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Wednesday, July 30, 2008

The Baltics - Moving Closer to a Correction?

By Claus Vistesen Copenhagen

Last time I had the Baltics under the spotlight I asked two overall questions. The first dealt with the extent to which the Baltics had entered a recession in the beginning of 2008 and the second question surrounded the risk of the Baltic pegs to the Euro. This time around and with the recent Q2 GDP release from Lithuania it would be nice to revisit the first of these questions. And with the market focus looking to shift from inflation to growth the second question is likely to become in vogue once again.

As the Q1 GDP numbers came in for the Baltics I concluded that it was very likely that the region had entered a recession. In light of the proverbial definition of a recession as a consecutive quarter contraction it seems clear the Lithuania managed to smartly skirt the recession in H01 2008. As far as I can see at this point and from Eurostat's data Estonia was the only one of the three Baltic economies that contracted in Q1 2008 (-0.5% and 0.1% for Latvia).

However and as ever before, the Baltics is increasingly getting stuck in stagflation and one of a particular sinister kind. In the case of the Baltics they may already be seeing the beginnings of a hard landing, whereas others continue to build up steam making it almost inevitable that they too will erupt at some point.

As can be observed, Lithuania just managed to avoid a contraction in Q1 and rebounded nicely in Q2. Yet, in light of the run-up to these numbers and the fact that Lithuania, on a y-o-y basis, grew at its lowest rate since 2004, I have little problem in maintaining my view that this is a hard landing. As for the break up of Lithuania's position it is a bit difficult to tell since the components do not feature seasonally adjusted figures. However, it seems that especially companies paired their investments going in to 2008 while consumers are still going strong. All three forward looking indicators in the form of confidence measures show that the expected trajectory of overall momentum is firmly down.

The other graphs reveal with some clarity I think that the Baltics may now be entering a whole new different growth dynamic with inflation and wages continuing their upward drift at one and the same time as growth is faltering. In this way, it is hardly about the potential recession and slowdown itself but about the economy, and growth rate, which will emerge. This point is similar to one I made recently in the context of the Eurozone and I do think it is important to realize the hole some of the CEE economies are about to dig themselves out of. In fact, depending on the reversion into wage and asset price deflation I would say that this slowdown marks a significant structural break in these economies' growth path.

Consequently, there is simply no way in which these economies can muster the inflows they have been receiving, and many face a decisive need to turn the boat around and become export dependent. The key link will be the extent to which we, absent a currency to devalue, will observe wage deflation to reign in the external position. Consequeuntly, with a fixed exchange rate to the Euro and an extremely wide external position the only way a correction can come is then through severe wage and by consequence price/asset deflation. The alternative would of course be to the abandon the pegs but that would then open up Pandora’s box as the currency most likely would plummet to reflect the external balance leaving Baltic consumers with Euro denominated loans and cash flows in domestic currency (get detailed argument and analysis here, here and here).

Another crucial link here would be Scandinavian banks who are effectively supplying these Euro denominated loans and thus how they, effectively, are financing the external deficits. We have thus on several occasions been hearing faint but rising voices about how, in particular, Swedish banks are exposed to the Baltic slowdown.

In a recent detailed analysis John Hempton from Bronte Capital serves up some nice points on the whole situation. What is particularly interesting is that he takes the time to scrutinize the books of Swedbank who is operating its subsidiary Hansabank which is, by far, the biggest foreign bank in the Baltics.

One of the important points to latch on to was the one conveyed in my last look at the macroeconomic balance sheet of the Baltic economies. In this analysis I showed that while loans in local currency are now falling on a stock basis (i.e. the amount of loans being paid out or written off outnumber the number of new loans taken out) it is still growing in Euro denomination effectively keeping growth in the overall stock of loans in the positive; even if the trend is inexorably down. Once I have Q2 data for all the Baltic economies I will post briefly on the development.

Yet, if you dig into the Q2 accounts of Swedbank (who are operating under the branded name Hansabank in the Baltics) you will see that they are still churning out positive growth rates in lending in Q1 and Q2. Over the course of H01 2008 Swedbank consequently expanded their lending operations with 7% in the Baltics and over the entire year, this number stands at 21%. If we compare this to the growth in deposits in the Baltics the H01 figure is 1% whereas it is 11% over the year. As such, levering of the balance sheet continued in H01 2008. In short, lending growth is still positive and the leverage multiple measured as the value of lending over deposits is growing.

I don't think it is entirely outlandish to draw a line between my initial results derived from macroeconomic data to these results from one of the biggest players on the Baltic finance market. Personally, I don't see how the growth rate can continue to stay in positive territory and this is especially the case since net interest income is now beginning to decline, if ever so slowly.

