The EM currency storm that began in Asia in May has hit Latin America (Latam), and, we believe, is spreading to Eastern Europe (EE). When it gets there, the storm is likely to cause more damage because of the weaker underlying fundamentals of the EE economies, compared to Asia and Latam. The story for EE currencies should be familiar – large C/A deficits and high credit growth make a dangerous combination in a global environment marked by risk-aversion. A sudden stop in capital flows that has always been a recognised risk for EE currencies in recent years is now likely to become a much more clear and present danger. We believe that HUF (Hungarian forint) and RON (Romanian leu) are vulnerable, and pressures on the pegs of LVL (Latvian lats) and BGN (Bulgarian lev) will likely be quite intense in the months ahead. Global Recession and Dwindling Capital Flows to EM The extraordinary policy interventions announced this week are nothing short of epic. However, we believe that they are primarily aimed at dealing with what Boston Fed President Rosengren calls a “liquidity lock” rather than the credit crunch. The global economy is still very likely to fall into a synchronous recession in the coming quarters, in our opinion. (The countermeasures deployed by the G7 governments this week have been substantial, and risky assets have staged a strong tactical rally. We, however, are unconvinced that this will mark a turning point in the global economy, and believe that the global credit crunch will likely continue to propel the real economy into a synchronous recession. How long and how deep this recession turns out to be is difficult to gauge at this point, but our sense is that it will inflict significant pain on the EM economies.) As global – especially developed economies’ – growth decelerates, so will capital flows to EM (see Risks of a Sharp Reduction in Capital Flows to EM, September 25, 2008). To reiterate, we believe that gross capital flows to EM could plummet from an average of US$750 billion a year during 2006-07 to under US$500 billion a year. Such a dwindling in capital flows is likely to especially starve EE economies of much-needed capital, and lead to downward pressures on their currencies. Why EE Currencies Are Vulnerable Investors should be familiar with some of the characteristics making EE currencies vulnerable. The fear was always that these vulnerabilities would pose a threat to EE if and when global conditions deteriorated. The sharp depreciation in the EUR since July may have helped to delay the currency storm hitting EE. But as Europe slows, and as European banks react to the credit crunch, EE currencies will come under increasing pressure, in our view. We summarise these key fundamental weaknesses of EE, in addition to a sharp economic slowdown already beginning to materialise in some countries. (Please also see 1992 Redux by Chaney et al., June 2008; Central Europe: Not So Fast Anymore, by Pasquale Diana, October 2008; Central Europe: FX Loans Give Central Banks Plenty to Worry About, by Pasquale Diana, June 2008; Baltics: Canaries in the Coalmine, by Oliver Weeks, November 2007; and CEEMEA: Deficit Disorders, by CEEMEA team, June 2007.) • Weakness 1. Sustained large external deficits. EE economies have higher C/A deficits than any other group of EM economies. Somewhat similar to the macro configuration of most of the Asian countries in the mid-1990s – prior to the Asian Crisis in 1997 – the high external deficit positions in EE reflect more high investment rather than low savings. (FDI flows into the region have been large, accounting for an average of 65% of these economies’ C/A deficits during 2003-07.) For EE as a whole, the C/A deficit is now roughly 9% of GDP – up from 2% in 2000 – with the Baltic states having even larger deficits (an average of 18.5% in 2007). (Specifically, here are the C/A balances for the individual EE economies: Latvia (22.9%), Bulgaria (21.4%), Estonia (18.1%), Serbia (15.9%), Lithuania (14.6%), Romania (14%), Turkey (5.7%), Slovakia (5.4%), Hungary (5.0%), Poland (3.8%) and Ukraine (3.7%).) The EE economies with the largest C/A deficits also tend to be the ones with fixed exchange rate regimes. Estonia, Lithuania and Bulgaria have currency board regimes, and Latvia has a regime close to a currency board. What this means is that if there is a sudden stop in capital inflows, i.e., if either foreign banks become constrained themselves or if the perceived risk rises in EE, interest rates