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Thursday, February 21, 2008

Cooling Down in Eastern Europe?

By Claus Vistesen Copenhagen

Just as we are nearing the transition from Winter to Spring here in Europe which traditionally promises to bring more pleasant and mild weather it seems as if Eastern Europe might just be getting a much welcome dose of cold air to quell its many overheated economies. This fresh breeze of cold air was inevitably coming in helped along from the breath of the illusive credit crunch and essentially it is also, in this respect, much welcome. Yet, the issue which now confronts Eastern Europe and many of her economies is not so much the confusing sequence of seasonality but rather how not to freeze over completely and tumble into a hard landing. Here at Alpha.Sources and elsewhere I have been adamant in my description of the issues in Eastern Europe and how I think the situation may turn out worse than many observers think. None of us know of course; we can merely asses the facts as they are presented for us and follow closely the incoming data. Two recent very worthwhile contributions to the debate on Eastern Europe and more specifically the Baltics are presented to us in the context of RGE's Euromonitor where Christoph Rosenberg and Karsten Staehr posts separately on the topic at hand. Christoph and Karsten seems to more or less agree with respect to the main thrust of their arguments. Both authors write in the context of a recent conference organized by the IMF and Eesti Pank where the Baltic situation was discussed. Karsten also refers to his recent article in the monetary review from the Danish Central Bank. Both the authors in question field arguments which are somewhat different from my own and my colleague Edward's and in this light I think it would be most interesting to go through some of the points and see whether we cannot learn something from each other?

Let us commence with the question of whether the Baltics will experience a hard or a soft landing? At this point in time it is very difficult to see. It is certain that we are now seeing signs of significant slowdowns not only in the Baltics but across the whole Eastern European edifice. The tricky question we all want to answer is the extent to which this slowdown will turn into a rout and a possible economic crisis of some sorts. In this entry I will focus on the Baltics as I try to scrutinize this question although I need to emphasise the need, in this context, to keep a weary eye on Hungary and Romania where especially the former is beginning to look increasingly shaky by the day. Regarding the Baltics Christoph makes the following important point ...

In particular, the financial sector is de facto owned and operated by Nordic banks. Since these banks have a strong stake in the Baltics’ economic future, a sudden Asian-style stop of funding seems unlikely. By the same token, however, these close ties put the fate of the Baltic banks into the hands of just a few Nordic parents and their ability to weather the global financial turmoil.

The dynamics here represent a very important point to take aboard. The past years' expansion and subsequent build-up of large negative external positions in the Baltics have mainly been driven by consumer and mortgage credit supplied by foreign (most notably Scandinavian) banks and credit institutions. In this way, the Baltic economies are very dependent on this link not only to keep the external position from not correcting too quickly which would happen if the foreign banks suddenly closed shop and retreated their fangs but also in order to keep and restore confidence in their economies and most importantly the currency boards tying their currencies to the Euro. Quite simply, the Baltics need these banks to now follow them down into whatever the current slowdown will bring. Will the banks be ready for this? So far, there has been no obvious signs of distress from the banks operating in the Baltics apart from words of warning from the rating agencies directed towards Hansa Bank and its operations in the Baltics. Some would even point to an upside in all of this. The recent 4th quarter results by two of Scandinavia's biggest banks Nordea and Danske Bank suggest, that they, contrary to their continental and transatlantic peers, have been dodging the incoming bullets from the credit market turmoil to such an extent that even Neo from the Matrix should be nodding approvingly. But the global credit market environment is only now waking up to the hangover from the past 5 years' exuberant credit expansion and we have already seen how the credit crunch has affected anything from regional cajas in Spain to indebted Hungarian households. In this light I remain less sanguine but concur that each day passing without further signs of distress is a good one. It remains certain then that a lot of importance can be hinged on the extent to which the foreign banks are willing to continue their operations in the Baltics as well as the extent to which they are willing to let the credit taps stay open. Karsten seems to be rather optimistic in the face of the credit market turmoil

The positive side effect of this [the subprime crisis] is that indebted borrowers in Estonia, Latvia and Lithuania will not face larger debt servicing payments, which again may reduce the likelihood of widespread bankruptcies. The global financial setback may thus have led to exactly the form of financial restraint that the overheating Baltic countries need.

