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Sunday, August 19, 2007

Will The Lat Come Under Pressure Again?

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

Obviously we need to wait and see how the financial markets respond to the latest move from the Fed, but my feeling is that the so called "credit tightening" (or liquidity crunch) isn't over yet (and not by a long stretch), and that even were the "liquidity crunch" to come to an end soon the consequences for the real economy are going to be important, since credit - both corporate and private, and possibly even sovereign - will more than likely be harder to come by. What this "harder to come by" really means is that you will have to pay more for it, especially if your credit valuation is not of the highest (as was the case with the US sub-prime home purchasers).

It is important to be clear here that what we have at this point is a liquidity crunch and not a generalized credit crunch, but evidently the danger is that the former spreads to the latter, which it may well do if the impact of the liquidity crunch on the real economy is seen as being sufficiently important as to warrant a good deal more caution in lending. It's as simple as that I think.

Basically liquidity crunches occur from time to time when asset prices decrease quickly, since banks typically demand more money and become more reluctant to lend out the money they already have. In order to maintain adequate liquidity (and guarantee its target refi rate) the ECB, for example, normally carries out a liquidity "top up" operation once a week. But what this means is that any sudden shifts in demand for and supply of funds which take place during the week in-between can lead to liquidity squeezes. When banks sense there is not enough liquidity in the system then they start to hoard it and as a consequence liquidity can dry up very quickly. In such situations the ECB (or the Federal Reserve, or the Bank of Japan) may provide liquidity at a higher frequency than normal until demand and supply stabilise again and overnight rates once more return to their normal levels. This is the process we have seen at work over the last week or so.

Now this kind of liquidity crunch is not to be confused with a more general credit crunch where credit conditions are tightened across the board vis-à-vis companies and consumers. At this point there are no real signs that this is happening. In the eurozone, for example, M3 growth and broad credit growth are still at very high levels and lending standards are still generally favourable. The problem is that if the current financial crisis intensifies, and in particular, if there are perceived to be ongoing consequences for the real economy which derive from the liquidity crunch, then there is a genuine risk that we may see a broader tightening of credit.

In order to address this we need to think about why this liquidity crunch has happened now, and indeed what it is that has been the immediate cause provoking it.

On the first count, the broad background has to be that the current cycle of economic expansion - which after all started back in 2001/2002 - is quite possibly nearing its peak. Volatility has been steadily creeping into the markets since the spring of 2006 - in Hungary, in Iceland, in Turkey - and often such events are early warning signals of bigger trouble coming further down the road, especially if the volatility increases.

Since the spring of 2007 volatility in financial markets has steadily increased, and the bigger problem is now with us.

As to the immediate cause, it is important to think about the fact - as few commentators seem to have done - that the whole issue has started with sub-prime lending in the United States. Now this detail would seem to be important for three reasons. In the first place these mortgages were made to people in what you might consider to be a "high risk" group for lending, and obviously the risk was too high. This appreciation will now lead all the banks and other financial institutions to examine all the other "high risk" assets they have in their portfolios and to begin the process of systematically discarding them. This I do think will happen.

Secondly, it is not insignificant that the high risk group which set things in motion was associated with the property sector and this little detail will have implications (see below) which reach right across the real economy given the important role which construction and housing have been playing in the current cycle.

Thirdly it is important to notice that the sub-prime defaults problem surfaced in the United States, and that the Federal Reserve started the interest rate tightening cycle at least a year before most of the central banks in the other major economies did (with the significant exception of the Bank of England). So this means that the sub-prime population in those other economies (who of course have also been receiving money) have yet to start experiencing significant "distress" in the way their US counterparts have. But they will do. It is just that we are most probably still at 6 to 9 months distance from that stage elsewhere, and this is just another of the reasons why I think the problem will be a drawn-out affair, and any real economy slowdown may also have some duration attached to it.

Coming back to any possible general credit crunch, as I say, were this to occur it would undoubtedly make itself felt at all levels, since the banking sector has clearly had a big shock, and any credit tightening will clearly involve individuals, companies and even governments (and again it is interesting to note that the Fitch rating agency has already replied to some of the criticism by downgrading Latvian government debt). Just how it may affect them is what we are now waiting to see. But it is important to bear in mind that such impacts on new and rollover credit would occur regardless of the extent to which central banks lower their base rates, since what will have happened is that the lending environment will have deteriorated, and this deterioration is likely to influence conditions in new lending (or rollover credit) for years rather than months into the future.

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

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

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

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

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

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

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

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

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

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

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


sam said...

