CEE and Baltic Currencies: Where Now?

Ever since the illusive credit turmoil began, sentiment in the marketplace has been fickle - and essentially, like the assets of which it consists, volatile. We started off with an adamant focus on downside risks to growth which then turned into a focus on and fear of inflation. Now, as the cyclical data has turned for the worse in Europe and many places in Asia, the focus seems to be reverting to growth.

Now, I won't go into the whole decoupling vs. recoupling discussion at this point since I think that this dichotomy is a false one. It never was about decoupling à la traditionelle but more about two interrelated points. The first would be the extent to which the world already has decoupled from the US in the sense that a key group of emerging economies are now set to ascend in economic prowess. The second would be the extent to which the decoupling thesis always built on a fallacy. The main point would be that the main fault line of slowdown was observed across economies with external deficits - something which, I am sure most will agree, is sure to impact surplus economies too.

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

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

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

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

(...)

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

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

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

Consequently we have seen how both Ukraine and Hungary have chosen to loosen the peg to the Euro. Other floating currencies in Eastern Europe have seen their yield advantage increase in an attempt to flush out inflation. This has not been without problems though, or more specifically, it is not clear that an appreciation of the currency is all for the good.

Two points here would seem particularly important. One is the simple question of whether in fact an appreciation is deflationary in a world where capital flows, and in particular the hot kind, act strongly on yield. However, another point would be specifically tied to the situation in Eastern Europe. As such, nominal appreciation of the currency also increases the purchasing power, which is not what many CEE economies need at the present time as they stand before the task of correcting a rather large external balance. Moreover, rising domestic interest rates will increase and exacerbate the credit channel by which loans denominated in Euros and Swiss francs become more attractive. I have shown this to be true, for example, in the context of Lithuania. The important thing to  note here would what would happen to the servicing of these liabilities should the domestic currencies depreciate.

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

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

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

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

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

The key here is that these high interest rates carry with them a high lock-in premium, which makes it difficult to reduce them without causing substantial pain to the currency. Add to this that, as long as interest rates stay in this territory, the incentive to borrow in foreign currency remains very appealing. In fact, the incentive structure here is quite disruptive as many of these economies have higher rates on domestic currency deposits and lower rates on foreign credit. This incites consumers and companies to place their deposits in local currency while funding themselves in foreign currency. Finally, there is of course the more standard Economics 101 point that whatever the nominal rate ascribed to a currency and an economy, the latter needs to be able to provide the structural demand for which to satisfy the yield. Otherwise you just pour more gasoline on an already raging bonfire.

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

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

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

Be Careful Indeed

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

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

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

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

Comments

[NOWHEREMAN:]

Well spoken Claus. I emphasize "spoken".
I hold dual Citizenship, do you? I was in Lithuania less than a month ago, but reside in the US. Have you visited the countries you are making such broad statements about.

The Biggest Fear these New European countries have is the costs relating to food and energy. If their currencies devalue, inflation will increase not decrease. I am quite sure the rest of Europe realizes this as well. Current inflationary costs stem from the previous 12 months.

Now do you live in a vacuum? Have any inkling about the Financial Crisis in the USA? Do you have any belief whatsoever that the US will stop the Dollar Spigot and let their financial insitutions float on their own?

So far, as far as my own mind can envision, the answer is a big resounding NO! They have just announced the extension of Emergency Loans into 2009. The Next move will not be an Increase in Interest Rates, but either an indefinite hold or decrease. The Fed "talks" one way but "walks" the other. Foreign Bank Reserves are increasing at an Annual rate of about 17% or roughly $357 BILLION dollars in the past 12 months.

Having said that, Europe, especially Germany knows the folly of a rapidly increasing money supply. They have had first hand experience. Do you actually believe they will reduce rates when internal wages are rising in addition to external forces. If the financial Crisis continues unabated, they will be forced to stop increasing their internal money supply to support the falling US Currency. The Dollars current strenght is just a bounce from an oversold position, it could go all the way to 76 or 2% Wow. Big deal.

Lithuania, has something the rest of the ECB lacks, Farmland, lots of it. Currently 50% is being used for Bio diesel, the other 50% is enough to sustain the food requirements for the rest of the country. They experienced the same massive housing bubble but it was not their money, it was Old Europe that did this. Prices have dropped enough that many Lithuanians have started to eye Beach area properties again. I know I did.

2008 Aug 06 10:34 AM

[NOWHEREMAN:]

I guess I might as well stick in another point. No one will read your views if you persist with multipage offerings. Most preferences are concise and to the point. If you must use outdated materials, at least try to extrapolate them into the future. The reader comes to read your opinion not what you used to get their opinion.

