Sunday, February 22, 2009

Weekly Focus: Pressures Mount in Eastern Europe

Focus in the financial crisis shifted to Central and Eastern Europe (CEE) during the past week - and to the large bank exposure to the region for Euroland banks. The CEE countries are caught in a very negative spiral of deleveraging, heavy amounts of foreign debt and economic crisis. With little room for manoeuvre in economic policy to underpin the economies, the economic outlook has turned increasingly gloomy. Ukraine, with a population of 45m, could be on the verge of defaulting. Austria's finance minister warned last week of the risk of an economic ‘catastrophe' triggering a ‘domino effect' of problems further west. Ukraine is arguing with IMF over budgetary policies in order to get a second tranche of USD16.4bn due this weekend. A compromise will probably be found and the money released but tensions are running very high.

Attention returned to European bank exposure to CEE after a Moody's report said that western European banks with subsidiaries in CEE were at risk of being downgraded. Austrian banks in particular have significant exposure in CEE with loans to this area as high as 55% of Austrian GDP. The turmoil hit European bonds where spreads widened to Euroland -and Austrian bonds were hit particularly hard. The euro also weakened on the news.

About half the loans in CEE come from European banks which expanded markedly during the boom years. This now creates the risk of a very hard credit crunch in CEE as European banks are likely to focus more on lo-cal markets and are under pressure from local gov-ernments to increase domestic lending as govern-ments are helping banks with capital and loans. At the end of the week the president of the World Bank, Robert Zoellick, called for the EU to help CEE countries. He said the World Bank is working with IMF and other institutions to help the region but needed more backing from the EU. Hopefully they get it soon.

Euroland: PMI data weaker than expected

The Flash PMI for Euroland disappointed in February as the slight improvement seen in January was re-versed. PMI manufacturing fell to at 33.6 from 34.4 (Consensus 35) and service PMI fell to 38.9 from 42.2 (Consensus 42.5). Both indices fell to new all-time lows. The data point to continued weakness in GDP in Q1.

The weakness in February PMI for Euroland is similar to the pattern seen in US regional surveys with de-clines in both Empire and Philly Fed indices. We still believe we are in a bottoming process in the PMI data, but these data indicate that it may take longer than indicated by the January numbers. The case for more ECB cuts is intensifying and this supports our expectations of a 50 basis point cut in March.

New orders fell slightly in February following a small increase in January. Inventories have been adjusted strongly during the autumn and the adjustment continues. The order-investment balance points to a re-bound soon - or at least stabilisation.

Flash PMI in Germany was overall weaker than expected. German manufacturing PMI rose slightly, but German manufacturing PMI did not rise last month, as in most other countries, so the rise in February may be a delayed reaction to what was seen elsewhere in January. The German service PMI was very weak and fell to a new all-time low. The German exposure to eastern Europe is turning into a big disadvantage at the moment and the intensification of the crisis there may weigh further on Germany in coming months. Next week the German Ifo is published, which is expected to stabilise, although the Ifo expectations may fall slightly.

Key events of the week ahead

  • Tuesday: German Ifo will be key event for the week. We look for an unchanged number at 83. Expectations may fall back, as indicated by PMI.
  • Other data of significance will be M3 Thursday, consumer confidence, final inflation numbers and German unem-ployment.

Switzerland: Still great uncertainty about the bank sector

Two stories dominated the news flow from Switzerland during the week: the settlement between Swiss banking giant UBS and the US authorities, and the uncertainty about Swiss banks' exposure to the particu-larly hard-hit countries of central and eastern Europe (CEE). While both stories have the potential to un-dermine the Swiss franc, the currency actually strengthened at the beginning of the week, briefly nudging up towards 5.07 against the Danish krone before falling again due to euro strengthening.

