UBS have appointed themselves defenders of the East, apparently. U B of ‘Save our Eastern Europe.’
They’re taking issue with recent reports of imminent EE/CE “meltdown“.
We don’t normally respond directly to articles in the financial press, but quite a number of clients have requested clarification on recent reports that Eastern Europe is now facing a financial “meltdown”, and one that threatens to take the stability of Western European banking systems down with it (this theme has suddenly appeared in quite a few articles, including those on gold, commodities and banks, but the one that was forwarded to us most often was “Failure To Save East Europe Will Lead to Worldwide Meltdown“, Daily Telegraph, 17 February 2009).
This is heady stuff, and of course has helped call attention to the state of Eastern European economies (for most economists, the irony here is that all the press notice comes at a time when nothing has really changed in terms of the underlying regional situation; we’ve been writing about Eastern Europe’s problems for a good long time now). However, we need to stress our view that the conclusions above are also highly exaggerated, with at least as much “hype” as hard analysis.
The bank says it’s EMEA economics team will soon be publishing an in-depth report on the issue, but in the meantime they’re putting out some general thoughts. Here they are, for what they’re worth. Firstly, they note things are indeed pretty bad in Eastern Europe:
First, the bad news. For a broad swathe of Eastern European economies (the Baltics, the Balkans, the former Yugoslav states, Ukraine and to some extent Hungary and Kazakhstan) the situation is indeed more severe. These countries have extremely high external debts, very levered financial systems, generally low FX reserve levels and now rapidly contracting economies — in short, there are clear concerns about the capacity to repay and a marked increase in default rates is very likely. Most of these countries also have a very concentrated group of commercial bank creditors.
Moreover, the remainder of Eastern Europe also has visible fragilities. Currencies in Poland, Turkey, Russia and the Czech Republic have all depreciated, and Russia’s domestic banking system has also come under significant stress. In the case of Turkey and Poland there is also a possibility that the IMF or the EU will have to provide additional financial support. In short, none of these is a perfectly stable economy with no domestic or external imbalances.
That’s the bad stuff. Now the good stuff.
First, the most onerous problems are in small countries. When we look at the actual dollar amounts involved, more than half of short-term external debt is held by large countries in the latter camp, i.e., Russia, Poland and Turkey, together with the Czech and Slovak Republics. And these are fundamentally different cases from the “severely” impaired list in the earlier paragraph: less levered banking system, less concentrated debt exposures, fewer pressures on growth, and in the case of Russia what is still a large stock of outstanding reserves and a current account surplus. So while there are clear risks here we’re not talking about anything close to the same level of payment incapacity, and in our view the gap between these country groups is still relatively wide.
Second, it’s really just about Eastern Europe. Once we turn our attention away from emerging Europe and towards Asia and Latin America, there are very few economies indeed that would fall into the same category on any of the above metrics. I.e., for developed commercial banks this really is an Eastern European issue rather than an EM-wide one.
And third, even in the most distressed cases above we’re probably talking about “orderly” default rather than an outright “meltdown”. The Baltics and the Balkans, for example, have seen surprisingly few signs of strain to date on pegged exchange rates or currency board arrangements, and in the absence of a mass exit from the local currency or an explosion in local interest rates the rise in non-performing loans will likely be a more gradual process tied to the contraction of the economy rather than a sudden macro balance sheet collapse. In our view, it’s really the Ukraine where we see the largest risks of a more wrenching impact from currencies and rates at this stage
This strikes us as reaching a bit.
There is of course, a different degree of stress facing the countries of Eastern and Central Europe, but the point is the knock-on effect. We reprise this chart from Monday — showing claims of Western European banks on Eastern European countries. Russia, Turkey and Poland (and we take issue with the premise that Poland is not “severely impaired“) may be in a less dire financial situation, according to UBS, but the distribution of exposure for countries like Austria still leans towards Hungary, Romania, Croatia et al. For what it’s worth, we think the point about “orderly default rather than an outright meltdown” is probably valid. But this is mostly semantics.
Anyway, UBS has some charts to support their premise. Click below to enlarge.
Here’s the commentary on the charts.
