Facebook Blogging

Edward Hugh has a lively and enjoyable Facebook community where he publishes frequent breaking news economics links and short updates. If you would like to receive these updates on a regular basis and join the debate please invite Edward as a friend by clicking the Facebook link at the top of the right sidebar.

Tuesday, October 21, 2008

Sweden Bails Out It's Banking Sector

Well, don't those days when everyone was arguing that the Baltic economies were going to be just fine, since they were such small beer that foreign banks would be only too happy to keep funding them until the cows came home. Well, the cows it seems have just reurned to their sheds.

Sweden has become the latest European country to take steps to stabilise its financial system by guaranteeing up to $205bn of new bank borrowing and creating a fund to take direct stakes in banks.

Stockholm had insisted there were few problems in its banking sector, but on Monday it was forced to match the stabilisation measures of other European governments and respond to fears its lenders might not escape the global financial crisis unscathed.

In particular there were worries a sharp correction in the economies of the Baltic nations of Latvia, Estonia and Lithuania could undermine its banks, which control two-thirds of lending in the three former Soviet states. Fears about this exposure were one reason share prices of Swedbank and SEB almost halved this year.

The new package involves a pledge to guarantee up to $205bn (€150bn, £120bn) of new medium-term bank borrowing and a separate SKr15bn ($2bn, €1.5bn, £1.2bn) fund that can be used to buy preference shares in any bank that needs a capital boost. As part of the legislation, which will go before parliament next week, the government will also assume the powers to take over banks.

This shoring-up of Sweden's banks could be thought of as an initial protection against any break in the Baltic pegs since as John Hempton points out in a detailed analysis of the situation:

If the Lati doesn't devalue its only because people (i.e. Swedbank) are prepared to continue to fund it. This is not pretty at all. All in Hansa owes Swedbank over 30 billion Swedish Kroner – all denominated in Euro and which can't be paid. The equity capital of Hansa (roughly 7 billion Swedish Kroner) is also going to default.

And there is always Claus Vistesen's most recent examination of the whole position if you are in the mood for a longer read.

And, oh yes, there is also the news that the Latvian central bank bought 24.8 million lati ($47.3 million) in the market last week to support the national currency after it weakened to the limit of its trading band, according to a statement by the bank.

The lats weakened to 0.7098 against the euro for the third consecutive week, prompting the bank to buy the currency to keep it within its trading band. The lats is allowed to move 1 percent on either side of a midpoint against the euro. The central bank has now bought about 151.5 million lati over the last three weeks to support the currency

Tuesday, October 14, 2008

The Baltic States May Soon Follow Hungary Into IMF Receivership

Well, the Icelandic authorities seem to have bitten the bullet, and after some coming and going agreed to accept assistance from the IMF. An IMF mission is on the island preparing a plan which will then be put to the Icelandic government (protocols here are important). Under negotiation are the terms of any possible loan. According to Einar Karl Haraldsson (a political adviser to the Icelandic government) the plan is expected to be finalized in the next few days, after which the government will have to decide whether to accept the aid and the terms under which it is being offered.

Meantime a growing number of countries now seem to be at risk of following Iceland and Hungary into the arms of the IMF, with the Baltic republics of Estonia, Latvia and Lithuania now looking particularly vulnerable, according to a warning from the International Monetary Fund itself yesterday.

Dominique Strauss-Kahn, managing director of the IMF, which was formally approached yesterday for assistance by Hungary as well as Iceland, said: "The fallout for most banking systems in emerging and developing economies has been limited so far but signs of stress are growing, " Strauss-Kahn said some banks in eastern Europe have become increasingly exposed to struggling property markets, having raised funds on international money markets in the same way as the ill-fated Icelandic banks.

For the time being the various national governments are denying the possibility, with Edgars Vaikulis, spokesman for Prime Minister Ivars Godmanis, being quoted in Bloomberg as saying "There is no reason to speak of threats to the Latvian financial system......Latvia's situation is different from some of the eurozone members.''

I'm sure that the latter statement is true, even if not in the sense that Vaikulis meant. Nonetheless the Latvian government has taken the step of raising guarantees on all bank deposits to 50,000 euros ($68,225), in line with an earlier decision by European Union finance ministers.

