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Tuesday, January 29, 2008

Emerging Market Correction and Pressure on the Forint

Unfortunately Hungary's coming correction seems to be getting very near now. Portfolio Hungary reports this morning on the latest readings on the Calyon Risk Aversion Barometer. Caylon reported on Monday that global equity gyrations continue to dictate the direction of emerging market currencies, with risk aversion remaining high and European equities closing lower again on Monday. Indeed many currencies remained under pressure throughout the trading session yesterday. Budapest Economics also said yesterday that the HUF continued to be the most vulnerable currency in the region, with the currency temporarily hitting 259 against the euro yesterday, although it did finally manage to stabilize at slightly stronger levels by the end of the session.

Mitul Kotecha, head of global FX research at Calyon, confirmed the Budapest economics view, saying Hungary's forint appeared to be highly exposed to rising risk aversion. “Reflecting the vulnerability to risk aversion, correlations between the Calyon Risk Aversion Barometer and some emerging currencies are quite high at present," Kotecha is quoted as saying, adding that Hungary's forint “appears highly exposed to rising risk aversion, with the 1-month correlation between the Barometer and EUR/HUF at a strong 0.85." Of course, the HUF is also suffering from deteriorating domestic fundamentals, an aspect which of course he did not ignore.

Stefan Wagstyl, picks up the theme to some extent, and has another long and relevant piece in the Financial Times this morning, reflecting just how a change in tone is taking place even as I write.

The turmoil in financial markets is turning into a nerve-racking test for the economies of central and eastern Europe and the former Soviet Union. Economists have said the fast-growing region faces a slowdown following the financial shockwaves reverberating around the globe. But the precise impact is uncertain, especially on weaker economies.

The differences are registering in the financial markets. As investors reconsider their strategies, they are becoming more risk averse. Some have turned against emerging markets, including the ex-communistregion. Others are discriminating more between countries.

The spread on five-year credit default swaps (a measure of risk) has widened by 26 basis points for the Czech Republic since last June and by 44 basis points for Poland. But for Serbia and Ukraine the increase is 151 basis points; for Kazakhstan it is 218 basis points.

Given the recent unprecedented credit-fuelled growth surge, this slowdown could be welcome in countries trying to cope with inflationary pressures, including Ukraine, Kazakhstan and Russia, and those facing labour shortages, such as Poland.

The benefits could be even greater in economies facing yawning current account deficits, notably the Baltic states, Romania, Serbia and Bulgaria. As Leszek Balcerowicz, the former Polish central bank governor, told a business conference this month: "We should welcome some amount of a slowdown, especially in the Baltic states, which have been growing the fastest . . . We don't have the information that would make us predict a hard landing. Based on the current information a soft landing in the countries which have been growing fastest is more likely."

I am not as optimistic as Wagstyl is here that we will see soft landings. The existence of virtual currency pegs - which will need to be broken during the correction - virtually guarantees an abrupt change, as does the level of household debt in non local currency .

Wagstyl had an earlier FT piece where he drew attention to the way in which ageing populations and labour shortages were playing their part in this emerging crisis.

Fuelled by strong economic growth and soaring foreign investment, employment is increasing in availability just as emigration has sucked around 5m workers from eastern to western Europe. According to Eurostat, the EU’s statistics agency, labour costs are growing at their fastest rate since the end of Communism – with a 30 per cent increase in nominal costs in Latvia in the year to last September and rises of more than 20 per cent in Romania, Estonia and Lithuania. In Poland, the largest new member, the rise was just under 12 per cent.

In real terms, average gross wages in Poland rose more than 7 per cent in the first nine months of 2007 and in Romania by nearly 16 per cent, according to the Vienna-based Wiiw research institute.

While unemployment levels in western Europe have stayed at around 8 per cent since 2002, in the east they have slid from 14 per cent to under 9 per cent. In the region’s booming capital cities, almost everybody who wants work has a job. Leszek Wronski, head of the central Europe division of KPMG, the accountant and management consultant, says: “We have a job market controlled by employees.”

Even if labour markets ease a little, there will be no return to the super-abundance of workers of five years ago. The region’s populations are ageing even faster than in western Europe and, with the added effects of migration, the number of working-age people is falling in the Baltic states and central Europe. Eurostat predicts that the population of the new member states will decline from 103.6m in 2004 to under 100.6m in 2015, with particularly sharp drops in working-age people.

However, for governments and companies alike, rising labour costs and growing skills shortages raise big questions about the region’s future competitiveness. Everything from decisions on investment location to education, migration and population policies is coming under scrutiny.

