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Friday, August 14, 2009

From Original Sin To The Eternal Triangle - Lessons From Central Europe

The non-biblical concept of original sin, as Claus Vistesen notes in this post, when propounded in its standard Obstfeld & Krugman textbook version refers to the situation where many developing economies who are not able to borrow in their own currencies feel forced to denominate large parts of their sovereign and private sector debt in non-domestic currencies in order to attract capital from foreign investors - as evidenced most recently in the countries of Central and Eastern Europe. Well, piling insult upon injury, I'd like to take Claus's point a little further, and do so by drawing on another well tried and tested weapon from the Krugman armoury, the idea of the "eternal triangle".

As is evident, the reality which lies behind the current crisis in the EU10 is complex, and has its origin in a variety of causes. But one key factor has undoubtedly been the decisions the various countries took when thinking about their monetary policy and currency regimes. The case of the legendary euro "peggers" - the three Baltic countries and Bulgaria - has been receiving plenty of media attention on late, and two of the remaining six (Slovenia and Slovakia) are now members of the Eurozone, but what of the other four, Romania, Hungary, Poland and The Czech Republic? What can be learnt from the experience of these countries in the present crisis.

Well, one convenient way of thinking about what just happened could be to use Nobel Economist Paul Krugman’s Eternal Triangle” model (see his summary here), which postulates that when it comes to tensions within the strategic trio formed by exchange rate policy, monetary policy, and international liquidity flows, maintaining control over any one implies a loss of control in one of the other two.

In the case of the Central Europe "four", Poland and the Czech Republic opted for maintaining their grip on monetary policy, thus accepting the need for their currency to "freefloat" and move according to the ebbs and flows of market sentiment. As it turns out this decision has served them remarkably well, since the real appreciation in their currencies which accompanied the good times helped take some of the sting out of inflation, while their ability to rapidly reduce interest rates into the downturn has lead to currency depreciation, helping to sustain exports and avoid deflation related issues.

The other two countries (Hungary and Romania), to a greater or lesser degree prioritised currency stability, and as a result had to sacrifice a lot of control over monetary policy, in the process exposing themselves to the risk of much more violent swings in market sentiment when it comes to capital flows. Having been pushed by the logic of their currency decision towards tolerating higher inflation, they have seen the competitiveness of their home industries gradually undermined, and as a consequence found themselves pushed into large current account deficits for just as long the market was prepared to support them, and into sharp domestic contractions once they were no longer disposed so to do.

A second problem which stems from this "initial decision" has been the tendency for households in the latter two countries to overload themselves with unhedged forex loans, a move which stems to some considerable extent from the currency decision, since in order to stabilise the currency, the central banks have had to maintain higher than desireable interest rates, which only reinforced the attractiveness of borrowing in forex, which in turn produced lock-in at the central bank, since it can no longer afford to let the currency slide due to the balance sheet impact on households. Significantly the forex borrowing problem is much less in Poland than it is in Hungary or Romania, and in the Czech Republic it is nearly non-existent.

The third consequence of the decision to loosen control on domestic monetary policy has been the need to tolerate higher than desireable inflation, a necessity which was also accompanied by a predisposition to do so (which had its origin in the erroneous belief that the lions share of the wage differential between West and Eastern Europe is an “unfair” reflection of the region’s earlier history, and essentially a market distortion). The result has been, since 2005, a steady increase in unit wage costs with an accompanying loss of competitiveness, and an increasing dependence on external borrowing to fuel domestic consumption.

So, if we look at the current state of economic play in the four countries, we find two of them (Hungary and Romania) undergoing very severe economic contractions - to such a degree that in both cases the IMF has had to be called in. At the same time both of them are still having to "grin and bear" higher than desireable inflation and interest rates. In the other two countries the contraction is milder, the financial instability less dramatic, and both inflation and domestic interest rates are much lower. Really, looked at in this light, I think there can be little doubt who made the best decision.


Here for comparative purposes are charts illustrating the varying degrees of economic contraction, inflation, and interest rates. GDP contraction rates actually present a little problem at the moment, since one of the relevant countries - Poland - still has to report. However Michal Boni, chief adviser to the Prime Minister, told the newspaper Dziennik this week that the economy expanded at an annual rate of between 0.5% and 1% in Q1. So lets take the lower bound as good, it is still an expansion.

The economy in the Czech Republic contracted by an estimated 4.9% year on year in the second quarter.

The Hungarian economy contracted by an estimated 7.4% year on year in Q2.

While the Romanian economy contracted by an estimated 8.8% year on year.

Inflation Rates

Poland's CPI rose by an annual 4.2% in July.

The CPI in the Czech Republic rose by an annual 0.3% in July.

Romania's CPI rose by an annual 5.1% in July.

Polands CPI rose by an annual 5.1% in July.

Interest Rates

The benchmark central bank interest rate in Poland is currently 3.5%.

The benchmark central bank interest rate in the Czech Republic is currently 1.25%.

The benchmark central bank interest rate in Romania is currently 8.5%.

The benchmark central bank interest rate in Hungary is currently 8.5%.

Wednesday, March 18, 2009

Polish Industrial Output Falls Again In February (Updated)

Polish industrial production fell for a fifth month in February, offering just the latest signal that the European economic crisis is really having an impact on Polish domestic growth. Annual output dropped 14.3 percent, following a revised decline of 15.3 percent in January, according to the Central Statistical Office. Output was however up 2.7 percent month on month.

Industrial output is now declining across the export oriented economies of central Europe, including the Czech Republic, Slovakia and Hungary, as exports to the region’s main trading partners in western Europe drop and investment plans are halted, slowing economic growth and pushing up the jobless rate. We also learned yesterday that employment dropped in February ny 0.2 percent over February 2008, registering the first annual decline since 2004. At the same time, wages increased 5.1 percent, their lowest increase in 27 months.