In my view the threat to the Baltic financial systems is real, as is the threat to the Bulgarian and Romanian ones. Action, of some form or another needs to be taken, and soon. Latvia and Estonia are now in deep recessions, and Lithuania, while still clinging on to growth, can't be far behind. Basically it is hard to see any revival in domestic demand in the immediate future, which means these countries now need to live from exports. But with the very high inflation they have had it is hard to see how they can restore competitiveness while retaining their currency pegs to the euro. The IMF will almost certainly insist on a currency float as a condition of rescue, and if you look at the speeches of Lorenzo Bini Smaghi and Jürgen Stark over the last year, it is clear that thinking at the ECB runs along pretty much the same lines. So better get it over and done with now I would say, and take advantage of the shelter offered in the arms of the IMF. Indeed the more I look at what is happening, the more it would appear that a division of labour was agreed to in Paris last weekend, with the EU institutional structure sorting out the mess in Ireland and the South of Europe, and the IMF taking care of all that broken crockery out there in the EU10.

In what is likely to become a sign of the times Hungary's MKB Bank announced that yesterday that it is going to stop providing euro- and Swiss franc-denominated loans until further notice. In defence of its decision MKB said the huge volatility registered in the value of forint in recent weeks, and especially the strong depreciation at the end of last week, make the outlook on the currency extermely uncertain. Most other Hungarian banks are expected to follow MKB's lead. This practice of bringing an end to the extremely dangerous practice of offering foreign exchange denominated loans in countries running large external deficits is now likely to come to a screeching halt all across the CEE and CIS economies, and bit by bit the IMF will have to be brought in to offer support during the transition back to reality.

For a full and thorough analysis of the current threat to the Baltic economies, see this whopping post this morning from Claus Vistesen.

The CEE and the Baltics - Moving Towards the Center of the Storm?

by Claus Vistesen: Lausanne

As I peer out my window over towards the Alps and the northern entrance to Le Vallé du Rhône I can't help asking myself whether some of those experiments which are habitually conducted a mere 40 kilometers from my current habitat haven't gone terribly wrong? With every passing day getting I find it more and more difficult to avoid associating all those worthy attempts to uncover that illusive Hick's Particle with the all-encompassing black hole into which our financial markets seem to be getting sucked with a disturbing velocity, despite the numerous efforts by the global financial authorities to invent some sort of monetary equivalent to "anti-matter".

But while the current crisis is pretty much a generalised global one, if there is one region where the crisis is making its presence more acutely than elsewhere, that place is Eastern Europe, and among the ranks of the regional casualties high on the list come the three Baltics countries, Estonia, Latvia and Lithuania. That this is the case should not really strike us as so strange. On many occasions since the credit crisis went global back in the summer of 2007 many analysts (including yours truly) have been flagging the risk of a hard landing in Eastern Europe. This unfortunate situation has now by and large materialised and the only question which really arises is how hard is "hard" going to be? A couple of recent tentative signs suggest that the big eye of the credit crunch, not unlike Sauron with his glance toward Frodo et al., is fixing Eastern Europe fast in its gaze.

In terms of Russia, we have already witnessed the speed with which financial markets have turned the tide for the erstwhile high powered economy. Now that oil is dipping into negative on an annual basis, the screw may just get turned a little more.

In Ukraine, the market for the state's sovereign debt almost collapsed during the past week as credit default swaps (insurance against loses on debt) rose almost 40% to 1700 basis points as rumours mounted on an early election as well as the government made steps to take over one of the country's big banks. Furthermore and as could be expected the Hryvnia took another beating. A similar situation seems be unfolding in Hungary where prominent government and central officials were dipatched spent part of their Friday trying to avoid a rout on the Forint in the spot markets. Meanwhile, and as a natural bed-fellow to this the stock market, and especially financials, were pumelled. In many ways, the Hungarian predicament resembles more and more a tragedy in the making which is also why the IMF is moving in to calm things down as well as attempt to bring the boat back on course.

