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Tuesday, February 24, 2009

Latvia Downgraded To "Junk" By S&P

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Five-year credit default swaps (CDS) for Latvia were quoted at a mid-price of 977.4 basis points, according to CMA DataVision, up from their Monday close of 943.7 bps. Five-year CDS for Lithuania hit a record high of 861.7 bps after the S&P move, compared with Monday's 831 bps. For Estonia, five-year CDS rose to 733 from 730.7 bps.
Below is a chart for Latvia's 10-year Eurobond (quoted yield to maturity) maturing on 5 March 2018, it is now trading some 700 bps in the mid (755 in the bid) over the closest (by maturity) German bund. Apart from noting today's market reaction it is possible to see how the spread, after settling down following the IMF-lead deal, has now opened right up again to the level of the previous October highs.

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

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

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

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

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

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

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

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

Fitch Worried By The Impact Of Political Turmoil On The IMF Loan

Fitch Ratings warned this morning that the collapse of Latvia’s government at the end of last week materially increases risks to the IMF-lead bailout plan since the agreed budget cuts may now be delayed.

“Fitch believed that a failure to maintain budget controls could delay the disbursement of international funds to Latvia, and lead to renewed pressure on Latvia’s currency,”.

The government collapse comes at a very delicate time, since an IMF mission is currently visiting, and growth (or should I say contraction) forecasts now suugest the contraction will be deeper than anticipated which will evidently mean further budget cuts. Latvia’s Finance and Economy ministries now estimate that the economy will contract 12 percent this year, revised from an earlier projection for a 5 percent reduction in gross domestic product. Latvia agreed to keep its budget deficit at 5 percent of GDP as part of its 7.5 billion euro bailout deal.

“A protracted delay in forming a new government or new elections could, however, delay the implementation of austerity measures and make it harder to keep the budget in line with objectives,” Fitch said in the statement. “This, in turn, could affect the disbursement of loans from the IMF and others.”

Fitch currently rates Latvian debt at BBB-, one level above junk, and “believes a failure of the IMF program would increase pressure on the domestic banking system and the currency peg, putting negative pressure on the country’s rating.”

“The extent of the recession and economic pain from the austerity measures being felt by the country increase the risk of a popular backlash and could thwart the sustained implementation of the IMF program,” Fitch said.

Sunday, February 22, 2009

Let The East Into The Eurozone Now!

“It’s 20 years after Europe was united in 1989 – what a tragedy if you allow Europe to split again.”
Robert Zoellick, World Bank president, in an interview with the Financial Times

(Click On Image To View Video)

World Bank president, Robert Zoellick, made a call this week - in an interview with the Financial Times - for a European Union-led and co-ordinated global support programme for the economies of Central and Eastern Europe. I agree wholeheartedly, and even if I have, reluctantly, to accept the point made last week by our Economy & Finance Commissioner Joaquin Almunia that our pockets, though deep, are certainly not bottomless (and thus it is probably beyond our means right now to rescue the non-EU Eastern states), I still feel we should make good on our responsibilities to those who are EU members, and to do so by opening the doors of the Eurozone to those who wish to join. Since this proposal is fairly radical, the justification that follows will be lengthy.

This is not a view I have arrived at lightly, but looking at the extent of the problem we now have before us, a problem which is growing by the day, and taking into account the fact that the origins of the economic crisis in the East must surely rest (at least in part) in the decision to make euro participation a condition for EU membership for these countries (a possibility which was subsequently withdrawn in the critical moment, when the going started to turn rough), and then assessing the risk to the Western European banking system which would be posed by simply sitting back and watching it all happen, I think this move is not only the least damaging of the policies we can now follow, it is the in effect the only viable path left to us if we are to keep the eurozone as an integral entity together.

If this proposal were accepted a new set of membership criteria would need to be drawn up, of course, but the underlying principle would have to be one of offering the certainty of entry as guaranteed forthwith, for those who chose to accept. Rules were made to be broken, and nothing should be so inflexible - not even the Maastricht eurozone membership criteria - that it cannot be ammended as circumstances dictate. And at this point even the undertaking that this - like the long awaited US Stimulus programme - was on the table, would be sufficient to provide immediate, and much needed relief. Flirting with doing nothing here is, in my opinion, flirting with disaster, both in the East and in the West.

Existing Maastricht Criteria

Convergence criteria (also known as the Maastricht criteria) are the criteria for European Union member states to enter the third stage of European Economic and Monetary Union (EMU) and adopt the euro. The four main criteria are based on Article 121(1) of the European Community Treaty. Those member countries who are to adopt the euro need to meet certain criteria.

1. Inflation rate: No more than 1.5 percentage points higher than the three lowest inflation member states of the EU.

2. Government finance:

Annual government deficit: The ratio of the annual government deficit to gross domestic product (GDP) must not exceed 3% at the end of the preceding fiscal year. If not, it is at least required to reach a level close to 3%. Only exceptional and temporary excesses would be granted for exceptional cases.

Government debt: The ratio of gross government debt to GDP must not exceed 60% at the end of the preceding fiscal year. Even if the target cannot be achieved due to the specific conditions, the ratio must have sufficiently diminished and must be approaching the reference value at a satisfactory pace.

3. Exchange rate: Applicant countries should have joined the exchange-rate mechanism (ERM II) under the European Monetary System (EMS) for 2 consecutive years and should not have devaluated its currency during the period.