Another interesting detail here, for those who study the details of economics, is that theindustrial output numbers are not that far removed from the picture painted in the Purchasing Managers' Index (PMI) since the PMI for the Polish manufacturing sector rose in February coming in at 40.8 (from 40.3 in January). Thus the slight improvement in February's situation was already evident in the PMI. Analysts at the time said the February PMI figure more than likely marked a rebound after earlier sharp declines and suggested a weaker zloty may have helped cushion perceptions of the downturn by making exports cheaper.

Polish Central Bank Cuts Rates

Poland’s central bank cut its benchmark interest rate by a quarter point on Wednesday, to a record low of 3.75 percent as concerns that the economy is stagnating offset worries that the zloty is weakening.

The bank, which has slashed official borrowing costs by 2 percentage points over the past four months, cut its 2009 economic growth forecast by more than half, to 1.1 percent, in February, with some rate setters saying there’s a risk of recession. JP Morgan and Bank of America expect a 1 percent contraction.

Poland’s inflation rate rose in February, the first increase since July, boosted by higher energy prices and a decline in the zloty. The annual rate rose to 3.3 percent from a revised 2.8 percent in January. Consumer prices increased 0.9 percent from the month before after gaining a revised 0.5 percent in January. The EU Harmonised rate was 3.6% in February.

The IPSOS Consumer Confidence Index fell by 4 points from the February level to 67 reach points. The decline is particularly marked in ratings for the economic climate, which fell by 7 points to 47. Such low ratings for the economic climate have not been seen since 1992. Poles evidently believe that the global economic crisis has now affected the heart of their country's economy.

Wednesday, March 4, 2009

How Not To Manage Eastern Europe's Financial Crisis (Part 1)

"Saying that the situation is the same for all central and eastern European states, I don't see that......you cannot compare the dire situation in Hungary with that of other countries."
Angela Merkel, Brussels, Sunday

"Happy families are all alike; every unhappy family is unhappy in its own way"

In Europe, leaders rejected pleas for a comprehensive rescue plan for troubled East European economies, promising instead to provide “case-by-case” support. That means a slow dribble of funds, with no chance of reversing the downward spiral.
Paul Krugman

Bank regulators from Bulgaria, the Czech Republic, Poland, Romania and Slovakia met today and issued a joint statement, ostensibly to reduce the some of the impact of what they term "alarmist comments" from the Austrian government about how the regional banking system is now in such a precarious state that it requires urgent action at EU level to prevent meltdown. The Austrian government are, of course, concerned about the impact of any meltdown on their own banking system. The result of this "reassuring statement" can be seen in the chart below (10 years, HUF vs Euro).

Within minutes of the joint statement Hungary's currency plummeted to an all-time low against the euro and to a 6.5-yr low versus the US dollar. In fact the HUF rapidly depreciated to 312 per euro from 307.50 before climbing back in later trading to 310. And the reason for this swift reaction? Hungary was not invited to join the statement. As the forint plunged, Hungary 's banking regulator hurriedly signed up to the statement, blaming the original omission on a communications mess-up, but the damage was already done.

“Each of the CEE Member States has its own specific economic and financial situation and these countries do not constitute a homogenous region. It is thus important first to distinguish between the EU Member States and the non-EU countries and also to clarify issues specific to particular countries or particular banking groups."

Well this just takes us back to Tolstoy, each of them have their own specific problems, but the underlying reality is that they all face problems, and are vulnerable, each in their own way.

Hungary's economic fundamentals are clearly much weaker than those to be found in the Czech Republic and Poland as things stand, but what about Bulgaria and Romania? And the Czech Republic and Poland are about to have a pretty hard time of it as a result of their export dependence on the West, and Poland has the unwinding of the zloty options scandal still to hit the front pages. So there is plenty of food for thought here before throwing Hungary to the wolves. A default in Hungary could very easily lead to contagion elsewhere, and then the impact in the West is very hard to foresee. We should not be playing round with lighted matches right next to our fireworks stock. "Hey, it's dark in here" and then "boom".

Yesterday it was Latvia's turn, and the cost of protecting against a Latvian default (Latvia is the first European Union member priced at so- called distressed levels) rose to a record following the announcement that the unemployement level rose from 8.3% in December to 9.5% in January, the highest level in nearly nine years. In fact credit-default swaps linked to Latvia increased nine basis points to an all-time high of 1,109 basis points, according to CMA Datavision in London. The cost is above the 1,000 level, breached last week, that investors consider distressed, and is now about 270 basis points above contracts linked to Lithuania, the next-highest EU member.

So two countries are being systematically detached here - Latvia and Hungary - and statements by EU leaders are unwittingly aiding and abetting the process. But we should all remember, after they have eaten Latvia and Hungary for breakfast, the financial markets will undoubtedly chew on other luckless countries over lunch (Romania's Q4 GDP data was out today, and it was a shocker, and S&P have already said they are "closely monitoring" the situation), before perhaps moving on to bigger game for supper.

And we should remember here, no one is too big to fall, and I have already been warning about the gravity of Germany's situation, with a rapidly ageing population, a hefty bank bailout of its own to swallow, and total export dependence for GDP growth. Final data from Markit economics out today showed that Germany's composite PMI fell to 36.3 in February from 38.0 in January. That was the lowest level registered since the series began in January 1998. And it means that the German economy - which is highly interlocked with the whole of Eastern Europe (Austria holds the finance and Germany the industrial exposure) - is certainly contracting more rapidly in the first quarter of this year than it was in the last quarter of 2008, and may well contract in whole year 2009 by something in the order of 5%. So maybe someone over there in Germany should be reading the poem you will see below aloud to "our Angela" right now (Oh, and if you don't speak German, you can find a translation here).