UBS stands accused by the US financial and tax authorities of having conspired with a large number of US customers in tax evasion and tax fraud, and agreed to a settlement on Wednesday - whereby the bank will pay fines of USD780m and provide details of certain customers. The disclosure of customer information is particularly controversial and there has been speculation about whether this is the beginning of less strin-gent bank laws in Switzerland and potentially the undermining of the Swiss bank sector. There is a particu-lar fear that customers of Swiss banks will reduce their deposits if uncertainty about the future of bank se-crecy increases. However, the Swiss government has stated that bank secrecy is still assured, and that it has only permitted the release of information on individuals guilty of fraud, which, unlike tax evasion, is a crime in Switzerland. Uncertainty about the application of the country's bank laws nevertheless put pres-sure on the Swiss franc, although we put most of Thursday's slide in the CHF/DKK down to a correction in the pricing of the euro, as the EUR/USD climbed sharply at the same time.

Another topic that has been very much in focus is uncertainty about Swiss banks' exposure to the crisis-stricken CEE countries. The CEE economies have been hit by the credit crunch and global recession, just like the rest of the global economy, but are particularly feeling the squeeze due to heavy borrowing in the region in recent years and the resulting external imbalances that have built up. Based on BIS data for bank lending to CEE countries, as shown in the following chart, the Swiss banks are not particularly heavily ex-posed. Less than 2% of total foreign lending has gone to CEE countries, which is well below the Austrian banks' exposure of 36% of total lending. Germany also has considerable exposure, but this accounts for a smaller share of GDP because the financial sector makes up a much smaller part of the economy than in Switzerland. We do not therefore believe that direct exposure to the CEE countries is the greatest element of uncertainty in the Swiss financial sector. We also need to remember that a large part of the borrowing in the region is denominated in Swiss francs, so further deleveraging in the region would actually boost the Swiss franc deleveraging of Swiss franc loans, which has been the most important driver behind the cur-rency's strong appreciation in 2008.

Key events of the week ahead

  • Tuesday, 09.15 CET: Q4 employment data.
  • Tuesday, 10.00 CET: Consumption indicator for January.
  • Friday, 11.30 CET: KOF leading indicator for Feb-ruary. We anticipate further deterioration in this important indicator despite improvement in most European PMIs in January.

UK: BoE preparing to print money - but may not reach zero interest rate

There were two particularly interesting points in the minutes from the latest Bank of England meeting out this week. First BoE made it clear that it saw it necessary to embark on quantitative easing in order to get inflation back towards the target in the medium term: "It seemed unlikely that the inflation target could be met solely by cutting the Bank Rate". BoE prefers increasing money through buying credit assets rather than government bonds as this will help the economy more directly: "In the present environment, where par-ticular credit markets are not functioning normally, it is appropriate to consider increasing the supply of central bank money by more unconventional types of asset purchases. Buying private sector assets in such markets …. would encourage the flow of credit to companies…The Committee unanimously agreed that the Governor should write on its behalf to the Chancellor to seek authority to conduct purchases of government and other securities, financed by the creation of central bank money…". We believe this letter could be pub-lished any day and that quantitative easing will commence in the very near future.

The second important takeaway from the meeting was that BoE is no longer likely to cut rates all the way down to zero. The members had a lengthy discussion of the disadvantages of zero rates, which might hurt banks' profitability and hence obstruct more lending. Since bank deposit rates are normally below the Bank Rate, a zero rate would be a disadvantage as deposit rates could not be lowered below zero. Instead, banks could not lower lending rates as much, but in some cases the banks were contractually obliged to do so and this would hurt their profitability. So where is the lower bound? Actually it was mentioned that one member (Blanchflower) wanted to go to the lower bound already at the February meeting. Since he voted for a cut of 100bp that would imply that they see the lower bound as 0.5%. We therefore no longer expect BoE to cut all the way down to zero but instead to cut to 0.5% in March and stop there.

GBP has been trading more or less sideways against EUR this week around 0.89. We believe that the quan-titative easing will give a push towards a weaker GBP and hence see a move to 0.93 on a three month hori-zon. Bond yields are in a bottoming process and caught between the outlook for quantitative easing on the one hand and heavy bond issuance on the other. We believe 10y yields could fall further towards 3% - the low reached earlier this year.

