Bursting bubbles - Markit

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Shaun Downey, chief global analyst at CQG and co-founder of I-Traders.com, compares the Asian currency crisis of 1997 with the current FX position for the eastern European economies and looks ahead to what the future may bring

Bursting bubbles T

he sheer scale of economic catastrophe across the world has meant that the woes of the eastern European economies have had less press coverage than otherwise could have been the case. Nevertheless, the size of eastern Europe’s problem is large and, in currency terms at least, is comparable in magnitude with the Asian currency crisis of 1997, which began in Thailand. Currently, when measuring the ratio of current account deficit to GDP, 11 eastern European countries are in a worse position than Thailand was just prior to the Asian crisis. Furthermore, nine eastern European countries are in a worse position than Malaysia was in 1997 (Figure 1). the markit magazine – Spring 2009

It can be argued that the impact of these problems has not been fully reflected or appreciated in the global markets. But, if help is not forthcoming urgently, the costs will magnify. The decision in early April by the G20 to release additional funds to the IMF may prove to be a timely and useful intervention, which should have particular influence within eastern Europe. However, fundamental issues still need to be addressed. While some of the countries with the worst current account deficits to GDP are relatively small economies, such as Moldova, others are more prominent, such as Croatia, Romania and Bulgaria – the latter having the worst numbers of all, with Latvia close behind. The

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Spring 2009 – the markit magazine

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“The credit crunch has brought all of eastern Europe’s credit booms to a shuddering halt”

Figure 1: Bigger Current Account Deficit Than Thailand in 1996: (8.1%)

Current account % of GDP

Bulgaria Latvia Georgia Estonia Rumania Bosnia Lithuania Tajikistan Serbia Moldova Croatia

2007 -22.0 -23.8 -21.5 -18.1 -13.9 -13.5 -13.5 -13.3 -12.7 -11.3 -8.6

2008 -24.9 -14.2 -24.6 -11.9 -10.5 -17.2 -14.5 -13.2 -18.2 -15.8 -10.0

Net financial flow % of GDP

External debt % of GDP

Short term external debt % of GDP

2007 37.9 26.0 22.3 -0.7 17.1 15.2 15.5 21.9 n/a 5.7 12.8

2008 88.2 53.5 n/a 135.9 47.5 44.2 65.9 36.8 58.7 65.9 87.5

2008 42.6 34.6 n/a 37.1 36.1 14.4 25.0 5.3 6.4 30.1 9.2

Bigger Than Malaysia, South Korea in 1996: (4.1% and 4.4%)

Current account % of GDP

Albania Kazakhstan Kyrgyzhstan Belarus Armenia Slovakia Hungary Slovenia Poland

2007 -7.7 -7.0 -7.0 -6.8 -6.4 -5.5 -4.9 -4.9 -4.7

Source: IMF – Net Financial Flow, GDP

the markit magazine – Spring 2009

2008 -7.9 -6.5 -12.0 -6.3 -11.3 -6.0 -5.0 -6.6 -5.6

Net financial flow % of GDP

External debt % of GDP

Short term external debt % of GDP

2007 6.9 7.0 9.5 11.6 11.0 9.4 6.7 5.7 3.6

2008 n/a 81.6 n/a 29.6 n/a 51.9 76.6 54.6 39.6

2008 n/a 4.5 n/a 62.1 n/a 56.2 9.5 7.0 23.7

problem these economies are facing has largely been created by significant capital inflows as property development and commercial investment fuelled by cheap labour have created credit bubbles via a rising currency. In 1997, Thailand’s situation was similar as net inflows were far higher than its current account deficit. This made the currency soar as the US dollar rose and the baht remained pegged to it in spite of government intervention. This, and its effect on international competitiveness, sowed some of the seeds of Thailand’s credit boom and resulting bust. This time, the credit crunch has brought all of eastern Europe’s credit booms to a shuddering halt as credit has disappeared, thanks to overseas investors and lenders retrenching to their homelands. While countries such as Latvia have indicated that they are in a critical state, the risk is that other more established and larger economies will be caught up in the same wave of panic, even though their debt is lower. Poland and the Czech Republic appear to be better-placed but they too may suffer. The fear is that defaults could swiftly move across the eastern bloc as currencies collapse one after another, which in turn would lead to large losses for foreign investors that would only increase the problem of a lack of credit. This has already happened to Russia and the rouble, despite the relatively robust state of the country’s economy – although the impact on its neighbouring currency, the Ukrainian hryvnia, has been far more dramatic.