in these economies will need to be allowed to surge substantially higher (currency boards are essentially fixed currency regimes without sterilisation), forcing the policymakers to face a difficult dilemma of accepting a painful recession versus re-pegging at a weaker parity. Our colleague Oliver Weeks believes that the Baltic states will likely choose to go through a painful recession rather than re-pegging. While we share this view, that the most probable scenario is that the pegs are preserved, we believe that, as the global slowdown persists and capital flows dwindle, pressures will intensify on these pegs and investors should buy protection against the risk of re-pegging. • Weakness 2. Sharp credit extension. Capital account liberalisation has also been more aggressively implemented in EE than in other regions in EM. Bank lending has surged sharply in recent years, with foreign-owned banks having a substantial presence in this region, particularly in the Baltics, Bulgaria and Romania. Much of the bank lending has been to households in the form of mortgages and housing loans. We illustrate the immense credit growth rates in Bulgaria, Romania, the Baltics and Turkey. In a way, the credit bubble the US has experienced in recent years had its counterparts in EE economies. • Weakness 3. Foreign currency mismatch. Households have accumulated large foreign exchange-denominated household debt. In Estonia and Latvia, total foreign currency debt has reached 30% and 24% of GDP, respectively. Not only do local residents have foreign currency exposure, but foreign investors also have large exposures to local currency instruments. In Turkey, Hungary, Poland and the Czech Republic, for example, non-resident holdings of local currency equities and bonds are around 30%, 18%, 17% and 10%, respectively. (These are the averages of foreign presence in the local equity and bond markets). This currency mismatch will be exposed when the dollar appreciates. Like other EM economies in a similar ‘low-gamma’ situation, the more the exchange rates move, the greater the momentum, as economic agents scramble to deal with the underlying currency mismatch. Which EE Currencies Are Most Vulnerable? Judging from the above ‘weaknesses’ of EE currencies, we believe that the Bulgarian lev (BGN), Romanian leu (RON), Hungarian forint (HUF) and the Latvian lats (LVL) are particularly vulnerable. While LVL might be the weak link among the Baltics, if the LVL peg breaks, we believe that other pegs could be in jeopardy. Further, Russia’s capital account is so porous that it will be essential for the CBR to control the expectations of the RUB. However, Oliver and we believe that if oil moves toward US$60-70 for a sustained period, even the RUB may be pressured lower. Stark weakness of EE currencies should, in turn, feed back to the AXJ and Latam currencies, pushing the likes of INR, KRW, IDR, BRL, MXN, TRY and ZAR lower. Boomerang Effects on Banks in Europe Just as the Asian Currency Crisis in 1997 undermined Japanese banks which had large exposures to Asia, problems in EE could have a negative feedback effect on European and Swedish banks. According to the BIS Quarterly Report, in the aggregate, EE economies now hold around US$1.64 trillion worth of foreign debt, US$1.50 trillion of which are borrowed from EMU, Swiss and Swedish banks, while US, UK and Japanese banks – together – have only US$120 billion of exposure to EE. What may perhaps be a surprise to many is that, of all the European countries, Austria has the largest exposure to EE (US$297 billion), followed by Germany (US$214 billion), Italy (US$212 billion) and France (US$176 billion). Finally, Swedish banks are by far the biggest creditor to EE, as Sweden accounts for US$83 billion of the US$123 billion in total foreign debt owed by the Baltic states. Bottom Line As the world falls into a synchronous recession, capital flows to EM will likely dwindle. More than any other parts of EM, Eastern European currencies, as a group, are likely to experience intense pressure, partly because of their large C/A deficits, which have been accompanied by extraordinarily high domestic housing credit growth, with a serious currency mismatch. While the falling EUR had protected these currencies from July to September, risks are skewed heavily to the downside for these currencies in the coming months, in our view. For more details, please see “EM: The EM Currency Storm Moves to Eastern Europe”, FX Pulse, October 16, 2008.