Als die Nazis die Kommunisten holten,
habe ich geschwiegen;
ich war ja kein Kommunist.
Als sie die Sozialdemokraten einsperrten,
habe ich geschwiegen;
ich war ja kein Sozialdemokrat.

Als sie die Gewerkschafter holten,
habe ich nicht protestiert;
ich war ja kein Gewerkschafter.

Als sie die Juden holten,
habe ich geschwiegen;
ich war ja kein Jude.

Als sie mich holten,
gab es keinen mehr, der protestieren konnte.

What Last Weekend's EU Summit Did And Did Not Achieve

Well reading the press on Monday morning it would have been fairly easy to reach the conclusion that nothing really happened yesterday in Brussels, and that a great opportunity was lost. The latter may finally be true, but the former most certainly is not.

Let's look first at what was not decided on Sunday. The leaders of the 27 member countries in the European Union most certainly did not vote to back a proposal from Hungarian Prime Minister Ferenc Gyurcsany for a 180-billion-euro ($228 billion) aid package for central and eastern Europe. They did not back it because it was not even seriously on the agenda at this point. These people move slowly and we need to talk them throught one step at a time. So what was on the agenda. EU bonds for one, and accelerated euro membership for the East for a second. And once we have the EU bonds firmly in place, then that will be the time to decide how we might use the extra shooting power they will bring us (boosting the ECB balance sheet would be one serious option they should consider, see forthcoming post from me and Claus Vistesen). That is when the emergency blood transfusion Gyurcsany was rooting for might come into play, but on this, as on so many items, the details of how we do what we do as well as the "what we do" will become important, so the moves we do take need to be well thought out, and systematic, they need to get to the roots of the problem, and not simply respond to problems on a piecemeal, reactive basis.

As Paul Krugman puts it "In Europe, leaders rejected pleas for a comprehensive rescue plan for troubled East European economies, promising instead to provide “case-by-case” support. That means a slow dribble of funds, with no chance of reversing the downward spiral." Amen to that!

But let's look at little bit deeper at what has been decided, or if you prefer, at what has been floated, and may be "decided" at the next meet up. Well for one, we have promised not to be protectionist, and for another, The World Bank, The European Bank for Reconstruction and Development (EBRD) and The European Investment Bank (EIB) have launched a two-year plan to lend up to 24.5 billion euros ($31.2 billion) in Central and Eastern Europe. This sounds a bit like trying to drain an Ocean with a teaspoon, and it is, so predictably the financial markets were not too impressed, expecially when they learned that not much of what was promised was going to be new money (as opposed to theacceleration of existing commitments), and especially when we take this sum and compare it with the likely quantities which are needed to "take the bull by the horms". EBRD President Thomas Mirow (who is more likely to give a low side estimate than a high side one) recentlly told the French newspaper Le Figaro that in his view Eastern European banks could need some $150 billion in recapitalisation and $200 billion in refinancing to stave off the risk of a banking failure in the region. At least.

"(It) sounds like a lot of money, but when (commercial) banks have lent Eastern Europe about 1.7 trillion dollars, 25 billion is peanuts," said Nigel Rendell, emerging markets strategist at Royal Bank of Canada in London. "Ultimately we will have to get a much bigger package and a coordinated response from the IMF, the European Union and maybe the G7."

So let's now move on to the positive side of the balance sheet, since as we know our leaders are a slowish bunch when it comes to grasping what is actually going on here, and an even slower group when it comes to acting on that knowledge once it has been acquired. The biggest plus to come out of last weekend's thrash is most definitely the fact that the idea of accelerating membership of the eurozone for the Eastern countries has now started to gain traction, if with no-one else then at least with Luxembourg Prime Minister (and Finance Minister, he is a busy man) Jean-Claude Juncker, aka "Mr Euro", who was quoted by Reuters on his way into the meeting saying he did not expect any early change to accession criteria for the single currency.

"I don't think we can change the accession criteria to the euro overnight. This is not feasible," Juncker told reporters as he arrived for a summit where non-euro eastern countries are due to call for accession procedures to be accelerated after their local currencies have taken a hammering on markets.

While in the news conference following the meeting he said that there was now a consensus that the two-year stability test required for a currency of a country hoping to join the euro zone should be discussed.

"I can understand that there may be a slight question mark over the condition that one needs to be member of the monetary system (ERM2) for two years, we will discuss this calmly," Juncker told a news conference after a meeting of EU leaders.

So something actually went on during the meeting, even if we are largely left guessing about what. Angela Merkel also left a similar impression that movement was taking place. "There are requests to enter ERM 2 faster," Merkel is quoted as saying. "We can have a look at that."

Now I have already spelt out at some length why I think the Eastern Countries should be offered accelerated membership of the eurozone forthwith (see this post) as has Wolfgang Munchau (in this FT article here).

The Economist, in a relatively sensible leader which I have already referred to, divides the Eastern countries into three groups. Firstly there are those countries that are a long way from joining the EU, such as Ukraine, Turkey and Serbia. As the Economist points out, while it would be foolhardy practically and hard-hearted ethically to simply stand back and watch, European institutions are pretty limited in what they can do apart from offereing some timely financial help or some sound institutional advice, and it is entirely appropriate that the main burden of pulling these countries back from the brink should fall on the International Monetary Fund.

