I wrote back in March on the financial crisis facing Iceland, a country that had reinvented itself as a hedge fund with a fishing fleet attached. Since then, the Nordic central banks have agreed an emergency $2.3bn swap facility to help Iceland stave off a currency collapse and speculative attention has moved to other countries running dangerously high current account deficits and dependent on short-term foreign capital flows for their financing. Most of the prime candidates are in Eastern Europe; the Baltics (Estonia, Latvia, Lithuania) with Bulgaria are all suffering double digit inflation and running huge current account deficits (ranging in 2007 from 22% of GDP for Bulgaria to 13% for Lithuania). The Baltics have rapidly gone from boom to bust with all three contracting in Q1 2008 from the last quarter of 2007 and a local property bubble is now bursting. One of the key problems is that they all run fixed exchange rates with the Euro in an updated version of the ERM system that saw the UK humiliatingly ejected in 1992 (don't central bankers ever learn?). They have therefore surrendered key flexibility in dealing with a sudden economic downturn, the risks exacerbated by the global credit crunch. By pegging to the euro and keeping their capital account open to foreign investors, Bulgaria and the Baltics have essentially given up an independent monetary policy and therefore are unable to tackle soaring inflation. Local real interest rates are negative (a common problem across the emerging markets; this year will see a widespread move toward positive real rates squeezing global growth) and annual credit growth has been as high as 40%; unsurprisingly, property prices have soared, having doubled in the Baltics since 2004. This unsustainable boom is now coming to an end. The only way to resolve these imbalances with no control over the currency or interest rates is through a painful recession, which as the UK found in 1992 may prove politically unsustainable. One obvious alternative is de-pegging from the Euro, but that is not the easy option it proved for the UK as households and companies in these countries have engaged in significant foreign currency denominated borrowing (echoes of Russia/Asia in 1998); in 2007, foreign currency loans accounted for 55% of total loans in Bulgaria, 79% in Estonia, 86% in Latvia, and 57% in Lithuania. If the pegs were abandoned and depreciation occurred, the consequent jump in debt service would hit economic growth hard. Although de-pegging would mean these countries would have monetary policy at their disposal to quell inflation, a currency depreciation would increase the value of imported goods, which could fan inflation further in the short-run. If any of them abandon the peg, it would almost certainly be the result of overwhelming speculative pressure, as with the UK in 1992 (George Soros, are you reading this?)
Romania appears to be undergoing many of the same boom-bust issues as its fellow EU newcomers in the Baltics and Bulgaria, high inflation, ballooning current account deficit (14% of GDP in 2007), and an expected slowdown in 2008 growth, but at least Romania has a flexible exchange rate. Hungary has seen several GDP growth downgrades so far this year as a stronger currency squeezes export growth, and will struggle to grow more than 2.5%. Ratings agency Fitch had seen the Baltics and Bulgaria as those newcomers most likely to gain from EMU entry. Consequently, de-pegging could have the unintended effect of hurting investor confidence, thereby reducing capital inflows into these countries, which would make a bad situation worse. There seems no way out of a major slowdown across Eastern Europe over the next couple of years. One huge long term negative for the region is demographic decline which complicates the economic picture (one of my favourite investment themes). From Poland to the Czech Republic, these countries face an historically unprecedented combination of structural problems, which in large measure stem from an extraordinarily high inward flow of funds accompanied by an equally high outflow of labour through migration, which leads to insufficient domestic labour supply to meet the needs of the high growth rate produced by the funds inflow and thus structural inflationary pressure. The impact of the migration outflow is further aggravated by the low and indeed falling number of young labour market entrants who are now becoming available, a direct consequence the collapse in fertility and live births experienced across the region following the fall of the Iron Curtain. These economies all need to experience very rapid "catch up" growth to converge on average EU living standards (like Spain, Portugal and Ireland in the 1990's) and thus achieve the resources which will make supporting the increasing number of elderly dependents both viable and sustainable. Like China, Eastern Europe is in a race against the demographic clock from a relatively low per-capita income level. The impact on the Eurozone of a slump in Eastern Europe would be significant, as apart from Asia, the region is the biggest market for German and Austrian capital goods exporters in particular. Southern Europe from Italy to Spain is already on the brink of recession, and this would prove a mortal blow for Euro bulls. I turned bullish on the Dollar back in March and am still long; I expect a move in the cross rate well below 1.50 over the Summer.
Posts
