The Beginning of the End for Baltic Pegs?
[Uff, that was an unduly quick write up and I have now corrected the most severe mis-spellings and typos accordingly]
Volatility seems to be on the rise in the market place (at least if the past days' trading is to be deemed representative). As per usual Macro Man provides an excellent looking glass into the markets where we saw on Monday how UK mortgage lender Bradford and Bingley went to the pillory (or more aptly with hat in hand) offering a 23% stake to leveraged buyout firm TPG Inc. for the net amount of 179 million pounds ($353 million) which you can only wonder why TPG was willing to squander. Yesterday we saw traders on the walls on rumours Lehman were in the bushes searching for that alluring Fed discount window; something which prompted Macro Man to ask whether in fact risky assets were in for a bad hair day?
Here at Alpha.Sources your devoted author is struck by hardship at school as he labours (with his mates) to finish a paper by next week on the juicy topic of determining the factors which guide prices and returns on subordinated debt in the European leveraged finance market. However, having updated his Eastern European (Baltic) excel sheets recently he feels compelled to move in with some observations on the evolution of bank lending in the Baltics and why investors should be a little bit weary of buying into the main trend at the moment where high inflation rates are leading markets to price in revaluation across the board in an Eastern European and Russian context.
The immediate context of overheating economies in Eastern Europe and the subsequent expectation of revaluation recently was epitomized in the flurry about the Hryvnia in Ukraine but also Hungary was 'forced' recently to scrap the Forint's trading band. In the context of this emerging market discourse and not least the growing pressure on Russia to let traders punt the Ruble (don't worry Macro Man, your day will come) I recently asked the simple question of whether in fact the process of nominal appreciation would a be a natural consequence of making the exchange rate more flexible. The point is simply that while nominal appreciation may indeed quell imported inflation it is also likely to add to an already raging inflation bonfire in Eastern Europe driven by excess domestic demand over capacity which is fuelling unsustainable wage growths, large external deficits and by consequence large inflation rates. As a response to my piece RGE's inhouse analyst on Eastern Europe Mary Stokes also moved in with an excellent writ in which she basically asked whether pegging currency regimes were to blame for the travails of many Eastern European countries?
As Mary eloquently sums up many Eastern European countries are now in a bind as real economic activity is plummeting at the same time as inflation remains. This is especially true for the Euro peggers (such as e.g. the Baltics and Bulgaria) where there now seems to be no meaningful adjustment mechanism except domestic deflation and should the pegs be abandoned (I think ultimately they will) where will this take these countries?
In this specific note I want to focus on the Baltics whom I have had under the spotlight several times at this space. Recently, we got evidence that all three Baltic countries had slowed sharply going into Q1 2008 essentially dropping into a recession. Traditionally, my analysis on the Baltics have been focused a lot on the financing of the three countries' external balance as well as the the currency composition of the credit inflows which make up a decisive part of the financing. Specifically I have been indulging my Lithuania fetish in an attempt to go deep in the context of one country in order to be able to make extrapolations on similar countries. Most recently I discussed the drivers and availability of foreign credit in Lithuania (Euro denominated loans). In the following I present a similar analysis for all three Baltic countries and the results should not be taken lightly I think.
The stylised facts are as follows:
- The monthly/quarterly increase in outstanding loans (measured on MFI's balance sheets) have slowed sharply in all three Baltic countries. This was also what (among many others) IHT homed in on recently as they linked the retrenchment of foreign credit by Scandinavian banks to the Baltic slowdown. Only yesterday we got another shot across the bow in the context of the increasingly strained love affair with Scandinavian banks and the Baltics as we learned how Sweden's Riksbank is getting more than a little bit concerned about how the slowdown in the Baltics will affects its position. However, the composition of loan flows tell a cautionary and important tale.