In the context of cooking, as it were, the books of Swedbank Hempton makes another interesting observation in his piece.

So what happens next?

Well if the Lati devalues (as would seem inevitable) then Hansa Bank has to pay Euro to Swedbank – and as its assets are in Lati it would be insolvent.

If the Lati doesn't devalue its only because people (i.e. Swedbank) are prepared to continue to fund it. This is not pretty at all. All in Hansa owes Swedbank over 30 billion Swedish Kroner – all denominated in Euro and which can't be paid. The equity capital of Hansa (roughly 7 billion Swedish Kroner) is also going to default.

This is a very big problem for Swedbank. Swedbank's equity is 68 billion SEK – but 20 billion is intangibles. Swedbank is probably solvent at the end of this – but only just. Swedbank will (at best) lose its independence. Swedbank is in turn wholesale funded – and the chance of it becoming Swedish Government property is not low.

Having lent that much to a country with a phoney fixed exchange rate in a currency they can't print – Swedbank management deserve it. Bad things happen to bad banks and this is a bad bank.

Now, Mr. Hempton certainly does not mince his words and even though he may come off as wing nutty the point being made is actually quite simple and valid. What he effectively is doing then is to move the perspective down a notch from the obvious macroeconomic crunch that would ensue as consumers defaulted on their loans to the predicament which would arise in the context of Swedbank's books.

What it means in macroeconomic terms is if the translation risk issue blows up, which it potentially will in the context of wage deflation (i.e. this would force down the pegs), Hansabank would effectively be screwed. Sorry for my harsh tone, but I cannot see how they could shore up their balance sheet unless the ECB moved in with a kind of 1:1 guarantee which let the Baltics de-facto adopt the Euro with one swoop. Now, if Hansabank goes, and this seems to be Hempton's argument, so could Swedbank and by derivative the inflows used to fund to external deficit to the Baltics. And then we are into the big royal mess.

Also, one could easily imagine a rather advanced game of Old Maid. Consequently, if Hansabank et al. suddenly move seriously into the ropes, de-pegging would almost certainly mean a significant write-off of Euro denominated loans. In this case, the Baltics may neatly shift some of the heat on to Swedbank who, almost certainly, will be running to the Riksbank and then perhaps on to the ECB.

Ultimately, I think the Baltics will fight long and hard against devaluation and much will depend on the severity of the correction. It may end up a perfect storm for them, but I want to stress that this would require the ECB to step in with some kind of de-facto, behind the curtains, guarantee to the currency board. That is to say, the ECB or the Riksbank would need to foresee the chain of events above (or a derivative thereof) and nip it, preemptively, in the b*t so to speak.

Quit With the Dooming and Glooming Already?

Uff that was some outlook was it not? I should immediately point out that much of this represent musings and it is still quite difficult to see where it ends. However, I have pointed out the shaky links between Scandinavian banks and the Baltics more than once before, so it should not come as a big surprise that I am massaging this topic.

If we move up the perspective to macroeconomics, the points above relate to a more general point concerning the Baltics and the manner in which the current imbalances potentially will be corrected. This consequently lays out a path well trodden here at Alpha.Sources. As the rest of the CEE countries, the Baltic economies have quite simply been converging too fast given their underlying capacity (read: demographic) constraints. In fact, given the loop sided nature of almost all CEE economies after two decades worth of lowest low fertility the whole convergence hypothesis was always going to hit shallow waters. As such, and coupled, in the past 5-6 years, with significant outward migration, these economies have quite simply been administering a growth strategy wholly incompatible with their underlying fundamentals.

This obviously does not mean that Eastern Europe will sink into the ground, but it does mean that a correction is due; both in terms of expectations and the trajectory of economic fundamentals. Note in passing here especially how this will affect Germany's ability to leverage its export muscle towards its Eastern borders. In a more broad policy oriented context I have also been amazed, even if I can understand it, with the push to de-peg from the Euro and subsequently raise interest rates. Sure enough, when you have imported inflation you want a strong currency but in administering this kind of policy you are also assuming that the implied process of nominal convergence can be speeded up; almost as if the CEE economies could attain nominal convergence with EU15 in one clean and bold sweep.

Conclusively, my guess is that while Q2 data will tell give us important forward looking indicators Q3 and Q4 may be where the real action is. As per reference to my points above I am watching FX markets in particular and, in the case of the Baltics, the link with Scandinavian banks and the potential ways in which these economies can correct.