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Wednesday, August 27, 2008

Poland's Central Bank Leaves Rate Unchanged

Poland's central bank left its benchmark interest rate unchanged for a second month as it assesses whether eight increases in the past 16 months have been enough to keep inflation within the limits it requires. The Narodowy Bank Polski kept its seven-day reference rate unchanged at 6 percent this week, although it did stress that further monetary tightening may be needed to bring inflation down to the target.

Slowing industrial output and retail sales indicate economic growth is itself slowing, and the bank takes the view that this, and the recent decline in global oil prices should reduce pressure on inflation after consumer prices rose at a rate of 4.8 percent in July, the highest level in eight years.

The bank said today that recent data showed the economy was gradually slowing while wage growth still remained strong. The central bank expect the inflation rate to stay above their 1.5-3.5 percent target range in the coming months, and indeed they have now been struggling for some 10 months get the rate down to their 2.5 percent target midpoint.

Monday, August 18, 2008

Polish Wages Continue To Rise Strongly In July

Polish average corporate wages rose more than 10 percent for a seventh consecutive month in July, suggesting that interest rates will be raised in the future. Wages rose an annual 11.6 percent to 3,229 zloty ($1,425), compared with a 12 percent rate in June, according to the Central Statistical Office today. Wage growth has been the main gauge of inflationary pressure by the Narodowy Bank Polski, which has so sar boosted its benchmark rate eight times since April last year, to the current rate of 6 percent.

Employment was up 4.7 percent from a year in July, and rose 0.2 percent on the month. Unemployment is thought to have fallen to 9.4% in July, down from June's 9.6%. Poland's inflation rate rose in July close to a seven-year high as accelerating wage growth spurred consumer demand. The annual rate rose for a third consecutive month to 4.8 percent from 4.6 percent in June.

The inflation rate may rise in August to as high as 5.1 percent, according to the central bank forecast.

Wednesday, August 6, 2008

Where Now for CEE and Baltic Currencies?

By Claus Vistesen: Copenhagen

Ever since the illusive credit turmoil began sentiment in the market place has been fickle and essentially, like the assets of which it consists, volatile. We started off with an adamant focus on downside risks to growth which then turned into a focus and fear of inflation. Now, as the cyclical data has turned for the worse in Europe and many places in Asia the focus seems to be reverting to growth. Now, I won't go into the whole decoupling v recoupling discussion at this point since I think that this dichotomy is a false one. It never was about de-coupling à la traditionelle but moreso about two interrelated points. The first would be the extent to which the world already has decoupled from the US in the sense that a key group of emerging economies are now set to ascend in economic prowess. The second would be the extent to which the de-coupling thesis always built on a fallacy. The main point would be that the main fault line of slowdown was observed across economies with external deficits; something which, I am sure most will agree, is sure to impact surplus economies too.

Now, that does not completely let the ECB off the hook since by maintaining a focus on inflation it also assumed the role, if only temporary, of the new anchor in a re-wamped version of Bretton Woods II as the Euro ascended to new highs. This bet on global re-balancing was always going to end in tears and in this light the Eurozone could not decouple from the US; that much, I think, is true.

The key issue here however, as I have argued time and time again is represented in two crucial interlocked questions which together form a key structural trend in the global economy. One is what happens when the surplus economies slow down and there is not sufficient demand to pull the economy back up? Demographics and a high median age are key variables to watch in this regard. The second question is the extent to which hitherto deficit nations can turn the boat around and increase savings (i.e. rely more on exports) and what it will mean for global capital flows when they begin this process?

In the context of the CEE economies the themes above are also present. In a recent note I detailed the change in sentiment from growth to inflation and what it might mean for Eastern Europe's economies and their respective currencies. The key situation as I sketched it was one of a dilemma.

On the one hand, the rampant inflation levels suggest that the exchange rate be loosened to allow appreciation and thus pour water on the roaring inflation bonfire. On the other hand however the Baltics, as well as many other CEE countries, are saddled with extensive external deficits financed by consumer and business credit denominated in Euros. It is not difficult to see that this represents a regular vice from which it will be very difficult to escape since as long as the peg remains deflation seems the only painful alternative as a mean of correcting.


Another point which is specifically tied to Eastern Europe is that if domestic nominal interest rate increase to keep up with inflation rates it will have a strong substitution effects towards Euro denominated loans. This can become a dangerous cocktail should the tide turn against the currencies.

Now that the focus seems to be changing back again it appears to be a good time to revisit the situation

Within this global nexus of what exactly to do with inflation relative to growth, many Eastern European economies has so far opted to go for inflation by raising interest rates. At an initial glance this seems quite reasonable and in many ways the CEE central banks merely latched on to market sentiment and expectations that many emerging economies would seek to use nominal appreciation as a tool to flush out inflation.