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De Facto Dollar Zone versus De Facto Euro Zone
October 20, 2008
By Stephen Jen & Spyros Andreopoulos | London
Summary and Conclusions We do not share the view that the dollar’s recent rally is due only to ‘deleveraging’. While we ourselves highlighted early on that cross-border risk-reduction would be a powerful driver pushing the dollar higher in an adverse global environment, we have also argued that there are important fundamental reasons why the dollar should rally. In this note, we highlight one particular macro factor that is dollar-positive. The composite C/A balance in the de facto dollar zone has steadily improved in the past three years, as it is in fact approaching a fully financed position, while, during the same period, the balance in the de facto euro zone has steadily deteriorated. Give the Dollar Some Credit The recent dollar rally came against the prevalent view – back in June/July – that the dollar could collapse due to the financial turmoil in the US. The general opinion during the sell-off in EUR/USD from the mid-1.50s down to the high-1.40s was one of scepticism. This scepticism persisted even as EUR/USD traded below 1.40 for the first time in this cycle on September 10. However, when EUR/USD definitively traded down to the mid-1.30s in early October, commentators grudgingly agreed that ‘deleveraging’ was the main and only reason why the dollar was able to rally, implying that, as soon as risk-aversion abated, the USD would resume its weakening trend. While we had pointed out, early on, that cross-border risk-reduction would push the dollar higher (i.e., risk-aversion would push the world up on the left side of the ‘Dollar Smile’), we also suggested that there were other fundamental reasons why the dollar should strengthen against the EUR, that the dollar’s rise is genuine and more deserving than many USD-sceptics may have in mind. First, a proactive Fed had already front-loaded most of the rate cuts early on. When inflation was the dominant concern, the dollar was punished for the easy Fed, and the EUR rewarded for the ECB’s vigilance on inflation. However, now it is more evident that the global economy is in a genuine slowdown, and because it is well-known that monetary policy changes act with a long and variable lag, a passive ECB should imply a risk premium on the EUR. Second, the EUR is over-owned, while the USD is under-owned by many real money investors both in the US and in Europe. Cross-border risk-reduction will probably not be ‘reversed’, i.e., cross-border risk will not be rebuilt after the dust settles. We will not repeat our thesis (our observation of the US real money accounts having heavily diversified out of the US since 2003 was made in The Biggest Dollar Diversifiers Are American, July 19, 2007), but only stress that part of the desire to move out of the US was related to the US C/A deficit, which in turn was a symptom of the US credit bubble. Thus, a prospective repatriation of some of these outflows would be a fundamentals-based story as the secular credit cycle turns, not a ‘technical’ matter associated with risk-induced deleveraging that might turn out to be temporary. Third, at 1.55-1.60, the EUR had been extremely over-valued. The first signs of Euroland weakness triggered a normalisation process, in our view. 1.60 was never a level that was sustainable, particularly when the global economy weakens. Fourth, the underlying trend of the US C/A deficit has been improving steadily since 4Q05. This particular development – a narrowing in US external financing needs – has thus far been dismissed by most as an unimportant driver of the dollar. We disagree. In this note, we elaborate our thoughts on the financing needs of the dollar area. De Facto Dollar Zone We first introduced the concept of the ‘de facto dollar zone’ in 2002 (see A De Facto Dollar Zone, April 25, 2002). The idea is that the dollar area should not be confined to the national borders of the US. Rather, it should include countries with less-than-fully-convertible currencies that are either hard or soft-pegged to the dollar. For example, the GCC (Gulf Cooperation Council) countries are hard-pegged to the dollar (Kuwait has a basket peg with a heavy dollar weighting) and actions need to be taken (e.g., interventions and monetary policy adjustments) to maintain these pegs. Similarly, much of Asia has been soft-pegged to the dollar (e.g., China). If we consider the C/A balance of the entire de facto dollar zone, we see that the dollar zone now has a significantly better external financing outlook than three years ago. We illustrate the evolution of the trade balances for the US and the de facto dollar zone. The C/A trends follow a similar pattern. The key reason for this trend improvement in external balance is that the rates of improvement of the savings-investment surpluses in the GCC and China have been even higher than the pace of improvement of the US C/A deficit. (Linearly) extrapolating based on the latest data, we expect the aggregate C/A balance of the de facto dollar zone to approach zero by 2009/10. In other words, within the next year or so, the de facto dollar zone could be almost fully self-financed, i.e., there will be no need for additional external financing from outside the zone. A similar calculation can be performed for the de facto euro zone. In addition to the euro area, there are many Eastern European currencies that are hard and soft-pegged to the EUR, whose currencies are not fully convertible on the capital account basis. Similar to the de facto