4. Long-term interest rates: The nominal long-term interest rate must not be more than two percentage points higher than in the three lowest inflation member states.

The Dimensions Of The Problem

European governments, the European Union and international financial organizations need to act fast on risks stemming form banks’ exposure in the eastern part of the continent to avert an escalation of the credit crisis, Nomura Holdings Inc. said. East European countries are struggling to refinance foreign- currency loans taken out by borrowers during years of prosperity through 2007, when economic growth averaged at more than 5 percent. The International Monetary Fund, which has bailed out Latvia, Hungary, Serbia, Ukraine and Belarus, warned on Jan. 28 that bank losses may widen as “shocks are transmitted between mature and emerging market banking systems.” “Swift action is needed to restore confidence and prevent trouble” to financial and economic stability in the euro region and emerging Europe, said Peter Attard Montalto, an emerging markets economist at Nomura International in London. “Any move should be quick. The situation has begun to decline more rapidly since the end of last year and there is risk that any action may come too late.”

Robert Zoellick is far from being a lone voice in the wilderness about the current level of risk to the coutries in the East, and indeed precisely those EU banks who have been most active in emerging Europe are now busily trying to convince EU regulators, the European Central Bank and Brussels itself to coordinate new measures to counter the impact of the financial crisis confronting the region. The problem in the East certainly now adds a new dimesion to the problems facing us here in Europe, since West European governments are now being simultaneously hit on a number of fronts, and the situation is become more complicated by the day.

In the first place most West European economies are now either in or near recession, and their domestic banking systems are, to either a greater or a lesser extent, struggling. The West European states are thus, by and large, already feeling stress on their own sovereign borrowing capacities. But, with greater or lesser effectiveness, these countries are still able to increase their debt, even if sometimes the surge in borrowing is very dramatic, as in the case of Ireland, which will see gross debt/GDP shooting up from 24.8% in 2007 to a projected 68.2% in 2010 (EU January 2009 Forecast).

The situation in Eastern Europe is very different, and their economies and credit ratings evidently can't support such dramatic increases in their debt levels. Thus, in the case of those countries with a significant home banking presence, like Latvia's Parex, or Hungary's OTP, the support of external organisations (the IMF, the World Bank, the EU) becomes rapidly necessary when the bank concerned starts to have liquidity problems. But as a result of the consequent bailout the debt to GDP ratio starts to rise in a way which then places even subsequent eurozone membership in jeopardy. Latvia's Debt/GDP is, for example set to rise from around 12% of GDP in 2007 to over 55% in 2010. With a 10% plus GDP contraction already in the works for 2009, it is clear that Latvia's debt to GDP will rise beyond the critical 60% level. Hungary's debt/GDP is already above, and rising. If we don't do something soon, these two countries at least are being launched off towards sovereign default.

But the other half of this particular and peculiar coin turns up again in a rather unexpected way, and that is in the form of those West European banks who have subsidiaries in CEE countries, and who find now themselves faced, not with bailouts, but with ever rising default rates. This difficulty evidently and inevitably then works its way back upstream to the parent bank, and to the home state national debt, as the bank almost inevitably needs to seek support from one West European government, or another (in fact Unicredit, which has difficulty getting money from an already cash-strapped Italian government is talking of applying for support from the Austrian government via its Austrian subsidiary).

Austria is, in fact, a very good case in point here, since, as Finance Minister Josef Proell recently indicated, the country had some 230 billion euros of debt outstanding in Eastern Europe, equivalent to around 70 percent of Austria's GDP. The Austrian daily "Der Standard" have also reported the analysts view that a failure rate of 10 percent in Eastern Europe's debt repayments could lead to serious difficulties for Austria's financial sector. And this is no hypothetical "what if" type problem since the European Bank for Reconstruction and Development (EBRD) has estimated Eastern Europe's bad debts could go over 10 percent and could even reach 20 percent in the course of the current crisis. Underlining the mounting concern in Austria, Proell tried last week to convince EU finance ministers to provide 150 billion euros is support to CEE economies as a first step in trying to contain the growing wave of defaults.

The total quantity of debt outstanding is hard to put a precise number on, but the Bank for International Settlements estimated that, as of last September, more than $1.25 trillion had been leant by eurozone banks, and if you add in U.K., Swedish and Swiss bank liabilities the number rises to $1.45 trillion.

Western Europeean banks have a very important market share in the East, ranging from a low of 65 percent in Poland to almost 100 percent in the Czech Republic. This basically means two things, that the region's businesses and consumers are extraordinarily dependent on uninterrupted capital inflows from the West, and that some West European banking systems are extremely sensitive to rising default rates in the East. Of course the problem goes beyond the EU's borders, and while EU bank market shares in the Community of Independent States is rather less significant than in the EU12, due to the still substantial domestic ownership which exists there, exposure to defaults is not unimportant, especially in Ukraine, Kazakhstan and, of course, in Russia itself. Further, there is South East Europe to think about, and countries like Serbia and Croatia.

Large Banks Take The Initiative

Getting near to desperation, some of the largest banks involved - Italy's UniCredit and Banca Intesa, Austria's Raiffeisen International and Erste Group Bank, France's Societe Generale and Belgium's KBC - have launched a common initiative to try to lobby for an EU wide solution to the problem.