Excesses of the past Nevertheless, Latvia is perhaps the primary example of suffering from the worst excesses of the past – it was the best performer on the way up and now is almost the worst on the way down. Latvia’s economy, which grew a staggering 50 per cent over four years between 2004 and 2007, contracted by 4.2 per cent in the third quarter of 2008 compared with the same period the previous year. The result was the worst in the 27-member European Union.

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Figure 2: Harmonised Long-term Interest Rates for Convergence Assessment Purposes (Percentages per Annum; Period Averages; Secondary Market Yields of Government Bonds with Maturities of Close to 10 Years) Countries

Feb 08

Mar 08

Apr 08

May 08

Jun 08

Jul 08

Aug 08

Sep 08

Oct 08

Nov 08

Dec 08

Jan 09

Feb 09

Slovenia

4.32

4.33

4.47

4.61

4.95

5.02

4.68

4.68

4.66

4.61

4.56

4.70

4.87

Slovakia

4.36

4.34

4.46

4.52

4.94

5.06

4.95

4.98

4.95

4.92

4.72

4.69

4.76

Finland

4.06

4.00

4.22

4.47

4.78

4.77

4.47

4.43

4.33

4.09

3.72

3.87

3.93

Non-euro area Bulgaria

5.24

4.85

4.80

4.95

5.17

5.17

5.17

5.17

5.17

6.00

7.76

7.14

7.09

Czech Republic

4.53

4.68

4.72

4.84

5.13

4.90

4.47

4.42

4.53

4.52

4.30

4.21

4.74

Denmark

4.08

4.04

4.29

4.42

4.82

4.78

4.49

4.37

4.43

4.06

3.50

3.44

3.55

9.03 10.64 11.50

Latvia

5.11

5.25

5.93

5.93

6.25

6.57

6.60

6.60

6.60

7.60

Lituania

4.51

4.36

4.59

4.80

5.33

5.49

5.47

5.45

5.40

8.16

9.00 13.95 14.50

Hungary

7.58

8.41

8.02

8.08

8.50

8.11

7.77

7.99

9.57

9.41

8.31

8.76 10.65

Poland

5.82

5.99

5.99

6.10

6.42

6.45

6.11

5.89

6.35

6.23

5.70

5.46

5.97

Romania

7.29

7.34

7.35

7.26

7.15

7.28

8.20

8.32

8.27

8.38

8.38

9.23

8.42

Source: EIU Current Account, External Debt, Short Term External Debt, GDP

In addition, Latvia’s banking sector – for years the most dynamic in the Baltic region – has become increasingly fragile. Latvia’s economy grew at a double-digit pace for years since it joined the EU in 2004. But it fell 10.5 per cent year-onyear in the last quarter of 2008. The country’s GDP is expected to decrease by another 12 per cent this year, while unemployment is forecast to reach 15 per cent. House prices are down 25 per cent, according to Global Property Guide. Overall, total economic contraction looks like it will exceed 20 per cent in 2009 – by anyone’s standards that is a depression, not a recession. In response, Latvia’s central bank has been forced to intervene on the foreign exchange market to prop up the Latvian lat, which is pegged to the euro within a 1 per cent band. In spite of the peg, the risk remains that the currency could continue to collapse and wipe out the remaining value of external lending from western banks. When a currency comes under pressure, the usual reaction from governments is simply to raise interest rates

