No Longer All for One?
April 23, 2009
By Oliver Weeks & Alina Slyusarchuk | London
Despite improving confidence in Euroland and widespread optimism on the impact of the post-G20 IMF, problems in the weaker parts of eastern Europe look far from over. We previously thought that the small absolute size of funding gaps, contagion risks, external support and closed FX markets made it likely that all three Baltic states would endure the intense pain needed to enter the euro at current exchange rates. Without a strong and early recovery in external demand, we now think that eventual devaluation is more likely for Latvia and probably Lithuania. Since the EU will not soften its euro entry criteria, only Estonia has a chance of EMU entry in 2011, in our view. We still expect EU and IMF support to continue and that the dominant foreign banks will not withdraw. However, fiscal pressure in Latvia and Lithuania looks likely to delay euro entry enough to make the current process of adjustment through wage cuts look intolerably open-ended. Estonian euro entry does not yet look a done deal, but external support for Latvia and Lithuania may mainly serve to postpone devaluation long enough to give it a chance, as well as to delay the impact on south east Europe.
Internal versus external devaluation: The pain of maintaining currency pegs across the Baltics remains huge and, in our view, has only ever looked bearable given a quick and credible exit strategy (euro entry). Previously, vast current account deficits have adjusted in line with the disappearance of private sector financing, but at the cost of extraordinary collapses in demand. Real domestic demand contracted by 14.8%Y in Estonia in 4Q08, and the pace of decline continues to accelerate. Real retail sales in February in Estonia, Latvia and Lithuania were down 19%, 27% and 21%Y, respectively. Industrial output is down 30%, 25% and 16%, respectively. We still think that it would prove more expensive for foreign banks to withdraw than to stay and absorb losses. However, any return of private sector credit is clearly a distant prospect as housing bubbles deflate and defaults multiply. Devaluations among trading partners have stabilized for now, but the challenge of regaining export competitiveness in the current global environment remains daunting (see also Eastern Europe Economics: Peripheral Risks, March 6, 2009). In Latvia’s case, only 23% of exports are to Euroland and a third is with countries, from Sweden to Ukraine, that have seen major FX depreciation against the EUR – so far negating the impact of wage declines. Lithuanian shoppers continue to flock to Poland. Official policy across the region remains one of ‘internal devaluation’, restoring competitiveness through wage and price adjustment. While Baltic workers and voters are highly flexible by international standards, the cuts this will require are extreme, and already proving hard to deliver. Political commitment to quick euro entry remains strong, but the distributional impact of choosing wage cuts over devaluation – putting more of the burden on workers than corporates – may prove politically difficult to sustain. External support, but not accelerated EMU: Historically, such adjustments are rarely successful without overwhelming external support or a deus ex machina such as EMU (see Baltic Economics: The Euro at the End of the Tunnel, June 13, 2008). Generous external aid will continue, and we expect Lithuania to receive an IMF/EU support package shortly. However, we think that spin may have run ahead of reality in some expectations of the IMF’s new scope to replace private sector funding. As current events in Latvia are demonstrating, even with new money the Fund is unlikely to be able to ignore exploding fiscal deficits, and since it still needs to be repaid the IMF may remain wary of seeing reserves it lends to central banks lent on for open-ended budget funding. The Fund’s own commitment to the currency pegs still appears lukewarm, justified mainly in terms of the EU and Latvian government’s wishes. The EU appears interested in limiting contagion, but fiscal deficits are also making EMU membership look increasingly remote, at least for Latvia and Lithuania. It remains our view that the ECB and Euroland governments will not tolerate any loosening of euro entry criteria. Internal strains within Euroland are already high, and existing decision-making mechanisms are already challenged enough to make adding new members an un-enticing prospect. As Slovakia has shown, a country that meets the Maastricht criteria is hard to exclude. However, for those that cannot meet the criteria soon, the strongest argument for maintaining the currency peg – that devaluation would delay euro adoption – becomes much weaker. EMU in 2011 conceivable only for Estonia: In this context, differences between the Baltic states look increasingly important. We previously thought that contagion effects would make it impossible to manage different exit strategies for the three states. Now, however, Estonia’s