as budget cut upon budget cut only feeds the contraction, which feeds the unemployment, which feeds the rise in non performing loans which feeds the bailouts which feeds the need for more spending and more cuts in services and staffing, which feeds the contraction and so on.

We need to break the circle, or are we just, like Dicken's Mr Mikawber simply going to hang around and wait for something or other to turn up? And if we are, then I'd be firmly locking and bolting the back door, since all those able bright young and educated people will be sneaking off elsewhere as soon as recovery starts up across Europe, and they won't be coming back, and then we really will be in a pickle, won't we? Or are we hoping they will be like his wife Emma, who let her maxim be "I will never desert Mr. Micawber!"

Non-performing Loans In Latvia

This is all so tragic, and so foreseeable (viz, my original post here, for example).

Krguman on me:

"Hugh puts his finger, in particular, on one gaping hole in the logic of the opponents of devaluation. We can’t devalue, they say, because the Latvian private sector has a lot of debts in euros, and a devaluation would make it very hard for borrowers to service those debts. As Hugh points out, the proposed alternative — sharp wage cuts, and basically a major domestic deflation — will also make it hard to service those debts."

Krugman on himself:

"In fact, I’d be a bit more specific than Hugh: other things equal, a nominal devaluation and a real depreciation achieved through deflation should have exactly the same effect on debt service (unless some of the debt is in lats rather than euros, in which case devaluation would do less damage.)"

The Latvian Financial and Capital Markets Commission yesterday with numbers on domestic loans currently in arrears.

By the end of Q1 2009, loans in arrears in Latvia amounted to 20.5% of the aggregate loan portfolio of Latvian banks (up 5.5 percentage points from the end of 2008). The aggregate loan portfolio of the Latvian banks was worth LVL 16.4bn (approx. EUR 23bn) at the end of March 2009. Of the bank loans issued to households in Latvia, 22.1% were in arrears at the end of March 2009. Furthermore no less than 21% of mortgage loans were in arrears by March.

Danskebank on the Commission report:

We are quite concerned about the speed at which the non-performing loans are rising. Considering the gloomy outlook for the rest of 2009 NPLs are probably set to increase even more. We highlight that there is not a 1:1 relationship between NPLs and loan losses, but nevertheless these data cause us to believe that bank loan losses will go much higher than current levels – particularly in Latvia but also in the other countries.

And finally Krugman, who can speak for both of us here:

"This looks like events repeating themselves, the first time as tragedy, the second time as another tragedy."

Amen to that!

Estonia's Trade Down, Unemployment Up As Recession Deepens

Estonia’s trade deficit narrowed to the lowest level in almost eight years in February as the deepening recession cut hard into consumption. The deficit shrank to 1.1 billion krooni ($93 million), the lowest since May 2001, compared with 1.6 billion krooni in January.



Exports fell an annual 26 percent and imports slumped 33 percent, according to statistics office data.





Having a very sharp fall in imports is, of course, one way to close the trade deficit, but the fall in living standards involved in doing it this way is hardly optimum, or enjoyable.

Unemployment Rises Sharply In March

As consumption falls, and with it demand for products and services, so unemployment rises, and at the end of March 54 979 unemployed were registered as unemployed with the Estonian Labour Market Board, an 18.5 percent increase on the February number and an estimated 8.4% of the economically active population. In the last year unemployment has now increased by 220 percent.

At the end of March 9445 young people in the ages of 16-24 and 14 188 persons of 50 or over were registered with the Labour Market Board. 53.6 percent of those registered were men. Registered unemployment was highest in Võrumaa (13.2%), Ida-Virumaa (12.7%), Valgamaa (11.9 %) and Põlvamaa (10.5 %). The lowest levels of unemployment were in Tartumaa (6.7%), Hiiumaa (7%) and Harjumaa (7.2%).







House Price Fall Continues

Median prices of apartments fell an annual 38 percent in Q1 2008 - to 10,495 krooni ($886) a square meter, according to preliminary data from the Tallinn-based Land Board. This compares with a 20 percent decline in the fourth quarter, and means prices have now almost halved from the peak hit in the second quarter of 2007.

The slump in prices adds to signs that what is now Estonia’s worst recession since independence in 1991 is deepening significantly. Rising unemployment and stagnating wages have made Estonians more reluctant to spend, and with retail sales falling an annual 18 percent in February, (the biggest drop on record dating back to 1994), there is little to cheer about. And indeed Estonian consumer confidence fell to a record low in March, according to research unit Konjunktuuriinstituut.