Then there are those East and Central European Countries who are themselves members of the Union, and here it is the EU that must take the leading role. A first group of these is constituted by the Baltic trio (Estonia, Latvia and Lithuania) and Bulgaria, who have currencies which are effectively tied to the euro, either through currency boards, or pegged exchange rates. Simply abandoning these pegs without euro support would both bankrupt the large chunks of their economies that have borrowed in euros and deal a huge psychological blow to public confidence in the whole idea of independent statehood. Yet devalue they must (either via internal deflation, or by an outright breaking of the peg) and either road is what Jimmy Cliff would have called a hard one to travel. As the Economist itself suggests, these countries have suffered the most painful part of being in the euro zone—the inability to devalue and regain competitiveness—without getting the most substantial benefits of participation, so although none of them will meet the Maastricht treaty’s criteria for euro entry any time soon (and since they are tiny - the Baltics have a population of barely 7m, and Bulgaria is hardly bigger), letting them directly adopt the euro ought not to set an unwelcome precedent for others and should certainly not damage confidence in the single currency (any more than it already is, that is).

On the other hand unilateral adoption of the euro is a rather more difficult issue for the third group of countries, those who are EU members, are not in the eurozone and have floating exchange rates: the Czech Republic, Hungary, Poland and Romania. None of these is here and now, tomorrow, ready for the tough discipline of a single currency that rules out any future devaluation, and they are large enough collectively (around 80 million) that their premature entry could expose the euro to more turbulence than it already has on its plate. But so could simply leaving the situation as is, since if these economies enter a sharp contraction (more on this in a coming post) then the loan defaults are only going to present similar problems for the eurozone banking system as their currencies slide. The big vulnerability for Western Europe from the Polish, Hungarian and Romanian economies, arises from the large volume of Euro and CHF denominated debt taken on by firms and households, mainly from foreign-owned banks. As the Economist puts it "what once seemed a canny convergence play now looks like a barmy risk, for both the borrowers and the banks, chiefly Italian and Austrian, that lent to them".

So we now have several EU leaders opening the door for the first time to the possibility of fast-track membership of the eurozone. As we have seen German Chancellor Angela Merkel said after the summit that we "could consider" accelerating the candidacy process, French President Nicolas Sarkozy said that "the debate is open", and Luxembourg Prime Minister Jean-Claude Juncker, who heads the Eurogroup of eurozone finance ministers, said he was willing "to calmly discuss" such a possibility. So the debate is open. When will the next meeting be? On Sunday I hope. A week in all this is a very long time for reflection in this hectic world. We need proposals, and concrete ones for how to move forward here. Especially since at the present time all our attentions seem to be focusing on the East, and there is also the South and the West (the UK and Ireland) to think about. Perhaps our leaders will be able to make time from their crowded agendas for a series of mid-week meetings on this topic.

And while the leaders dither, the markets react, and as Bloomberg reports the dollar surges as everyone seeks a safe haven during the coming storm.

The dollar rose to the highest level since April 2006 against the currencies of six major U.S. trading partners.... and .... The euro dropped to a one-week low against the greenback as European Union leaders vetoed Hungary’s proposal for 180 billion euros ($227 billion) of loans to former communist economies in eastern Europe. The Swedish krona fell to a record versus the euro on speculation the Baltic region’s borrowers may default, and the Hungarian forint and Polish zloty tumbled.

The Hungarian forint led eastern European currencies lower today, falling 3.1 percent to 243.86, while Poland’s zloty lost 3 percent to 3.7796. The forint fell to a 6 1/2-year low of 246.32 on Feb. 17 as Moody’s Investors Service said it may cut the ratings of several banks with units in eastern Europe. The zloty touched 3.9151 the next day, the weakest since May 2004.

EU leaders spurned Hungary’s request for aid at a summit in Brussels yesterday. Growth in Poland, the biggest eastern European economy, will slow to 2 percent, the slackest pace since 2002, the European Commission forecasts.

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.

Monday, February 2, 2009

Central Europe's Manufacturing And Consumers In A State Of Shock

Central Europe's economies continued to contract in January - lead by their manufacturing industries - under the combined weight of a credit crunch and a slump in demand for their exports. My feeling as all three economies - Poland, the Czech Republic and Hungary - are now in recession. Hungary's is clearly the worst case, and events are moving rapidly and negatively there, but the slowdown in the Czech Economy is also very pronounced, and Poland seems finally to be falling into line, following some internal financial chaos back in October. Based on back of the envelope type calculations derived from the PMIs I would say their economies were contracting at the following pace in January.

Q-o-Q Y-o-Y
Hungary -1% -4%

Poland -0.7% -3%

Czech Republic -1% -4%

These are only provisional assessments based on the PMIs and Consumer Confidence Indexes. They will be subject to calibration as we move forward and receive the real data, but all this should give us some general idea of what is happening, something which is badly needed in view of the suddenness of the change.

Hungary PMI

Hungary's manufacturing purchasing manager index (PMI) fell once again to a all-time low of 38.6 in January, down from 40.8 in December, according to the Hungarian Association of Logistics, Purchasing and Inventory Management (HALPIM) today. Any PMI index figure above 50 indicates expansion while a figure below 50 shows contraction in economic activity. The index hasd been above the critical 50 mark for more than three years before it dropped below (to 42.6) in October last year.

The January figure is the lowest recorded since September 1995 and is a further sharp drop from January. The last time the January index was below 50 was in 2005 (48.5) and then in 1997 (49.1), but these contraction were much softer.
“In view of the current situation we can confidently say that the five month negative record of 1998 will be broken. We are facing the gravest crisis of the manufacturing industry in almost 15 years," the HALPIM said.

GKI Confidence Index

Economic sentiment also plunged in January with the GKI index falling to a record. The overall index fell to minus 39.8, the lowest since measuring began in 1996, from minus 36.7 in December. The sub components for business and consumer confidence also fell to new lows.