UniCredit is the largest lender in Poland and Bulgaria, while Erste is number one in Romania, Slovakia and the Czech Republic, with KBC occupying the position in Hungary, Intesa in Serbia, and Raiffeisen in Russia and Ukraine. Hungary's OTP Bank, emerging Europe's number 5 lender and the largest one in its home country, does not formally belong to the group. On the other hand OTP is actively looking for support.

OTP Bank Nyrt., Hungary’s biggest bank, said it’s in talks over a “role” for the European Bank for Reconstruction and Development, as it announced a 97 percent drop in fourth-quarter profit and “substantial” job cuts. As well as a possible EBRD involvement, OTP may also seek funds from Hungary’s emergency loan package from the International Monetary Fund, the European Union and the World Bank to “better serve the economy,” Chairman and Chief Executive Officer Sandor Csanyi said at a press conference in Budapest today. “There’s a chance the EBRD will assume a role in OTP, but I must stress that we plan no issue of new shares,” he said. OTP “doesn’t need to be saved,” Csanyi added.
Chancellor Angela Merkel, while expressing support for the bank initiative, has stopped short of offering concrete assistance or suggesting measures beyond those which are already in place.

The president of the European Bank for Reconstruction and Development, Thomas Mirow, wrote in the Financial Times this week the bank proposals "deserve full support as a worsening crisis in emerging Europe will threaten Europe as a whole".

The Austrian government has already announced it is trying to raise support for a general European Union initiative to rescue the region’s banking system. The government has set aside 100 billion euros in cash and guarantees to stabilise its banking sector. Next in line in terms of exposure are Italy ($232 billion), Germany ($230 billion) and France ($175 billion).

Unicredit is publicly rather dismissive of the problem (as can be seen from the slide below which from a presentation they gave earlier this week, please click on image to see better), but Italian investors are far from convinced by their arguments, as witnessed by the fact that their stock has plunged 41 percent this year, and by the fact that they were forced to sell 2.98 billion euros in 50 year bonds this week to shore up their Tier I capital after investors only bought about 4.6 million shares, or 0.48 percent, from their most recent rights offer. UniCredit, which said last month it is considering asking for government assistance, has also been disposing of assets to raise money and it plans to pay shareholders their dividends in yet more shares. Nationalisation of banks to supply credit lines to the private sector is one hypothesis currently being studied by Silvio Berlusconi, according to a Financial Times report this morning.

(Click on image for better viewing)
The Austrian proposal includes funds from the European Investment Bank, the European Central Bank and the EU Cohesion Fund. The Austrian government has offered money of its own and has been urging Germany, France, Italy and Belgium as well as the EU itself to contribute. One feature, however, stands out in all of the proposals which have so far been advanced: they are loan based-support. What Soros calls the "tricky question" of fiscal allocation from Europe's richer member states has not so far been raised, but it will be, since it will have to be.

And of course, Austria's concern is far from being altruistic, as Austria's economy and sovereign debt stability depend on finding a solution. It is hardly surprising to learn that credit-default swaps linked to Austrian government debt soared this week - by 39 basis points to a record 225 - on concern the country will need to bail out the domestic banks itself as they report losses and writedowns linked to eastern European investments. Erste, which said last week that full-year profit probably slumped by almost 26 percent, is in talks with the government to get 2.7 billion euros ($3.4 billion) in state aid. RZB has asked for 1.75 billion euros.

The European Central Bank on the other hand, seems reluctant to extend emergency financial help to crisis-hit countries beyond the 16-country eurozone. The ECB did not have “a mandate to be a regional United Nations agency”, Yves Mersch, governor of Luxembourg’s central bank, recently told the Financial Times. Such comments reveal the level of resistance which exists within the ECB’s 22-strong governing council to the idea of offering financial support to countries outside the zone.

The ECB has so far offered loans to Hungary and Poland, but has attached what some consider to be excessively strong conditions on facilities allowing them to borrow up to 5billion and 10billion euros respectively. Mr Mersch, whose views are thought to be widely shared in the ECB, suggested the central bank was worried about setting precedents if it relaxed its stance on helping individual countries. While some euromembers might favour assisting nearby nations, “we must not forget that other people might be sensitive to different countries”.

Who Bails Out The West European Banks In The East?

Governments and EU officials are struggling to formulate a coherent response to the economic and financial turmoil that has started to engulf the eastern part of the old continent. EurActiv presents a round-up of national situations with contributions from its network. Leaders of EU countries from central and eastern Europe will meet on 1 March ahead of an extraordinary summit on the same day with the bloc's other members, it emerged on Thursday (19 January). Polish Prime Minister Donald Tusk has invited his counterparts from the Czech Republic, Slovakia, Slovenia, Romania, Bulgaria, Lithuania, Latvia and Estonia for the talks to ensure the 27-nation meeting on the financial crisis is not dominated by the interests of Western member states. See full Euractiv article on background.

The EU has so far provided emergency balance-of-payments assistance to two of the East European member states in difficulty - Hungary and Latvia, and EU ministers did agree in December to more than double the funding available for such emergency lending to 25 billion euros ( so far Hungary has been allocated 6.5 billion and Latvia 3.1 billion). It is also quite probable that such lending will now have to be extended to the two newest southeast European members, Romania and Bulgaria, since their ballooning current account deficits and dramatic credit crunches mean that they are steadily getting into more and more difficulty.

