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Saturday, May 31, 2008

Currency Dilemmas in Eastern Europe

by Claus Vistesen: Copenhagen

We are certainly getting a fair share of the market action in Eastern Europe at the moment. Of course, such a perspective will depend on the bias of the observer but I definitely think that recent events within the Eastern European economic edifice suggest that the economic climate is beginning to steer towards downside risks as well as markets in some spheres are decidedly jittery. Moreover, the market focus and discourse has also turned from a focus on the down side economic effects from the credit crisis to a focus on the risks of lingering and increasing inflation.
This is natural I think but the main tendency remains not least in the context of Eastern Europe. In short, we are now moving into a period where the global economy, in key areas, will be dominated by stagflation.

Not too long ago we learned that the Baltic countries with all probability have entered a recession going out of Q4 2007. Now, economies move up and down as we know but the situation in the Baltics is still quite remarkable since with a real economy grinding to a screeching halt you would not exactly expect wage growth in the double digit territory. Yet, this is exactly what we are observing across the Baltics and indeed in the rest of the Eastern European edifice; the recent alarming numbers from Estonian Q1 wage cost being a case in point. A hard landing it is then as Bloomberg also tries to define as follows:

An economic ``hard landing'' is when fast growth spurs inflation, which in turn erodes consumers' buying power and quickly leads to a recession.

This not quite true I am afraid since what we have on our hands in the Baltics and what we are likely to see across many other Eastern European countries is stagflation. And note that this is an entirely different kind of stagflation than the Disney World variety keeping central bankers in Washington and Frankfurt awake at night. No no, this is a regular Alfred Hitchcock specimen. We are consequently talking about a major correction here which may likely turn into deflation at some point. The problem, as I have outlined before, is that these countries are now effectively out of labour which means that there is simply no slack in the economy to fall back on, hence the lingering inflation even in the context of a rapid de-acceleration of growth. Obviously, this cannot go on. Just as well as the unemployment rate cannot drop to 0 the price level will have to correct but the process will most likely be very inelastic and especially so in a context of fast paced global headline inflation pressures.

If this represents the dire economic prospects of many Eastern European countries what might they do to steer clear of the worst casualties?

This question coupled with a renewed focus on the risks of persistent inflation shores up at a major dilemma with respect to management of the currency not least for countries currently pegging to the Euro. The Baltics fall in this category. On the one hand, the rampant inflation levels suggest that the exchange rate be loosened to allow appreciation and thus pour water on the roaring inflation bonfire. On the other hand however the Baltics, as well as many other CEE countries, are saddled with extensive external deficits financed by consumer and business credit denominated in Euros. It is not difficult to see that this represents a regular vice from which it will be very difficult to escape since as long as the peg remains deflation seems the only painful alternative as a mean of correcting. But at this point nobody knows quite how long such a process should undergo as well as whether it would be politically viable. If the peg is abandoned though, two important reservations should be made. First of all I am not at all sure that the exchange alone can quell the inflationary pressures and secondly it is not certain that the currencies will appreciate at all once de-pegged since the current account deficits may well weigh so much as to move the currencies in the other direction. Of course, initially they will but you can easily imagine a situation in which interest rates would have to be kept in recession provoking territories in order to ensure that the inflows are obtained.

Looking beyond the Baltics, the dilemma of letting the exchange rate appreciate to combat inflation versus the risk of a prolonged slump as it proves impossible to restore competitiveness can hardly be better illustrated at the moment than by the flurry surrounding the chain of commands at the Ukrainian central bank and the currency over which it presides. Obviously, the spectacle in Ukraine has the added flavor that it has essentially thrown the central bank into limbo as internal authorities wrestle for the final say. Edward has an excellent and quite amusing overview of the debacle here.

Basically, it has been recognised for a while now that with inflation running at some 30% on an annual level the central bank has been under considerable pressure to allow the Hryvnia to trade more freely against (e.g.) the USD. A week ago we thus learned that the Hryvnia was already beginning to nudge upwards agains the USD in the interbank markets, climbing as far as to 4.74, because traders speculated that the central bank had quietly abandoned the daily market operations to keep the Hryvnia within the official rate of 5.05 to the USD (with a band at 4.25-5.05). At this point deputy governor Oleksandr Savchenko cautioned as per reference to the dilemma cited above that the Hryvnia would only be allowed to appreciate if it coincided with an amelioration of the external deficit. Little could it be known that the topic, which at the time seemed highly speculative, was to race to the forefront of the agenda last week as the Ukrainian central bank has scrambled to agree with itself on what actually to do.

As such, internal differences of opinion within the central bank were made embarrassingly obvious as the board vetoed a decision by Governor Volodymyr Stelmakh to restate the official USD/HRY rate to 4.85 in an attempt to put a lid on inflation. Once again the dilemma of how to combat inflation while harboring a large current account deficit hovered the debacle as Petro Poroshenko, head of the central bank council noted that such an appreciation would be out of tact with realities of the Ukraine's external balance. Thus the rate of the USD/HRY was restated to the original 5.05. This value looks increasingly unrealistic however as the Hryvnia is trading persistently out of the band. This means that in due time we will probably see an attempt, by the central bank authorities, to lift the trading band.

