April 17, 2009
A couple of weeks out of the office has allowed for a period of reflection over the CEEMEA battlefield and a number of big picture take-outs come to mind.
First, and even for a big theme/picture bear like myself, I have to accept that there has been a huge risk rally over the past month, and this is building some optimism that this might be more than a bear market rally; PLN/HUF/TRY have rallied by 10-15% across the board, with the EMBI+ tighter by some 150bps over the past 2 months. Nevertheless, I remain "doggedly" in the skeptics camp, essentially because in my mind the scale of the real economy adjustment, on-going is so huge that I doubt that we yet know the full impacts in credit space and ultimately back into financials and onto public finances. A 15-30% loss in industrial output and 20-40% loss in export revenues across the CEEMEA region must have serious consequences for good and bad economies/companies alike. Referring to the title of a piece I published in November 2007, warning of the risks of rising private sector indebtedness in Emerging Europe, "we ain't seen nothing yet". Famous last words!
Second, the G20 response earlier this month has nevertheless certainly helped to shore up confidence/helping alleviate some short term concerns over liquidity, particularly in the CEEMEA region. The provision of the new FCL facility from the IMF for the likes of Mexico and Poland, fundamentally sound economies which have been willing to swallow their pride and accept IMF assistance, will/has helped stop the rot/buy time. I am not sure though that the G20 commitment of US$1 trillion for IFIs to help bail-out EM's is all that it was initially made out to be, or indeed is the golden bullet that some have suggested. Indeed, Willem Buiter does his usual and highly effective hatchet job on the G20 promises of aid in his FT blog from April 8 (see "The green shoots are weeds growing through the rubble in the ruins of the global economy"). Essent! ially, B uiter's line is that the package was essentially window dressing, with very little new money committed. On a similar line, the vice governor of the Czech National Bank, Mojmir Hampl, is quoted this morning as suggesting that "...world leaders in London were giving out money which they don't have, to an institution that does n't need such a sum and should n't have it at its disposal". He went on to argue that behaving irresponsibly in economic policies will now be easier thanks to the increased IMF cushion. Not sure that I would agree with the overall Czech uber-orthodox "laissez faire" line thus far through this crisis that concerns over CEEMEA, at least, have been over-stated, and that there is no need for a pan-CEEMEA bail-out. Undoubtedly the CEEMEA region has faced a liquidity crisis, albeit we would still argue that the region is generally far from insolvent, but still there are a number of individual countries which could still threaten to become insolvent if the situation deteriorates still further. IMF/EU money helps resolve issues to do with liquidity but it is only one part of the process of overhauling economies with more fundamental problems, for example, Latvia, Ukraine and Hungary. Rather than the relaxed IMF lending terms implied by the new FCL, these economies arguably need tough, more standardised IMF programmes, to provide a framework/benchmark both for governments and investors in terms of the course of reform. And, note that sometimes, indeed very often IMF programmes do fail. Romania, for example, appears to have reached a provisional agreement for a new US$17.5bn two-year IMF stand-by agreement, but has a long and chequered track record in terms of its IMF programmes. It is interesting to see that the IMF does still seem to be playing relatively tough with the likes of Latvia/Ukraine, holding back credit disbursements for promises of more reform.
Third, concerns over external financing are easing more generally, as the lack of credit availability, a deflation in domestic dem! and, cur rency corrections where currencies are able to adjust (actually not that many in CEEMEA), has resulted in a generalised narrowing of current account deficits across the region. At the same time some restructuring of private sector external liabilities (e.g. in Kazakhstan, Latvia and Ukraine) and the provision of official financing (IMF & EU) is helping underpin capital accounts/support reserves. This has helped ease pressure off currencies, for the time-being at least. Note that our estimates/forecasts suggests that excluding Russia and Kazakhstan (which still ran large current account surpluses in 2008), Emerging Europe's current account deficits will narrow from US$177bn in 2008 to around US$96bn in 2009, showing a reduction relative to GDP from 6.7% to 4.9%; the improvement relative to GDP is not larger as we expect a larger nominal decline in US$ GDP as currencies adjust weaker. We assume still that current account surpluses narrow very significantly in Russia and Kazakhstan, and that Russia still likely posts a current account deficit in 2009. Encouraging from a different perspective is clear evidence of liability management by some cash rich corporates/banks, particularly in Russia. Banks/corporates have used the period of depressed global markets to buy back debt in the market, particularly short term maturities, and in Russia's case this does act to ease concerns over debt roll-overs for 2009, and perhaps even into 2010.