The situation in Ukraine and Hungary is important. It highlights the flipside of de-pegging from the Euro (and in the case of the Hryvnia, the USD) in the expectation that subsequent appreciation will help quell inflation. Such a strategy perhaps seemed clever at the time (personally, I always had my doubt), but now as the tide turns downside risk is substantial. From a macroeconomic point of view this is extremely significant. a major part of Eastern Europe's expansion has been supplied by foreign credit and more importantly with loans denominated in foreign currency (mostly Swiss and Euro loans in Hungary and Ukraine). It does not take much of an economist to see the potential abyss of downside risk in the form of translation exposure. As Edward puts it in a recent note;

Basically, the crossover we need to be thinking about in macroeconomic terms is the one between the Swiss Franc and the Hungarian Forint, given the exposure of Hungarian households to Swiss Franc denominated mortgages, and the impact on internal demand which is to be expected if the current dramatic decline continues.

To cap it all off, the significant increase in stress levels of Eastern Europe aslo appears to be sending tremors towards Austria where the banking sector is highly involved as intermediary for swiss denominated consumer and housing finance.

And in the Baltics?

While things are likely about to get very interesting in Eastern Europe the recent tumultous events in financial markets seem to have spared the Baltics from the worst repercussions. This only goes for the more theatrical "Iceland type" events however. If we look at the real economy it is evident that a sharp correction has now begun, something which was confirmed as the data from Q1 2008 rolled in. If we take a look at the most important data pieces, the Baltics have now almost entered a collective recession (even if Lihuania is performing above par).

Both in Estonia and Latvia output contracted for the second consecutive quarter in the second quarter while output in Lithuania stayed surprisingly strong. On the inflation front it finally seems that the pressure is abating somewhat even if of course this is a process that works with considerable rigidities relative to the decline in output. In this way, the Baltics still find themselves in a situation of stagflation.

One very interesting development in this regard however is the evolution of labour costs. If we look at the development up until Q1 2008 the y-o-y increase was one of 7-10% per quarter, but that changed strikingly in Q2. As such, in Estonia and Latvia quarterly labour costs fell to 2.9% and 2.4% respectively Lithuania entered wage deflation. It is still too early to gauge a trend here but it is obvious that for the Baltic economies to correct while simultaneously maintaining a fixed exchange rate regime the correction mechanism would fall entirely on the domestic sector's ability to become more competitive.

And this is now becoming more than a passing preoccupation.

In this way, and while the external deficits have been reduced (mainly due to a sharp drop in imports) the imbalances are still very much present, not least because a negative income balance remains to keep the balance in red. As I have argued before this can only go on until it can't, which is a cryptic way of saying that something at some point has got to give. Unfortunately for the Baltics, the watchdogs of global credit markets (the rating agencies) have begun to seriously turn their scent on to the contradictory fundamentals of these three economies.

Last week, the Baltics's sovereign ratings were consequently collectively downgraded by Fitch Ratings which followed an earlier decision by Moodys to lower the region to negative. The reason cited will not surprise regular observers of these economies (indeed readers of this blog's eastern europe installments). Head of sovereings in Europe Edward Parker from Fitch consequently noted that the worse than expected correction in financial markets coupled with the vulnerable macroeconomic enviroment as the main reasons for the downgrade. More specifically, the mixture of external deficits funded to a large extent by inflows of credit (e.g. some 30% for Lithuania) supplied by foreign banks lies at the root of the decision and incidentally, as it were, also at the root of the macroeconomic vulnerabilities of the Baltic economies.[1]

In this context it is interesting to initially peruse the graphs plotting cross currency exposure and overall leverage (Latvia data only for households).

The point conveyed by the graphs above is one of the main reasons for an increasing risk of a more than traditional adverse outcome from this crisis. It is thus important to understand that the Baltics are still dependent on inflows of foreign credit even as the economy slows and that this shows up, in part, through the substantially higher leverage in foreign currency relative to the total leverage ratio. Especially the extra graphs in the Lithuanian case is interesting in that it shows how the marginal increase in total leverage from 2003 and onwards almost exclusively can be attributed to an increase in leverage of foreign currency loans relative to foreign denominated demand deposits.

This is of course where things begin to get interesting because if we look at the companies supplying the credit to the Baltics, they are increasingly looking to get sucked down into the maelstroem that has fit financial markets. Most prominently is of course the Swedish bank Swedbank which perhaps has the biggest exposure to Baltic markets (through Hansabank). Analysts have persistently been voicing warnings on Swedbank's aggressive lending policy in the Baltics, but if we look at activity in Q2 Swedbank continued to expand credit to the Baltics. And this is not a mere problem of a Swedish bank potentially having to retreat from a growth market gone sour. No, this has the potential to become a full blown macro catastrophe in which the Swedish Riksbank will be faced with the rather odd dilemma of having to bail out a domestic bank, in part, in order to allow the relatively benigh unwinding of macroeconomic imbalances in the Baltics.