The outlook for industrial production and orders led a decline in the business confidence index to minus 30.5 from minus 28.2 in December. The outlook for export orders improved “minimally,”. Fifty-eight percent of exports are sold in the euro region, which is in its worst recession since the single currency began trading a decade ago. Concern about future job losses dragged the consumer confidence index to a record of minus 66.1 from minus 60.8 in December.

Polish PMI

Morale in Poland's industrial sector rose for the first time in almost a year in January, but output growth remained mired firmly in negative territory, according to a purchasing managers' index survey published Monday. The survey of 300 industrial companies prepared by Markit for ABN AMRO showed Polish manufacturing PMI increased to 40.3 in January, from 38.3 in December. This is an improvement, but the contraction is still a strong one.

"Though slightly improved from the exceptionally weak December data, the latest survey findings underline the headwinds confronting Polish manufacturers in January. Output, new orders and employment all contracted sharply and, overall, the first batch of 2009 PMI data point to further aggressive rate cuts by the central bank in the first quarter following greater than expected reductions in the main policy rate in both November and December. Inflation concerns have eased despite the falling zloty, as the PMI showedfurther falls in price pressures in manufacturing." - Trevor Balchin, Economist at Markit Economics
Polish Consumer Confidence

Poles have become much more pessimistic about the outlook for their economy in recent months and the Ipsos Consumer Confidence Index fell by 11 points to 84.17. The assessment of the current economic climate suffered the most serious deterioration.

(Please click over image for better viewing)

The consumer rating of the current economic climate plummeted by 15 points to hit 69.59. This is one of the lowest levels since Poland joined the European Union. Consumers are worried about the future of the Polish economy, and their worries are linked particularly to the situation on the job market. Currently some 52% of Poles expect unemployment figures to rise over the coming 12 months, while only 6% expect them to fall. This is a radical change, particularly when compared with January 2008, when only 13% expected a rise in unemployment and 39% expected a decline.

The deterioration in consumer sentiment was also to be seen in the ratings for willingness to buy, which in January fell by 8 points to 93.88 (the lowest level for 3 years). In particular expectations regarding the material situation of one's own household deteriorated. Ratings of the current situation in regard to buying durables also weakened somewhat. Nevertheless, consumer appetite is far from dead, and there are more people still considering this a good time for buying than those who disagree.

Czech Republic PMI

Czech industry continued its steep decline in January with the Czech Purchasing Managers' Index falling to dropping below the 50 mark (to 31.5) for the seventh consecutive month. As compared with December (32.7), the PMI was hit by series-record declines in new orders and employment, while deflationary pressure was also evident as both input and output prices continued to fall sharply, according to the report from Markit Economics and ABN Amro. The figure for output rose for the first time since September, to 29.5, indicating a slightly weaker rate of contraction than in December but still the second lowest in the survey's history.

Czech Consumer Confidence

In January 2009, the Czech economic sentiment indicator decreased by 3.2 points m-o-m (it was down by 8.6 points down in December). The business confidence indicator fell by 2.8 points and the consumer confidence indicator dropped 4.8 points. Compared to January 2008, the composite confidence indicator balance was down 30.8 points, the confidence of entrepreneurs is 34.7 points down and the confidence of consumers is down by 15 points. Indicators were thus at their lowest levels in almost ten years.

The survey taken among consumers in January indicates that, compared to December, consumers expect for the next twelve months worsening of the overall economic situation and a slight decrease in their own financial standing. In January, the share of respondents expecting a rise in unemployment increased again. The percentage of respondents planning to save money decreased. The consumer confidence indicator decreased by 4.8 points, m-o-m; it is by 15 points down, y-o-y.

Thursday, January 29, 2009

Poland's Economy Contracts In Q4 2008

Poland is probably sliding into a “technical recession” as the slowdown in its biggest trading partners batters the economy in the largest of the European Union’s eastern members, Citigroup Inc. said.

Poland’s economy probably contracted as much as 0.2 percent in the fourth quarter from the prior three months and will shrink about 0.5 percent this quarter, according to Citigroup’s Warsaw-based economist Piotr Kalisz. The slump may mean the government risks missing its budget-deficit goal of less than 3 percent of gross domestic product, he said.

“The slowdown could be a surprise to the government, which still counts on almost 2 percent economic growth,” Kalisz said. “The Polish government could be forced to revise the budget in mid-2009 and raise the deficit ceiling. However, the government prefers to stick to fiscal discipline rather than fiscal stimulus,” limiting the size of the revision, he added.

Poland’s central bank lowered its key interest rate by three-quarters of a percentage point as slowing economic growth forces companies to cut investments and employment, capping inflation. The Narodowy Bank Polski lowered the seven-day reference rate to 4.25 percent.

“The recent macroeconomic data justify such a scale of reduction as a reaction
to slowing economic growth and waning inflationary pressure,” said Jaroslaw
Janecki, chief economist at Societe Generale in Warsaw. “We expect the end of
the easing cycle in May or June, with the key interest rate at 3.5 percent.”

Barlinek SA, Poland’s largest maker of wooden floors, fell in Warsaw trading after a decline in the zloty caused losses on its hedging transactions.

Barlinek declined 0.06 zloty, or 3.8 percent, to 1.52 zloty, after earlier declining to a record low. The WIG Index rose 0.9 percent.

Kielce, southeast Poland-based Barlinek said its loss on currency deals that will be settled in 2009 and 2010 stood at 51.3 million zloty ($15.6 million) as of Dec. 31. The company recorded a profit of 10.4 million zloty on currency contracts settled in 2008, it said in a regulatory statement yesterday.

Echo Investment SA, a real-estate developer also controlled by investor Michal Solowow and based in Kielce, gained 0.05 zloty, or 2.6 percent, to 1.96, rising for the second time this week and recovering from a 10 percent drop.