Malthus was a great economist who was proven wrong because of technological breakthroughs but may be proven right in the future. Academic Economists look at previous models to forecast. Thats why, in the USA, if there is a consensus of economists who say that they expect such and such for the next 12 months, the prudent thing to do is the exact opposite.

The next Nobel Prize winner will be an Economist who will be able to provide a concise formula on why the Fed did what it did in 2007 going forwards, and why it was precisely the wrong thing to do.

Good luck in your endeavors.

2008 Aug 07 12:41 AM

[Claus Vistesen:]

Hi Paul,

Thanks for your comments and best wishes.

I am sorry that you don't think my piece is self contained. I really do not have any excuse here other than the fact that it was ultimately meant as a follow-up to one of my previous notes on Baltic and CEE currencies;

clausvistesen.squaresp...

I realize that this may not square well with the majority of SA readers who only read my stuff on occasion and out of
context.

First of all, on this.

"I hold dual Citizenship, do you? I was in Lithuania less than a month ago, but reside in the US. Have you visited the
countries you are making such broad statements about."

No, unfortunately I do not and I am yet to visit any of the Baltic countries. I welcome anybody on the ground to prove me wrong with respect to my analysis. You should not think otherwise for a moment. I am arguing on the basis of statistics and second-hand reports, but who isn't these days? If I held myself to the standard of primary, "on the ground", research before I could say anything, I would not be saying much at all. But then again, some would perhaps prefer it that way ;).

This however brings me neatly to this.

"Lithuania has something the rest of the ECB lacks, Farmland, lots of it. Currently 50% is being used for Bio diesel, the
other 50% is enough to sustain the food requirements for the rest of the country."

I think this is an excellent and important point. I would indeed say that this argument could be generalized to many CEE
economies in the sense that they too have spare farmland. In a world where the agricultural sector may be about the flip-flop the
value chain these parcels are definitely a huge asset; not least in the context of potentially correcting the external imbalance.

However, I think you are forgetting one thing because who, prey tell, is going to work all that land across the CEE edifice?
You see, demographics DOES matter and while I agree that Malthus is staging somewhat of a comeback I believe that this is
built on a fallacy. Consequently, it is not about population size per se, but population structure. It is here exactly that the Baltic and CEE growth model (with their subsequent dear nominal currencies) do not work.

The point here would simply be that they are trying to enjoy emerging market style catch-up growth saddled with structurally
broken population pyramids. Now, this "break" in the population pyramids primarily stems from two decades worth of lowest-low
fertility as well as a steady outward trickle of the most productive cohorts.

Basically, I hold the view that many CEE economies (especially the Baltics) simply have been growing way beyond their capacity limits and that this is why we are where we are today. In this way, I would take an issue with this statement:


"Current inflationary costs stem from the previous 12 months"


I think that this is too simplistic. It is true that the credit turmoil inspired energy shock is a recent phenomenon and it remains to be seen how elastic headline inflation is on the downside. However, I think it is crucial to note that the propensity for CEE and Baltic economies to stoke inflation is very high due to their recent high growth levels and subsequent low, and declining, level of capacity.

You are obviously right that devaluation/depreciati... would equal an increase in inflation (de-facto) but isn't the alternative inflationary too? I mean, as long as the currencies stay dear, the incentive to tap foreign credit remains, as well as the external imbalance becomes almost impossible to correct. Also, a high relative currency also implies that the economy can actually muster the inflows which will follow.

Ultimately, many CEE economies are likely to face wage and, by consequence, consumer price deflation in order to correct the
imbalances. I hold this to be highly probable almost regardless of what happens to the currencies. In this sense, it DOES
seem quite improbable that the Baltic pegs will fall at this point from a kind of Soros like attack. I think it is much more likely that the peg be abandoned to shift the credit loss onto the financing side of the CA deficit (i.e. foreign credit
institutions).


"The next Nobel Prize winner will be an Economist who will be able to provide a concise formula on why the Fed did what it did in 2007 going forwards, and why it was precisely the wrong thing to do. "

I am not so certain about this, but we will see in the fullness of time I guess.

Oh and this...

"Well spoken Claus. I emphasize "spoken"."

Yes, I know that SA readers demand, and rightly so, high standards when it comes to the written deployment of Shakespeare's tongue. Or perhaps I got this one wrong. In any case, rest assured that I will strive to prevent the bar from lowering too much.

"Good luck in your endeavors."

Thanks a lot and to you too

best regards

Claus

2008 Aug 07 07:27 AM