Key events of the week ahead

  • Nationwide house prices out during the week. We expect a rise in line with what has been seen in HBOS and Rightmove figures.
  • Q4 GDP data will provide details on the advance GDP out 23 January.

USA: Support package for hard-pressed homeowners

Barack Obama unveiled the final part of his financial rescue plan on Wednesday night - a support package for US home-owners. The package has three main elements: (1) wider access to refinancing of Fannie Mae and Freddie Mac mort-gages, (2) restructuring of mortgages for homeowners at risk of default, and (3) keeping mortgage rates down through further injections of capital into Fannie Mae and Freddie Mac (see Flash Comment - USA: Obama's housing plan).

The refinancing element of the housing plan means that homeowners with Fannie Mae and Freddie Mac mortgages (which account for around half of all outstanding mortgages in the US) will be able to refinance these loans even if they exceed 80% of the value of their homes. The Obama administration estimates that 4-5 million homeowners meet all of the criteria for refinancing except for the current 80% LTV rule. Under the new rules, they will be able to refinance their loans at today's lower interest rates. The Federal Reserve and the Treasury are already making massive pur-chases of mortgage bonds to bring down mortgage rates, and we believe that it makes sense to ease the 80% rule and so ensure that more homeowners can benefit from the drop in rates. The Treasury will also be increasing its in-jections of capital into Fannie Mae and Freddie Mac in order to avoid any loss of confidence in the two institutions and the resultant increase in interest rates.

When it comes to homeowners who do not have Fannie Mae or Freddie Mac mortgages and are at risk of failing to make their monthly repayments, Obama has set aside USD 75bn from the TARP to help cover the cost of restructuring these loans. The idea is for the government and the lender to share the cost of bringing monthly repayments down to a sustain-able level, which has been set at a maximum of 31% of the homeowner's monthly income. The final guidelines on how the restructuring of loans is to proceed, including which homeowners are eligible for restructuring, will be announced on 4 March. For now, all financial institutions wishing to receive aid through the financial rescue package must comply with the guidelines, and Fannie Mae and Freddie Mac will be using them for loans that they own or guarantee.

In the coming week, attention will focus on Fed Chairman Bernanke's semi-annual monetary policy report (read more under Fixed Income).

Key events of the week ahead

  • Tuesday: Conference Board consumer confidence ex-pected to fall to 34.0.
  • Tuesday: Bernanke to present semi-annual monetary pol-icy report to Senate - Wednesday to the House.
  • Wednesday and Thursday: Existing home sales expected to drop to 4.73m, new home sales to rise to 333.000.
  • Friday: We expect a downward revision of Q4 GDP growth to -5.5% q/q AR from -3.8% q/q AR.

Asia: China praised in G7 communiqué

Relations between China and the Obama administration in the US got off to a shaky start when treasury secretary Timothy Geithner accused the Chinese of exchange rate manipulation in a congressional hearing. This sparked fears of fresh trade policy tensions between China and the US, including fears that the People's Bank of China might retali-ate by scaling back its purchases of US government bonds. What was overlooked was that Geithner also said that it is currently far more important that China is stimulating domestic demand. According to press reports, which have not been officially confirmed by the Obama administration, the president subsequently contacted the Chinese and as-sured them that the new US administration would not be aggressively pursuing the exchange rate issue. Ultimately the Americans are happy with what China has delivered to date in the economic sphere, as it has eased its fiscal pol-icy markedly relative to many other countries, and there are even signs that this is beginning to have an impact. This is why we saw China being singled out for praise for the first time in a G7 communiqué following the meeting of fi-nance ministers and central bank governors in Rome last weekend. China was praised first and foremost for its rapid fiscal policy response and its assurances of a more flexible exchange rate in the longer term.