Property and land sales fell an annual 40 percent to 5,316 transactions, the lowest since the second quarter of 2003, the Land Board data showed. The value of sales more than halved from a year earlier to 4.7 billion krooni.

Tourist Numbers Drop

Tourism was down in February 2009, with only 121,000 tourists making overnight stays, 15% less than in the same month last year, according to Estonia Statistics.

In February 58,000 domestic tourists and 63,000 foreign tourists visited parts of Estonia. 77% of foreign tourists stayed in Tallinn, 7% in Pärnu and 5% of Tartu. The number of foreign tourists in Tallinn was down 14%, in Tartu and Pärnu visits were up by 2% (in both cities). In February compared to the same month of the previous year, the number of foreign tourists from Estonia’s main partner countries in tourism — Finland, Russia, Latvia and Germany — decreased. The number of tourists from Sweden remained more or less constant.

Inflation Falling, But We Aren't In Full Fledged Deflation (Quite) Yet


Estonia’s inflation rate fell in March to the lowest level in almost five years as the Baltic nation’s worsening recession and declining fuel prices cut demand. The rate dropped to 2 percent, the lowest since April 2004, from 3.4 percent in February. Prices fell a monthly 0.5 percent.

So while headline inflation is falling year on year, and will soo be in negative territory, there is still a long way to go. In fact both the general and the core price index have been falling for some moths now.

But remember that the general tendency in the Eurozone is also deflationary, so prices will be falling elsewhere too, which simply means that there is rather a lot of heavy lifting still to be done on the wage and price front in Estonia, in fact over 90% of the "correction" still lies out in front in these terms.






Baltic Countries Downgraded

Fitch Ratings cut the credit ratings for Estonia, Latvia and Lithuania one notch, citing growing risks to Latvia’s international bailout which could spill over into the other two countries. Latvia’s rating was lowered to BB+, one level below investment grade, from BBB-, while Estonia’s rating fell to BBB+ from A- and Lithuania’s to BBB from BBB+, the rating service said in a statement today. All three Baltic countries had a negative outlook, meaning further downgrades are possible. This detail is not unimportant for Estonia, since the ECB has a rule (temporarily suspended at present) that it will not accept assets as collateral which do not have at least an A- rating from one credit rating agency. So any languishing in the BBB+ range will make euro access more difficult.

How Not To Convince People You Are Capable Of Having An Internal "Devaluation"

The news coming out of Estonia is obviously none too good at the moment. This morning we learnt that both Estonian industrial production and retail sales plunged at the most rapid rate on record in February, giving us very clear evidence that the recession is now deepening. Industrial output (adjusted for working days) fell an annual 30 percent, the biggest drop since 1995, following a 27 percent drop in January, while retail sales, excluding cars and fuel, fell 18 percent, the most since 1994. Month on month, output fell a seasonally adjusted 3.5 percent. And the situation is hardly likely to improve in the short term, since, as Danske Bank point out, all Estonia's main partners are themselves now in deep recessions, so the possibilities of an uptick in activity - even were the economy competitive - are really pretty restricted.

“Industrial production is in freefall, and we expect a continuation of this trend in 2009,” Danske Bank A/S said in a note ahead of the report. “Only an improved outlook for Estonia’s main trading partners, Finland, Sweden, Germany, could change this trend, but this is hardly feasible before the beginning of 2010.”

In fact, while the crisis is a general one, some countries are obviously faring far worse than others, and Estonia’s industrial production dropped the most in the entire 27-nation European Union in December and January. And even if things do start to pick up again elsewhere in 2010, it is hard to see the Estonian economy benefiting that much, since it will still be grappling with price competitiveness issues (see below).




At the present time, as we can see in the index chart below, output is now down around 30% from the 2007 peak, and it continues to fall. Clearly the rate of decline will reduce at some point, and then we may flatten out at quite a low level, but this flattening out will be very different from a rebound, since there is no reason whatsoever to expect a rebound at this point.

Retail sales also fell sharply in February, by 18% when compared with the same month in the previous year. The latest decline dwarfed the 10% fall we saw last month, and may well signal much worse to come. As the statistics office said "In February, the retail sales decreased to their lowest level so far" (see index chart below).

The decline was attributed to the economic slowdown and to deteriorating consumer confidence. According to the Estonian Institute of Economic Research, consumer confidence dropped to a record low of minus 37 in March from minus 35 in February. Compared to the previous month, retail sales declined 7% at constant prices, and after seasonal and calendar adjustments, fell 2%.