euro entry prospects look significantly stronger than those of its neighbours. Subjectively, it looks easier to absorb. Its GDP is just €14 billion, half the size of Lithuania’s, and it is 25% richer than Latvia and Lithuania in per capita terms. Its Scandinavian links are closer, and it does significantly better than its neighbours on competitiveness measures such as the OECD/WEF/EBRD rankings on governance quality, innovation, etc. More importantly, it is also closer to meeting objective Maastricht criteria such as inflation. We do not think that mid-2010 euro adoption, as earlier suggested by the Estonian government, is possible for any country. For January 2011 entry, we would expect HICP inflation to be measured between April 2009 and March 2010, so current levels are already crucial. The reference rate excludes countries in deflation but will likely be around 2.0%, on our estimates. Estonia’s March inflation of 2.0%Y makes this feasible. March readings of 8.2% for Latvia and 7.7% for Lithuania make 2011 euro adoption impossible on this criterion alone. Fiscal criterion very difficult for Estonia…The fiscal criterion will be much more challenging for Estonia than inflation. After large wage and pension hikes in 2007-08, the 2008 deficit already hit 3.0% of GDP. For 2011 euro entry, Estonia would need to keep the 2009 deficit below 3.0%, while hoping not to be judged strictly on the sustainability criterion (perhaps less of an issue, given the size of deficits in Euroland). With a GDP contraction likely closer to 15% than the 8.5% assumed in the budget, and 70% of central government spending driven by entitlements and tax earmarks, this will be far from easy. The EC may not react positively to the 7.5% deficit the Finance Ministry currently projects for 2010 and to temporary measures like a planned suspension of state payments to the private pension system. Yet, given the upside from euro membership and that other criteria are attainable, a heroic Italian-style round of tax hikes and spending cuts may be possible. Already in February the government achieved a robust parliamentary majority for cuts. Importantly, Estonia’s recent history of fiscal surpluses and its tiny domestic banking system make large one-off bailout costs unlikely and leave government debt, currently 4.8% of GDP, no obstacle for EMU. …but much harder for Latvia and Lithuania: For Latvia and Lithuania, the outlook is again considerably more difficult. Latvia’s fiscal deficit was already around 4.0% of GDP in 2008. Its existing IMF program only targets a 4.9% of GDP deficit for 2009 and 2010 – which would leave 2013 the earliest possible euro entry date – but even this looks unattainable to us. Spending is already well above target, prompting the IMF to delay loan disbursement. Political consensus on austerity appears weaker than in Estonia, understandably as the euro looks remote anyway. Multiple demonstrations suggest that the limit of popular tolerance for cuts is being reached. Contingent spending risks are also high. The government has already guaranteed Parex debt, and other locally owned banks also look likely to have difficulty rolling syndicated loans. Government debt under the existing bailout program will already be very close to the Maastricht‘s 60% of GDP threshold by end-2010, and rising rapidly. For Lithuania, the situation is so far slightly less difficult, but its domestic banks (15% of the system against 40% in Latvia and 1% in Estonia) also pose a significant risk to government finance. The government is targeting a 2009 deficit slightly above 3.0%. This makes sense since 2011 euro entry is not an option anyway, but bringing this down in 2010 will be far from easy, and may be too late. With government debt at 16% of GDP, an international bailout program similar to Latvia’s could also see the 60% debt threshold threatened. Devaluations not imminent, but now probable: We do not think that devaluation is imminent for any of the Baltics. Small and closed financial markets make it very hard to force or accelerate the process from outside. We think that Lithuania will receive an EU/IMF aid package before long, and that disbursement will resume in Latvia. IMF funds are currently plentiful and even Ukraine appears to be on the verge of a large disbursement with minimal compliance. It makes little sense to us for Estonia to choose to devalue while 2011 EMU is still an option. However, if the EMU exit strategy is unfeasible in the next few years for Latvia and Lithuania, we now think that both will eventually choose devaluation. International aid may serve to delay this until Estonia can be convincingly seen as being on course for 2011 euro entry, likely early in 2010. A Latvian devaluation before this would risk having a negative impact on its neighbours too. Devaluation would be highly disruptive and no easy option. However, unless the global economy recovers more quickly than we think likely, the alternative to a 2010 devaluation looks like almost open-ended aid and pain.