The core of the problem is that the East European economies enjoyed strong credit driven booms, which fuelled higher than desireable inflation and lead to strong foreign exchange loan borrowing which simply bloated current account deficits. Now capital flows into emerging Europe have dried up as the global financial crisis has raised investors' risk aversion and prompted them to dump emerging market assets, leaving foreign-owned banks as the only source of loans for companies and consumers.

Italy's UniCredit, the biggest lender in emerging Europe, warned at the end of January that there was a clear risk of the global credit crunch gripping the region. UniCredit board member Erich Hampel stated at a Euromoney conference in Vienna that the bank was committed to fund its subsidiaries in the CEE countries and would continue to lend, but at the same time made absolutely clear that in order to do this his bank would need government support, whether from Austria, or Poland, or Italy itself.

Hampel said Bank Austria would decide during the first quarter whether to tap the Austrian government's banking stability package for fresh equity. " he said. "Our budget is under discussion now and clearly assumes growth in lending and in funding to the East. "

And according to a report from the Austrian central bank the fact that a relatively small number of Western European groups - including three Austrian ones - own most of the banks in Central and Eastern Europe means that there is the risk of a "domino effect", implying the crisis would spread quickly from one country to another. "How capital flows into (emerging Europe) will develop depends on the financial strength of the parent groups and of the sister banks, and on whether the parents are willing and able to fund their subsidiaries," the bank's half-yearly Financial Stability Report said. "The risks to refinancing are increased by the danger of a domino effect, because a large part of the foreign capital in many countries comes from a relatively small number of Western European banks," .

"What we see is that the emerging European economies have lost all sources of funding but banking," said Deborah Revoltella, chief economist for central and eastern Europe of UniCredit, the region's biggest lender. The task to carry whole economies through a downturn comes at a time when parent banks already face a double challenge: a likely sharp rise in loan defaults at their eastern subsidiaries and more difficult and expensive refinancing for themselves. "The international banks cannot solve this situation," Revoltella said. "They can do their part, and it's fundamental that they do their part but we have to take care of the other sources of funding which are missing now."
And it isn't only Austria who is worried, since Greek central bank governor George Provopoulos warned Greek banks only last Tuesday against transferring funds from the country's bank package to the Balkans, where they have invested heavily.

Regional Risks

In our view GDP growth is like to be negative in all CEE countries this year. In those countries “least” affected by the crisis (i.e. Poland, the Czech Republic, Slovakia and Slovenia) GDP is like to drop at least 2-5%, while those countries worst affected (i.e. the Baltic States, Bulgaria, Romania and Ukraine) are likely to face double digit declines in GDP. In other words, in terms of expected output lost in the region this is as bad as or even worse than the Asian crisis of 1997-98.
Danskebank - CEE: This Looks Like Meltdown

The problem that the EU has in adressing the situation in the Eastern member states is that what we have on our hands is not only a banking crisis, there is also a strong credit crunch at work, one which is now having a severe impact on the real economies in the region. Most of the economies in the region are already in recession, and those that are not soon will be (I have intersperced a number of relevant graphs throughout this post which should give some general impression of what is happening). Thus these countries are all taking multiple hits at one and the same time.

1/ In the first place they have an economic contraction on their hands, in some cases becuase they are struggling with a steep decline of export demand from western Europe, in others because their externally financed credit boom has now come to a sharp and painful end.

2/. Most countries in the region have some form of foreign currency exposure, although at present this is largely household and corporate rather than sovereign. In a number of countries -notably Hungary, Romania, Bulgaria and the Baltics this is particularly onerous since most of the mortgages were taken out in euros or Swiss Francs, and the default risk is now rising as their economies either deflate (internal devaluation) or their currencies fall as part of the regional sell-off. The danger is that as the bailouts are implemented at local level this exposure is steadily transferred over to the sovereign level, creating a dangerous dynamic which can endanger future eurozone membership. States which default will be unlikely candidate members.

3/. These countries are also suffering the impact of significant asset writedowns, as those assets bought at very high prices during the boom - some at up to six times their book value - now have to be written down, further weighing on earnings and weakening financial and corporate balance sheets.

4/ Finally there is significant contagion risk. The comparatively small number of foreign lenders involved has lead IMF economists and the credit ratings agencies alike to repeatedly warn of how the risk that a seemingly isolated incident in one country may rapidly spread right across the region.

"I don't think it's an exaggeration to say that the whole banking sector and financial system (in the region) rests on the response of parent banks," said Neil Shearing, economist at Capital Economics. "If they withdraw funding it's not very difficult to see how there would be a very severe financial crisis sweeping across the region, and the whole region en masse would have to go to the IMF," he said.

Governments in the region have already taken what measures they can. Most increased deposit guarantees from 20,000 to 50,000 euros following the EU October Paris meeting. Lithuania went further and upped the limit to 100,000 euros, while Slovakia, Slovenia and Hungary all now offer unlimited protection. But this begs the question, who guarantees the government guarantees in the event they are called on.

So the problem has now become a very delicate one, since the banks want to maintain their presence in the region even while almost every factor imaginable is working against them. The latest such factor is the threat of credit downgrades for their core business in Western Europe, and Moody’s Investors Service warned only this week that some of Europe’s largest banks may be downgraded because of loans to eastern Europe, a warning which sent Italy's UniCredit to its lowest level in the Milan stock market in 12 years.

