Economic sanctuary

IFR Central and Eastern Europe 2009
10 min read

The financial downturn is putting enormous pressure on Central and Eastern European currencies, as well as the euro. Membership of the single currency is seen as a key way of protecting these economies from the vagaries of the recession, and the contagion their problems may have in Western Europe, but Europe’s politicians are loathe to relax the rules to speed their entry. Hardeep Dhillon reports.

Currencies in Central and Eastern Europe are coming under increasing pressures as economies weaken in the face of continuing market deterioration. Recent discussions at European Union and country level have focused on the potential softening of euro membership criteria to accelerate the entry of Hungary, Poland and the Baltic states of Latvia, Lithuania and Estonia into the euro. This has been brought about by the need to protect countries from continued currency depreciation and financial instability.

European Central Bank president, Jean-Claude Trichet nonetheless ruled out changes to euro membership rules to fast track eastern EU member countries. “Sticking to the rules is very important for the stability of the European Union,” he said on March 5.

Early entry into Exchange Rate Mechanism 2, the fixed exchange rate system prior to joining the euro, would still require countries to wait two years before European Monetary Union. Early adoption of the euro would also require a change in the EU treaty, which EMU member states have clearly stated will not happen.

“The conclusion is that relaxing the Maastricht criteria in this environment would be a bad idea and would weaken the euro as an institution,” said ShahinVallee, emerging markets strategist at BNP Paribas.

Nonetheless, there are clear benefits of early euro membership. Currently, the main appeal for most of these economies is the instant elimination of the risk of a systemic banking crisis in the region, said Arend Kapteyn, chief economist for Europe, Middle East and Africa at Deutsche Bank.

“There are massive potential foreign exchange mismatches on corporate and household balance sheets because many banks in the region have been lending in foreign exchange-denominated or indexed loans, and most of this is unhedged,” he said.

“Falls in exchange rates have brought large problems for balance sheets in CEE, given the propensity for foreign currency lending,” added Chris Scicluna, senior emerging markets economist at Daiwa Securities SMBC.

The Baltic nations and Bulgaria, whose currencies are pegged to the euro, would have been better off if they had adopted the euro, he said. Being pegged at current uncompetitive rates, without actually having the benefits of euro membership, means these currencies risk a beating. “Were the Baltics to devalue their currencies now, there would be a horrendous shock to balance sheets and I do not see the appetite for that at the moment,” he said.

Pegged countries cannot devalue their currencies to give any cushion on the way down, said RBC Capital Markets’ senior emerging markets strategist Nigel Rendell. “Fixed exchange rates are a double-edged sword as they are good for generating stability but this kind of halfway house of ERM2 is not ideal for long periods of time, as seen with the Baltics,” he said.

In addition to the Baltic states and Bulgaria, Rendell views Hungary and Romania as vulnerable due to their relatively high interest rates and large euro and Swiss franc borrowing. The Czech Republic enjoys better fundamentals, he said, as there was no comparable borrowing binge “largely because Czech interest rates were lower than in the euro zone and there was no point in borrowing in foreign currencies.”

One source of pressure, particularly for Poland, is the exposure of the local corporate sector to FX options and structures. Firms are betting on the continuing appreciation of the zloty. Now, with depreciation, losses could affect a number of local companies, though it is uncertain which companies could suffer and whether any will go bankrupt as a result. “This could perhaps happen across the region as we see very large depreciation in CEE currencies which people were not expecting, and that could have an effect on banks and corporates as well,” said Jon Harrison, emerging markets strategist at Dresdner Kleinwort.

The Polish national regulator disclosed PZL18bn worth of unrealised losses in the corporate sector due to FX options. If these were to be exercised or closed to limit potential further losses, BNP Paribas’ Vallee forecasts the corporate sector would need about US$5bn to close outstanding FX positions. “This could become a real issue in Poland and also presents higher risk to the balance of payments than what is currently priced in and which we think is currently understated,” he said.