Echo had a total loss of 238.6 million zloty on zloty contracts last year, it said in a regulatory statement yesterday. Net income for the year will be at least 100 million zloty because the company increased the value of property on its balance sheet.

“The information” from Echo “is positive for investors, since until now it wasn’t known what type of hedging the company had,” Maciej Wewiorski, an analyst at Dom Maklerski IDMSA, said by phone today. “It’s apparent that the company didn’t speculate on currency moves,” he said, adding that the hedging strategy was “very clear” and it “worked as it should.”

Cersanit SA, Poland’s largest producer of bathroom fittings, also controlled by Solowow, fell 0.3 percent to 9.75 zloty after falling 6 percent yesterday.

The company’s loss on outstanding currency contracts stood at 52.9 million zloty at the end of 2008 and it recorded an 11.7 million-zloty loss on deals settled last year, it said in a regulatory statement after the close of trading yesterday.

Wednesday, January 21, 2009

The Forex Lending Crunch Means Trouble Is Looming Large In Poland

Poland now looks set to become the latest shoe to drop in the ongoing crisis which is steadily extending its reach from one country top another, right across the whole of Central and Eastern Europe - the latest and possibly the last in the sense that if Poland does role belly side up this will probably be the one which finally does turn the apple cart well and truly over.

Italy's UniCredit, the biggest lender in emerging Europe, said on Wednesday there was a clear risk of the global credit crunch gripping the region and it was up to international banks to help to avert it. UniCredit board member Erich Hampel said in a presentation at the Euromoney conference in Vienna that the bank was committed to fund its subsidiaries in those countries and would continue to lend to consumers and companies. It called on other banks active in the region, the European Union, the International Monetary Fund, other institutions and the countries concerned to launch a joint plan to stem the threat that funds could stop flowing and choke economic growth. "The international financial crisis is questioning future developments and the risk of a credit crunch is clear," said Hampel, who steers most of UniCredit's emerging European units as head of its Bank Austria arm. "A number of interested parties are involved and the support to the region should come from all of them together," Hampel said. "Coordination is essential and a 'Plan for CEE' should be designed."

Eastern Europe is - as Unicredit's Eric Hempel argues in the extended quote above - quite simply falling headlong into a very severe credit crunch, as funding for bank lending steadily dries up. And, unfortunately, as the evidence mounts that Poland is caught in the teeth of this crunch, its real economy falls deeper and deeper into the dreaded pit with each passing day. FT Alphaville's Izabella Kaminska has the forex loan story here (see also see here last Friday). Basically all I have to add are some charts (and some real economy analysis) to add a bit more weight to the point and illustrate more explicitly the speed with which things are now moving forward.

How Important Are Forex Loans In Poland?

Poland’s exposure as to foreign-currency lending has already been extensively documented and analysed on this blog, but just in case there is still anyone out there who holds defiantly onto the view that the extent of such lending in Poland is simply too small and too recent to have any sort of severe impact on the economy, let's take a look at the recent progress in such lending, at least as far as household behaviour goes. As can be seen in the first chart below, since the middle of 2007, the rate of growth in zloty loans has slumped steadily, while forex borrowing has gone up and up, until..... until last November, when the whole thing turned. It now pretty clear that something quite important happened to the Polish banking system back in October - as I attempted to analyse in this post which was written at the time.

The extent of the transition can also be seen from the monthly chart for outstanding household loans, where again zloty loans can be seen to have have virtually stagnated, while forex ones went shooting up and up, till they seem to have hit a something akin to a "dead stop". Nor does the loan "revaluation" argument help us here, since during the period under consideration the zloty has been falling (see chart below) and hence the book value of the capital stock of forex loans should rise, not fall. (I mean, unfortunately, and from a large number of comments I have received on my blogs over the last 18 months, I have to say that this is the part of the story that many of those who have taken out unhedged forex loans in Eastern Europe simply do not "get", it isn't so much the payment stream you need to look at (influenced by the relative interest rates in the two currencies being compared) but at what happens to the capital value - that is what happens to the outstanding sum you owe, as measured in your own local currency, or at least in the currency in which you are paid.

And for those who are interested in how domestic monetary policy works these days (ie how effective central bank interest rate policy is at containing lending in a small or medium sized open economy with access to global finance) it should not come as a surprise to find in the chart below that the uptick in enthusiasm for forex loans really started to gain momentum after the Polish central bank started to raise interest rates, as the short term interest rate differential with Swiss Franc loans simply grew and grew under the impact of monetary tightening.

Systematic Slowdown In Industrial Activity

This application of standard monetary policy by the Polish central bank did have one result, however, and that was that the value of the zloty shot up (in particular here when compared with the euro, which is what really matters for exports), and with it the relative cost of Polish industrial products. And what did this lead to? Well, a steady deterioration in the trade deficit for one thing.

And, of course, an ongoing contraction in industrial output for another. Poland's industrial output continued to fall in December, with statistics office data showing today (Tuesday) that output fell 4.4 percent year-on-year, after dropping 9.2 percent in November. In month-on-month terms, industrial output also fell 3.7 percent, (following a whopping 15.4% drop in November over October) while seasonally adjusted output fell 7.4 percent year-on-year, showing business conditions are quickly deteriorating.

Wage and employment data for December on Monday also suggested companies, in response to falling demand for their products, were starting to lay people off. The pace of wage growth in December was the lowest since 2006.

Business confidence in Poland's industrial sector fell in December to its lowest level since surveys began in June 1998 as plummeting new orders depressed output and employment, according to the latest 300 industrial company survey prepared by Markit Economics for ABN AMRO. The survey also found that the Polish manufacturing purchasing managers index dropped for the seventh consecutive month - to 38.8 from 40.5 in November.

