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Tuesday, July 10, 2012

Whom The Gods Would Destroy

The Times They Are A Changin, as the old song goes. Neither in jest nor in total earnest was a truer word ever said in terms of the 2 year old Euro Debt Crisis. The to-ing and frowing of the last few days as the commitment to decision of the most recent summit started to wobble only serves to underline how hard it is at times to change. These days I have no central "Euro" scenario. Only tail scenarios exist, under which the debt crisis veers in either one direction or the other accodring to the decisions taken or the absence of them. Naturally this makes the eventual outcome very hard to forsee, which is why the financial markets are having such a hard time of it, and why we see so much volatility.

In the case of the full banking, political and fiscal union scenario the efficient causes which could make it happen are obvious: just keep the various participants looking down into the abyss often enough and long enough. In the case of complete breakup things are rather different, since it is hard to concretise what would actually bring it about, although the risk is evident, and indeed in many ways it seem a more probable end point than the other one.

After thinking about this for some time, the conclusion I have reached is that it is towards political risk, and the progressive destabilising of Europe's democratic systems, that we need to look, which is what makes recent events in Romania look like something rather more than a mere historical footnote.

According to Princeton Professor Kim Lane Scheppele:
"A political crisis has gripped Romania as its left-leaning prime minister, Victor Ponta, slashes and burns his way through constitutional institutions in an effort to eliminate his political competition. In the last few days, Ponta and his center-left Social Liberal Union (USL) party have sacked the speakers of both chambers of parliament, fired the ombudsman, threatened the constitutional court judges with impeachment and prohibited constitutional court from reviewing acts of parliament – all with the aim of making it easier for Ponta to remove President Traian Basescu from office. They hope to accomplish that by week’s end".
Well, in fact it was on Saturday President Basescu's opponents finally achieve that last objective, since in a majority vote by the two chambers of the country's Parliament he was effectively impeached. He was suspended from office for 30 days, during which time a referendum on his future is to be held.

As Lane Scheppele points out, it is hardly coincidental that the country has just fallen back  (Spain style) into a double dip recession following a very sharp drop in output in 2009/10. Despite having received an initial 20 billion euro EU/IMF rescue loan in 2009 and a further 5 billion "top up" one in 2011 the economy still struggles to find air. The country's economy plunged by 6.6% in 2009, only to fall  by another 1.6% in 2010. It then recovered slightly in 2011, before finally fall back again in the last quarter of last year - output fell by 0.2% in Q4 2011 and by a further 0.1% in Q1 2012 according to Eurostat data. Thus GDP is still below the pre crisis peak - at levels first seen towards the end of 2008 and moving backwards in time.

IMF East Europe Programmes Under Increasing Pressure

Whom the gods would destroy they first make mad, as the saying goes. Romania, a country which urgently needed an IMF bailout just two years ago, and which is now back in recession,  saw fit to decide that June would be a good time to restore public sector wage cuts introduced to restore competitiveness under their IMF programme.

The decision followed a series of anti austerity riots back in January, which lead to the demise of the then  Liberal Democrat government lead by Emil Boc.

"The protests escalated on Jan. 14 and Jan. 15 in Bucharest, when people threw stones, torched cars and broke into stores, injuring about 60 persons, before winding down in the following days after riot police tightened security and set up checkpoints".
The government which replaced the Boc administration, lead by the former head of Romania's foreign intelligence services  Mihai-Razvan Ungureanu, lasted barely three months.

"Voter support for the current coalition was cut by more than half in the past two years to about 18 percent after Boc’s government slashed public wages 25 percent and increased taxes to meet international pledges. Boc resigned on Feb. 6 after protests over austerity turned violent."
At the heart of the protests were the 25% public sector wage cuts introduced under the IMF austerity programme. In fact both President Traian Basescu and prime minister Victor Ponta are in favour of restoring them, and the IMF even agreed to a relaxation in this years deficit targets to make some improvement possible, even though unrealistic increases in public salaries lay behind the countries high pre crisis inflation level, and formed part of the background which lead to the call to bring in the Fund.

