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Monday, August 15, 2011

Is The Risk Accompanying Estonia's Eurozone Membership Really So Low?

"But the go-ahead Estonians are already scenting the next challenge. Should the single currency crumble, they are determined to be on the inside track for any new German-centred “super-euro”. Goodbye “eastern Europe”; welcome to the “new north”."
Edward Lucas, writing in The Economist

Estonia's economy put in another sterling performance in the second quarter of this year, even if the expansion rate fell back to quarterly 1.8%, down from 2.4% in Q1, and 2.5% in the last quarter of 2010. Well, you didn't expect the economy to keep growing at such strong rates for ever, did you? Evidently not. The interannual rate peaked at 8.5% in the first quarter, and dropped back slightly during the last three months to 8.4%, still this is no mean pace.

But given that the good things in life don't last forever, the real question now facing analysts and policymakers is not whether a fall of a tenth of a percentage point is significant, but rather the much more critical one of just how long the Estonian economic expansion can be kept going in the face a a more general European slowdown, given that the economy is now almost entirely dependent on export expansion for GDP growth?

Exports have been very strong so far this year. Although imports have more or less risen in lock-step.

Consequence, while the goods trade deficit has been substantially reduced, what remains stubbornly resists being eliminated.

Which draws attention to another feature of Estonian goods exports, a lot of them are processed products which are effectively re-exports of previously imported components, hence the value added component supplied by Estonian manufacturing is comparatively small. The share of value added in manufacturing (as a % of GDP) has risen sharply in recent quarters, from the earlier crisis lows, but at around 19.5% it is still up only about 1.5% on the pre-crisis levels. However, within this the share which is oriented to exports has undoubtedly risen.

Still, with value added in manufacturing under 20% of GDP, driving growth forward in the future is not going to be easy, especially now that a Europe-wide slowdown is gradually taking hold. And in a sign of what may now be to comme, exports fell sharply in June, to around 950 million Euros, from an average of 1.1 billion euros in the March to May period.

Indeed industrial output hit a local high in March, and has subsequently fallen back.

Retail sales are barely up from their sharp drop, and are unlikely to give much momentum to the economy in the months and years to come due to the substantial debt overhang which the household sector is still struggling with.

Likwise there is not much sign of a return to life in the construction sector outside government sponsored infrastructural activity.

Unemployment has fallen, but continues to remain high, and in fact the 7,000 drop between Q1 and Q2 is really quite small when seasonal factors and the fact exports were growing furiously are taken into account. It would thus not be surprising to see the numbers of unemployed once more rising going into the winter.

So the big question here is not whether Estonians worked hard to contain their fiscal deficit (which they obviously did), or whether they carried out some form of internal devaluation (they surely did). The key question is whether their internal devaluation went far enough, and whether the exchange rate with which the Estonians entered the Euro was not too high for their needs (a mistake the Germans made in the late 1990s, and which they subsequently paid for in quite costly fashion).

What does not seem to be generally understood in this whole "Estonia" debate is what the expression "export dependence" means. It doesn't simply mean that exports will play a significant part in forthcoming Estonian growth (I think that all parties are now agreed that this will be the case). It means that the level of household indebtedness coupled with the ageing population phenomenon means that domestic consumption driven growth is now a thing of the past, and what is worrying about the Estonian situation is the comparatively small size of Estonia's manufacturing industry.

New credit growth has all but disappeared in Estonia.

Something which is in many ways reminiscent of what happened in Germany following the unwinding of their 1990s consumption boom.

People are still waiting for the return of a housing boom in Germany (see mortgage chart below) but they will wait idly, demography virtually guarantees that, just as they will wait idly in Estonia for a return of the good old days, and meanwhile precious time is being lost.

Estonia's current account has now corrected:

Just as the German one did before it.

But Estonia still has some way to go before it realises CA surpluses on the scale which Germany does. And it still has even more way to go before it recovers the level of economic output attained before the onset of the crisis. Despite the strong recovery of the last year, Estonian GDP is still 10% down on its earlier peak.