The new business indicators dropped at the fastest rate in survey history, and the new orders index fell to 32.2 in December from 35.6 in November, with new export orders decreasing to 31.4 from 40.1. So we can obviously expect the January result to be even worse.

Previously, as can be see in this chart for the EU Economic Sentiment index, Poland had been faring rather better than some of its Central European neighbours (like Hungary and the Czech Republic). But the downward movement is now evident and pronounced.

This slowdown in industrial output has also been accompanied by a levelling off in construction activity, which has been trending down in year on year terms since the late summer, but which even fell back month on month in November (by 1% over October) for the first time in many months.

In fact if we look at the actual index, rather than the year on year growth numbers, we will see that activity levels have been pretty stagnant for six months or so now.

After the sub-prime crisis banks became more restrictive in their lending policies. It is hard for real estate companies to get loans for their projects. Developers have to delay significant part of their pipeline projects, in most cases till an unspecified date in the future. The significantly tightened lending policies for households will worsen already weak demand for housing. Additionally, the already anemic investment activity should deteriorate further. It should be more and more difficult for real estate developers to sell their projects in the market and this source of money is also drying up.
Polish Equity Market Monitor - Citi Poland - January 2009

Retail sales levels have also flattened out recently, although they have continued to rise slightly in recent months. November 2008 retail sales grewth by just 2.7% year on year confirmed a fast slowdown in domestic consumption following 7.9% growth in October and 11.6% growth in September. While the Penkon consumer confidence indicator is now showing its lowest readings since 2005.

It is most likely that the good times for the retail industry are over. The drivers that fuelled sales and margins of Polish retail companies – rising consumer vdemand and strong Zloty, have disappeared and we do not expect them to return within foreseeable future.
Polish Equity Market Monitor - Citi Poland - January 2009

The Credit Noose Tightens

The core of the East Europe problem is that savings in many parts of the region are not sufficient to underpin growing loan books, thus the banks in the region - which are largely foreign owned - have needed to draw on their parent companies to bolster their balance sheets. When many of the parent banks entered into their own refinancing problems last year as the global financial crisis spiralled out of control, this channel of funding was transformed from being a source of strength into being a source of weakness.

In addition, at the start of last summer the Polish currency soared to record highs against the euro, and many Polish companies took out hedging contracts, effectively betting on further zloty appreciation. Now, as the currency has weakened and weakened, many of these very same companies have found themselves with substantial losses.

The Polish financial watchdog estimated last month that local banks may need to take out as much as $284 million in provisions to cover for client losses on currency options, which currently amount to 155 million zlotys ($49.33 million) among Warsaw-listed companies. And that figure could obviously grow if the zloty continues to weaken.

The zloty is currently at its lowest level since the end of 2004 - around 4.306 to the euro. Furthermore, it seems the government’s promise of accelerating the process of euro-adoption - which helped calm the zloty’s decline back in October - is failing to reassure markets. In fact most analysts seem to think that at this point having a 2012 entry target is as good ashaving no target at all.

Euro/PLN Cross - Please Click On Image For Better Viewing

Izabella Kaminska quotes the view of RBC capital, who basically argue that there is no way that the assigned date was ever going to be achievable:

On top of all this, there is no guarantee that Poland will meet the five Maastricht convergence criteria. Holding the PLN stable within the ERM2 bands for two years may prove to be a tall order while the budget deficit, which has been squeezed lower purely as a result of recent strong economic growth, will widen sharply as the economy slows, breeching (SIC) the 3%/GDP limit and disqualifying Poland from Euro entry.
As Izabella says there is a sort of catch-22 at work here: the only way Polish zloty can be saved from further weakening is Eurozone membership, but Eurozone membership becomes ever more distant as the zloty weakens due to the Maastricht criteria. Yet if we look at what has been happening to competitiveness in Poland in recent years (see REER comparison chart with Germany below), it is clear that due to the combined effect of wage inflation and a rising currency, there is some correction still to be made (not comparable with the Baltics or Hungary, but still) if Poland is recover its lost export prowess.

And here's another chart from Citi Poland showing how unit labour costs have steadily risen, and productivity has steadily fallen. The critical crossover point seems to have been somewhere towards the start of 2007. This pattern has been repeated in one CEE country after another, and really lies at the heart of the current economic crisis in the region.

In an attempt to boost liquidity in short-term Swiss franc money markets the National Bank of Poland has set up a currency swap agreement with its Swiss counterpart and the European Central Bank. The agreement will now last until at least the end of April. But while this agreement is obviously providing some relief it is clearly far from solving the problem.

“Today, the SNB, the ECB and the NBP are jointly announcing that they will continue these one-week euro/Swiss franc foreign-exchange swap operations at least until the end of April to support further improvements in the short-term Swiss france money markets,” according to the Polish central bank statement earlier this week.

UniCredit Under Threat?

At the heart of the forex lending (and exposure) in the East lie a small number of major banks whose head offices are to be found in large cities in the core countries of the EU (Western) old guard. Among these, indeed in pride of place here, comes Italy's Unicredit . (See my longer post on Unicredit here). Now it is true to say that Unicredit's Polish subsidiary - Bank Pekao - is relatively immune to the forex lending problem, since it refused to offer mortgages in foreign currencies, and its loan-to-deposit ratio at about 90 percent (compared with an average of about 110 percent for Polish banks generally) is fairly healthy. These features and a capital adequacy ratio of around 11 percent should offer Pekao a reasonable buffer going into the slowdown, but this is not the same thing as an absence of risk, since any serious deterioration in operating conditions inside Poland will affect PLN loan default rates as well as Fx ones, although evidently the banks with fx loan exposure are much worse positioned.