So one of the most sensitive issues in the current crisis of Romanian leadership is the question of public sector wages, and this whole question has a long history. What happened back in 2009 was not a case of long established living standards being suddenly slashed, it was a case of them being cut back to where they were before they were raised in an unsustainable way in order to win elections. As I said in my December 2008 post "Romania's Economy Heads Off Quietly And With No Fanfares Into It's Deepest Crisis in a Decade". (More background information about how wages and prices were accelerating out of control in the run in to the crisis can be found here, and here.)
"Perhaps the highest profile decision in the context of the recent Romanian fiscal deficit "cause celebre" was the one taken on 8 October by the Romanian Parliament, when it agreed to a pay rise for teachers which was calculated to be in the region of 50%, and this against the explicit wishes of Calin Popescu Tariceanu, the prime minister, who headed the then minority liberal government. The main worry arising from the teachers’ pay increase, aside from the concerns over how it will be funded, centres on the impact it will have on the pay demands of other public-sector workers and, in turn, of private-sector workers. If such wage pressures are not resisted, then they will obviously only weaken further an already weakened Romanian competitiveness and in all probability would drive inflation back above the 10% mark in 2009. This would be the result in normal circumstances, but the Romanian economy is not in normal circumstances right now, and it is highly unlikely that the present credit crunch and the pressure from the international financial markets will leave time for this inflation spiral to run its course. Much more urgent matters are likely to make their presence felt first".
But the problem is only partly that undoing these wage reductions is a highly questionable measure - Romania, like so many other periphery countries, is, after all, supposedly going through an "internal devaluation" process - the other part of the equation is that the austerity measures - as we are seeing elsewhere in Eastern Europe - just aren't working in the sense of restoring stable, sustainable growth, and we aren't getting an adequate analysis of why this might be. Exports are falling back as the Euro Crisis deepens, and raising wages is seen as a way to unerpin growth in difficult times. But is the Romanian economy really competitive enough, is the export sector large enough, and is it not overly dependent on demand from a  European Union which isn't going to enter a positive momentum dynamic anytime soon? Instead of applying what is evidently a populist measure wouldn't the money be better spent on putting these issues straight for the longer term.

Extreme Example Of A General Problem?

At the end of the day Romania is not that different from many other countries in the region, and the political problems we are seeing there could easily arise elsewhere, if perhaps in a more restrained form. Following the bursting of a forex credit driven boom in 2009, domestic demand is now notably underperforming.

Construction has fallen into a slump.

Unemployment, while not that high in comparison with the Baltics or Spain/Greece, has been rising. And with the rising unemployment has come a surge in non performing bank loans - they reached 15.9% of the total in March, a number which may be even higher if the IMF's warnings about the need for vigilance over loan "evergreening" are anything to go by.

And the flow of credit, while hard to quantify, has all but seized up.

The reason the availability of credit is hard to measure is that some 60% of total private sector borrowing is forex denominated, which means that as the value of Leu falls the total stock of debt rises, distorting any attempt to measure new credit (the above chart is for local currency denominated household loans only, but it gives a clear impression of the state of affairs). This issue misleads some observers - IMF analysts included - into concluding that credit is flowing again. The IMF state in their latest report that during the first quarter "lending to the nonfinancial corporate sector increased 8.1 percent, while household credit grew only 2.1 percent", but much of this apparent increase is surely due to the upward revaluation effect, especially as the leu fell sharply in the aftermath of February's disturbances.

Internationally Competitive?

Despite the fact that exports have done comparatively well since the onset of the global financial crisis, the country still runs a goods trade deficit as well as a current account one, even if both of these have improved since 2009. They have notably gotten better, and then gotten stuck.

The initial surge in exports post the great recession was impressive, even if as in so many other countries it has petered out as 2012 has progressed and the uro crisis deepened. Exports year on year are now down over the comparable month in 2011.

Romania was awarded a second EU/IMF loan of 5 billion Euros in February 2011, due to the country's exposure to the European sovereign debt crisis.

The exposure passes through three channels, dependence on European markets where demand is falling for exports, the domestic banking sector depends heavily on credit from West European parent banks which are themselves affected by the crisis in their own countries, and thirdly the fact that the country is perceived by investors as one of the weak links in the Eastern chain, implying it is very exposed to contagion risk. In particular, with more than 80 percent of the Romanian banking system controlled by foreign banks (including a number of Greek-owned banks which account for around 14 percent of total bank assets), Romania is particularly vulnerable to spillovers from banking issues elsewhere in Europe.

