Sunday, August 3, 2008

Fixed currency and bankrupt states - Estonia next

One of the things about fixing your currency is that you can’t print whatever you are fixed to.

Indeed that is the advantage of fixing your currency. Fixing your currency forces and monetary credibility because it effectively removes the printing press as an option. But if you don't respect that force you pay a nasty price.

Its iconic – but when a country with weak economic credentials fixes its currency it tends to have an economic boom. The fixed currency in Argentina last time round was very popular because of this.

But – if you don’t maintain discipline on fiscal and monetary policy you hit the wall very hard indeed. The usual response to a downturn (just loosen monetary policy) becomes unavailable. As a result you get smashed.

So it is with this in mind that I report two stories from the Baltic Business News. The first one might have been triggered by my blog (which has been somewhat controversial in the Baltic States):

Hansabank Estonia CEO: devaluation would bankrupt Estonian economy

The Estonian CEO of Hansabank, Priit Perens, told aripaev.ee that in case loans have been handed out in EEK, devaluation would make the situation easier, but as loans are based on EUR, devaluation would bankrupt Estonian economy.

“Traditionally, ca 70-80 pct of loans in Estonia are based on EUR, so devaluating would make the situation worse. Devaluation would mean that in order to repay the loan, you’d need more EEK than before. It would, in essence, bankrupt Estonian economy,” Perens said and added: “No one is interested in devaluation right now – everyone would loose from it. In a situation, where loans were based on EEK, devaluation would help to ease the loan burden.”

To the question, whether Swedbank has been adding addition pressure to Hansabank lately, Perens responded with a curt: “No.”

Followed quite literally by the second article:

State doesn’t have money to pay pensions in 2009

Gertrud Levit

In 2009, pensions are growing by EEK 2.7 billion when compared to this year, taking up 21 pct of state budget. The state, however, can’t cover the growing pensions from social tax.

Pension index is recalculated every year and it depends on the yearly growth of consumer price index and accruing of social tax. That is why in the coming year a fifth of the planned state budget (EEK 20.4 bln) is taken up by pensions. The state can’t cover all of it from social tax, the Ministry of Finance shed light to the state budget, writes aripaev.ee.

Both inflation and the growth of social tax have been higher than expected, which is why pensions will be growing more than usual in the coming year as well.

The Ministry of Finance isn’t worried about only pensions. The capacity of foreign investments, co-investments and setting aside money for health insurance fund are jumping higher as well, but most of the money accrued to the state budget has a certain goal. Meaning that the funds can’t be used to cover holes, even if the state treasury has the needed amount of money.


You can’t make this stuff up but the last article is a little strong. Estonian politicians still hope to balance the budget.

The State is bankrupt and it can’t print money because the currency is fixed.

It can’t borrow because people expect it to devalue. They are about to have pretty severe austerity measures right into a recession...

The interest rate in Kroon is much higher than the interest rate in Euro – so the domestic population borrow in Euro.

What can I say other than so long and thanks for all the fish.

This is too familiar

10 comments:

Anonymous said...

Have they passed this point in Latvia yet?

It's sought of like watching a train wreck in slow motion.

I'm interested to see how all this turns out.

Anyway John, Having come across your blog only recently and living in Clovelly I'm eager for some more posts.. Good work..

John Hempton said...

Yes.

And if you are in Clovelly I will walk down to the cafes to meet you.

Contact me.

J

Aaron Krowne said...

Isn't the real problem that they build long-term imbalances into their budgets? Printing money doesn't actually help anything: it just spreads the misery to everyone. All you're doing then is reconciling balance sheets but this is totally artificial, as you've still failed to match expenditures to promises dated to when those promises were made.

In other words only a politician could love the "solution" of inflating, because of the one thing it does achieve: allow them to escape blame.

Anonymous said...

John - have you seen the interest rates (between banks) in Latvia?

Take look at:
http://www.bank.lv/images/img_lb/fininfo/RIGIBID_RIGIBOR.XLS

What is your comment on rates coming down during last months?

James said...

Couldn't the Euro itself be viewed as a bunch of currency pegs: countries with weak economies and poor fiscal policy in effect pegging to Germany? We saw big booms in some of these countries over the last few years; now are they going to hit the wall hard without the ability to use monetary policy to ease the pain--and maybe drag the rest of the Eurozone down with them?

John Hempton said...

Jame's comment about the euro being a bunch of pegs is spot on.

So is the US dollar. There is little resemblance between the economy of Southern California driven by aerospace and entertainment and the economy of Michigan driven by autos.

But the currency is pegged.