Important Disclosure Information at the end of this Forum
RBI Maintains Easing Policy
April 23, 2009
By Chetan Ahya | Singapore & Tanvee Gupta | Mumbai
Policy Rate Cuts – In Line with Expectations The Reserve Bank of India (RBI) reduced the repo rate (the rate at which the RBI infuses liquidity) by 25bp to 4.75% and the reverse repo rate (the rate at which the RBI absorbs liquidity) by 25bp to 3.25% on April 21. It left the cash reserve ratio (CRR) unchanged at 5%. The 25bp cut in the policy rates was in line with our expectation but below market expectations (as per Bloomberg survey) of a 50bp cut. The market was also watching for a potential capping of the reverse repo amount (the amount that banks can park with the RBI at the reverse repo rate). This move would have forced banks to park their surplus liquidity in government bonds. However, the RBI did not initiate this measure as bond yields had already been declining. We believe that the RBI is saving this measure for any potential need in the future. The rate cut, however, was enough to push 10-year bond yields down further by 21bp during the day to 6.18%. Key Highlights of the Policy Statement Some of the points, which the monetary policy statement touches upon, are as follows: Calming markets’ concerns on liquidity: The monetary policy statement has lucidly summarized the measures taken by the RBI to inject liquidity into the banking system since the Lehman event. Cumulatively, it has injected US$84.6 billion. Moreover, the statement also reconciles that the gap between government borrowing in April-September this year with the same period last year will be almost matched by open market operations (OMO) of US$16 billion and buybacks of market stabilization bonds of US$8.4 billion. Our comment: We believe that banking system liquidity conditions will remain benign also due to further moderation in credit demand. Building in downside to growth trend: The RBI has reduced its growth estimate for F2009 to 6.5-6.7% as compared with 7% estimated in January 2009. It also released its estimates for F2010 GDP growth at 6%, assuming a normal monsoon as per the India Meteorological Department estimate. Our comment: We expect GDP growth at 4.4% in F2010 to be lower than the RBI’s estimate. Our estimate is based on extremely weak global growth estimates. Morgan Stanley’s global growth estimate for 2009 is -1.9%. Moreover, we believe that India will also suffer because of the excesses committed in the recent past. During the last four years, in parts India has also pursued loose monetary and fiscal policy, which fueled the growth. However, this is now showing up in the form of rising non-performing loans (NPLs) in the banking system and high burden of fiscal deficit and public debt. We believe that the effect from these excesses will restrain the pace of growth recovery. Increased concerns about banking sector asset quality: The monetary policy stance text added the comment of “preserving credit quality” while reaffirming the RBI’s aim to “ensure a policy regime that will enable credit expansion at viable rates”. The policy statement also mentions that “it may be noted that bank credit had accelerated during 2004-07. This, combined with significant slowdown of the economy in 2008-09, may result in some increase in NPAs. While it is not unusual for NPAs to increase during periods of high credit growth and downturn in the economy, the challenge is to maintain asset quality through early actions. This calls for a focused approach, due diligence and balanced judgment by banks.” Our comment: The RBI’s decision to allow banks to restructure loans but still show them as standard assets will understate the official NPLs. However, we believe that there has been a rapid deterioration in asset quality in the banking sector, and the RBI’s increased concern in this area is justified. We believe that the underlying NPLs will rise to 7-8% compared to the last official estimate of 2.3% as of F2008. We believe that NPLs are already rising in the real estate sector, unsecured personal loans and SME loans. Credit demand slowdown: Bank credit growth has already slowed to 17.3%Y as of end-March 2009 compared to the recent peak of 29.1%Y as of October 2008 and 22.3%Y as of end-March 2008. Indeed, the segment-wise breakdown indicates that apart from real estate and NBFCs, loan growth has decelerated in almost all other sectors. RBI data also reveal that private sector banks have become extremely risk-averse while the public sector banks are being encouraged to continue to maintain credit growth. While the credit growth of public sector banks decelerated to 20.4%Y as of end-March 2009 from 22.5% a year ago, it slowed sharply to 10.9%Y for private sector banks and 4%Y for foreign banks (versus 19.9%Y and 28.5%Y growth, respectively, registered in March 2008). Our comment: A large part of the loan growth by public sector banks has been due to these banks taking over assets from fixed income mutual funds facing large redemptions post the credit turmoil in September 2008. We believe that the decline in commodity prices and continued risk-aversion will continue to slow bank credit growth to 10%Y by C4Q09. Banks’ lending lagging policy rates: While the RBI has been aggressive in reducing the policy rates since the last quarter of 2008, its effective pass-through into market interest rates did not happen commensurately. The policy statement highlighted that “while the response to policy changes by the Reserve Bank has been faster in the money and government securities markets, there has been concern that the large and quick changes effected in the policy