New Finance Ministry Forecast


Estonia’s Finance Ministry announced today (Tuesday) that according to their latest estimates the economy will shrink 10 percent this year, if their “worst-case scenario” is realized. This is only in line with what most experts are now saying (although, truth be told, none of us really know) but as recently as last November, the Ministry were forecasting a 3.5 percent contraction for this year and an expansion of 2.6 percent in 2010. Not surprisingly therefore Finance Minister Ivari Padar is having to do his sums again and is now proposing budget cuts of 3 billion krooni ($260 million), as well as a temporary halt to the transfer of pension contributions from workers and employers into the second-pillar pension fund.

But this is now one "chop" on top of the next, since the Estonian Cabinet agreed only last month to cut the fiscal deficit by about 8 billion krooni, or 8 percent of the total budget, in an attempt to ensure the shortfall doesn’t exceed 3 percent of GDP. According to Padar, without further measures the deficit would reach 2.9 percent of GDP this year under the main scenario and but rise to as much 6.1 percent under the worst-case (but possibly more plausible) scenario. Detailed proposals on how to lower the fiscal deficit are to be presented to the government on April 9.

Naturally analysts like myself are rather sceptical about all this. Forecasts have been consistently behind the curve in Estonia, and there is no risen to imagine that this situation won't be repeated across 2009, and 2010, especially looking at the macro data we see coming in. The statistics office announced today that Estonia had a budget deficit of exactly 3 percent of GDP last year, when the economy shrank 3.6 percent. The shortfall was thus precisely equal to the threshold allowed by the EU as one of the conditions for euro entry. Also, when we consider that the country moved from a surplus of more than 2% of GDP in 2007, then it is clear that the rate of deficit creation was very high in the last quarter of 2008.

SEB AB’s Ruta Eier makes the point that with the economy quite probably shrinking by as much as 10 percent this year (or more), the risk of breaching the budget deficit goal is significant. “The chances of meeting the deficit criteria this year seem rather small, especially with the economy shrinking at such rates,” she said in her latest report. Indeed she estimates that first-quarter GDP may shrink by over 15 percent, on an annual basis. Violeta Klyviene, senior Baltic analyst with Danske Bank, is more or less in the same line, and suggests that the budget gap may reach 5 percent of GDP this year unless the government cuts spending further.

So spending cuts are looming, but these will add to unemployment and reduce total domestic demand, so, in effect they will lead to a further contraction in economic activity, which will lead to a higher deficit, which will mean more cuts, and yet more contraction, and so on. This is all a very difficult situation really, which is why I think another approach is needed.

In part bank lending will be another important detail, but bank lending will depend on loan defaults, and these will depend on unemployment, and since even the Finance Ministry are forecasting unemployment at 12.2 percent this year and 15.6 percent in 2010, then defaults are surely set to rise, and with them distress in the banking sector. Indeed, while the Estonian economy at the present time is producing few sellable exports, one thing it is producing are loan defaults: indeed we might say at the present time that the present government strategy is turning Estonia's economy into one huge loan-default assembly line, rocketing backwards as it is with neither steering wheel, nor brakes.

Threat to Euro Membership?

In any event, whatever the eventual size of the deficit, it will need financing, and Estonia’s Finance Ministry is at this very moment seeking a loan for these very purposes, on top of funds already approved by the European Investment Bank.

Of course, one of the reasons that these deficit numbers are so important is that they impinge on Estonia's strategy of seeking Euro membership, and we also learnt today that Estonia’s government has set Jan. 1, 2011, as its new official target. This is an effective abandonment of Prime Minister Andrus Ansip's earlier plan to try to join the euro area on July 1, 2010, although the official position is that this option is still being kept open, despite the fact that European Monetary Affairs Commissioner Joaquin Almunia politely made it clear on March 19 that the plan to join in July 2010 was too ambitious, at least under current criteria.

My feeling is still that Estonia's representatives should be actively working with other East European countries to get these criteria changed, since if we don't achieve that position, the spiraling cycle of contraction, deficit, and economic and political instability may well see eventual euro membership put off into a far distant future.

Are We On The Right Road?

Basically, I feel the whole process of addressing the economic issues presented by the boom-bust cycle are being inadequately - almost incompetently - handled. My own view is that the country urgently needs a devaluation of the kroon, but this is evidently a minority, rather than a majority view. So be it. But then if we are going to go down the internal deflation road, then at least lets do it seriously.