Being pegged there cannot be easy adjustment. The adjustment mechanism is that people move.

That is why in the US almost nobody seems to live in their home town and the airports have such huge volume.

--

In the US the Spanish are a different tribe to the Germans but their currencies are pegged.

The imbalances can - and to some extent are - solved by migration. That is why Polish workers make up the UK building industry...

But to the extent that they can't move (and movement in Europe is much more limited than the US) you have to force the countries to be fiscally disciplined or the peg will get smashed. That is what the Mastricht criteria is about.

I had a post on my premonition of disaster in Spain... if you look at the core of Europe Spain is the odd-man out. It should float but can't as it is permanently pegged...

But outside the core the chance of the Balts meeting the mastricht criteria is low...

Juris said...

Hi from Latvia!

First of all, thank you very much for being active in responding to questions from other readers! That adds much to the value of the blog.

I would like to discuss the devaluation in Latvia. What do you, John, and fellow readers think on the opinions:

1. The worst ending for the Latvian economy is devaluation.

Among all other points I would mention just one, which gets too little attention to my mind. To a large part due to being in EU and seeing alternative to the Lat, trust of people and business in the local currency will never be regained if devaluation happens. That means tendency to Euro-izing the economy, but, as the supply of Euros will be more than very short (as potential investors from Europe and US will be more than reluctant to invest in the troubled Latvia, given that they do not feel safe enough even about Western economies) :
1) the Latvian economy will be paralyzed, because of very short supply of „real money”=EUR
2) the market rate for EUR will skyrocket anyway: if the devaluation itself will not be dramatic enough to crash all economy, the market will press for more devaluation. So we will be dead with 15% devaluation, as we will with 80% devaluation – just in different ways.

2. Supposing (1) is true, there is nothing that could trigger devaluation, except bad actions by government or Central Bank of Latvia.

My point is that Latvia as a whole can stay a bankrupt borrower for a long time, because
1) the financial markets are too shallow to attack the Lat. Any attempt can be easily prevented by Central Bank (year 2007 has proved that nobody cares about short term Lat rates)
2) the creditors of Latvia are not interested to „foreclose”, in real terms they own illiquid assets (including mortgaged properties) and there is no „bank-run” possible as one has to get the Lats before the bank run starts. Most of the investors wanting to take Euros out of the economy first have to find someone who will give them Euros. Want to sell your foreclosed or investment property in Latvia? Want to sell your equipment? Want to sell your shares in Latvian businesses? OK – find somebody who will pay you Euros – another foreign investor. Hitting down the real estate sector or business will not take out more Euros than Latvia owes – only less. Forget about getting Lats - there are not so many of them around in Latvia and nobody is really lending and borrowing them.
3) the government debt is very low; in crisis they still can borrow Euros or dollars to prevent hitting the bottom.


My alternative to devaluation is recession with the specific that in the nearest future there will be dramatic inflation, driven by prices for energy and other commodities in world markets. High uneployment, lower real wages (hookers and beer get cheaper as well :), at this point Mr. o'Leary throws in some planes to Riga for brits who cannot afford Amsterdam or Asia anymore due to problems in all western economy), higher poverty, banks taking losses and gradual restructuring across all economy. The restructuring and growth can be achieved due to three conditions: (1) lower competition for labor force due to slowdown in western europe, (2) some EU money coming in, (3) existing development potential in Latvian businesses, which has not been realized due to (3.1) high profit margins (3.2) recent growth rates close to or even above manageable level from business management perspective (3.3) high domestic demand, which limited incentives to focus on export markets.

John Hempton said...

The long comment from Latvia deserves commentary. Excuse the shouting but my commentary is in ALL CAPS.

Hi from Latvia!

First of all, thank you very much for being active in responding to questions from other readers! That adds much to the value of the blog.

THE COMMENTS ARE GENERALLY HIGH QUALITY - AND I AM LEARNING. SO THANKS DUE FROM ME.

I would like to discuss the devaluation in Latvia. What do you, John, and fellow readers think on the opinions:

1. The worst ending for the Latvian economy is devaluation.

WORST FOR WHOM. IT IS CLEARLY TERRIBLE FOR THE BANKS. IT IS BAD FOR SOME PEOPLE WHO HAVE BORROWED IN EURO - WHICH IS A LOT OF THE LOANS. IN ARGENTINA THE LAW WAS CHANGED SO PEOPLE WERE ONLY OBLIGED TO REPAY IN PESOS... DON'T KNOW HOW IT PLAYS OUT HERE.

Among all other points I would mention just one, which gets too little attention to my mind. To a large part due to being in EU and seeing alternative to the Lat, trust of people and business in the local currency will never be regained if devaluation happens.