- Essentially, the flow of total loans in domestic currency is negative for all three Baltic countries. However, the flow of total loans in positive (i.e. still increasing) and thus only held up by a flow of foreign denominated loans (largely Euros). Basically, we are observing that economic agents are shifting their liabilities into Euros which, we should remember, is perfectly rational if we expect the purchasing power of the domestic currency to increase or if interest rates are lower for Euro denominated loans. Ultimately of course such moves are also not, with the current imbalances, accomodative for the technical workings of the peg since at some point push will come to shove if economic agents continue to act as they are currently doing (i.e. the balance sheet risk is huge here).
As we observe the stock of household (and I would imagine also corporate) loans in the Baltics are overwhelmingly in Euros. This is hardly news and at this point it is well incorporated into the market discourse on the Baltics. Yet, if we look at the evolution we can see that since the credit turmoil began (more or less) economic agents in the Baltics have been shifting their liabilities into Euros. This effect seems especially pronounced in Lithuania where a hump in LTL loans is now giving way to an increase in Euro denominated loans. The immediate underlying driving force cannot be read from the graphs above in the sense that this may be a sign of loan rollover/conversions as well as a sign that the flows are simply changing.
I think that these three graphs tell a tremendously important story. As we can see the total stock loans denominated in domestic currency are now in decline across the Baltics which reflects the general economic slowdown and tightening of credit conditions. However, as I also showed recently in the context of Lithuania the negative interest rate spread in favor of Euro denominated loans seem to favor Euro denominated loans. This, perhaps coupled with expectations of revaluation, is helping to keep the change in loans in a positive reading solely on the back of an increase in Euro denominated loans. I think this is important. General economic conditions prescribe that we should observe a downward trend in loan taking. Such tendencies are clearly observable in the graphs above. The lingering trend in the context of Euro denominated loans can be due to two things in my opinion. A favorable interest rate spread over domestic currency loans as well as an expectation that the domestic currencies should increase in purchasing power on the back of strong inflation pressures and thus perhaps an expectation that Euro membership is not as far away as it may look.
Buy Eastern Europe at your peril!
It is indeed a bit difficult to see what is going on here. One tendency which is clear at this point is that the market discourse has changed towards a more adamant focus on inflation (Bernanke's recent life line to the USD should tell us as much). In an Eastern European context this has lead market participants to expect revaluations across the board to quell overheating economies. So far, Ukraine and Hungary have responded and much more importantly Russia is now also under the spotlight to let the Ruble float. As I have persistently argued the effect of such measures are far from certain. In fact, what initially goes up may well come down as the realities of the imbalances hit the market place. A very real side effect here would be the cross currency balance sheet effects as Baltic corporations and households would be paying off loans in Euros with a depreciating cash flow in the form of the domestic currency.
In the context of the Baltics, the pegs look increasingly strained. I want to emphasise that de-pegging is not certain to bring relief as such but absent any action on this front the Baltics will be entering the current downturn without any adjustment mechanism. De-pegging needs to be weighed on a tough scale. On the one hand it may strengthen the currencies which may (or may not) help ease inflation but it will also suck up even more purchasing power in an already very imbalanced economy. Should the domestic currencies conversely plummet inflation would run out of control in turn forcing the central bank to raise interest rates to such a level that could push the economy into deflation (which may well be the end result anyway). In short, the Baltics are effectively stuck between a rock and a hard place and it is not evident what should be done. If de-pegging means revaluation at this point it would in fact not be so smart since this would only exacerbate the substition effect in favor of Euro denominated loans. However, we also know how the foreign banks have tightened credit standards significantly with all the problems this is bringing in the context of sustaining the inflows to finance the external deficits.
If this is the dilemma facing the Baltics and other Eastern European countries it does not take much of trader to see that it matters whether you buy or sell (if you want to play this at all that is). As I have argued I would be weary to buy in expectation of continuing nominal appreciation in Eastern Europe (and in the Baltics should the pegs be abandoned) but concur that in light of the current market context it would perhaps be the safest bet. If, however, I should really bet on all this I would be positioning myself through straddles (i.e. put and call options to benefit from potential volatility both ways). 3 to 6 month would be good maturities to aim for I would argue.