Ukraine on the Brink?
I am back in the saddle or more specifically I have now finished my studies for the year (only one year left now!). This means that regular services will now resume here at Alpha.Sources. Over the course of the summer I will also be working on a slew of papers whose summaries have been collecting dust on my hard drive for a while. Finally, I suppose that I shall also be indulging myself on some well earned R&R. Whew, who would think a vacation could be so busy?
Anyway, moving back on track I though that the recent travails of Ukraine is a good example of what it really means to be stuck between a rock and a hard place. The story is by now well known (see volumes of posts here and here). Economies across the Eastern European edifice are now effectively stuck in stagflation and one of a particular sinister kind which makes the US version look like a veritable walk in the park. In Ukraine, things turned from bad to worse with the most recent inflation reading for May clocking in at a most uncomfortable 31.1% after having increased 30.4% in April. As Stefan Karlsson points out this is almost hyper inflationary territory and highlights the most serious issues confronting Ukraine at this point in time.
Unfortunately for Ukraine, in the current global economic edifice there are only so many things one can do. One would be to severely restrict fiscal spending forcing a surplus on the economy to drain some of the excess demand. However, Ukraine also has a nasty external deficit to finance which means that the balance act is not for the faint of heart. As such choking off demand could effectively halt the inflows making the Hryvnia very difficult to defend; not least since it was recently allowed to float more freely. Meanwhile, Ukraine as most other economies and indeed financial market participants have, in the recent month, been caught in the shift of focus from growth to inflation. This was a theme I latched on to about a month ago when I asked whether in fact the dog was getting wagged by its tail. Recent messages from global central banks and not least the staunch message from the ECB that the bank might actually raise rates come next meeting are highly suggestive of this shift in focus towards inflation. Joachim Fels, who have recently been re-introduced at Morgan Stanley's GEF with a slew of notes on the global liquidity situation, moves in a with a fine update on the change of market discourse.
In an Ukrainian and indeed Eastern European context this has materialised itself in a flurry about using nominal exchange rate appreciation to flush out inflationary pressures. In concrete terms it has prompted many economies to ponder their peg or semi peg to the Euro as well as most Eastern European central banks are now clearly exhibiting a tightening bias. Most recently it was exactly Ukraine's turn to adjust the peg as the Hryvnia was allowed to trade in a wider band. Yet, as I have persistently been arguing this is also something of a dilemma since one thing is to wish for appreciation by letting the currency float freely and it is quite another to get it. Moreover, and given the most precarious state of the external position it is not certain that the strengthening of the currency will solely be a force of good.
The dilemma Ukraine which confronts can hardly be better illustrated than by the recent downgrade of the country's credit rating to B+ by S&P. Yields on Hryvnia denominated sovereign debt predictably spiked (or prices fell; whichever way you like to see it) following the decision and now the Ukrainian benchmark bond expiring in 2016 runs a coupon of 7.85%. Now, one can always quibble about the significance of these credit ratings, not least their legitimacy. However, they do seem to have an importance and it is exactly the mixture of hawkish credit rating agencies and a stagflating economy that looms as the potential push which could tip some the Eastern European economies over the edge. Moreover, the reasons cited for the downgrade are, in itself, pretty interesting. As such and if we go back to the debacle about the Hryvnia band S&P moved in, at the time, with a warning that nominal appreciation to choke off inflation would not cut it. The argument which I have also pointed towards several times was that inflation at this point in time also was caused by non-monetary factors. Or more importantly ... by monetary factors outside the reach of domestic monetary policy . And before the collective mass of Austrians and Monetarists pull out the knee jerk fiddle that inflation above and beyond is a monetary phenomenon I would advise a brief stop at Edward's recent posts on global inflation which provide considerable differentiation to that statement. To top off the cake with the proverbial cherry, S&P also cited the widening external deficit as a reason why a moonshooting Hryvnia would not make the imbalances any smaller.
In this light I had a bit of a chuckle when I read the reasons cited for the recent downgrade. Apparently, S&P are now very concerned about inflation and in fact so much that this was cited as the main reason for the downgrade. Perhaps S&P's analysts and me have read different textbooks. However to me, it is seems quite impossible for Ukraine in one week to resist nominal appreciation because of a widening external position only to be slapped in the face by a downgrade a week later on inflation concerns. As I stated earlier there are many ways to fight inflation but given S&Ps apparent u-turn with respect to discourse it is not an easy task for Ukraine to turn the boat around faced with the current market expectations. Of course, the S&P may itself be wondering just how to deal with the rapid deterioration in Eastern Europe in the sense that, given the trajectory of economic fundamentals, a downgrade was inevitable.
A Race to the Bottom?
The recent tightening of the noose in Ukraine can hardly be surprising for careful observers of the region. My view of Eastern Europe is that some of the economies are now in a race to bottom. The Baltics are in a recession and Ukraine is about to spiral out of control with respect to inflation. Hungary, albeit showing resilience recently, is not out of the woods either. Especially, the relentless hiking campaign by the central bank will take hold at some point. Moreover, the longer rates go the more difficult it will be to defend rate cuts since the floating Forint will run the risk of suffering the rout. This is the price of engaging in market driven revaluation with no safety net and the end point is very likely to be deflation. In this light, the ECB's decision to tip its toe with a pre-announced rate hike should not be taken lightly since if it materialised Eastern European will have to follow if their currencies are not to sink.
I realize that my narrative on Eastern Europe continues to be one of doom and gloom. Given the economic fundamentals I think such a strong position is valid although, as usual, heterogeneity is still present across economies and asset classes. However, rising global headline inflation is not all for the bad. Both Ukraine, Romania, and Hungary earn a considerable income of agricultural exports, an income bill which will certainly grow healthy in the coming quarters. However (and I really do not have numbers on hand) if oil remains to relentlessly soldier on the windfall may end up with little net positive effect.
For market purposes I also want to reiterate a point I made recently that investors should be careful buying into the revaluation of Eastern Europe. Surely, the recent figures from inflation merits expectations of nominal appreciation but risks also loom that could make the movements go in the other direction. Especially, my feeling is that if global central banks are now going for a hiking trip (I strongly doubt this) some of those recent floaters could get squeezed. In this light, the ECB's decision come July will be interesting.