Concern about the position of the entire Unicredit group has been mounting steadily of late, as witness be the latest research report from Moody’s Market Implied Ratings group, which highlighting nagging doubts many observers have over the degree of the bank’s exposure to Central and Eastern Europe. The note, written by analyst Lisa Hintz, suggests UniCredit’s CDS-implied rating of A1 may well be “an overly optimistic signal of the bank’s level of credit risk”.

UniCredit largely avoided the proprietary trading and structured product problems suffered by the other large European banks. However, the financial problems arising from the economic downturn, such as imbalances, could cause deterioration in UniCredit’s loan portfolio, and we do not believe this is reflected in the trading levels of its credit default swaps.

UniCredit’s CDS-implied rating is A1, down three notches from a recent high of Aa1 and one notch below its senior unsecured rating of Aa3. We still see this as an overly optimistic signal of the bank’s level of credit risk, in that it doesn’t capture UniCredit’s comparatively thin level of capitalization and heavy exposure to Central and Eastern Europe. This exposure came after a rapid expansion which has left the bank with an unseasoned loan portfolio.
Loans to Central and Eastern European clients made up 13% of UniCredit’s assets at the end of 2007. These made up an even greater portion of its revenue—21% in the third quarter, and at the top of the list in both cases - see charts below - comes Poland. Fortunately no one is suggesting that the level of loan defaults might be anything like the 60% anticipated in Ukraine (or Russia??, both of which fortunately make up a much smaller part of their portfolio). This CEE activity means UniCredit leads its rivals Austria's Erste Group Bank and Raiffeisen International, France's Societe Generale, Belgium's KBC and Hungary's OTP in terms of both emerging European assets and exposure.

Indeed, UniCredit fell again in Milan today, after the Italian central bank warned yesterday that bank lending is declining and interbank liquidity is insufficient. UniCredit dropped as much 6.5 percent to 1.26 euros, the lowest intraday price since May 13, 1997, and traded at 1.29 euros as of 9:55 a.m. local time. UniCredit shares have now fallen 77 percent since January 2008. The Bank of Italy said yesterday there has been a “significant deterioration” in the general economic scenario and that “lending growth continues to decelerate” because of the high cost of funding for banks. “The situation just seems to keep spiraling in a negative way and if confidence in and among banks doesn’t return there’s no easy way out,” said Giulio Baresani Varini, head of investments at Banca MB SpA in Milan.

Meanwhile UniCredit Bank Austria AG, Austria’s biggest bank, plans to decide whether it will ask for Austrian state aid as part of the national bank bailout programme by the end of March. “We plan to make a decision by the end of the first quarter,” Chief Executive Officer Erich Hampel told journalists in Vienna today. Hampel said in December that Unicredit Bank Austria would need “about 2 billion euros” to increase its Tier 1 ratio, a measure of financial strength, to 9 percent from 7.6 percent at the end of Sept. 30.

But of course it isn't only Unicredit and its subsidiaries who are affected. BRE Bank SA fell to a three-month low on the Warsaw stock exchange this morning, leading Polish banks lower, as loan provisions and losses on derivatives cut into fourth-quarter earnings. The bank - which is a subsidiary of Commerzbank AG - slumped as much as 16.3 zloty, or 10 percent, to hit 146.9 zloty before recovering to 147 zloty at 10:32 a.m. in Warsaw, the lowest level since Oct. 27. The benchmark WIG20 Index was down 3.2 percent and has fallen 8 percent so far this year. The index slumped 48 percent last year, posting its biggest annual decline since its creation in 1994.

Despite 2008 being the worst year in a relatively short history of Polish equity market, with WIG20 down 48% we are not looking for a turnaround in 2009. The performance of the Polish market should still be strongly influenced by global markets which are likely to take some time to recover given the scale of a global macro slowdown not seen since 1945. The illness appears to be very serious and you simply need time to properly recover. We expect the WIG20 index to be down this year by some -10% to -15% (driven largely by expected weak performance of the banking sector).
Polish Equity Market Monitor - Citi Poland - January 2009

So Just What Are The Chances Of A Polish GDP Contraction In 2009?

Well the chances of a contraction of some order in Poland in 2009 are non negligible in my opinion. We are evidently not talking here of something of the order of the Baltics, Romania and Ukraine, or even of the order of Hungary, but still the extent of the slowdown in Poland (or the Czech Republic) should not be underestimated. Average corporate wages rose at their slowest pace in since November 2006 last month, suggesting economic growth is slowing more sharply in the wake of the global financial crisis than many seem to think.

The latest central bank forecast suggested that Poland’s economic growth will slow to 3.7 percent this year from about 5 percent in 2008, but this is very optimistic, and far from everyone agrees. Citi Poland come in with a much lower forecast, and in my opinion a much more reasonable one.

The Polish economy is not immune from global disruptions and an incoming and unavoidable slowdown is already visible. The question is when we will see the recovery. The answer is not easy as so far we have not yet seen the weak GDP numbers which are just around the corner. Looking back at the most recent slowdown during 2000-2003 period we observed 10 consecutive quarters GDP numbers below 2.5% and within that 5 sequential quarters when GDP growth came below 1%. However, this time the most recent 3Q08 GDP number came in at 4.8% so we see a lot of bad macro news ahead of us.

In 2009 we expect GDP growth slowing to 1.4%, driven predominately by deterioration in investment growth as banks started to be very restrictive in lending while corporates are looking for savings and are rather rapidly scaling down investment programs.
Polish Equity Market Monitor - Citi Poland - January 2009

I would go somewhat further. I think it is perfectly possible to see a recession in Poland at some point in 2009, not necessarily a strong one, but a recession just the same.