FX mismatches in the household and corporate sector are five times greater than those in Asia prior to the 1997-98 crisis. On average FX loans equal 54%, over half of the total loan book, added Kapteyn. If the region’s currencies continue to depreciate or lose another 20%-30%, most of the banking system would be on the edge of insolvency: the only way CEE can avoid an Asian-style banking system meltdown is to contain the extent of currency depreciation, which may involve a step up in central intervention, he warned.

Central banks are becoming more decisive in their actions to limit further currency depreciation. Cutting rates rapidly to some extent exacerbated currency weakness.. “Measures have been effective in reducing the pace of depreciation of currencies, otherwise there could have been a risk of currency collapse which we think has been pretty much averted in the major countries,” DK’s Harrison said.

The region in general is likely to witness further currency weakness despite FX intervention, predicted BNP Paribas’ Vallee. Hungary is limited in further action as the IMF would frown upon the shedding of more reserves. “Poland will probably have more scope to intervene, but doing too much could weaken their position further and tip them into a real balance of payments crisis if reserves erode too quickly,” he said.

Most CEE countries exhibit large current account deficits, with some in the region of 10%-20% of GDP, and so are heavily reliant on foreign capital to plug those shortfalls. As there is a lack of foreign capital, central banks have tried to use rhetoric and verbal intervention to prop up exchange rates, which can seem futile. “Currencies are judged on the fundamentals, like current accounts and fiscal balances, and if you are not keeping those in order then all the verbal intervention in the world is not going to save your currency from sinking,” said Rendell.

Take Russia which has vast foreign exchange reserves but has managed to whittle those down fairly rapidly after injecting liquidity to support the banking system and defend its exchange rate. “If there is negative sentiment in the market and a region as a whole is moving in one direction, even widespread FX intervention does not save your currency. Central bankers try their best but they have very limited ammunition in this kind of world,” Rendell said.

“Market conditions are very much hampering what central bankers can do,” added Daiwa’s Scicluna. “I think recent attempts by them to influence currency markets are quite understandable but central banks are facing a policy dilemma, as they are running out of scope to lower interest rates because of currency weakness.”

The high beta economies of CEE countries have grown rapidly over the past few years and been big recipients of foreign direct investment, particularly in the auto and electronics sectors. “Current account deficits have been financed in part through FDI and so countries are very exposed to a slowdown in developed economies, which is causing a lot of volatility in their currencies,” said DK’s Harrison.

The emergence of supply/demand mismatches in capital markets has come as key sources of EMEA balance of payments pressure. This lack of market access is a real structural problem for the region, said Deutsche Bank’s Kapteyn. Issuance in the syndicated loan market is running at 40% of levels in the preceding three years, and there has not been a single syndicated loan to an emerging market bank yet this year. “This is a major problem from a currency perspective, as countries are unable to refinance their loans and so either have to find alternative sources of have to buy FX, which is driving these currencies weaker,” he said.

On average 75% of the CEE banking system is owned by foreign parent banks, which have been providing sources of funding for local subsidiaries and rolling over their exposure rather than withdrawing capital. “In recent years you had a net inflow of money, not just from foreign parent banks but also Eurobonds and syndicated loans, which now have effectively stopped. Foreign parent banks are broadly rolling their exposure, but not increasing it, effectively resulting in no net inflow. Coupled with other sources of financing drying up, and in some cases still sizeable current account gaps, you are left with a net outflow and weaker currencies,” he said.

Questions have been raised over the supportiveness of subsidiaries but Daiwa’s Scicluna does not envisage parent banks will cut and run from the region. His optimism is backed up by the provision of government support to western European banks and the potential synergies on offer, in addition to the recent examples of UniCredit and Erste banks recapitalising their Ukrainian subsidiaries.

The situation in CEE is likely to get far worse before it gets better. “Eventually, we believe that most of CEE will end up with some sort of IMF bailout package,” said RBC’s Rendell. “Outside of Slovenia and Slovakia, with their currencies now safely inside the euro, perhaps only the Czech Republic will escape unscathed.”