For example, I was horrified to read in the Estonian press that Prime Minister Ansip, is saying that the intended benefits of the new Labour Contract Act may be at risk of being postponed because theSupervisory Board of the Unemployment Insurance Fund did not reach agreement with the Government to raise the unemployment insurance payment rates from January 1.

My impression, as an outsider I know, was that the Labour Contract Act was one of the cornerstones of the labour fexibility process which is so vital to the internal deflation strategy, so how can agreement not have been reached on a key clause in the Act?

"The most important provisions of the Labour Contract Act were agreed between employers and employees. The Government accepted them and asked whether all these benefits fit the unemployment insurance tax rate of 1.5% and the unambiguous response was that they will indeed," said Ansip. He added that the social partners promised back then already that if the benefits would not be covered by the existing payment rates, the benefits would have to be cut.

According to Postimees Online, Ansip stated in a radio interview that the crisis surrounding the Labour Contract Act is the fault of both employers and employees. Sorry, but isn't the job of government to see that these kind of logjams don't arise, and especially in delicate moments like these. My point, however, would not be to discover who exactly is responsible for the mess, but to ask a more fundamental question: how can it be that people are still bickering about this kind of thing in the face of a national emergency, when the survival of your economy and banking system is at stake?

Gentlemen, this cannot be taken seriously.

"We certainly cannot allow to fail to fulfil the Maastricht criteria due o the eficit of the Unemployment Insurance Board that would exceed the planned levels," emphasised the Prime Minister.

Well quite, but the fact that this is even being discussed like this suggests that the hope of clawing through to the daylight is much slimmer than might have been hoped.

Another question revolves around the issue of what kind of adjustment process Estonia is actually committed to. Certainly we are a little short of precise numbers of the kind the IMF spell out in the Latvian case. And the public statements of leading members of the administration do little to reassure us they know what they are about here. Andres Lipstok, the Governor of the Estonian Central Bank, has, for example (see interview extract below) suggested that Estonia's average salary cannot be lowered sharply. Does this man understand what he is talking about at all, I ask myself when I read a statement like this. I fully accept his right to believe that devaluation would contribute nothing to the Estonian economy, but surely, he must understand that substantial internal price deflation is the only half-way viable alternative, that this will be hard, and that this will mean substantial reductions in wages and prices. Basically he doesn't seem to have grasped that Estonia has a competitiveness problem at all, and that all these arguments about not wanting to be a low wage economy (and hence turning the nose up at lower skilled activities) and Estonian wages being lower than the EU average are how we got in the mess in the first place. With an economy imploding at a 10% per annum rate, you can't afford to be that choosy, you know. All I can say is, what's the weather like on his planet?

“One must emphasize that wages in Estonia are still low compared to EU’s verage. Those entrepreneurs and analysts, who think that Estonia should lower alaries remarkably to remain competitive, are wrong. He added that Estonia can’t and won’t be a country with very low wage level. “Estonia’s wage level keeps rising ogether with economy, after necessary correction,” Lipstok said. Inflation is also lowing down. In past 6 months the prices have not grown, after price adaption that ollowed after Estonia joined EU in 2004. The inflation will likely be negative in 009.

For the competitiveness of the economy are no less important to the slowdown in wage rowth. The fast increase in wages in previous years was in part a response to apidly increasing profits. However, at the beginning of last year, the wage level, hich clearly threatened the competitiveness of Estonia. Approximately 15 per cent short of the increase is clearly too much at a time when output per worker is educed. In its first few months, however, wage growth actually stagnated compared o the previous year.

At the same time, it must be stressed that the wages in Estonia, the European Union verage is still low. Analysts and traders are wrong who think that maintaining the ompetitiveness of the Estonian average wages significantly lower. After the ecessary correction will result in the climb to the wage level in Estonia, together ith the overall development of the economy.

At the same time, wage growth has been delayed to stop the inflation of prices.. After the accession to the European Union, followed by adjustment to the price is not for the general price level increased over the last half of the year. 2009 inflation is likely to be negative.

The Price and Wage Correction Is Too Slow

In order to understand why I am being so critical of the Estonian administration in this post, and to see what is wrong with the path on which Estonia is set at the moment we need to keep permanently in mind the objectives that the country has set itself for the coming months and years, which is to carry out a substantial reduction in wages and prices over the next two years (as an alternative to a one off devaluation). Exact estimates are hard to come by here, but we must surely be talking in terms of a very sharp downward adjustment in prices and wages, something of the order of 20% during 2009 and 2010. And my beef is that we see little evidence of that kind of correction taking place. In fact this view is only reinforced on reading the economic policy formulations from the central bank. In its February 2009 statement Eesti Pank had the following to say:

Inflation has fallen rapidly and will not exceed 2% in 2009. The price level is not projected to rise in 2010, either. Many companies have changed their operating strategies and have brought prices and wages into line with the new market situation. This is also proved by rapid changes in the labour market: employment has started to drop, flexible working contracts are becoming more widespread, and nominal wages have started to decline in some sectors.