Consequently we have seen how both Ukraine and Hungary have chosen to loosen the peg to the Euro as well as other floating currencies in Eastern Europe have seen their yield advantage increase in an attempt to flush out inflation. This has not been without problems though or more specifically it is not clear that an appreciation of the currency is all for the good. Two points here would seem particularly important. One is the simple question of whether in fact an appreciation is deflationary in a world where capital flows, and in particular the hot kind, act strongly on yield. However, another point would be specifically tied to the situation in Eastern Europe. As such, nominal appreciation of the currency also increases the purchasing power which is not what many CEE economies need at the present time as they stand before the task of correcting a rather large external balance. Moreover, rising domestic interest rates will increase and exacerbate the credit channel by which loans denominated in Euros and Swiss francs become more attractive. I have shown this to be true, for example, in the context of Lithuania. The important thing to do note here would what would happen to the servicing of these liabilities should the domestic currencies depreciate.

What happens next then? Or more concretely, even though CEE currencies, in general, have enjoyed a rally on the back of market expectations of nominal appreciation fed by hawkish central banks what happens if and when central banks reverese course?

An initial warning shot across the bow was handed to us as the governor of the Czech central bank mused that he might lower rates come next meeting due to the strenght of the Koruna and the subsequent effect on exports. Also Poland recently opted to abandon the hawkish stance as rates were kept steady. In light of this event Macro Man managed, as ever, to hit the proverbial nail on the head.

There is little more bearish for a currency these days than abandoning the inflation fight in a pursuit of growth; this is particularly the case when the market is heavily positioned the other way.

This is exactly the issue which now confronts many Eastern European economies. What to do as growth visibly tanks at one at the same time as inflation stays high. One thing here would be for the central banks to hold their raising cycle which in itself should ease the pace of appreciation but what if they need to lower rates.

Now the numbers above do not, in themselves tell anything remotely interesting. For one, the difference between the economies are quite big. For example the Czech Republic has been able to gain, with a comparatively low interest rate, currency appreciation which has actually helped the external balance in so far as it has made imports cheaper. Obviously, at this point the benign effect on the trade balance is just as much down to decreasing domestic demand as the value shield of a dear currency. On the other hand, if we consider especially Ukraine, Romania, and Hungary the price has been dearer and the subsequent effect on inflation less pronounced. One could always argue that the situation would have been much worse, but one thing is certain; the ensuing loss of competitiveness has not been compensated for with a decrease in inflation. And one has to wonder whether pushing nominal interest rates ever higher would be a sound solution.

The key here is that these high interest rates carry with them a high lock-in premium which makes it difficult to reduce them without causing substantial pain to the currency. Add to this that as long as interest rates stay in this territory the incentive to borrow in foreign currency remains very appealing. In fact, the incentive structure here is quite disruptive as many of these economies have higher rates on domestic currency deposits and lower rates on foreign credit. This incites consumers and companies to place their deposits in local currency while funding themselves in foreign currency. Finally, there is of course the more standard economics 1-0-1 point that whatever nominal rate is ascribed to a currency and an economy the latter needs to be able to provide the structural demand for which to satisfy the yield. Otherwise you just pour more gasoline on an already raging bonfire.

Obviously, as long as the local currency remains strong and on an upwards march or the trading band is kept in place the show goes on. But the longer this structure lingers the more difficult it will be to break free; and break free they must since I am quite sure that Eurozone membership is off, for the immediate future at least.

Another more hard hitting point would simply be that whatever growth momentum these economies had going into 2008 it is now steadily levelling off. Now, these economies need to rebalance their external accounts at the same time as they labour under the yoke of slowing growth, high interest rates which are difficult to reduce and/or a quasi fixed exchange rate to the Euro. Can you feel the chilling cold of deflation blowing across the Urals? I can.

Basically, the past years' rapid process of nominal convergence will now need to be kicked into reverse, since it is quite obvious that many CEE economies have been riding a blade too tough.

Be Careful Indeed

Last time I massaged this specific topic I summarised by ominously stating that the CEE economies and their central banks should be careful what they wished for in terms of using higher interest rates and subsequent nominal appreciation of their currencies to flush out inflation. The key point was that the effect would likely be limited and only further worsen the imbalances in the economies. And thus, here we are.

Another more subtle point in the context of market reactions would be the boomerang effect which comes from the currency appreciation as interest rates are increased (and the peg/band abandoned) to the subsequent plunge when the economic tide turns. In line with the change in global sentiment towards growth and deflation (see e.g. here) and the fact that other hitherto strong yielders (e.g. the Kiwi and Aussie) are beginning to falter we may be at an inflection point in the whole discourse of upwards movement in CEE currencies. Stephen Jen's recent tour of global FX markets is a fine addition to this argument.

As ever, this is obviously still a dilemma for most of these economies since inflation continues to rage ahead. In Romania for example the PPI rose at its highest pace since 2004. However, as long as the credit tap stays open and as long as the purchasing power is increasing so will the the demands for higher wages stay strong. This is particularly true in the context of the CEE economies as these are in possession of structurally broken population pyramids after two decades worth of lowest low fertility and, in the cast of the latter decade, net outward migration.

The main point I would like to emphasise here is that correction is coming and that it will only become harder the higher the currencies move upwards. In a more general light this correction will not be a small one and it most certainly will not be felt exclusively in Eastern Europe. Basically, the big hidden data point in all of this is the dependence of Germany on CEE imports. So far, this has moved along just nicely but Germany is in for a rude awakening once the link breaks ... and break, I am afraid, it will.