But In Some Ways Romania's Problems Are Not Typical

Like so many of the country's in the region (the Baltics, Bulgaria, Hungary, Serbia, Ukraine, etc), Romania's population of around 21.5 million is now steadily falling.

And like the Baltics, many Romanians now work outside the country. But unlike the Baltics, where demographers like Mihail Hazans have carried out systematic research to try to determine the extent of the problem (research which has even helped the Latvian government formulate policy), no such care has been taken in the Romanian case. Indeed, a search for information on Romanian migration on Eurostat reveals an empty data field.

Yet large numbers of Romanians now live and work outside their country. According to the Romanian statistics office, the Romanian labour force in 2011 totalled 9.9 million people, of whom 9.1 million were employed. At the same time, as of 1st January 2012 there were 896,000 Romanians registered as residents in Spain.

And on 1st January 2011 there were 969,000 Romanians registered as resident in Italy.

So it is safe to say that - given some Romanians must be in countries other than Spain and Italy - the total number of Romanians living and working outside their country must be more than 2 million. So the population numbers must be significantly overstated, as must the size of the labour force. The Latvian statistics office are in the process of revising their data (see table below, especially the revisions for 2011, which have yet to be interpolated into the earlier data, the correction is large and significant, click on graphic if you can't read), and it is incredible that neither the EU nor the IMF are enforcing a similar procedure on other countries in the region, and in particular Bulgaria and possibly Poland (in an EU context).

The real issue is that a growth model which involves a country with long term below replacement fertility living in part from remitances raised via population export is not sustainable, and someone in a responsible position somewhere should be warning on this.

Between A Rock And A Hard Place

Naturally, opinions vary about the degree of success of the IMF programme. Andy Macdowall, writing on the FT Beyond Brics blog is prepared to give the fund a qualified thumbs up - "While eurozone policy makers thrash out the growth vs austerity debate, the evidence from Romania seems to be that the traditional medicine works."

And many may say, well Romania is a poor country so aren't you being a bit harsh on these public sector wages issues Edward? Possibly. But for anyone following the whole evolution of the Romanian inflation/wage rises dynamic over the last decade, alarm bells should be now ringing.

Romania's problem is one of growth, and how to get it. With the country in a severe credit squeeze, and domestic demand so weakened by the population exit, the only way to sustainable growth, as in so many other cases, is through exports, and in particular through exports beyond the frontiers of the EU. Artificially boosting demand by paying government employees more won't solve that problem, and arguably it will make it far worse.

The easiest way to raise exports would be to devalue, but in Romania's case this is hard, due to the high level of exposure to forex loans. In fact the IMF try to argue that such devaluation is not necessary. "The exchange rate remains in line with fundamentals and Romanian exports remain competitive.", they say. In fact we see this argument in one country after another. The issue is not that existing exports are not competitive, but that the country as a whole is not sufficiently internationally competitive to produce a large enough export sector to support growth. The Fund still expect private demand to do the work: "Private demand, buoyed by solid credit growth, is expected to rebound and contribute to growth along with stronger absorption of EU funds. Growth should accelerate to around 3 percent in 2013 and average 3½-4 percent through 2016".

I think they just haven't grasped yet the importance of the demographic components in a CEE context. These growth numbers are way too high, and internal demand (with all those middle age range people gone "missing") just isn't going to become a driver again. Higher wages in the public sector isn't going to solve this problem.

Really I think the problem with the Fund's current approach is that they have locked themselves into an ideological corner (austerity, privatisations and structural reforms) and just are not open to listening to "out of the box" perspectives. Given the complexity of the problems we face this is a very dangerous way of doing things.

Of course, not everything about Romania is problematic - compared to Western Europe, for example,  the fiscal deficit problems have been comparatively smaller - which makes it strange that so much of the Fund's attention has been focused on fiscal issues rather than the broader macro economic structural problems . But, then agan, we are talking about emerging, and not developed markets here, so a deficit of 6.5% of GDP last year is not to be sneezed at.