Let me be blunt: this is thoroughly unsatisfactory as a policy objective, and completely unrealistic (head in the clouds) about the severity of Estonia's adjustment problems.

The pace of deflation at this point is just far too slow to be convincing. According to Statistics Estonia, the percentage change in the consumer price index in February 2009 compared to January was -0.3%, while compared to February of the previous year it was still a positive 3.4%. However, ss reported by the German Federal Statistical Office, the consumer price index for Germany is expected to rise by only 0.5% in March 2009 over March 2008 (down from February's +1.0% - according to initial results available from six Länder). This is the lowest inflation rate registered in Germany since July 1999. Compared with February, prices are expected to drop by 0.1%.

And if we look at the EU harmonised consumer price index for Germany, the downward trend is even clearer, since year on year prices are only expected to increase by 0.4% from March 2008 to March 2009 (February: +1.0%), while compared with February, the index will be down 0.2%.

And the point about looking at German inflation (or rather deflation) is that Estonia is not carrying out this correction in a vacuum. What is important here is relative prices, and if all your neighbouring countries are aither devaluing their currencies, or having internal price deflation (due to thelarge contractions they are experiencing, Commerzbank estimate the German economy itself may contract by 7% in 2009) then you have to do more, and go that bit further, not do less. Otherwise when the recovery does, finally, come, you will simply be left behind, since you will still be uncompetitive.

Nor is Germany an isolated case, inflation in Italy, the euro region’s third-biggest economy, also slowed to a record low in March, with inflation dropping to an annual 1 percent from a year earlier, compared with 1.5 percent in February. And, of course, over the last three months prices ahve actually fallen. And Spanish consumer prices declined for the first time ever (on an annual basis)in March, highlighting concerns that deflationary pressure will emerge right across the European economy. Consumer prices fell 0.1 percent from a year ago using the European Union’s calculation method after a 0.7 percent increase in February.

Indeed inflation rates across Europe are now falling near to zero, and fell to the lowest on record in March according to the initial estimates, adding to concerns that deflationary pressures are emerging throughout the whole region. Inflation in the euro area slowed to an annual 0.6 percent in March from 1.2 percent in February, the lowest rate since the data were first compiled in 1996

And most of Europe's economies are facing contractions in the 5 percent per annum region, so Estonia has a tough benchmark to work against, one which is even tougher when those who make policy are totally unrealistic about the magnitude of the task facing them. I would remind Estonian policy makers: it is a fairly easy thing to say that those economists who don't agree with you don't know what they are talking about, and quite another thing to establish that you, yourselves, do.


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

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

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


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

The Latvian Cat Is Out Of The Bag

Reuters this morning:

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

and Nordea flash comment:

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

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

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

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

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

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

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

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

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

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

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

Financial Crisis -> Real Economy Crisis -> Political Crisis

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

Update Dombrovskis "Corrects" Himself

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

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

Joke - How do you know when a country is in crisis? Well, on the buses on the way to work, and in the bars and cafes during the mid morning break, everyone is reading the economy rather than the sports section in the local newspaper.

Several pieces of news out over the last week are relevant to the whole debate we are having about how to drag the Estonian economy (kicking and screaming it would seem) out of its current slump. In the first place the Estonian parliament passed a supplementary 2009 budget at the start of the week, in an attempt to address the ongoing crisis in the economy and the dramatic decline in revenues. The cuts were approved by 61 votes to 35 against in what was also an effective vote of confidence in the present government. So at least it is clear that the majority of Estonia's politicians back the present course, and the degree of public support for the current path is greater than it would seem to be in, say, Latvia. That is, naturally a very positive point.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

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

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

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

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


Joining The Eurozone

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

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

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

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

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

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

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

Current Account Deficit

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



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

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

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



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



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

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

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

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

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

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

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

Q4 2008 GDP

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

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

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

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

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



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


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




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


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


The Credit Driven Expansion Is Over


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

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

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

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

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

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


Finally, The Impact Of The Property Crash.

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

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

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

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

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



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


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




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

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


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

Monetary Policy Always Flawed

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

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

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

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

Housing Oversupply And Declining Construction Activity

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

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