Estonia's Recession Deepens As Latvian Finances Struggle To Find Air

Estonia's economy shrank again in the third quarter - by an annual 3.3 percent, thus clocking up the second-worst performance (after Latvia) in the 27 nation European Union, and offering us plenty of signs that the country's worst economic recession since 1994 is set to deepen. The contraction fulfils the basic technical criterion of recession since it follows a 1.1 percent fall in the second quarter according to data released by the statistics office yesterday (Thursday).




With the global market crisis and credit crunch weighing on the world's leading economies, and especially with Germany - the eurozone's largest economy and principal economic powerhouse itself entering recession, the prospects for any export driven recovery have definitely now faded off into the distance. Estonia and Latvia now lead the Eastern European slowdown, following repeated warnings over the past year of about the risks of an economic "hard landing'', warnings which were not unfortunately headed due to hopes that the eurozone itself would hold out against the US downturn (the United States is still not technically in recession) and that Scandinavian Banks would have little trouble funding growing forex debts (these banks are themselves now seeking support from the Swedish government). As I said, Estonia's economy is contracting the second fastest, since Latvia's economy shrank 4.2 percent in the third quarter, and currently has the worst growth rate in the EU.

``The effect of the financial crisis on the real economies of our main trading partners remained modest in the third quarter but will definitely increase,'' according to Martin Lindpere, an economist at the Estonian central bank. ``External demand is therefore expected to weaken in the coming quarters, and unfortunately, the contraction of the Estonian economy will accelerate.''

The central bank forecast suggests the Estonian economy may shrink between 1.8 percent and 2.7 percent this year, and between 2.1 percent and 4.5 percent next year. Really there is a high degree of uncertainty attached to next years forecast, since nobody is really sure at this point how bad things can get, either inside or outside the Baltics (Russia's economy is unwinding fast even as I write), or when exactly recovery will commence.

Quarter on quarter the economy contracted by 1%, following a revised 1.1% contraction in the second quarter.

All the signs are that the contraction may even accelerate in the fourth quarter. Estonian industrial output, which dropped 3.8 percent in September, has fallen in six of the seven months up to September, and looks almost certain to contract further in October-December . Likewise retail sales which have also been down for six of the past seven reported months.

More Trouble On The Way As The Currency Pegs Come Under Pressure


Lithuania, Latvia and Estonia mayall need to devalue their currencies over the next year as they seek to stave off a recession, according to a recent report from Bank of America Corp. With inflation still running at around three times the average rate across the 15-nation euro region and a slump in domestic demand that looks like it will be very hard to turn around amid the need to export may leave the Baltic states with little alternative but to abandon their currency pegs in the second half, on the view of David Hauner, a Bank of America strategist based in London.

``They will keep the pegs at the current exchange rates well into 2009, but reset the rates to devalue against the euro later, when markets have calmed,'' b Hauner said.

The Lithuanian litas and Estonian kroon have been little changed over the past three months based on their currency board systems that peg them to the euro at fixed rates. The Latvian lat is allowed to rise or fall 1 percent from a midpoint to the euro. The countries also participate in the European Union's exchange-rate mechanism, under which central banks must keep currencies within a 15 percent trading band against the euro.

Andres Sutt, deputy governor of the Estonian central bank, said the kroon's peg
to the euro will remain unchanged and that a devaluation would ``lack any
economic rationale.''

"The competitiveness of Estonian exporters has remained good; wage growth, inflation and loan growth have declined very rapidly, as has the current account deficit, lowering Estonia's dependence on external financing,'' Sutt said "The finances of banks operating here are also strong. All this characterizes the flexibility of the Estonian economy and its ability to adjust.''

In fact Estonia and Latvia continue to run a goods trade deficit, making it impossible to drive headline GDP growth from exports. Latvia's central bank Governor Ilmars Rimsevics also said ecently that "devaluation is an absolutely unrealistic scenario,'' while the Lithuanian central bank Governor Reinoldijus Sarkinas was cited by the Baltic News Service on August 19 as saying that the exchange-rate system "shouldn't change at all.''

Nonetheless the economic rationale for devaluation becomes more compelling by the day, as the Baltic countries if they are one day to enter the euro will need to do so at a much lower partity than the current one to be able to get growth in the longer term.