aggressively. However, such attempts at protection can result in economic collapse, as was seen most recently in Iceland. Governments often attempt to protect via tighter fiscal policy as they themselves come under pressure from the IMF or from major international investors that have a high-level stake in the country’s economy. Alternatively, the currency could be allowed to fall, leaving the country’s creditors – domestic and foreign – to take the loss. In this way, the pain can, theoretically at least, be exorcised as quickly as possible and all toxic debts can be realised and valued. In Thailand’s case in 1997, the situation was slightly different – the government had used up all its reserves defending the currency against attacks from the FX market that eventually led to a forced move away from its pegged rate to the US dollar. The currency subsequently collapsed when it floated and then, because of its continued weakness and a rise in interest rates, a long deep recession occurred. This was exacerbated by the government’s delay of nearly a month before calling in the IMF.

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The reluctance to follow a harder line in the current crisis is highlighted by the relaxing of mark-to-market rules. Such a move indicates that by declining to tackle the problems head-on, regulators create more uncertainty and smokescreens, which – in eastern Europe at least – will deter investors and restrict confidence in local banks.

Divergence in rate patterns However, a glance at Figure 2 shows some divergence in interest rate patterns between eastern European economies, with the worst-placed countries having been forced to increase rates, and only the bigger and more stable economies such as Poland, allowing falls in rates. Note how sharply rates have begun to rise in the countries deemed to be in the most danger, namely Latvia, Lithuania and Hungary. A look at the currency movements shows that the weakness across the board on most eastern European currencies began in August 2008 and has seen dramatic collapses. So far this year, there has been some stabilisation and a minor corrective phase against both the dollar and euro. This is true even of the countries in worst trouble. It appears that the raising of rates is working, but the risk of a sudden implosion remains very real. With currency correlation so close, it is worth looking at the technical characteristics of some of the main players, such as Hungary and Croatia, and comparing them with more relatively stable players, such as Poland and the Czech Republic. The first startling picture that comes from the long-term quarterly charts is how accession to the EU led to a dramatic rise in countries’ currencies as the prospect of eventual membership of the euro suggested much lower interest rates and sensational economic growth. Much of this came true, but the unsustainability of such an explosion of credit combined with a sudden global reversal of fortune means that benefits of membership are beginning to unravel. From a technical perspective, it leaves Spring 2009 – the markit magazine

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behind the possibility of extended weakness economically and in the currencies themselves. Beginning with the Czech krona against the euro, the 1990s saw a period of extended sideways movement and little in the way of trend movement before the reality of monetary union began to strengthen the currency by more than 30 per cent. This came to an abrupt halt last summer. So far, the peak in the retracement has risen barely a third of that original move; with the recent past seeing the currency strengthen sharply. It now lies just halfway between the 2008 low and the January 2009 high. See Figure 3. Figure 3

Figure 4

Figure 6

Source: CQG Inc

The Croatian kuna against the dollar followed a very similar pattern to the Czech krona, doubling in strength from 2000. So far the retracement has been very modest, giving back just over 10 per cent of that rise. This seems to be out of kilter with the fundamentals as Croatia lies at number nine in the list of the current account deficits that are worse than Thailand’s was in 1997 (Figure 1). This suggests that sustained weakness is probable against both the dollar and the euro. See Figure 5. Figure 5

Source: CQG Inc

In contrast, the Polish zloty has had a different history against the euro. In the 1990s, its sustained and relentless fall halved its value. Monetary union had no more tangible effect than to create a long period of sideways movement, before 2004 saw a huge rally as the economy grew on a wave of modernisation.

Dramatic move

Source: CQG Inc

The move since last summer has been dramatic, as the entire rally from 2004 to 2008 has been wiped out in just six months. The velocity of this move means that while the last few months have seen a minor correction, it is a salutary lesson in how good analysis and technical timing can produce rewards in emerging markets way beyond what would be possible in most major currencies. Only the slide in sterling is comparable in recent times. See Figure 4.

The Hungarian forint against the euro also painted a similar picture as the Polish zloty, especially until 2004, with extended weakness through the 1990s followed by a long period of sideways movement that decoupled from the zloty until mid-2008. The devaluation in this period is just over 10 per cent and again seems an unequal response to the fundamentals. A classic technical measurement

the markit magazine – Spring 2009

of recording the length of time that a sideways pattern is maintained and projecting that beyond a break-out point suggests a devaluation of huge proportions – moving some way towards 425 from the present 296 forints to the euro. See Figure 6.