Which is why it is worrying that Estonian inflation continues to run above the Euro Area average. This is not the way to improve competitiveness, and it is horribly reminiscent of the path which was trodden by peripheral economies to the West and the South after they joined the common currency. It doesn't really seem that too many lessons have been learnt here.

Strangely, as a country which has recently entered the common currency, country risk seems to have followed a path which is rather nearer to that of its Baltic peers than to that of equivalent Euro Area countries. Credit Default swaps on Estonia have fallen and remain down, whilst those of its East European Euro peers (Slovenia and Slovakia) have risen as one might expect as the crisis of confidence in the currency has grown.

It is not my intention here to single out Estonia for special - negative - treatment (that would not be warranted) but the value being placed on the CDS really is incredibly low for a country that just entered a Euro Area whose outlook could, at the very least, be considered as reasonably uncertain. It is being priced as part of core Europe, when in reality it forms part of Europe's periphery. Evidently, were the Euro to break in two, Estonia would incline towards riding with the German lead group, but given the fact that the country now has a totally export dependent economy, and a currency which was arguably over valued at the time of Euro entry (and continue to have ongoing above-Eurozone-average inflation) it is not clear how prepared the country would be to handle the challenges of being attached to the new, and ultra-high value, currency which would be created.

Thus we find that a country which two years ago was being valued as having the third-riskiest sovereign debt in the European Union is now trading in quite another league, and finds itself included among the European "top ten" sovereigns in terms of price. Last week, while French CDS were hitting Euro era highs of around 160 bps, Estonian ones were sitting pretty at around 115. And just after S&Ps downgraded US sovereing debt, they upped the Estonian rating by two notches to AA-.

Their Valour Is Not In Doubt

"That he which hath no stomach to this fight,
Let him depart; his passport shall be made,
And crowns for convoy put into his purse;
We would not die in that man's company
That fears his fellowship to die with us".
William Shakespeare, Henry V, the Saint Chrispin's Day Speech

So the question I ask myself (as I did in this earlier post), is whether this kind of realignment in valuations makes any kind of economic sense? Of course positive comparisons with the United States and France are flattering, but am I the only one to see something funny going on here? Is contagion risk being reasonably priced in, is the risk of Euro Area break up being adequately priced, and if it isn't, do we not face the risk of a sudden (and hence destabilising) adjustment in the not too distant future?

Is there now nothing left to economic life but fiscal policy, or have we all collectively lost our sense of perspective? How can an economy which still shows the living scars of its earlier sharp distortions be so highly rated?

Obviously, it is clear that the Estonian Sovereign was never, even during the worst moments of the financial crisis, and under the most severe of worst case scenarios, the third riskiest to be found within the frontiers of the EU (Estonia was the only EU country to have a budget surplus last year - worth 0.1 percent of GDP - while public debt totaled a mere 6.6 percent). On the other hand it is the case that Estonia faced an extremely challenging crisis in 2008/09, and had the Euro peg collapsed in one of the four East European countries who had one at the time then the pressure of private debt could certainly have confronted the country with some very complex and difficult choices.

But Their Wisdom, And Sense Of Foresight.........

Following the argument along a bit, it is far from clear that the current level of Estonian CDS prices risk in in any more satisfactory way than it did at the height of the crisis, since membership of the Eurozone has brought with it both positives and negatives. The 0.28% contribution of the country to any future EFSF bailouts may not seem like a very big deal, but in comparison to Estonian GDP the sums involved may well be far from trivial. The country does not have, and is not likely to have, either a fiscal deficit or a sovereign debt problem, nor does it have a home grown banking system which might need bailing out. The risk to Estonia comes from elsewhere, from its association with Ireland, Spain, Greece, Portugal and Italy. Depending on how far the core EU countries are willing to finance debt and absence of growth in those countries the Eurozone's future is far from clear. If, as Edward Lucas speculates, a division to go with the strong currency German lead component which could be created in the case of break-up, Estonia's leaders may live to rue the day they missed the opportunity to make a substantial devaluation in the currency before entering the Eurozone.

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

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