MIGHT BE RIGHT. ARGENTINE EXPERIENCE SAYS THAT. BUT MEXICO SAYS OTHERWISE.

That means tendency to Euro-izing the economy, but, as the supply of Euros will be more than very short (as potential investors from Europe and US will be more than reluctant to invest in the troubled Latvia, given that they do not feel safe enough even about Western economies) :

IN OTHER WORDS WE DON'T GET A DEVALUATION BUT A MASSIVE MONEY SQUEEZE. FOR SOMEONE SHORT SWEDBANK THAT IS PERFECTLY ACCEPTABLE.

1) the Latvian economy will be paralyzed, because of very short supply of „real money”=EUR

THAT IS THE GOOD CASE.
2) the market rate for EUR will skyrocket anyway: if the devaluation itself will not be dramatic enough to crash all economy, the market will press for more devaluation. So we will be dead with 15% devaluation, as we will with 80% devaluation – just in different ways.

AGREED
2. Supposing (1) is true, there is nothing that could trigger devaluation, except bad actions by government or Central Bank of Latvia.

YES - BUT IF THE RECESSION IS BAD ENOUGH - SAY 15 PERCENT UNEMPLOYMENT AND FALLING PRICES FOR HOOKERS - THEN THERE WILL BE A CLAMOUR FOR A DEVALUATION.

My point is that Latvia as a whole can stay a bankrupt borrower for a long time, because
1) the financial markets are too shallow to attack the Lat.
ABSOLUTELY. SWEDBANK WON'T LEND YOU LATS.

Any attempt can be easily prevented by Central Bank (year 2007 has proved that nobody cares about short term Lat rates)
AGREED
2) the creditors of Latvia are not interested to „foreclose”, in real terms they own illiquid assets (including mortgaged properties) and there is no „bank-run” possible as one has to get the Lats before the bank run starts. Most of the investors wanting to take Euros out of the economy first have to find someone who will give them Euros. Want to sell your foreclosed or investment property in Latvia? Want to sell your equipment? Want to sell your shares in Latvian businesses? OK – find somebody who will pay you Euros – another foreign investor. Hitting down the real estate sector or business will not take out more Euros than Latvia owes – only less. Forget about getting Lats - there are not so many of them around in Latvia and nobody is really lending and borrowing them.
YES - SO THIS IS A STORY WHERE YOU STOP BAD CREDIT BEING RECOGNISED BY EXTENDING MORE CREDIT. I WOULD ARGUE THAT IS WHAT SWEDBANK IS DOING NOW...

3) the government debt is very low; in crisis they still can borrow Euros or dollars to prevent hitting the bottom.

I AM NOT SURE ABOUT THAT. BUT THEY HAVE SOME FLEXIBILITY. THE DEBT IN THE BALTIC STATES IS PRIVATE DEBT.


My alternative to devaluation is recession with the specific that in the nearest future there will be dramatic inflation, driven by prices for energy and other commodities in world markets. High uneployment, lower real wages (hookers and beer get cheaper as well :), at this point Mr. o'Leary throws in some planes to Riga for brits who cannot afford Amsterdam or Asia anymore due to problems in all western economy), higher poverty, banks taking losses and gradual restructuring across all economy. The restructuring and growth can be achieved due to three conditions: (1) lower competition for labor force due to slowdown in western europe, (2) some EU money coming in, (3) existing development potential in Latvian businesses, which has not been realized due to (3.1) high profit margins (3.2) recent growth rates close to or even above manageable level from business management perspective (3.3) high domestic demand, which limited incentives to focus on export markets.

LOCAL DEFLATION, INCREASING COST OF CORE IMPORTS. NASTY SITUATION. STILL REMAIN SHORT SWEDBANK.

THANKS I can stop shouting now... I really appreciate it. That I think is probably just as likely as a devaluation. Swedbank remains solvent - but you still make a lot of money being short...

J

James said...

Europe's situation seems to me to be more precarious than America's because America is politically unified (that is, there is a strong federal government) while Europe is politically fragmented. The member countries vary considerably in their fiscal policies. During good times, this wasn't a big deal--everyone prospered--but I think the coming economic downturn will provide a big test for the Euro. I wonder if it will survive.

John Hempton said...

James is right when he says that America is unified with a strong central government. It took a very bloody war to get there...

Monetary union will FORCE internal European migration - resulting in the breakdown of food and cultural differences.

Its deliberate. The centralists want to unify Europe without another bloody war...

But James is right. It is difficult - and a downturn will test it.

J

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