Source: CQG Inc

Hedging currency When looking at the potential for such huge and prolonged trend movements, a key question arises: what is the best currency to hedge against the eastern European bloc’s weakness? Given the proximity of the western European EU members and the higher level of their banks’ involvement in the eastern European region, the euro is not likely to be the best performer in this regard. While sterling has taken a battering recently, it has stabilised against the dollar and avoided a huge secondary break that would more than likely have occurred with any breach of the £1.35 to the dollar level. This is because of a huge vacuum that was created in the previous sterling collapse in 1984. The V-shaped bottom and the velocity of the rejection of the move towards par meant that a swift fall was possible (and still is) as there is no support until par itself. See Figure 7. Market Profile shows how little time was spent both falling and rising from 1.3600 in 1984 and 1985. This highlights how there is no support below that point. Looking at sterling’s fundamentals against both the euro and dollar, they appear to be increasingly in its favour. Housing is a key barometer to solving

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Figure 7

Source: CQG Inc

and stabilising the world’s crisis, and the UK has a far more positive outlook in this area. This is due to a rising population, the collapse in housebuilding and, most importantly, the early signs of cash buyers entering the market. They are encouraged by the low interest rates on savings and reluctance to invest in shares at the moment. It is important to note that cash buyers do not appear on the mortgagee approval statistics and houses bought at auction do not appear on the surveyor’s statistics either. Therefore, while any rise in these statistics is to be welcomed, it will not show the true picture. The rise in prices seen in March 2009 is the first sign of such activity. In the US, while some commentators have pointed to a recovery, the underlying fundamentals are still chronically

weak. The Case-Shiller Index in March shows the falls accelerating downwards in all 20 cities surveyed and, while sales have risen, the sales to inventory ratio is unchanged. There remains a huge backlog to be processed before a recovery can be seen as sustainable. The classic lesson that has not been learnt by the woes of Japan is the fact that, without a large cohesive and connected policy response of both fiscal stimuli and quantitative easing, any early shoots of recovery see interest rate yields rise – which quickly shuts off the recovery and stabilisation of house prices. In this respect, the Bank of England has been the most proactive central bank – the only error being the placing of a monetary limit in quantitative easing. This gives the markets a target to aim for, which is never wise.

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Conversely, the European Central Bank remains stubborn, although in mitigation it would need permission from politicians across the EU to embark on such measures. Even then, the ECB would have the insoluble problem of not only how much to buy, but which currencies and what part of the curve to buy. This means it is unlikely to happen and destines the euro’s economies to a long and protracted downturn. The dollar has no such worries and has the added benefit that when the current fiscal stimuli are seen to have failed in the coming months, the likely event of a swift downtrend in stock markets will see the dollar’s safe-haven status reassert itself. This is without the additional dollar impetus that is likely to come from the re-emergence of inflation, due to the worldwide increase in food prices. All financial traders should pay very close attention to the coming crop cycle that will begin to take shape from May. From a technical perspective, many commodity markets, including oil, have simply retraced back to what was the top of fair value for many years. For example, the normal high on crude was $35, with any spike quickly extinguished and usually caused by war. It is no coincidence that oil has simply moved back to that zone and rallied strongly back to $50, in spite of a glut in availability. As commodities become more expensive once more, more dollars will be needed to buy them. Therefore, when looking for the best-performing currencies, both the dollar and sterling appear to have better fundamentals than the euro and should outperform over the coming months. The huge volume of bond issuance expected by the UK government is a double-edged sword. If the debt is bought, it will be a huge plus for sterling as international investors must buy the currency as well. However, any sign of failed auctions will be sterling negative, and must be followed closely. In 1997, there was little to choose between the major currencies’ performance when Thailand was forced to float the baht, but it should be different this time. Spring 2009 – the markit magazine