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SP8 | ifr special report | April 2009 FOREIGN EXCHANGE

CEE FX vs Asia 1997

Index currencies 220

Thai baht vs US dollar 97-98 S Korean won vs US dollar 97-98 Malaysin ringgit vs US dollar 97-98

180 140 100

Swiss franc vs Polish zloty 07-08 Swiss franc vs Hungarian forint 07-08 Euro vs Romanian new lei 07-08


Jan 97 Oct 07

Source: Deutsche Bank

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 inter- vention, 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 fundamen- tals, 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

Apr 97 Jan 08

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Jan 98 Oct 08

Apr 98 Jan 09

Jan 98 Oct 98

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 sup- portiveness 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.”

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