There are obviously two principal drawbacks to devaluation against the euro, the first of these is that foreign exchange debts will suddenly rise, and this is why the Baltic countries will undoubtedly need EU aid in sorting out the mess. Secondly there will be a delay in euro membership. Countries aiming to adopt the euro must spend at least two years in the Exchange Rate Mechanism, or ERM-2, to demonstrate the stability of their currency. Lithuania and Estonia began participating in the system in 2004, the same year they entered the European Union. Latvia joined a year later. If the Baltic countries devalue then the clock will need to be reset, but then again, eurozone entry with the economies in an economic slump (rather than a mere recession) does not seem to be an attractive proposition either. These economies will need time to get things straight again, so the delay in euro entry does not seem to be an inordinately large obstacle, in and of itself.

Lithuania's ambition to be among the first countries in eastern Europe to adopt the common currency was thwarted in May 2006 as inflation accelerated. Estonia and Latvia were also forced to delay the changeover, and of course it has been this whole process of delay that put the spanner in the works and has lead to the whole boom bust cycle taking the form it has, as euro membership ebbed off into the distance.

``If your real exchange rate is overvalued, there are two options: either devalue, or accept a recession to make inflation fall relative to the trading partners,'' Hauner said. ``So the Baltics have the choice between a deep
recession or postponing euro-zone accession. I think they will choose the latter.''

EU Readying-Up Aid


The Baltic States now have some hard decisions to take, but the EU and the IMF are there ready to support. The European Commission hopes to come to a decision on providing financial support for Latvia "fairly soon", according to European Commission spokesman Jonathan Todd.

``We've been in close touch with the Latvian authorities for the past week and those contacts are continuing. We hope to be able to adopt a decision fairly soon,'' Todd told journalists at a Brussels press conference today.

Latvian authorities also themselves reported on Wednesday that they were in talks with the European Commission about possible financial assistance following the decision to take over Parex Banka AS, Latvia's second-biggest bank, as liquidity tightened and depositors withdrew funds. Following the nationalisation Latvia added about 200 million lati ($357.8 million) in liquidity to Parex to shore up its finances.

``We don't need the money now,'' said Edgars Vaikulis, a spokesman for Prime Minister Ivars Godmanis, yesterday. ``We are just in consultations,'' he said. Turning to the International Monetary Fund for support in the future was also a possibility, he said.

Latvia's 26 banks lost about 461 million lati, or about 4.6 percent of their total deposits, during October, according to a statement from Latvia's Financial and Capital Markets Commission. Latvia would prefer to turn to the commission and not the IMF, according to Karlis Leiskalns, head of the Latvian Parliament's budget and financial committee, speaking on Latvijas Radio this week.

``I can't say that Latvia won't go to the IMF for help,'' he said. ``The IMF will come with conditions, and one of the basic conditions will be to cut the social budget. I'm completely against taking from the IMF, unless the state becomes bankrupt.''

More Credit Agency Downgrades In The Works

Moody's Investors Service have announced that they may cut their ratings on Latvijas Krajbanka AS and Norvik Banka, citing concerns about the Latvian lenders' asset quality due to the worsening recession in the Baltic country. Moody's have assigned a negative outlook to both banks' D- bank financial strength ratings and Krajbanka's Ba2 long-term deposit rating and Norvik Banka's Ba3 long-term deposit ratings.

``The economic downturn, which is already under way, is now likely to be more acute than previously anticipated and thus have a negative impact'' on both banks' asset quality ``in the near future,'' Moody's said.

Earlier in the week Fitch cut Latvian debt to the lowest investment- grade rating of BBB- and signaled it may reduce again to the category of high-risk, high-yield or junk.

``In the absence of substantial and timely international financial support, Latvia faces the likelihood of a severe financial and economic crisis and a further downgrade of its ratings,'' Eral Yilmaz, associate director for Fitch's sovereigns group in London, said in a statement.

Update Wednesday 19th November

The Latvian central bank bought 189.8 million lati ($338 million) in the domestic foreign exchange market last week to support the national currency after it weakened to the limit of its trading band, according to the latest statement from the central bank. The lats fell to 0.7098 against the euro for the seventh consecutive week, prompting the bank to buy it. The currency is allowed to rise or fall 1 percent from a midpoint to the euro. The central bank has now bought 483.1 million lati over the last seven weeks. It had foreign currency reserves of about $5.4 billion at the end of October, which means that at the present rate of attrition there are enough foreign exchange reserves to hold out for about eight months, though obviously an EU/IMF bailout will cover this end of the problem, the question is why, given Latvia's need to export, you would want to defend the present exchange rate if you are having to enter an IMF programme in any event.