SSE.LT

Encouraged by a message from Bank of America with precise projection of Baltics devaluation I have decided to summarize why the analysts could be right in their estimations. Apart from inflation, economic recession and credit crunch, as stated by the BoA, I would like to stress other interrelated macro economic phenomena, which theoretically should be ended by a change in currency rates. Mainly, these are:

1. Hot money effect

2. Current account deficit

3. Reserves/ M2 + Gross external debt coverage

4. Low competitiveness

5. Parex Bank… and international relations

1. Hot money - funds which flow into a country to take advantage of a favourable interest rate, and therefore obtain higher returns (Wikipedia). Or in other words, money which is transferred to a country’s foreign reserves not from net exports, FDI and interest income. The country benefits from hot money inflow, since it increases demand for local currency and fills up FX reserves. However, when country’s economic performance worsens, hot money funds are going out of the country as quickly as they were going in. Lithuania’s hot money accounts for ~LTL83bn (EUR24bn), which have accumulated since the last 9.5 years. The figure is equal to 75% of total Lithuanian GDP for the last four quarters and 510% of Lithuanian foreign exchange reserves!

20% of our economy in 2007 and 3/4 of the latest 12 month economy is fueled by highly volatile, speculative funds of the foreigners, who where trying to obtain abnormal returns in developing economies like Lithuania, Latvia and Estonia, and who will kill our economies if they would try get their money back! I didn’t calculate the figure for Latvia and Estonia, but I have little doubt the picture will have different patterns there. The whole idea is clear – local government and financial corporations together with the central bank should try to prevent capital outflow. Otherwise, if “the money” moves, we’ll see unpleasant currency pressure.

2. Current account deficit – an extension of the previous idea. Historically, three Baltic states have been facing significant current account and trade balance deficits. Meaning, we have been consuming much more than we were producing and actually be able to produce: cars, computers, TVs, clothes, energy, you name it. Hot money and various credit funds financed our need for consumption. Now hardly anybody wants to lend money, or offers ~20% annual interest, but just want to receive their credits back. We will be obliged to turn to FX reserves. Just another source of currency pressure.

3. Reserves/(M2+Gross ext debt) coverage – ratio depicting how much domestic currency can be physically exchanged. That’s a ratio of panic – for how long time the country will be able to buy domestic currency and sell EUR/USD or any other foreign money. If we assume that all citizens own equal amount of local currency, only 11-13% of them will be able to exchange it for Euro or US dollar. But only if current peg rates are used for conversion.

4. Competitiveness of the Baltic states soon can become negative. It means that it is so low, that it makes no difference either you name it low or negative. The case is simple – all our exports are becoming more and more expensive. Not only because of ~20% inflation, but because of other CEE currencies’ depreciation. Poland, Hungary, Romania, Russia – all of them have their currencies depreciating, which makes their exports much more attractive than Baltic goods, services and labour. Do we have to lose trade competitiveness and step into 5-7 years of recession, or we should accept fast pain, but expect fast recovery? I’ll leave that without an answer.

5. Parex bank is not actually a problem. Not because it is of low importance, but because it is beyond our countries’ control. Parex case simply demonstrates for me how we should not behave with our neighbor countries: should not prevent international dialogs, should not support inadequate leaders, should not provoke and irritate our trade and diplomatic partners. Since we sometime do these things, we can not control the consequences.  Thus, if we lose an economic partner because of our political silliness, we could say goodbye not only to Parex, but to many more corporations and money funds which are operating in Lithuania, Latvia and Estonia. Otherwise, where there all those queues in Riga when Parex bank failed?

Probably, Parex accident was not a revenge, but a simple money transfer. However, the scale of the accident should be noticeable. Competitiveness is less visible, but more harmful. M2 together with local panic will play a fatal role without a control. Current account and hot money – and all prosperity which is perceived to be “for free” will be given a stage little been later. If we face Latvian Lat devaluation (and in a few moments the same things in Lithuania and Estonia), just prepare for the major explanation from our officials: “It happens”.