This is kind of reverse causality relative to the way I have traditionally narrated the credit crunch in the context of the Baltics and Eastern Europe. However, this does not mean that Karsten is not right in the main. My main gripe would be that the slowdown was bound to come anyway as the labour market tightening and subsequent credit fuelled wage growth was bound to finish at some point entirely because of reasons endogenous to the Baltic situation. In this light, the credit crunch hardly comes at a convenient time since it may lead to the credit and financing of the external balance being pulled too quickly.

The second point I want to discuss is relates to the whole situation surrounding the currency pegs in the Baltics. Many commentators, including yours truly, have emphasised the risk of a run on one of the Baltic currencies which would take the form of a Asian crisis style test of the currency boards and thus ultimately by derivative the ECB's willingness to provide assurance. Christoph however seems to be lees convinced ...

These pegs have proven to be remarkably resilient, surviving the Russian crisis as well as recent attempts by outside market players to take positions. Speculators have not found a chink in the armor because the spot market is tiny and a forward market non-existent (contrary to the impression generated by those quotes on Bloomberg screens). From the Baltic governments’ point of view, abandoning the euro pegs, even in the face of mounting external pressures, would likely create more problems than it solves, given that many households and enterprises have borrowed in euros.

The illiquidity, or in the case of the forward market non-existence, of the FX market in the realm of the Baltic currencies is an important case in point. It is unlikely that the Baltics will be the first in line in connection with a potential currency run in the context of Eastern Europe. That dubious honor seems to have landed at the front step of Hungary and Romania. However, the fixed exchange rate regime represents another mounting problem for the Baltics in the current situation. How are they going to correct? This brings us into the heart of the predicament in my opinion and thus how the Baltics are in a bit of a bind. Consequently and as Christoph himself points out fiscal stimulus can not be used to counter the current downturn since in the end we are talking about a deficiency of external and not internal demand. Yet, this is also a textbook case of the ever recurrent trilemma often cited in the context of international economics. With free capital movement and a fixed exchange regime monetary policy is out as well as is de-valuation. Moreover and as noted, since fiscal policy also seems to be out of the question (some are even talking about a contraction) we are basically letting the reigns go hoping that the chariot won't fly off the cliff. Those of you with Austrian inclinations would undoubtedly be cheering away at this point emphasising out that this is the one and only way that these economies can correct. This is a discussion for a separate post but suffice to say that there is a distinct possibility that all this will end in deflation since absent the adjustment mechanisms cited above this is the only conceivable way to break the vice. It is important to note that there is nothing deterministic about this scenario but it may in fact happen. And once we allow ourselves to consider the possibility we need to ask whether it wouldn't really be better to devalue in order to restore external competitiveness? However, this can hardly be seen as an ideal outcome either since as Christoph notes in a faint sentence, and as I have analysed extensively, Baltic enterprises and households would be severely exposed as a large part of the outstanding stock of loans are denominated in Euros. This brings us back to the question of deflation and whether the foreign banks would stay put in such an execrable macro environment and ever so important how such an environment would affect the tendency of net outward migration. I cannot say that the chain of events will play out as I am suggesting. But there is a risk. In the concrete context of Karsten and Christoph they both seem to end their analyses on a somewhat open note with a tendency to lean towards the soft landing scenario.

So, if this was the immediate cyclical perspective how might the longer term structural perspective aid us in the answer of whether in fact this will be a soft or hard landing. Following a graph of quarterly growth rates (y-o-y) in the Baltics Karsten makes the following noteworthy point ...

The figure clearly shows the very high trend growth in the Baltic countries, only interrupted by the downturn in 1999 as fallout from the Russian crisis. Given the low initial income levels, part of the impressive growth performance can probably be explained by ‘catch up’, where import of technology and organisational knowledge speed up growth. In 2006, the purchasing power adjusted GDP per capita in the Baltic countries still amount to approximately 50-60% of the EU27 average.