It is extremely important in this regard to be aware of the narrative that Swedbank and the rest of the short term credit providers effectively are the only ones keeping the boat afloat. The logic, as brilliantly detailed by John Hempton here, goes as follows. The credit needed on a flow basis to sustain the Baltics' external deficit is being supplied by foreign banks and mostly through loans denominated in Euros (this last thing being very important). Consequently, this presents Swedbank et al. with a rather delicate problem. For the Baltic currencies (or one of them) not to devalue they need funding and more importantly, they need funding on their way down into whatever abyss that may now have opened. Now, as my colleague Edward pointed out in another context it is not the most pleasant of dilemmas to be confronted with the choice of having your throat slit with the stanley knife or the chainsaw. However, this may the situation which now confronts Swedbank, the Baltics, as well as potentially the Swedish Riksbank in the current situation which increasingly resembles some of Kafka's best creations. Hempton makes it very clear when he says;

If the Lati doesn't devalue its only because people (i.e. Swedbank) are prepared to continue to fund it. This is not pretty at all. All in Hansa owes Swedbank over 30 billion Swedish Kroner – all denominated in Euro and which can't be paid. The equity capital of Hansa (roughly 7 billion Swedish Kroner) is also going to default.

The juicy point here is of course the presence of massive translation risk which would arise as the liabilities (denominated in Euros) multiplied in value relative to the asset side.[2] More importantly, this would not only potentially crash Swedbank but also potentially the Baltic economies, and this is something we should attempt to avoid.

However, it is not easy to see where to go from here. One fascinating correlation between micro and macro data is epitomized in the graphs below which shows the evolution in the total stock of loans broken up on currency denomination.

First of all, it is very interesting to peruse the graphs shown above in connection with the graphs plotting cross currency and overall leverage (Latvia data only for households). In my opinion these graphs, taken together, resemble the epitomy of the kind of risk the Baltics face. As such, it is not only a case of devleveraging which, given the multiples, would be bad enough; it is also about the crisis that would emerge if the pegs were abandoned to restore competitivness. However, whether to keep the pegs or not may not be entirely up the Baltic economies themselves. Rather we can easily imagine a situation in which the decision of whether to keep the pegs would reside within the halls of a Swedish bank and perhaps even ultimately the Swedish Riksbank.

How does this compute then?

One way to approach the answer is to look at the total evolution of loan stocks (accounted on a flow basis. One striking feature is that the growth of loans denominated in Euros continue to markedly outpace loans denominated in local currency. This is a well known story in the Baltics and one which I have discussed several times [3], but the key point here is that as the economic edifice now visibly crumbles credit flows continue to enter the Baltic economies. Given the rapid deteriration of the real economy this seems rather contradictorary. However, it is is not, and it essentially means two things.

First of all, it means that whoever is doing the credit service increasingly is throwing good (and presumably scare) money after bad money. From a standard profit maximizing point of view this would seem and odd behavior unless of course there is more to the story than meets the eye. This brings us to the second point and was detailed above in the context of Swedbank et al. and their exposure in foreign currency (with receivables in domestic currency). Ultimately, the situation in the Baltics surrounding the pegs is beginning to resemble more and more like the attempt to cling on to something which is becoming more and more unsustainable by the day. Obviously, the foreign banks could stick it out, but the question is whether they can afford it.

In fact, I believe the only scenario which we, with certainty, can say will not continue is the current one in which lending is expanded on a linerging basis. As such, we need de-leveraging and we are going to get it one way or the other. The only question is whether it will be through Swedbank et al. closing the tap or through a move by Baltic authorities to loosen the peg (in which case Swedbank would be in grave trouble). The alternative would of course be a significant bout of internal deflation which we, with the incoming wage cost data, may already be seeing. The problem with this process though is that it takes time at the same time as it is politically unacceptable. I would seriously question in this regard the usefulness of continuing to look toward the future for potential Euro membership. At some point it should dawn on market participants and politicians alike that this is very unlikely to materialize.