And last year gross government debt was only around 32% of GDP, although it has been rising rapidly.

The thing is the structural problems need to be addressed, and the economy needs to be put back on a sustainable path, and this just isn't happening at present. If government money is to be spent it would be far more worthwhile to use funds finding a solution to the Forex loans problem (as to some extent they have done in Hungary) rather than offering stimulus to an economy that won't be stimulated in its present condition.

While government debt is low, external debt isn't, and is was just over of 72% of GDP at the end of 2011. If the country continues to run a current account deficit and experience weak growth this debt looks set to grow - and especially if the leu maintains its trend of hitting ever lower levels against the Euro. As a rapidly ageing society Romania, like all CEE societies needs to reduce its external indebtedness and built up its savings base for the future.

So resources should be consumed resolving this external debt problem, and making the country less sensitive to movements in the exchange rate. That way the central bank could once more have access to independent monetary policy. The current monetary policy rate is 5.25%, for a country having a double dip recession after a very sharp fall, that is quite incredible, and compares with the 0.5% benchmark rate now offered by the central bank in the Czech Republic, where the cheap forex loans trap wasn't fallen into to anything like the same extent.

In addition serious efforts need to be made to stop the negative migration drift. If this doesn't happen neither the country nor its economy will ever be stable and sustainable. The IMF praises the fact that the country has met its programme targets despite the evident deep structural deficiencies the economy faces. In the latest programme review they even state that “Romania’s overall track record under the programme continues to be strong.” I almost choked when I read that bit, but maybe it is a typo, and they are talking anout another country, since it is hard to see how the observation applies to Romania. There is a lot of talk about structural reforms in the energy and transport sectors, but from a macro point of view what is going on there looks more like a total mess to me. Perhaps they should take a second look at the programme, maybe there was something less than adequate about the objectives and  targets which were set in the first place. Curiously, while the report mentions the fact that "weather related disruptions weakened performance in the first quarter", I couldn't find a reference to the fact that the country is back in recession - rather than experiencing fragile growth - in the entire document.

Stop The Slide To The Edge!

Recent events make clear that in addition to all its economic woes Romania is now increasingly facing the added issue that the politics of austerity are crumbling. This phenomenon has already been seen in Hungary, and to some extent in Ukraine. Short term risks to Romania’s economy have risen substantially due to the ongoing euro area financial crisis which is being transmitted to the country via credit stress in the financial sector, reduced export growth, and more difficult sovereign debt financing. In the longer run the outlook is bleak, as the country’s population is steadily falling – over 15% of the country’s workforce now live and work abroad – and finding ways to support the continually ageing population is becoming a real challenge.

Romania’s GDP contracted during 6 of the 8 quarters between Q3 2008 and Q3 2010, with a total fall peak to trough of 8.7%. Despite a timid recovery since (boosted largely by exports and agriculture) the economy was still 5% below its pre-crisis peak at the end of last December. What little growth there is comes entirely from exports, as domestic demand continues a slow decline. Romania has enjoyed substantial export growth since the crisis, but still runs a goods trade and current account deficit, making the country continually dependent on external financing.

This connection between political instability and IMF programmes in the East is becoming habitual. We have seen it in Ukraine, and we have seen it in Hungary. There is obviously something deeply wrong with the way these programmes are designed, since none of them (including Latvia) could be claimed to have achieved the objective of returning the country to robust and stable long term growth. We can only hope that what we have seen in the East will not now spread to the South, though I can't say I am especially convinced it won't.

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

Monday, August 22, 2011

Eastern European Growth - Coming Rapidly Off The Boil?

The latest round of EU GDP data, brought to light a reality which many who have been closely following the economies of Eastern Europe already suspected: that the heavily export dependent economies in the region would almost inevitably be dragged down by the rapid slowdown in Europe's principal economic motor, the German economy (see this post for background).

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%.

Monday, March 30, 2009

Romania What Next?