dollar zone concept, we compute the overall savings-investment balance for this de facto euro zone and monitor its evolution. We have the following thoughts: • Thought 1. Divergent C/A paths. While the aggregate C/A deficit of the de facto dollar zone has been declining sharply, approaching zero in a year’s time, the path of the aggregate C/A balance of the de facto euro zone has headed in exactly the opposite direction. Specifically, since 2002, we have seen a structural deterioration in the external balance of both Euroland and the de facto euro zone. While the overall trade balance of the euro zone still shows a small surplus, the euro zone’s C/A balance has actually gone into a deficit position (-0.5% of GDP expected in 2008, according to the IMF WEO), and the trend is likely to persist in the foreseeable future. These divergent paths reflect the opposing trends in the household savings of the US and the euro zone: rising in the former but falling in the latter. In terms of the levels of external balance of the de facto dollar zone and the de facto euro zone, the former could be more fully financed than the latter in a year’s time. • Thought 2. Core versus periphery. The ‘core-periphery’ relationships are exactly the opposite in the two de facto currency areas. The US has a C/A deficit, but the other members of the de facto dollar zone have large C/A surpluses. In Europe, this relationship is exactly the opposite: the peripheral members of the de facto euro zone have large C/A deficits while the euro zone has a small deficit. And, within the euro area, Germany has a large surplus (7.3% of GDP), while Spain, Portugal, Greece and Ireland have large C/A deficits (10.1%, 12.0%, 14.0% and 5.0% of GDP, respectively). These relationships between the core and the periphery reflect, to some extent, the different levels of development and growth strategies of the AXJ economies and the EE economies. In any case, as far as currencies are concerned, the more committed are the GCC and the AXJ countries to the dollar, the better supported it is. On the other hand, for the euro zone, the more committed the East European countries are to the euro, the less supported it is. • Thought 3. Loyalty toward the dollar. While we first introduced the de facto dollar zone concept in 2002, and have recognised the trend improvement in the zone-wide C/A balance for some time, we only make this observation now because, prior to July, it was not clear whether the GCC and the AXJ countries would ‘remain loyal’ to the dollar. Pressures were intense at times for the RMB and the GCC currencies to revalue against the dollar. However, now that the dollar has reasserted itself, it is much less likely that the members of the de facto dollar zone will choose to leave the zone. China has even stopped letting the RMB appreciate against the dollar; there is no more talk about GCC revaluation. Thus, the stabilisation of the dollar has significantly emboldened the structural integrity of the de facto dollar zone, making the discussion of the trend improvement in the aggregate C/A balance much more relevant now than it was three months ago. Bottom Line Cross-border risk-reduction is one, but not the only, reason why the dollar is strong. Among the fundamental factors supporting the dollar, we believe that the trend improvement in the C/A balance of the de facto dollar zone is crucial. In a year’s time, it is possible that the de facto dollar zone will be better financed than the de facto euro zone.
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ECB to the Rescue
October 20, 2008
By Elga Bartsch | London
The ECB Has Cut by 50bp, and Could Do More Soon While we expect more ECB rate reductions before year-end, we believe that the ECB will focus on addressing liquidity issues first. In fact, as we wrote this, news came in saying that the bank was making far-reaching changes to its collateral framework and its refinancing operations. Historically, in an easing cycle the ECB has moved in bold steps of 50bp, almost as often as in small steps of 25bp. Another refi rate cut could come as early as November, we think. We also would not rule out another inter-meeting cut, if financial market turmoil resumes. That said, a bold cut of 50bp in December, when the ECB staff are rolling out a fresh set of staff projections, would seem to be more likely at this stage. Looking further ahead, we even start to see scope for more policy action than the total of 125bp of ECB easing that we had pencilled in before the major central banks embarked on coordinated rate cuts last week (see Euroland Economics: A More Severe Downturn, October 3, 2008). Admittedly, there are some downside risks to our refi rate target of 3% for the middle of next year. But we feel that the need for aggressive ECB action on the interest rate front is lower than in the last easing cycle. The last easing cycle eventually brought ECB interest rates down by a total of 275bp, from 4.75% for the refi rate in May 2001 to just 2% in June 2003. We believe that there is less need to ease this cycle for four reasons: • First, contrary to 2001, when the refi rate peaked out at 4.75%, the ECB did not really embark on a restrictive monetary policy stance in its tightening campaign. As any car driver will know, if you haven’t slammed on the brakes to slow the vehicle, you also won’t have to push the accelerator hard to get it back to cruising speed. • Second, while Euroland headline inflation will likely fall in the months ahead on the back of lower commodity prices and very favourable base effects, the decline in inflation will