Moody’s argues there will be “continuous downward rating pressure” in the region as a result of worsening asset quality and western banks’ reliance on short-term funding. UniCredit’s Bank Austria subsidiary earned almost half its pretax profit from eastern Europe in 2007, Raiffeisen International Bank-Holding almost 80 percent and Austria’s Erste Group Bank more than 60 percent, according to Moody’s.

“The most risky parts of the western European banks’ businesses are in eastern Europe and when you decide to cut risks, you cut back on the most risky assets first,” Lars Christensen, an analyst at Danske Bank A/S in Copenhagen, said by telephone today. “This could add further risk in the region as the economies there may face large current account deficits if funding from western European banks is withdrawn.”

As a result last Tuesday we saw a surge in the cost of protecting bank bonds from default, lead by Raiffeisen International Bank-Holding and UniCredit. Credit-default swaps on Vienna-based Raiffeisen climbed 26 basis points to a record 369 and those for UniCredit soared 23 basis points to an all-time high of 213, according to data from CMA Datavision in London. Credit-default swaps on Erste increased 24.5 to 307, Paris- based Societe Generale rose 6 to 116 and KBC in Brussels was unchanged at 240, according to CMA prices.

The rising cost of insuring against default by a “peripheral” European government is likely to weigh on the euro, according to Merrill Lynch & Co. “This remains an important background negative for the euro,” Steven Pearson, a strategist in London at Merrill Lynch, wrote in a note today. “European banking-sector exposure to Eastern Europe, often via foreign currency lending, is an additional euro negative story that is gaining air-time.” Emerging market central banks may move away from holding European government bonds in their reserves as widening yield spreads between debt of different euro-zone economies makes bonds more difficult to trade, Pearson said.

So Why Would The Euro Help?

Well, in the first place, four of the Eastern economies - Bulgaria, Latvia, Lithuania and Estonia, are effectively stuck, since their currencies are pegged to the Euro. They are in the unenviable position of being stuck between the proverbial rock and the hard place. They are now faced with US depression type economic slumps, and massive internal wage and price deflation all at the same time. Would Euro membership help? Well lets look at what the IMF said in their most recent report on the stand-by loan arrangement for Latvia.

Accelerated adoption of the euro at a depreciated exchange rate would deliver most of the benefits of widening the bands, but with fewer drawbacks. Unlike all other options for changing the exchange rate, the new (euro-entry) parity would not be subject to speculation.

By providing a stable nominal anchor and removing currency risk, euroization would boost confidence and be associated with less of an output decline than other options.Euroization with EU and ECB concurrence would also help address liquidity strains in the banking system. If Latvian banks could access ECB facilities, then those that are both solvent and hold adequate collateral could access sufficient liquidity. The increase in confidence should dampen concerns of resident depositors and also help stem non resident deposit outflows.

However, this policy option would not address solvency concerns and has been ruled out by the European authorities. If combined with a large upfront devaluation, there would be an immediate deterioration in private-sector solvency, which could slow recovery. Privatesector debt restructuring would likely be necessary. Finally, the European Union strongly objects to accelerated euro adoption, as this would be inconsistent with treaty obligations of member governments, so this option is infeasible.

Basically, devaluating the Lat and entering the euro directly was the IMF's preferred option for Latvia, "euroization with EU and ECB concurrence" was the second option, and keeping the peg and implementing massive internal deflation only the third. The problem was that the EU, in its wisdom felt euro adoption "would be inconsistent with treaty obligations of member governments" - as would I suppose bailing out Austria and Ireland be "inconsistent with treaty obligations of member governments under the Maastricht Treaty. Go tell it to the marines, is what I say!

And this is not just Latvia, but four entire countries (little ones, but still countries) that are effectively being thrown to the wolves here.

Downward Pressure On Currencies, Upward Pressure On Interest Rates

Nor is the position of those with floating currencies - Poland, Hungary, the Czech Republic and Romania - much better, since their currencies are now coming under substantial pressure, and as a result defaults are growing, defaults which will only work their way back upstream to the Western Countries whose banks will have to stand the losses.

At the same time, the risk of a sharper, 1997 Asian-style adjustment cannot be excluded, given the similarities between Asia before the eruption of the crisis there in 1997 and the situation in emerging Europe. Beyond any considerations about valuation, the FX market may overreact as it did during the Asian or Russian crises in 1997 & 1998. To halt the downward spiral of currency depreciation, a substantial rise in interest rates combined with a tight fiscal policy under an IMF programme could be necessary.
Murat Toprak & Gaelle Blanchard, Societe Generale

Obviously there is now a sense of urgency here, and the warning signs are everywhere, for those who know how to read them. According to Zbigniew Chlebowski, the chairman for the Polish ruling party’s parliamentary group speaking in an interview earlier this week, the Polish government has been in official talks with the European Central Bank over joining the pre-euro exchange-rate mechanism “for several days.” So consultations are getting to be fast and furious.

And Hungarian, Polish and Czech government debt, which has been among the highest rated in emerging markets, is now being downgraded by bondholders. Investors are currently demanding 20 basis points more yield to own Hungary’s bonds than similar-maturity Brazilian debt, which is rated four levels lower by Moody’s Investors Service, according JPMorgan bond indexes. The risk of Poland defaulting is currently running at about the same as Serbia, ranked six levels lower by Standard & Poor’s, based on credit-default swap prices, while Czech 10-year bonds yield the most compared with German bunds since 2001.