There are three key points to make here. First, external debt problems are clearly concentrated in Eastern Europe (highlighted in orange) and other EMEA economies; with the exception of Korea, there is not a single major emerging country in Asia or Latin America with short-term debt of more than 15% of our GDP measure.
Second, within EMEA there are nine or ten smaller countries where the relative size of short-term debt is onerous; by our figures Israel, Ukraine, Slovenia, Bulgaria, the Slovak Republic, the Baltic states and Lebanon all face payments of 25% of adjusted GDP or more over the next 12 months.
But third, the largest economies (and the largest nominal debtors) have less of an issue. Poland is visibly below the most impacted group in terms of exposures, and Russia and Turkey actually fall in the middle of the EMwide sample, with around 10% of GDP by our adjusted measure (the green bars in the chart)
Exactly the same point applies when we look at the underlying state of financial leverage in the emerging world. There are a number of ways to approach the question of leverage exposures; our single most preferred measure is the net increase in credit/GDP ratios over a given period of time, in this case between 2001 and 2008 (Chart 3). Here, again, (i) the problems are concentrated in Eastern Europe, (ii) smaller economies saw by far the most aggressive increases in credit as a share of GDP, and (iii) leverage growth in Russia, Turkey and Poland was much more moderate.
This is equally true when we look at loan/deposit ratios in the domestic financial system (Chart 4)
Finally, turning to external FX reserve cover, we once again find the same pattern. Chart 5 shows the “gap” between the outstanding stock of foreign exchange reserves and the gross 12-month external financing requirement (defined as the sum of the current account balance and the short-term stock of external debt) as a share of GDP. A positive reading means that if no new gross external capital were available for the next year, the country in question would “burn through” all its FX reserves before the end of the period, while a negative reading indicates that reserves are at least sufficient to live through a year of capital “drought”.
As you can see, the number of countries with outright absolute gaps is relatively small, and again predominantly populated by Central and Eastern Europe. We note that Poland and Turkey do fall into the positive group, primarily due to the size of their outstanding current account deficits, which highlights the risk that they will need to turn to the IMF or other financing sources in case of new gross capital shortfalls.
So, UBS is hanging their hopes on Russia of all places.
For many readers, the natural response to the above charts is that we seem to be putting a lot of faith in the health of the largest emerging European economies — and in particular Russia’s ability to “hold it all together” at a time when all the recent numbers in the Russian economy seem to be pointing the other way.
As we ourselves noted only a few days ago, the CIS economies (Russia, Ukraine, Kazakhstan and Belarus) have been moving visibly towards traditional macro crisis territory, with short-term interest rates jumping to 20%-plus per annum at a time when all other EM central banks are busy cutting (Chart 6) and currencies weakening much faster than anywhere else in the emerging world (Chart 7). Russia’s continued FX reserve losses are well-known, falling from nearly US$600 billion at the peak to only US$388 billion as of end- January. How can we be sure that Russia isn’t facing another large-scale default on public and private obligations?
There’s no absolute guarantee, of course, but we still believe the near-term risks here are significantly overstated. As Clemens stressed once again in last Monday’s global EM conference call, the recent managed depreciation of the ruble and the strong hikes in domestic policy interest rates are stabilizing factors in the economy, and we don’t expect the same pace of FX reserve losses going forward as we saw in over the past 4- 5 months (we should be publishing the full transcript of the call shortly, and would defer the reader to that report for further details).
We also note that CDS markets would seem to agree. The blue line in Chart 8 [below – click to enlarge] shows the unweighted average sovereign CDS spread for all Central and Eastern European economies (excluding Russia), while the green line shows the spread for Russia. Clearly investors continue to price in heightened risks for the Russian economy – but Russia was the only country in the entire region to actually record a fall in spreads from both the October 2008 peak and the fourth-quarter average.
The market would seem to disagree.
Russia’s Micex exchange, we note, was suspended again for an hour this morning — after the index fell 6.6 per cent.
5 reasons to remain bearish on CEE – FT Alphaville
“Europe is now the epicenter” – FT Alphaville
Lenders ratings hit by warning over eastern Europe – FT