Have the Baltics Entered a Recession?
[Update added below: Stefan Karlsson responds to the recent data from the Baltics noting that we are now definitely in a recession (although I am not sure that Estonia contracted in Q1 2008 while Latvia and Lithuania certainly did); as for the recession call ... he may very well be right.]
Last Friday Macro Man was looking for pink flamingos or more aptly as he put it:
"(...) what's the next pink flamingo, if any? Where are the remaining high conviction, deeply-positioned trades that might get washed out by the hand of fate (and/or the tap on the shoulder from the market risk manager?)"
As any mildly astute economist will know it is extremely difficult to call the exact turning point of the cycle and thus the point in time where a recession starts. Usually, such issues are resolved post mortem when the economic data has been firmly revised. Moreover, the actual determination of a slowdown's or a recession's starting point also quickly turns into a battle royal between economists as the alphabet soup of different national account measures easily ties up the discussion as we end up comparing apples and pairs. However, at this point in time I don't think we have the luxury to engage in such a battle among economic gentlemen. I don't think so because the Baltics' (and many of the other Eastern European countries') situation is a bit more complex than your average US type recession where a you clean up the mess with a couple of quarters of negative growth. What we consequently need to understand is that, depending on the turn of events and response from markets, the current slowdown may turn out to have quite far reaching consequences for the region. With these ominous remarks let us turn to the evidence suggesting that the tide is now finally turning in the Baltics. In fact, we can only at this point say something decisive about Latvia and Lithuania since Estonia has not yet posted Q1 08 figures. The pace of growth however has been consistently lower in Estonia throughout 2007 compared to 2006 and in Q4 Estonia posted a growth rate of 0.9% q-o-q which is of course more than respectable but a significant slowdown in relative terms. What remains to be seen now is whether Estonia will kick off 2008 with negative growth rates or just eek out a positive showing. Indicators for retail sales suggest that Estonia may be lagging Latvia so I would not be surprised if Estonian Q1 is positive on a q-o-q basis. In the context of Latvia my colleague Edward Hugh has been keeping a watchful eye. Back in March he asked the question of whether we were heading into a recession in Q4 2007? At the time, strong circumstantial suggested that this was the case and now with the recent flash estimate from Q1 it is safe to say the coffin has now been supplied the final nails;
(...) in constant price terms - Latvian GDP hit a peak at some point between Q2 and Q3 2007 (lets say August 2007) and since that time has been steadily CONTRACTING. Now I know there are probably hundreds of different ways of skinning a chicken, and of course you can read data everywhichway you want to, and there are seasonal factors to take into account, but as far as I am concerned there is no getting away from it, on any reasonable criterion the Latvian economy is now in recession, and has been since the middle of last year.
This leaves us with Lithuania and consequently my little fetish here at Alpha.Sources in looking at this small Baltic economy. Since we just recently got Q1 2008 GDP figures (provisional estimates too I would imagine) we should have a fairly strong picture of what is going on. First, we will have the visual inspection;
As can be observed in the figure above Lithuania stalled sharply from Q3 to Q4 and now posting a contraction in Q1 08 on a q-o-q basis. On a y-o-y basis the economy is still growing but this figure is basically pointless in so far as goes the determination of where the economy is at in the present time. The first graph speaks for itself and in this context the two additional graphs plotting the indexed values of GDP do not really add much to the general picture. I still think they have merit though. Especially the last one is interesting as it shows the 'momentum' of the slowdown. Basically the chart shows the rate of expansion relative to the previous period without saying anything about the level of growth (which is shown in graph number two).
I have been very cautious in pulling out the R-word in connection with the Baltics let alone Eastern European in general. I still am. However, what is clear at this point is that we are now observing a hard landing. The rate of the slowdown since it began in the middle of 2007 leaves no other conclusion I think. What happens next then? This question is not at all insignificant. What we now have on our hands in the Baltics is, in macroeconomic terms, quite a predicament. Basically, the economic momentum now seems to be unwinding far too fast relative to the pace by which the inherent imbalances present in these economies can be expected to respond. Large external deficits and pegging currencies here are important since it means that the latter cannot adjust. The only possible alternative if the rout continues is consequently a transition into price and wage deflation. It is still early to say whether this will materialize but it is now a real risk rather than a theoretical possibility. Additionally, we now need to watch all those foreign banks who have set up shop across the Baltics helping to finance all those credit inflows. Will they stay or more specifically can they afford to? This is also now a question which must be considered as more than an academic question.