So even while he doesn't directly go into how long term fertility may be playing a role in the drama we are watching unfold before our eyes, his mention of "population policy" seems to be a euphemism for this very topic. And if fertility isn't an important determinant in what has been happening, I would be grateful is someone could explain to me why we aren't seeing similar sorts of labour shortages in places like Thailand, Turkey, Chile, Brazil or Argentina, all of whom are growing - or have been, Turkey has slowed recently - very rapidly at the present time.

Back on the 28 August 2007 - just after the financial "turmoil" started - I posted the following, in a piece which still looks extremely good when looked at in the cold light of today, on Global Economy Matters:

"But any looming "credit crunch" is also likely to affect the so called "risk appetite" (that is the willingness to invest in riskier areas or activities) and the place where this is most likely to be felt is in the emerging market area. Those emerging markets which are considered to be most vulnerable will undoubtedly have the hardest time of it, and this brings us directly to Eastern Europe I think and to economies like those in the Baltics, Latvia, Estonia and Lithuania), to Hungary, and then maybe (if there were to be contagion) to the larger economies like Poland and Romania. Alarm driven reports about the dangers of a hard landing in the Baltics have been floating around for some months now (I say alarm driven not because the danger isn't real, but because most of the reports are quite superficial, and don't really appreciate the magnitude of the problem). Whatsmore, as the Bank for International Settlements pointed out in the June edition of its quarterly review , in 2006 Eastern European economies accountedfor a staggering 60% of new emerging market credit:"

At the start of September, and as part of an in depth analysis of Turkey, I posted the extract you will find below. The issue here is foresight, and our ability to see things coming. What is happening now has been obvious for some time, completely obvious, even if many people have had difficulty in seeing it. I completely resist the idea that economics cannot be scientific. I think it has to become much more of a science. But if we are to get from here to there we first need some paradigmatic models which enable us to see things coming rather better than we appear able to do right now.

In a much quoted paper - published back in 2004 by two UCLA economists (Schneider and Tornell) - it was argued that:

"In the last two decades, many middle-income countries have experienced boom-bust episodes centered around balance-of-payments crises. There is now a well-known set of stylized facts. The typical episode began with a lending boom and an appreciation of the real exchange rate. In the crisis that eventually ended the boom, a real depreciation coincided with widespread defaults by the domestic private sector on unhedged foreign-currency-denominated debt. The typical crisis came as a surprise to financial markets, and with hindsight it is not possible to pinpoint a large "fundamental" shock as an obvious trigger. After the crisis, foreign lenders were often bailed out. However, domestic credit fell dramatically and recovered much more slowly than output."

In starting off with this quote I really want to draw attention to two things.

First off, the way in which the current sub-prime liquidity problem in the banking sector of many developed economies is now steadily extending itself into a credit crunch in several emerging market economies. We are now beginning to see a clear and all too familiar pattern. There has been a lot of talk about the Asian crisis, and evidently there are some similarities with the pre 1998 situation, especially, as I shall be arguing over the coming days, in the emerging economies of Eastern Europe.

Secondly there is the "typical crisis came as a surprise to financial markets" argument, since it puzzles me why exactly this should be, or better put, why it should be assumed as a "stylised fact" about currency crises that such major events are in principle not forseeable. I find this very hard to accept. Are we really so inept we are not able to see trouble coming when it finally does come? Is economic theory really so useless in the face of complex "on the ground" facts. Something inside me resists this view. We ought to be able to see things coming, even if we need to distinguish between the where and the when. What I mean is that it should be possible, if the theories you are working with are worth any sort of candle, to pinpoint the areas of likely vulnerability. On the other hand, given that often seemingly random events precipitate the ultimate unwind, it is pretty well impossible to say in advance which random event will turn out to be the detonator on any given occassion.

The sub prime debt issue in the US is a good case in point here, since only at the start of August the Federal Reserve were assuring everyone that problems associated with the US housing market were well under control, while obviously they weren't and aren't, and equally obviously, now, such problems will be seen from the vantage point of hindsight to have played a key role in the events which are now unfolding before our eyes.

So even with this caveat, and with due regard for the well known problem of human fallibility, lets see if this time any of us are able to do just that bit better than normal, and in attempting to see things coming lets see if we can learn something which may make us better able to handle and foresee macro economic problems in thefuture.

For a fuller analysis of the specifics of Hungary's present crisis see "Just Why Is Hungary So Different From The Rest of the EU10?", "Hungarian Central Bank Leaves Interest Rates Unchanged" and "The EU Comission Warns Hungary on 2008 Budget Deficit".

For e theoretical exposition on why fertility matters to the EU10, see Claus Vistesen "Catch Up Growth and Demographics - Evidence from Eastern Europe".