“Everybody is running for the door,” said Lars Christensen, head of emerging-market strategy at Danske Bank A/S in Copenhagen. “The markets have decided the central and eastern European region is the subprime area of Europe.”

The currencies of these currenciies are tumbling on investor concern the region’s economies are among the most vulnerable to the global credit crisis. Poland’s zloty has fallen 35 percent against the euro since August, the forint - which has fallen around 13% since the start of the year, and about 25% since last August -weakened to a record low of 309.71 this week. At the same time the Koruna hit the lowest level since 2005.

(Chart above - Polish Zloty vs Euro)

The zloty has risen - against the previous trend - by 3.2 percent this week, following a decision by the Finance Ministry to enter the market (on Wednesday) and started selling euros from European Union funds for zlotys. Prime Minister Donald Tusk said yesterday the currency must be defended “at any cost.” The Czech central bank stated it regards the buying and selling currencies to manage the koruna as an “exceptional” tool that it’s resisted using since 2002, with the implication that it may not be able to resist much longer, although interest rate hikes (as practised in Hungary) seem to be the more likely approach in the Czech Republic. Such gains as have been obtained for the zloty are likely to be short lived (intervention is a tool of desperation, not of strength, and rarely has any lasting effect) and they can hardly exhaust EU funding they badly need to spend on stimulus type projects in the face of the downturn defending the indefensible, as Russia has been learning to its cost in another context.

“It [currency intervention ]is for us an exceptional tool at our disposal,” Tomas Holub, head of its monetary policy department, said in a telephone interview today. “Of course it’s one of the potential tools, but so far no decision has been taken in this direction.”

After intervention the only real tool left is interest rate policy, and fear of further currency falls is now acting as a serious brake on monetary policy as the pace of economic contraction gathers speed in one country after another. “A lowering of interest rates at the current levels of the exchange rate is completely out of the debate,” Deputy Governor Miroslav Singer told E15 newspaper earlier this week. “The question is whether to raise, and by how much.”

Really the suggestion that all these countries simply traipse off to the IMF (one after the other) in search of help is shameful. There is simply no other word for it, shameful. As Oscar Wilde put it, losing one child may be an accident, but losing all your children, now that has to be negligence! Let them in, and let them in now, before the whole house of cards collapses on top of each and every one of us.


This article is the second in a series of five I am in the process of writing on ways forward with Europe's financial and economic crisis.

The first was Why We Need EU Bonds.

Subsequent articles will deal with:

a) The need for Quantitative Easing In The Eurozone
b) What might a new Stability and Growth Pact look like?
c) Why as well as rewriting the banking regulations we also need to do something about Europe's demographic imbalances.

Update: The Danskebank View

With which I wholeheartedly agree.

This week the crisis in the CEE markets has intensified dramatically after the publication of a number of reports putting a negative focus on Western European banks’ exposure to the overly leveraged CEE economies. The crisis is clearly developing in an explosive fashion and there is a very clear risk of an Asian crisis style meltdown. The economies in the region are already in free fall, and at least one country – Ukraine – is dangerously close to sovereign default. Rapidly rising concerns have led policy makers across Europe to call for immediate action to avoid a dangerous collapse that potentially could spill into the euro zone. However, policy makers seem very divided on what to do in the current situation.

Earlier this week Lithuanian Prime Minister Andrius Kubilius called for coordinated action from the EU to try to solve the problems in CEE. Later in the week the World Bank’s president Robert Zoellick echoed Kubilius’ cry for help.

However, the EU Commission does not seem very excited about a coordinated effort to avoid meltdown. Rather Joaquín Almunia, EU monetary affairs commissioner, this week said that he would prefer a country-by-country approach to crisis management. In our view, a country-by-country approach to crisis management entails a number of risks, as there is a strong potential for contagion from one CEE country to another due to the significant integration in the financial sector across the region. Therefore, we think that there is urgent need for a more coordinated effort to stabilise the situation– otherwise this crisis will drag out and uncertainty remain elevated for an extended period.

Friday, February 20, 2009

Latvia's Government Resigns

Latvia’s four-party coalition government resigned today after two of the coalition partners called for Prime Minister Ivars Godmanis to step down. President Valdis Zatlers told a news conference in Riga today that he had accepted the resignation and that talks on forming a new government would begin next week, a timing that coincides perfectly with the forthcoming visit of an International Monetary Fund mission.

“I told the parties this was the moment of truth,” Godmanis, 57, said adding that a government that has resigned may not have the authority to sign international documents. The IMF has some requests for the government and the “it’s very important for them to know our position,” he said, declining to say what the requests were.

Zatlers said on Feb. 13 that Godmanis had “lost his trust” after the government abandoned plans to cut the number of ministries. Zatlers then said on Feb. 16 that Godmanis had admitted he made a “mistake” and agreed to continue with plans to reorganize the government.

The IMF in its report on the Standby Arrangement for Latvia said the following:

Maintaining the peg also requires substantial political commitment.