Finally, we may ask the question of whether it is enough? I don't think so and while it still may end up being part of the correction I think that the extent to which these economies need to shore up their competiveness will also include a tweak of the currency peg [4].

Where do We Go From Here?

At the current juncture in financial market the answer to such a question is bound to riddled with uncertainty. In Lithuania, the people just elected a new parliament and while people may be more worried about the immediate need to secure stable gas deliveries from Russia and winter approaches, it is difficult to see how the attention on the crisis can anything but increase as we move forward. In this respect, and as an aside, Lithuania does seem to somewhat different from its northern bretheren in that the leverage ratios and debt multiples are not as high as in neither Estonia nor Latvia. Obviously, this may ultimately come down to comparing one ugly duckling with a slightly less ugly duckling.

As regards Latvia, Alf Vanags and Morten Hansen recently published a detailed analysis on the future path of the Latvian economy faced with the incoming financial crisis and potential global recession. Their conclusion is rather dire with respect to the potential loss of output between and now and 2010. As the authors make painfully clear, this fact obviously brings into the question the whole idea of convergence towards the illusive EU15 living standards not to speak of the convergence towards their own steady state which we really don't anything about at this point.

I would tend to apply the same analysis to Estonia even if Estonia seems to benefit from a stronger external environment and in particular with the economy's strong affiliation with the Finnish economy.

Ultimately however the immediate challenge for the Baltics at this point in time is damage control and more specifically how to wrigle themselves out of the current vice of dependence on credit inflows at the same time as the economy needs to restore competiveness. So far, the show goes on with Swedbank in particular continuing to supply the credit. However, if the recession rolls in, in a manner predicted by most analysts the ensuing squeeze of consumers may make it difficult for Swedbank not to sustain massive losses, not to mention what would happen with the peg and households and companies' liabilities.

The end point of all this clearly appears to envision a fiscal response; at least as a part of the solution. What is critical for the Baltics at this point is consequently that the currenct economic downturn is managed in such a way to minimize the risk of a collapse of the financial system as foreign banks shut down operations. Whether this entails the maintaining of the Euro peg is a difficult question to answer. One thing is pretty certain however and this is that the kind of wage and price deflation needed to correct the imbalance would be a disaster for any political leadership.

Of the three economies Latvia clearly seems to be the most vulnerable to a rout, and given the proximity of the economies sudden unexpected events in one country could easily spread to the others. Here is to hoping that it does not come to that.


[1] - Sometimes things actually fit together.

[2] - Here the asset side would be both deposits as well as future cash flows which would be in domestic currency (for households). For Swedbank itself, main point Hempton highlights is simply the fact that Hansabank would become an immensely heavy ball and chain since the whole thing would have to be written down with the devaluation itself.

[3] - See for example Christoph Rosenberg's brilliant piece on drivers of FX loans in Eastern Europe. As per reference to my own analysis (limited to Lithuania though) Rosenberg finds that lower interest rates on Euro loans as well as the fact that these economies effectively has outsourced the developmentment of their financial system to foreign banks are strong explanatory factors.

[4] - One thing which could provide relief here would be a slump of the Euro which would allow the CEE economies to restore competitiveness at the same time as maintaining the peg to the Euro. However, I think this is rather unlikely because it would imply a level of the Euro which would be in accordance with either the US' need to correct nor the ECB's inflation focus.

Monday, October 13, 2008

Latvian Exports Continue To Slow In August

The total turnover in Latvian foreign trade at current prices was 952.0 mln lats in August 2008 – down 60.4 mln lats or 6.0% over July and down 59.6 mln lats or 5.9% than in August last year, according to Central Statistical Bureau data. The reduction is largely the result of falling imports, although the rate of increase in exports steadily reduces.

Exports were down month on month by 1.9% and year on year they were up by 4.1%, but these are current, non inflation corrected prices. Imports were down 8.3% on the month and 11.1% on the year.

Latvia's monthly foreign trade deficit stood at 226.2 million Lats in August, down from the 272.6 million Lats registered in July, although the change here is really the product of the substantial decline in imports which is taking place as a result of the recession.