The important point here is the idea of catch-up growth and more specifically how catch up growth is related to the demographic profile of almost all Eastern European countries. You see, the very impressive growth spurt we have observed since the Baltics' accession into EU has not come without a cost. Two stylised facts are important to tune into here. Firstly, there is the steady trickle of labour out of the CEE and Baltic economies into Western Europe. All these 'Polish plumbers' which has become the catch-all phrase for the east-west migration have undoubtedly aided in amending supply side issues in the receiving countries and in some cases even boosted trend growth (e.g. in the UK). However, it has also intensified the pressure on wages and thus inflation in Eastern Europe not only because of their physical numerical absence but also because of the human capital component as many of these workers are those in the highest end of the value chain (i.e. most productive) relative to the countries they are leaving. The second point we need to remember is quite simply the point that the Baltics and their Eastern European peers have moved through the demographic transition far more quickly than economic development has had time to really sink in. Notable and important differences clearly exist between the Baltics and many Eastern European countries but the stylised facts remain. So, this is, in fact, not a question of being right or wrong in terms of calling the immediate cyclical outcome of the slowdown but about a deeply structural problem. In this specific light it would be most severe if the Baltics and/or Eastern European countries tumble into deflation since this would potentially intensify the emigration as well as make it much harder to accomplish that much allured catch up growth. In essence, I agree then with Christoph when he concludes ...

The lesson for the governments and citizens in the Baltics is that they should lower their expectations, be it with respect to income growth, large-scale public investment projects or speedy euro adoption. Modesty and prudence are the best insurance against falling into the Portuguese slow growth trap—or experiencing a sudden Asian-style output contraction.

This is indeed the case but take note. The lowering of these expectations may be much more permanent and enduring than you might imagine and as such it is rather important that the tumble is not too rough. I guess that my main addition to Christoph's list of solutions as he presents them is quite simply that we take a look at the demographic edifice of the region and individual country since if we don't, the situation is not likely to improve much in the long run.

In Summary

In this note I have reviewed a number of arguments recently made on the Baltics from Karsten Staerh and Christoph Rosenberg over at RGE's Euromonitor. I think the two authors' analyses are very solid but I do have a few objections and niggles when it comes to the main conclusions. I concur that the extent to which the Baltics or one of three will experience a hard landing is a difficult question to answer at present. It is clear that Q4 2007 marked the beginning of a notable slowdown across most parts of the Baltics and Eastern Europe and now we will see how 'bad' it turns out. Above, I have highlighted reasons as to why I tend to lean towards the pessimist narrative but also realise that both Christoph and Karsten field arguments to the contrary. There are three main reasons why I am on the pessimistic side of the median ...

  • The risk of contagion. Events in Hungary and Romania point to a deterioration of economic fundamentals by the day. The laws of economics do not as such prescribe that this need to affect the Baltics but since the underlying issues are much the same I do think that the risk of contagion is there. The most important potential transmission channel of such contagion would be the extent to which a debt crisis and subsequent withdrawal of foreign credit in one country could lead to similar events in another country.
  • The lack of adjustment mechanism due to a fixed exchange regime and translation risk due to unhedged cross-currency liabilities of households and corporations. The main risk as I see it is that one or more of the Baltic countries will slip into deflation on the back of the current slowdown. The alternative which would be to un-shackle from the Euro hardly seems positive for two overall reasons. Firstly, the ensuing debt burden levied on economic agents in possession of Euro denominated loans would be quite severe and secondly there would be political issues as the prospect of future entry into the EMU would be seriously dimmed.
  • Finally, I tend to assign a rather strong weight to demographics as a variable in this whole situation. In my opinion a large part of debacle many Eastern European countries now find themselves in is due to their unique demographic situation. Focus is needed here I believe and especially we need focus on attempts to raise fertility and to keep people from leaving. As a Dane I see how those Polish plumbers have been a most welcome addition to an overheated Danish construction industry and I can also see how Ireland and the UK have benefited from Eastern European labour. But, we need a more balanced focal point on this and one which also takes into account the impact on the sending country. Remittances are fine indeed and so are claims that migration is temporary but this is also part of the whole edifice. In this way, the degree to which Eastern Europeans choose to stay in their current country of residence seems to be somewhat proportional to the potential severity of the current slowdown.