If this commitment were to falter, there is a risk that the execution of the difficult but necessary policies required under the authorities’ program could also weaken. However, all political parties are strongly committed to the exchange rate peg. Thus the revised 2009 budget was passed by a 57-21 majority, despite the exceptional fiscal tightening measures it contained. Maintaining this commitment through an anticipated prolonged recession could be challenging.

The authorities’ unequivocal commitment to the exchange rate peg has determined their choice of program strategy.

Though this commitment augurs well for program ownership, the authorities also recognize that their choice brings difficult consequences, including the need for fiscal tightening and the possibility that recession could be protracted, perhaps more so than if an alternative strategy had been adopted.

Of course this program ownership disappeared almost as quickly as the ink dried on the paper they all signed. Basically the problem of maintaining political will during what was always bound to be a very harsh economic correction lay at the heart of my critique of the decision to attempt to maintain the peg. See my:

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


The Long And Difficult Road To Wage Cuts As An Alternative To Devaluation

and Manuel Alvarez Rivera (Election Resources On The Internet) writes:

I wrote at the beginning of this month that "Governments in Latvia are usually short-lived - since regaining independence in 1991, the Baltic republic has had more than a dozen cabinets - in no small measure because of its constantly changing and fractious party system. From that perspective, the question may be not so much whether Prime Minister Godmanis will remain in power, but for how long".

As it was, the "how long" turned out to be an unexpectedly short reprieve: on February 20, Latvia's coalition government became the second casualty of the global financial crisis, after the People's Party and the Union of Greens and Farmers - the two largest parties in the government and the Saeima (Parliament) - announced they had lost confidence in Prime Minister Ivars Godmanis, and forced him to step down.

President Valdis Zatlers will start consultations with leaders from all political parties in Parliament on the formation of a new cabinet. However, the upcoming government will have to implement further unpopular measures to cope with the worsening economic situation, and an early election remains a distinct possibility.

The full text of Manuel's background on the current political crisis can be found here.

Monday, February 9, 2009

Latvia's Economy Falls At A 10.5% Rate In Q4 2008

Latvia's economy is in freefall at this point in time. The economy contracted 10.5 percent in the fourth quarter of last year, the sharpest fall in the entire European Union, as the credit crunch bit deep, consumer demand collapsed and manufacturing spiraled downdards.

The drop in gross domestic product, the largest since quarterly annual records began in 1995, compares with a revised 5.2 percent drop in the third quarter.

Industrial Output Keeps Falling

Latvian industrial output declined by a working day adjusted 14.2% year-over-year in December, after falling 13.9% in November. Manufacturing was down 18.2% on an annual basis, while mining and quarrying production were down 10.6%. Month on month, industrial output dropped a seasonally adjusted 2.5% in December, compared with a 3.1% fall in the previous month.

Over the fourth quarter, industrial output decreased 6.3% over the third one and was down 12% from the previous year. In 2008, industrial production fell 6.7% compared to the previous year. At the same time, manufacturing output dropped 8.3%, while mining and quarrying output rose 2.4%.

Exports Fall Again In December

Latvia's trade deficit - at LVL 226.8 - was up in December over November, when it had been 210.5 million. Exports were down by 4.6% over November and by 11.1% over December 2007. Imports were up by 0.4% over November, and down by 15.2% over December 2007.

Exports Month on Month: the most rapid increase was in fish exporst (up by 22.5%), meat and fish products (up by 15.3%), tobacco products (up by 14.5%), (alcoholic and non-alcoholic beverages (up by 12.7%), pharmaceutical products (up by 20.5%), machinery and mechanical appliances (up by 18.1%). Exports fell in the following categories: rubber and articles (by 35.5%), iron or steel and their products (by 13.3%), wood and wood products (by 19.6%), furniture, bedding and lighting equipment (by 15.8%), clothing (stiched by 20.6%, unstitched by ).

Exports year on year: exports increase of cereal crops (exported mostly to Denmark, Morocco and Yemen) (3.3 times), alcoholic and non-alcoholic beverages (by 33.5%), essential oils, perfumery and cosmetics (by 45.5%), machinery and mechanical appliances (by 24.4%). There were declines in the export of iron and steel (by 54.5%), motor vehicles (including rail transport) and parts thereof (by 34.6%), rubber and articles thereof (by 41.4%), wood and wood products (by 39.3%), furniture, articles of bedding and lighting equipment (by 32.8%).

Imports month on month: unstitched clothing imports were down over November (by 34.9%), rubber and articles thereof (by 23.9%), mineral fuel, oil and refined petroleum products (by 16.3%). There were import increases in iron and steel (by 74.1%), machinery and mechanical appliances (by 31.2%), motor vehicles and parts thereof (by 15.8%), pharmaceutical products (by 24.1%), on vegetable and animal oils and fats; waxes (by 56.8%), meat and fish products (by 10.1%), coffee, tea and spices (by 8.0%).

Imports year on year: the most notable annual decrease was in imports of wood and wood products (by 63.0%), of motor vehicles and parts thereof (43.6%), articles of iron or steel (by 36.4%), rubber and articles thereof (by 30.0%), of electrical machinery and equipment (by 27.3%), unstitched clothes (by 23.0%). Imports of pharmaceutical products increased (by 40.9%), fish (by 25.3%), meat and offal (by 20.0%), meat and fish products (by 10.8%).