With capital inflows to the CEE economies slowing to a trickle in Eastern Europe, a sharp correction is now underway in most countries' external imbalances and in particular in their current-account deficits. For the CEE-6 (Poland, Czech Republic, Hungary, Romania, Bulgaria, Turkey), net private capital flows are forecast to slow to $59.5 billion in 2009, down from an estimated $161.9 billion in 2008, according to estimates from the Institute For International Finance. The basic concern is that those countries with significant external deficits are extremely vulnerable to foreign capital reversals, especially in the current environment of global credit tightening.

FDI flows (which are generally considered more stable and less susceptible to rapid outflows than other capital flows) have been the main form of financing for current-account deficits in recent years, but such inflows are set to slow sharply in 2009. The Economist estimates that between 2003 and 20007 FDI inflows (on average) covered almost 100% of the current-account deficit in the ten EU member states. In 2008, this coverage fell to an estimated 55%

As FDI has fallen back, debt - particularly intra-bank lending - has become the main financing vehicle for the current-account deficits. Nevertheless, intra-bank lending – that is, lending between foreign parent banks and their subsidiaries in the region – is falling back sharply in 2009, with nett bank lending to emerging Europe, excluding Russia, being projected at around $22 bn in 2009, down from $95 bn in 2008 (according to the Institute for International Finance)

Now the central issue is that such corrections in external imbalances can take pplace in one of two ways - either domestic demand drops sharply and/or the currencies weaken significantly. In the case of those countries with an exchange rate peg the second route is not open, hence what we are likely to see is a very sharp contraction. Such contractions are already evident in the Baltics, but what about Bulgaria. How sharp will the correction in Bulgaria be? Only today capital economics have come in with a forecast of 5% contraction over the year. But how realistic is this, let's look at some data.

One of the first points I would like to look at is the external trade situation. It is very clear that the Romanian trade deficit is decreasing. The January 2009 goods trade deficit was down to 576.4 million euros, from 2394.7 million euros in January 2008. But as I am saying, it is quite important to understand how this improved trade balance is being achieved. It is not being achieved through an increase in exports, but rather through a decrease in imports, which are falling more quickly than exports are falling. In fact in January 2009 exports were down by 24.3% (in euros) over January 2008, while imports were down by 37.4%, as the following charts make clear.

The consequence of this decline in external trade is that Romania's current account deficit is falling rapidly, and was already down to nearly 12 percent of its gross domestic product (GDP) in 2008, with most of the improvement in the deficit taking place in the last three months of the year. The current account deficit in 2007 was 14 percent of the GDP, and most analysts had been expecting a widening of the gap in 2008, with some predictions even rising as high as 18 percent.

National Bank of Romania Governor Mugur Isarescu is already expressing concern about the pace of the change, particularly because the fact that Romania's government was already operating with a fiscal deficit of around 5% of GDP in 2008, means that the ongoing contraction in private sector activity will need to be accompanied by a contraction in government spending too. Isarescu has been calling for "burden sharing" between the private and public sector, but with the IMF now in on the act, then it is pretty clear that the public sector will not be escaping its share of the pruning.

"I said we have no alternative to adjusting the current account deficit. The entire program of economic policies, be it the former or the current government's, should be focused on this adjustment, that should not be made by the market forces only, since it will be a lot more painful," Isarescu noted.

Central Bank Keeps Interest Rates On Hold

Romania’s central bank kept the Monetary Policy Rate unchanged at 10 percent today. The rate is the highest in the European Union, but the central bank governor Mugur Isarescu said he is pinning his hopes on the International Monetary Fund bailout averting a deepening recession. Romania was awarded a 20 billion-euro financing package last week to help cover the financing needs of the current account and budget deficits. The first 5 billion euros is scheduled to arrive in May.

Global financial turmoil has weakened the leu by 12 percent against the euro and 26 percent against the dollar in the past year as investors pull out of riskier nations. The loan makes Romania the sixth country in eastern Europe to receive an international financing package as the region’s economies struggle with declining demand from the west and growing external deficits, since Hungary, Ukraine, Belarus, Latvia and Serbia have also received bailouts to help avoid defaults and aid banks.

The leu, which has weakened by 12 percent against the euro and 26 percent against the dollar in the past year has recently recovered to some extent from the very low levels hit in January.

Please Check Back Later. Post To Be Completed.

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.