Fourth, as concerns over external financing ease, the crisis is likely to move into another stage, of deep recession, with the pressure point moving on to public finance. We now forecast real GDP growth across the region slowing from 3.8% in 2008, and indeed trend growth of 6% over the previous decade, to a contraction of 4.2% for the full year in 2009. We see limited scope for a marked recovery in 2010, with perhaps the best case being a flat-lining of growth. Recession will inevitably mean wider budget deficits and larger budget financing needs. Scope to cover these via! non-deb t creating inflows, e.g. privatisation, will be limited, meaning increased resort to debt financing. Where market funding is unavailable, funding will hopefully be provided via official financing (EU/IMF); albeit this will still likely have some strings attached. Excluding Russia, budget financing needs are expected to increase by around 2% of regional GDP, equivalent to around US$50bn for 2009 alone. The latter excludes the costs of bank recapitalisation.
Fifth, while balance of payments trends suggests less pressure on currencies to correct, the dismal growth outlook, both for 2009, and indeed for 2010, would suggest a longer term trend for weaker currencies across the region. Herein we retain our view that without a marked improvement in the growth outlook for 2010, we are likely to see Russia try to further correct its currency weaker later in the year. And, even with IMF-bail-outs/financing, other floating regimes in the region will likely see FX weakness even from currently depreciated levels; as policy makers cut rates in response to the still dominant trend to deflation. Fortunately for those with fully free floating FX regimes, they also tend to be those with much less exposure via externally denominated debts. Key concerns remains over those economies with fixed (Baltic Republics, Bulgaria, BiH) and more managed exchange rate regimes (Croatia, Hungary and Romania) where the contraction in domestic demand, and hence real GDP will be much more severe given the inability to let the exchange rate take some of the strain. As Fitch highlighted earlier today, in warning of ratings downgrades in the offing across the region, the extent of the recession/adjustment required will raise question marks over political stability across the region. Note herein on-going political instability in Ukraine and Moldova, and changes in leadership/government in Latvia and Hungary.
Sixth, returning to the issue of solvency, and perhaps providing some bigger picture regional perspective. While we see pu! blic sec tor debt profiles deteriorating across the region, as budget deficits widen and bank restructuring/recapitalisation costs are borne by the public sector, this is still from a relatively favourable base; the ratio of public sector debt/GDP across the region stood at only around 40% across the region at the outset of the current crissi, versus generally much higher ratios in Western Europe. While, NPLs are likely to rise to higher levels in Emerging Europe, than in Western Europe, these economies are still relatively under-banked, as reflected in the ratios of banking sector assets/GDP of something of the order of 100%, around one third the level in Western Europe. Relative to GDP, hence the cost of cleaning up banks across the region should be much lower than in developed market economies. High foreign ownership stakes (60-70% across the region) should, in theory help to spread the costs of bank recapitalisation (this seems to be the case in Ukraine), assuming that foreign banks remain committed to the region. Net-net, while in the short term the region looks set to be disproportionately impacted by the current crisis due to short term liquidity constraints (to some extent partially alleviated now via access to IMF/EU funding), they could well still emerge in relatively more favourable positions than their Western European peers, due to the relatively stronger public finance profiles; albeit they may be less able to safely inflate away heavy stocks of public debt than their developed market counterparts.
Recommendations: Given our still dismal growth outlook for the region, we would still be short currencies which are meaningfully able to adjust weaker to cushion the impact of the growth slowdown, i.e. PLN, CZK, TRY and ZAR; recent recoveries in these currencies appears to have set much better entry levels for these trades. Counter to this the combination of lower FX liabilities (Czech, S Africa) and IMF support (PLN/TRY) should open the way for continued rate cuts in these economies, suggesting r! unning r eceiving rate positions in these economies. We remain less constructive on the rigid/semi rigid FX regimes across the region and would suggest still playing these through long CDS protection. The logic herein is that given exchange rates have limited scope to adjust, the hit to growth, and public finance profiles in these economies will be that much more severe. Russia stands somewhere in between, we are encouraged by the fairly dynamic, and pragmatic response of the Russian authorities to the current crisis, and unlike other economies in the region they are still sitting on a huge fiscal reserve. They reacted relatively quickly in dropping their hard rouble policy last year, and expect a similar response later this year, assuming real GDP growth is slow to return. A willingness to let the currency adjust, should be credit positive, as it should help shore up growth in 2010, while also will conserve FX reserves to meet sovereign/quasi-sovereign external debt payments falling due. The fact that the government has also been closing the umbrella in terms of sovereign support for strategic corporates, also suggests conservation of foreign exchange reserves to meet sovereign/quasi sovereign liabilities falling due. Long Russia (sovereign/quasi sovereign) cash credit would still appear a compelling trade, as buy-back momentum endures/underpins the market. We would though still be short rouble on a slightly longer 6 month view.
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