rates by the Reserve Bank have not fully transmitted to banks’ lending rates.” During the second half of F2009 (September 2008 to March 2009), while the RBI reduced the policy rate (repo rate) by a total of 400bp, the public sector banks lowered their lending rate in the range of 125-225bp, private sector banks in the range of 100-125bp and five major foreign banks by 0-100bp. Our comment: We believe that banks are delaying lending rate cuts due to a) the lag in repricing fixed maturity deposits, b) rising credit costs, and c) risk-aversion due to their concerns about credit quality of the borrower. While we expect lending rates to decline further, we believe that they will continue to lag policy rates by six months. Further Rate Cut Likely We believe that the weak growth trend and further deceleration in inflation will provide comfort to the RBI to continue with the easing policy. We expect the RBI to cut the policy rate by another 25bp over the next 3-4 months. We maintain our view that the banking system liquidity will continue to improve, with credit growth continuing to decelerate below deposit growth. Assuming that total credit growth decelerates to 10%Y and deposit growth to 15%Y by end-December 2009, the average credit-deposit ratio for banks will decline to 70.9%. Hence, we expect 10-year bond yields to decline to 5.5% by the end of the calendar year. While we do not envisage any major problem in meeting the government’s borrowings, in the event of any discomfort displayed by the bond market, the RBI will likely choose to either cap the reverse repo amount or increase the open market bond purchase amount. For more details, please see India Economics: RBI Maintains Easing Policy, April 21, 2009.
Important Disclosure Information at the end of this Forum
Disclosure Statement
The information and opinions in Morgan Stanley research were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley C.T.V.M. S.A. and/or Morgan Stanley & Co. International plc and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Asia Limited and/or Morgan Stanley Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley Taiwan Limited and/or Morgan Stanley & Co International plc, Seoul Branch, and/or Morgan Stanley Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services licence No. 233742, which accepts responsibility for its contents), and/or Morgan Stanley India Company Private Limited and their affiliates (collectively, "Morgan Stanley"). As used in this disclosure section, Morgan Stanley includes RMB Morgan Stanley (Proprietary) Limited, Morgan Stanley & Co International plc and its affiliates.
Global Research
Conflict Management Policy
Morgan Stanley Research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.
Important Disclosures
Morgan Stanley Research does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. Morgan Stanley Research is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.
With the exception of information regarding Morgan Stanley, research prepared by Morgan Stanley Research personnel is based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue research coverage of a company. Facts and views in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.
To our readers in Taiwan: Morgan Stanley Research is distributed by Morgan Stanley Taiwan Limited; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.
Morgan Stanley Research is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of and takes responsibility for its contents in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin);in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, supervised by the Spanish Securities Markets Commission(CNMV), which states that it is written and distributed in accordance with rules of conduct for financial research under Spanish regulations; in the US by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research it has prepared, and approves solely for purposes of section 21 of the Financial Services and Markets Act 2000, research prepared by any affiliates. Private UK investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. In Australia, Morgan Stanley Research and any access to it is intended only for "wholesale clients" within the meaning of the Australian Corporations Act. RMB Morgan Stanley (Proprietary) Limited is a member of the JSE Limited and regulated by the Financial Services Board in South Africa. RMB Morgan Stanley (Proprietary) Limited is a joint venture owned equally by Morgan Stanley International Holdings Inc. and RMB Investment Advisory (Proprietary) Limited, which is wholly owned by FirstRand Limited.
Trademarks and service marks in Morgan Stanley Research are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. Morgan Stanley Research or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request.
The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at wholesale customers only, as defined by the DFSA. This research will only be made available to a wholesale customer who we are satisfied meets the regulatory criteria to be a client.
The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA.
As required by the Capital Markets Board of Turkey, investment information, comments and recommendations stated here, are not within the scope of investment advisory activity. Investment advisory service is provided in accordance with a contract of engagement on investment advisory concluded between brokerage houses, portfolio management companies, non-deposit banks and clients. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely to this information stated here may not bring about outcomes that fit your expectations.
|
![](/img/clear.gif"){kind=spacer}