likely be less pronounced than it was in downturns historically. In fact, there is a risk that the economy is about to experience a downshift in its potential output growth on the back of the re-pricing of natural resources and more recently of credit. This negative supply shock would seriously limit the disinflationary pressure emerging on the back of the slowdown in demand. • Third, according to our currency team, the euro is likely to slide down to 1.25 against the US dollar by the end of next year – a decline that would be roughly equivalent to an additional 75bp of easing, according to our simple monetary conditions index. • Last but not least, the ECB has started to make significant changes to its open market operations, which together with the government action taken across the euro area, could go a long way in bringing market interest rates closer to official policy rates. As a result, effective interest rates could eventually fall by more than official policy rates. A Key Change in the ECB’s Liquidity Procedures … The most obvious liquidity measure is the ECB’s decision to switch its main refinancing operation and more recently also its longer-term refinancing operations from a variable-rate tender to a fixed-rate tender and guaranteeing the banks’ full allotment at that operation. Starting with this week’s operation, the participating banks thus can be sure that they will get as much funds as they need at a fixed rate. Contrary to the US, where the effective fed funds rate has been quite a bit below the fed funds target, in the euro zone the effective refi rate at which the banks obtained funding from the ECB stood considerably above the official level. This positive spread should now collapse – effectively this adds a good further 50bp to the ECB easing. In addition, the bank has narrowed the corridor around the refi rate created by the marginal lending facility and the deposit facility from 200bp to 100bp, in an attempt to reduce the volatility in the overnight rate. As a result, banks can now get overnight emergency liquidity from the ECB at a 50bp penalty over the refi rate. At the same time, they can get a remuneration of a 50bp discount versus the refi rate on any excess cash that they might have. … to Reduce Money Market Dislocations The initial market reaction to the coordinated rate cut was disappointing across the board, especially as far as the money market is concerned. Thus, the current focus of the ECB and other central banks, in our view, will likely be on considering different ways to overcome the money market dislocations. The measures announced this Wednesday should help substantially to alleviate these dislocations. From an economic point of view, there are two different types of risk that have likely kept banks on the sidelines in the interbank lending market and instead induced them to hold onto cash, as evident from the sharp increase in the use of the ECB’s deposit facility: the refinancing risk and the counterparty risk. Concern #1 – Refinancing This is the (perceived) risk of not being able to refinance oneself either in the market or at the ECB. Even at the ECB, under the variable rate tender, there was always a risk of being outbid by other banks and left to go to the marginal lending facility for overnight funds at 100bp over the refi rate. The change to the ECB’s tender operation effective from this week onwards should go a long way towards reducing these concerns. One gauge of the extent of hoarding of liquidity by European banks would be the use of the deposit facility at the ECB. In addition to tweaking its own operational procedures, the ECB has announced – together with the Federal Reserve, the Bank of England and the Swiss National Bank – that it will operate the same fixed-rate tender procedure also for the USD facilities it currently offers under the USD swap agreements with the Federal Reserve. Concern #2: Counterparty Default This is the situation of asymmetric information about the financial situation of different counterparties in interbank lending. Here, the government guarantees announced over the last few days should help to limit the perceived counterparty risk. While there is still some uncertainty about what kind of interbank lending will be guaranteed and at what price for the institution in question, it is clear that in many cases the extent of the guarantee could include Libor. Hence, the ECB, like other central banks, will likely want to see how the measures taken so far will affect money markets in the days and weeks to come before it contemplates further interest rate reductions. Reviewing the Collateral Framework, Enhancing Liquidity As we wrote this, newswires reported that the ECB had taken significant measures to enhance the eligible collateral list and enhance liquidity provision to the euro area banking system. The details of the changes announced can be found at www.ecb.int. In my mind, the change of the longer-term refi operation to a fixed-rate tender with full allotment goes a long way towards reassuring banks that they will be able to obtain three-month term funding from the ECB. Next to this, the bank announced additional longer-tem refi operations to be held, notably four more six-month operations. Lowering the minimum rating requirements from A- to BBB- will not only add to the pool of eligible assets, but also show the determination of the ECB to clear the logjam in the euro area money market. It could also be an indication of more drastic action on the interest rate front to follow. Stay tuned.
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