I want to thank you for your continuing efforts to explain what is happening in the Baltics in general and Latvia in particular. I live in Latvia and will be heading to the bank tomorrow to move our family's savings out of Lats and into Euros while the peg is still intact. (Or is there a better idea?). I'm nervous, sure, but we are at least in the fortunate position of having no debts or mortages on our properties. Still, it is disconcerting to anticipate a steep decline in the potential selling price of real estate, but such is life. Please keep up the good work. Your information is invaluable.

Edward Hugh said...

Hello Sam,

Nice meeting you. I've enjoyed viewing the photos. Also thank you for your comment. Somehow it adds a personal dimension to all this which in many ways reminds me of what a large responsibility we economists have. (I do also have some communication with Latvian Abroad and All About Latvia, this is one of the things I like about blogging I suppose).

I wish I could be the bearer of better tidings. I think history has been so unkind to all the peoples of Eastern Europe, they really do seem to be entitled to be dealt a kinder set of cards than the ones they actually have.

Really, I think you will appreciate that, even if I could hardly claim to be widely read on this blog, I do want to be responsible, and thus am unlikely to say anything which I feel could be in any way damaging to the Latvian outlook.

However, if you ask me this question:

"Or is there a better idea?"

Then I have to say that I personally can't think of one. For the rest, at this point, you will have to read between the lines I'm afraid.

I will try, when I find the time, to treat the currency peg issue in a somewhat theoretical fashion, but I fear it is reality itself which will put it back on our collective agendas in a much more practical one. I simply don't see how you can have the level of cost inflation (and the wage increases have still to feed through to producer prices and the end customers over many months) and still hope to sell exports. And if you are going to cut domestic demand, which is what they are doing, then selling exports is the only effective way to live.

Some benefits can of course come from productivity improvements,but this is a longer term issue.

The politicians are going to take a lot of stick for all this moving forward, and while I am sure that they are all far from perfect I think it is unfair to load all the blame on them for the whole damn mess.

There are deep structural issues at work here, some of them related to the workings of the entire global financial system, others related to global migration flows, etc.

As Carsten Valgreen says in a paper I cite, central bankers and governments in small open economies have effectively lost control over their own affairs. They are no longer masters of their own destiny (indeed, even the "mighty" US isn't in the control it used to be, if you look at what the Federal Reserve had to do last Friday, and the dependence on China government purchases of US Treasuries).

So obviously on some level, what can little old Latvia (or Iceland) really do?

All of this needs a lot more thinking about, and I think we all need time to assimilate what is happening.

In the meantime, just remember, whatever happens next is not the end of the road. There are always remedies available, and time normally heals. What is needed is a general change in attitude I think. What is it they say, "we live and learn".

We are always learning, if we weren't we would be already dead. And we can always do things better.

OK, maybe that's enough homespun philosophy for one day :).


"Still, it is disconcerting to anticipate a steep decline in the potential selling price of real estate, but such is life."

It is hard to say how far this can go really. We have to wait and see. But essentially if the majority of people have bought their homes to live in, short term changes in the book values of their homes shouldn't be that big an issue.

The problem is that the sharp rises in property prices (across the globe really) have encouraged people to treat homes as speculative assets, and this isn't so good, especially if you live in a country where the population is likely to fall.

Basically the worst affected here will be the highly leveraged, ie those young people with mortgages which constitute a high proportion of the old (higher) book value of the property. One thing which worries me is that some of this property may have been bought by migrants working in the UK or Ireland, with the monthly installments being met from remittances.

The problem is that many of those people may never return and live in those homes (depending) and this in itself constitutes a price distortion.

On the other hand, I do believe that there is safety in numbers here, and while a difficult time may lie ahead, ultimately a political settlement will have to be reached between the government and the banks who funded the whole thing in the first place. Unfortunately, between here and there we will probably see a huge tug of war, and a lot of angst for those who are in debt.

Please stay in touch.


sam said...

Thank you so much for your detailed response. You have an easy fluency in your expression. I am grateful. (and glad you enjoyed the photos).

I understand your reticence to openly state your opinion on the devaluation issue, and I appreciate your careful response.

Yes, Latvia and all of Eastern Europe has had a sad history which seems destined to continue. Although we personally have benefited in the run up of property values, I agree that it will be those with heavy debt obligations who will feel the weight of coming events, especially if, as some have suggested, the Lat is devalued to 1:1 with the Euro.

There are, as you say, structural, migrational, and demographic shifts taking place which will have profound effects on Latvia. We are headed for turbulent times and in some ways will become a test case for how capitalism copes with an ageing, emptying, state on a small scale. I'm just glad that you are following our situation out here on the raggedy edge of Europe.