The trials faced by Ukraine are not without an immediate precedent since only two months ago Hungary moved in to scrap the trading band keeping the Forint in the relatively wide band at 240.01-324.71 to the Euro. As with the debate on in Ukraine the decision by Hungary was taken in a similar light. When the decision was made the Forint was trading much closer to the 240 mark which indicates that the Forint was allowed to trade freely in the anticipation that the Forint would move in a direction which could help quell inflation. As with Ukraine who is visibly in a state of confusion about what exactly to do the decision in Hungary cannot be said to have been an easy one. At the time I stated the following which I feel is still a relevant point.

By letting the Forint flow freely they are consequently hoping that the ensuing appreciation will help the central bank in its uphill struggle to bring back inflation within target. I put emphasis on hoping here since it is far from certain I think that the Forint can be expected to stay elevated vis-à-vis the Euro. So far though the markets seem to be indulging the central bank in its move. After having been the emerging market whipping boy of this year the Forint saw a hefty appreciation on the back of the move. Yet, as noted, this may not last. Moreover, the scrapping of the trading band has also effectively opened up the door to all those unhedged liabilities which the households and cooperations and households have taken up.


Having said all this however, I do think that this move was the only reasonable way that Hungary can begin, ever so slowly, to wriggle herself out of the wrench in which she is now situated. The problem is that the scrapping of the band in order to do something about inflation as well as to stay credible in the face of increasing market pressure may not work out as expected in the longer term. This is not an argument for not doing it though but inflation is not Hungary's own problem and what we thus need to realize is that Hungary effectively is the first economy to really have entered the malice of stagflation.
So far the move by Hungary seem to have paid off in so far at the Forint has not weakened materially as it is currently trading at around the 245 mark to the Euro. In fact, if we look at the three months in which the Forint has traded freely it has strengthened from around 263 to its current value of 245ish.

So, given the recent battle of wills at the Ukrainian central bank the apparent successful comparative strategy in Hungary should the Eastern European economies (including of course Russia here) steadily let their currencies climb to take up the fight against inflation? Well, if we leave aside the obvious question that allowing for free trading of your currency does not exactly mean that you get it what can we say about the viability of this strategy?

Be careful what you wish for

Basically, the discussion about exchange rate regimes in Eastern Europe can be expanded into a much wider debate about emerging markets resisting nominal appreciation of their currencies vis-à-vis the US dollar and the Euro. Recently, the Economist had a large piece on global inflation which ties in with this discussion as well as Morgan Stanley's Stephen Jen recently noted how exchange rate appreciation might in fact be inflationary. It is thus important to understand that it is far from certain that letting the currency appreciate will have any material effect on inflation. In fact, in an Eastern European context this will only increase the purchasing power of the consumers thus fuelling already overheating economies. Another point which is specifically tied to Eastern Europe is that if domestic nominal interest rate increase to keep up with inflation rates it will have a strong substitution effects towards Euro denominated loans. This can become a dangerous cocktail should the tide turn against the currencies.

In light of the comments made above I think that the following points are important to take away.

There has been decisive change in market discourse from a focus on growth to a focus on inflation. This has lead to expectations by investors that emerging economies will allow their currencies to appreciate more swiftly against the G3 currencies. Apart from the usual suspects in the context of the petro exporters and China this has also lead to investors punting on revaluations (essentially decisions to let the currency float) in the context of Eastern Europe as well as in Russia.

In an Eastern European context I believe that such expectations may be unfounded or at least that they do not adequately take into account the downside risks. Obviously, the market's reaction to the recent debacle in Ukraine is mixed. As such, S&P moved in noting how inflation was likely driven by non-monetary factors and that the move, given the market's initial reaction, would almost definitely worsen the external position. Ironically, all this is based on an ex-ante assumption that the Hryvnia will actually now appreciate steadily as per function of market movements. This is far from certain I feel.

Demographics may be able to help us here. Basically, the global economy is characterised by a process where money goes for top line yield. In this context rising interest rates and nominal currency appreciation act as a very strong magnet for inflows of funds. In such a situation it takes a strong and essentially balanced demographic profile to be able to carry the load without running into a spiral of overheating. Brazil may indeed have an adequately strong demographic edifice but Eastern Europe and Russia decidedly have not.

In fact, what we are missing at the moment is indeed economies with the adequate capacity to suck up the excess liquidity; especially as the US has dropped the baton of the global consumer of last resort. This is why I feel that encouraging a process of steady currency appreciation in an Eastern European and Russian context may ultimately lead to a severe pro-cyclical effect and thus even more overheating. The risk is that when the backdrop comes it will be all the more grim.

Stephen Jen may actually be right when he says that currency appreciation is inflationary in a world where excess liquidity goes for yield. As I have said before I don't think that any of this warrants complacency vis-à-vis inflation but currency appreciation driven by either higher nominal interest rates and inflows will, in many cases, lead to overheating. No where is this more true I feel than in Eastern Europe. To peg or de-peg and to fix or let float? These two questions seem to be high on the agenda for many Eastern European central banks. In many ways, this is understandable. Strong headwinds from global inflation as well as an increased focus on this in the market discourse may eventually be what forces many countries to loosen the reigns on their currency. After Hungary and now Ukraine the Baltics, with their pegged currencies, seem set to enter the spolight. If we apply the prevailing market logic there is certainly enough inflation to go around even for a sharp currency appreciation. However, as I try to point it is not certain that you get what you want in the context of de-pegging and actually you may end up getting more than you bargained for. One thing is thus certain. If liquidity moves in favor of Eastern Europe at this time in the cycle the only viable way for these economies to correct will be through a prolonged period of deflation. The thing is that given their demographic structures nobody knows how far such a process would be and whether politicians can see it out, this latter point being particularly important in Hungary and Ukraine.