In Japan, the LDP-dominated coalition government is becoming increasingly paralysed in a situation where an ex-traordinarily weak economy is crying out for action (see Flash Comment - Japan: GDP plunge on drop in exports). The Aso government is hugely unpopular, and finance minister Shoichi Nakagawa's resignation following his controversial behaviour at the G7 meeting may very well be the final nail in the coffin. Internal tensions within the LDP are rising af-ter the still highly popular former premier Junichiro Koizumi publicly criticised prime minister Taro Aso. A rift in the LDP can no longer be ruled out, and it seems more and more certain that the LDP will lose power in the next elections, which need to be held by September this year. This political uncertainty has meant that the fiscal policy response has been relatively weak. The first stimulus package, covering fiscal year 2008/09 (which ends on 31 March), has still not made it through parliament. In the wake of the weekend's G7 meeting, the government has said that it will present a major new stimulus plan for fiscal year 2009/10, but it is extremely doubtful whether it will be able to get it through parliament. There is therefore a major burden of responsibility on the shoulders of the Bank of Japan. But with inter-est rates already close to zero, there is not much leeway here either, despite the BoJ's increased use of unconven-tional means of easing monetary policy (see Flash Comment - Japan: BoJ to start purchasing corporate bonds). It will therefore largely be up to stronger international growth to drag the Japanese economy out of the current slump.

Key events of the week ahead

  • In Japan, there is a busy week ahead in terms of in-coming data. Wednesday brings the trade balance for January, while Friday brings industrial produc-tion, inflation and unemployment for January and the manufacturing PMI for February.
  • In China, a quiet week lies ahead, the only important release being leading indicators for February.

Foreign Exchange: CEE meltdown hits EUR and SEK

The past week has seen sharp deterioration in central and eastern European (CEE) currencies. The market has begun to get serious jitters about the consequences of the economic and financial crisis engulfing these previously so successful growth markets. But the crisis has of course also affected Euroland and the CEE countries have now become a millstone around Euroland's neck, not least for many banks exposed to the region that had a nasty shock when Moody's announced during the week that it may downgrade a num-ber of Austrian and Swedish banks with CEE exposure. Exports from Euroland to CEE countries are also in virtual freefall.

The market is therefore now asking itself: who will foot the bill for the heavy debt and imbalances in CEE countries? There is no doubt that German taxpayers are beginning to fear that they will have to reach into their pockets along with the IMF. But whoever ends up with the bill, our emerging market analysts believe that the crisis in the CEE countries is set to worsen in the coming months, and liken it to the Asian crisis of the 1990s (see the article CEE: This looks like a meltdown). Besides these problems to the east, Euroland is also battling with major economic problems internally, best illustrated by the continued widening of the spread between ten-year government bond yields in Germany and economically hard-pressed countries such as Portugal, Greece, Spain and Ireland.

The consequences for the European G10 currencies were plain to see during the week. EUR/USD contin-ued to slide, hitting a new low for the year of 125.1. Even otherwise beleaguered sterling rallied against the euro, despite the Bank of England (BoE) possibly moving toward a zero interest rate and probably commenc-ing quantitative easing in March. However, one of the big losers in the FX market over the past couple of weeks has been the Swedish krona, hit by the combination of an economy exposed to global growth, banks exposed to the Baltic States, the prospect of Saab having to go it alone without assistance from GM or the Swedish government, and the Riksbank moving toward a zero interest rate, or equivalent.

So what should we expect in the weeks ahead? It is important to remember that things can change fast, es-pecially in the FX market (and politics). Should a little risk appetite emerge in global markets, EUR/SEK will fall back and the EUR/USD will rally. It is therefore likely that we will see a slight reversal of the past week's big movements due to positioning in the market, etc. But we doubt that this will make the problems in Euro-land and the CEE countries disappear. On a one-month view, we see the arrow pointing clearly downward for the EUR/USD, and the Swedish krona trading at a relatively weak level. In Sweden, we are focusing particu-larly on GDP data, which we expect to be very weak (see article on Sweden). Sterling is a little trickier. We expect the BoE to commence quantitative easing, maybe as early as March, and interest rates to come down further, and the UK economy is definitely not looking good. But the UK does have less exposure to the CEE countries than Euroland. We anticipate further sterling weakening and would therefore prefer to take a position in the "cable" (GBP/USD) or possibly even against the Norwegian krone.

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