I am really sorry to start this week on such a nasty note but I do think that the genie is out of the bottle in the context of the Baltics. Now we need to watch carefully where it goes from here. If economic momentum (or lack thereof) continues to linger in the current territory we should be a prepared for a rapid change of fundamentals in the Baltics.
Stefan Karlsson chimes in and decisively note that the Baltics are now in a recession (or stagflation) ...
The Baltic states for long enjoyed the highest growth rate in the EU and was therefore held up by many free market advocates, including me, as a good example of the positive effects of low tax and low spending policies. However, unlike most others, I also warned already back in 2005 that the Baltic boom had an unsound element in the form of excessive monetary expansion. After I wrote that, these excesses became worse and worse, so my general assessment of the Baltic economies and particularly Latvia became more and more bearish.
In recent month, the state of the Baltic economies has deteriorated quite significantly. First of all, consumer price inflation have gotten worse and worse, with Estonia seeing an inflation rate of 11.4%, Lithuania an inflation rate of 11.7% and Latvia an inflation rate of 17.5%.
Oh, and while it is true that I am not calling it a recession yet we DID see a contraction in Lithuania and Latvia in Q1 2008 (i.e. basically a recession) but Estonia seems to be exiting Q1 with positive growth rates; at least we cannot call it yet I think but we will see soon enough. At this point, this is a question of semantics I think and as I said we definitely have that hard landing on our hands.
In the post above I field evidence to show that both Lithuania and Latvia definitely contracted in Q1 2008 leaving us only with Estonia to complete the picture. Today we completed it then as the Estonian statistical office posted preliminary figures for Q1 2008.
As can readily be observed Estonia (and thus the Baltics) are now in a recession. As Bloomberg reports this is taking some commentators by surprise ...
Estonia's economy, one of the fastest growing in the European Union last year, expanded an annual 0.4 percent in the first quarter, underscoring concerns the Baltic region is slipping into recession. The expansion compares with 4.8 percent in the previous quarter and 10.1 percent in the same period last year. The result is short of the 3.4 percent median estimate by seven estimates and may be echoed by Lithuania and Latvia, which said on May 9 that growth was less than half the pace of the previous three months.
``These numbers are disastrous,'' Neil Shearing, an emerging- markets economist at Capital Economics Ltd. in London, said in an e-mail. ``The speed of the slowdown in the region has even taken us by surprise.''
I have no interest in being coy here at Alpha.Sources but for those of my readers who have stood through my analysis of the Eastern European region (full overview here and here) and the Baltics in particular this should come as no surprise at all. Some are of course still in denial as Bloomberg also quotes Moody's Investors Service Vice President Kenneth Orchard for saying that it is not certain we are seeing a hard landing. Well, excuse me Mr. Orchard but could you please point me to your definition of a hard landing? Obviously, the worst may in many ways still be to come which might be what Orchard is talking about here. In this way, the Baltic countries have massive external deficits at the same time as they are pegging to a (at least hitherto) appreciating Euro. This is a recipe for quite a predicament I am afraid. As an intial shot across the bow in relation of what we can expect todays news also led to the slashing of the equity price of two Swedish banks with deep operations in the region.
Stockholm-based Swedbank, the owner of the biggest bank in the three Baltic states, declined as much as 4.8 percent to 150.5 kronor, and traded at 154 kronor as of 5:04 p.m. local time. SEB, which generates a third of its earnings from the Baltic countries, fell 4.4 percent to 140.25 kronor following the Estonian release. The banks have lost 17 percent and 15 percent in market value this year, respectively.
Equities move up and down as we know but it is crucial to understand that the Baltics depend on funding from these banks if they are not to collapse completely under the yoke of their external balances and no currency to correct. Of course, they could un-peg (which could very well be the end result I think) but then you run into the issues of translation risk. So, this is really, if ever, a question of being stuck between a rock and a hard place. If I am to end on a somewhat sympathetic note I could be inclined to agree with the tone of Mr. Orchard above in the sense that we don't really know how bad this will turn out. However, the initial cards have now been dealt and it looks like the devil is holding all the aces. In short; a major downside now prevails.