During the fourth quarter as a whole Latvia's foreign trade deficit hit a total of LVL 692.1 million - LVL 100 million less than during the third quarter. Imports totalled LVL 1.6898 billion and exports LVL 0.9977 billion. Since during the third quarter the respective figures were LVL 1.9761 billion and LVL 1.1822 billion, both imports and exports fell between quarters.During 2008 as a whole foreign trade turnover - at current prices - was up 0.3% or by LVL 31.5 million when compared with 2007. Exports grew 8.7% or by LVL 351.7 million and amounted to LVL 4.392 billion, whereas the volume of imports was down 4.1% or by LVL 320.2 million and totalled LVL 7.46 billion. Total foreign trade turnover at current prices in December 2008 reached 819.4 mln lats – less by 12.3 mln lats or 1.5% than a month before and less by 130.7 mln lats or 13.8% than in December 2007, according to provisional data of Central Statistical Bureau data.

Inflation Still A Big Problem

Compared to December 2008 the average consumer price level in January 2009 was up by 2.2%. The average prices of goods rose by 2.1%, but of services - by 2.3%. In January prices of goods and services grew almost in all main commodity groups (except clothing, footwear and fuel), but the main influence was the tax change. Price growth of housing services, tobacco products and vegetables had the greatest impact on the price increase.

Price increases in food (+3.5%) were mainly influenced by the rise of value added tax (VAT), moreover, due largely to seasonal factors the prices of vegetables and fruit went up by 12.8% and 4.4%, respectively. Prices of alcoholic beverages on average increased by 3.3%, and that was mainly influenced by the ending of sales campaigns, while the growth in tobacco product prices (+7.0%) was influenced by the growth of excise duty.

The VAT change influenced the prices of water (+16.3%), sewerage (+16.8%), refuse collection (+16.6%), electricity (+4.6%) as well as pharmaceutical products, books, newspapers and periodicals. Price increases were also recorded for heating, natural gas, pet food, individual care goods, non-durable household goods, passenger transport services, housing maintenance services, catering services and outpatient services.

Due to continuation of seasonal sales campaigns, clothing (-5.7%) and footwear prices (-7.0%) decreased. Fuel prices on average decreased by 4.9%. Compared to January 2008, consumer prices increased by 9.8%, of which prices for goods increased by 8.9%, and for services by 12.2%. The annual average rate of change in 2008 was 14.9%.

Producer prices also continue to rise sharply, and were up by 9.5% in December, although the export PPI has been falling steadily, and was only up by 1.6%.

Basically it is hard not to form the opinion looking at this price data that, given the presence of a currency peg, and the need to lower prices rapidly to get exporting, that the VAT raise was a very bad decision indeed, since it both weakens domestic consumption further and keeps inflation running at quite a high level, something which makes wage reductions very hard to swallow.

Wednesday, February 4, 2009

Is Latvia still headed for an early election?

Guest Post by Manuel Alvarez-Rivera,
Electoral Resources On The Internet

The economy is in crisis, and expected to decline by as much as ten percent this year. The coalition government's hold on power is shaky at best, following public protests that turned violent. An embattled cabinet minister tenders his resignation. This may all sound very familiar, and it should: recent developments in Latvia appear to be at times almost a blow-by-blow re-enactment of the events that took place in Iceland last month, which culminated in the collapse of that country's coalition government.

That said, the four-party coalition cabinet of Latvian Prime Minister Ivars Godmanis remains in power for the time being, having survived a parliamentary vote of confidence on February 4. Nonetheless, an early general election - one year ahead of schedule - remains a distinct possibility: last January, President Valdis Zatlers threatened to propose dissolving Latvia's unicameral parliament - the Saeima - by March 31 unless it passed constitutional amendments that would give voters the right to propose the dissolution of the legislature.

The President of Latvia is constitutionally entitled to propose the dissolution of the Saeima. A national referendum is then held on the proposal, and the Saeima is dissolved and fresh elections called if a majority of votes is cast in favor of dissolution; otherwise, the president is automatically removed from office, and the Saeima proceeds to elect a new president to serve for the remaining term of office of the removed head of state. If an early poll does indeed take place, it would be carried out under Latvia's relatively straightforward proportional representation system, reviewed in Elections to the Latvian Saeima (Parliament) (which also includes nationwide- and constituency-level results of the 1998, 2002 and 2006 parliamentary elections).

As in Iceland, there is widespread discontent with the political establishment, although that sentiment appears to run far deeper in Latvia: recent surveys indicate trust in government has falled to its lowest levels since 1996 - only one in ten residents of Latvia is satisfied with the government's work - while a Latvijas Fakti poll taken last January shows that just two opposition parties - the pro-Russian Harmony Center and the populist New Era Party - stand above the five percent threshold required to secure parliamentary representation.

However, even if such an extreme outcome were to actually occur - the poll numbers were skewed by a very large number of respondents (fifty-four percent) that were undecided or indicated they wouldn't vote - it would be in keeping with persistent trends in Latvian post-independence electoral politics, in which every parliamentary election brings a different winner from the preceding vote, along with a wave of usually drastic changes in the party composition of the Saeima.

Governments in Latvia are usually short-lived - since regaining independence in 1991, the Baltic republic has had more than a dozen cabinets - in no small measure because of its constantly changing and fractious party system. From that perspective, the question may be not so much whether Prime Minister Godmanis will remain in power, but for how long.