Month on month the most rapid decrease at current prices was in exports of inorganic chemical products – by 92.6%, of wheat and meslin – by 53.3%, of pharmaceutical products – by 23.1%, of perfumery and cosmetics – by 16.3%, machinery and mechanical appliances – by 8.0%, of sawn wood – by 7.0%, but there was an increase in exports of articles of apparel and accessories knitted or crocheted – by 25.0%, of prepared or preserved fish, crustaceans, molluscs – by 21.1%, of iron and non-alloy steel – by 20.0%, of articles of iron or steel – by 12.7%.

Compared to August 2007, the most notable increase was in exports of wheat and meslin (exported to Morocco, Norway and Estonia) – up by 320% times, of iron and non-alloy steel – by 69.3%, of articles of iron or steel – by 32.7%, of electrical machinery and equipment – by 8.7%, but the exports of wood in the rough decreased by 43.4%, of sawn wood – by 43.2%, of semi-manufactures and articles of plastics, scrap – by 6.7%, of articles of apparel, not knitted or crocheted - by 3.5%.

Saturday, October 4, 2008

Latvian Credit Downgraded As Retail Sales Continue Their Decline

As reported in this post, on Friday Fitch Rating Service announced they were cutting long-term sovereign ratings for Estonia, Latvia and Lithuania, citing worsening financial conditions in Europe. Latvia's long-term foreign-currency Issuer Default Rating was cut to BBB from BBB+. The outlooks were kept negative.

The move by Fitch follows an earlier decision by Moody's Investors Service to lower its Latvia outlook to negative. The outlook change affects Latvia's A2 foreign currency and local currency debt rating. The outlook on the Aa1 country ceiling for foreign currency bonds was kept at stable. Moody's A2 rating is five levels above investment grade. Kenneth Orchard, senior analyst at Moody's wrote in the statement: "Although it is not Moody's central scenario, Latvia's economy is vulnerable to a sharp reduction in foreign capital inflows.''

Latvia has low levels of government debt and no foreign bonds maturing for over five years, so there is little serious danger to Latvia's public sector funding. On the other hand Latvian interest rates to households and companies are expected to rise and the number of non-performing loans to grow as a by-product of the ratings changes and the global financial market turmoil which lead to them.

``Credit is becoming more difficult to access, and if you can access it, it will be in smaller sums and at a higher interest rate,'' Janis Brazovskis, vice-chairman of the Latvian Financial and Capital Market Commission, speaking in an interview on Latvijas Neatkariga Televizija's program 900 Seconds.

According to Brazovkis, interest rates will rise by between 0.5 and 2 percentage points for Latvian borrowers. Overdue loan payments may rise to 2 percent of total credits from the current 0.7 percent. Brazovkis stressed that Latvia's exposure to the U.S. financial system was "extremely minimal,'' and that Latvian lenders did not invest in "toxic financial instruments,''. This is undoubtedly true, but on the other hand I have never actually seen anyone suggest that Latvia's problems were a by-product of poor quality investments made in the US - in other words this would simply seem to be yet another one of those famous "red herrings". Latvian lenders also did not buy toxic instruments, since they were effectively selling them - to eg Swedish investors. Latvia, like the US, the UK and Spain, has a current account deficit, and it is the current account deficit countries who were effectively issuing the toxic instruments to finance their external borrowing at rates which were below the real level of the risk being assumed. If lending practices in Latvia were not lax (which is the normal argument directed towards the United States), then I simply do not understand the chart below - which shows bank lending going off a cliff once documentation and lending rules we tightened up in the spring of 2007.

So the problem is, it seems to me, that the people who bought instruments issued by the Latvian banking system (or who created instruments elsewhere to then inject funds into Latvian banks) are the ones who have the problems, and they are unlikely to be so forthcoming in the future, which is why credit will remain tight in Latvia (about this Brazovkis is undoubtedly right) and interest rates may well rise. Which is just one more reason why we should not expect any imminent revival in Latvia's flagging retail sales (see below) - and by imminent I do mean over the next few years. This recession is in for the long haul.

Retail Sales Continue To Decline

Month on month seasonally adjusted retail sales (at constant prices) were down by 1.2% In August. Compared to August 2007, and according to working-day adjusted data, at constant prices, total retail sales decreased by 8.9%.

The largest volume decreases were in food products – down by 10.3%.