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April 2009 | ifr special report | SP7 FOREIGN EXCHANGE


The financial downturn is putting enormous pressure on Central and Eastern European currencies, as well as the euro. Membership of the single currency is seen as a key way of protecting these economies from the vagaries of the recession, and the contagion their problems may have in Western Europe, but Europe’s politicians are loathe to relax the rules to speed their entry. Hardeep Dhillon reports.


Economic sanctuary C


urrencies in Central and Eastern Europe are coming under increasing pressures as economies weaken in the face of continuing market deteriora-


tion. Recent discussions at European Union and country level have focused on the potential softening of euro membership criteria to accelerate the entry of Hungary, Poland and the Baltic states of Latvia, Lithuania and Estonia into the euro. This has been brought about by the need to protect countries from continued currency depreciation and financial instability. European Central Bank president, Jean- Claude Trichet nonetheless ruled out changes to euro membership rules to fast track eastern EU member countries. “Sticking to the rules is very important for the stability of the European Union,” he said on March 5.


Early entry into Exchange Rate Mechanism 2, the fixed exchange rate system prior to joining the euro, would still require countries to wait two years before European Monetary Union. Early adoption of the euro would also require a change in the EU treaty, which EMU member states have clearly stated will not happen.


“The conclusion is that relaxing the Maastricht criteria in this environment would be a bad idea and would weaken the euro as an institution,” said ShahinVallee, emerging markets strategist at BNP Paribas.


Nonetheless, there are clear benefits of early euro membership. Currently, the main appeal for most of these economies is the instant elimination of the risk of a systemic banking crisis in the region, said Arend Kapteyn, chief economist for Europe, Middle East and Africa at Deutsche Bank.


“There are massive potential foreign exchange mismatches on corporate and household balance sheets because many banks in the region have been lending in foreign exchange-denominated or indexed loans, and most of this is unhedged,” he said.


“Falls in exchange rates have brought large problems for balance sheets in CEE, given the propensity for foreign currency lending,” added Chris Scicluna, senior emerging markets economist at Daiwa Securities SMBC.


The Baltic nations and Bulgaria, whose currencies are pegged to the euro, would have been better off if they had adopted the euro, he said. Being pegged at current uncompetitive rates, without actually having the benefits of euro membership, means these currencies risk a beating. “Were the Baltics to devalue their currencies now, there would be a horrendous shock to balance sheets and I do not see the appetite for that at the moment,” he said.


Pegged countries cannot devalue their currencies to give any cushion on the way down, said RBC Capital Markets’ senior emerging markets strategist Nigel Rendell. “Fixed exchange rates are a double-edged sword as they are good for generating stability but this kind of halfway house of ERM2 is not ideal for long periods of time, as seen with the Baltics,” he said. In addition to the Baltic states and Bulgaria, Rendell views Hungary and Romania as vulnerable due to their relatively high interest rates and large euro and Swiss franc borrowing. The Czech Republic enjoys better fundamentals, he said, as there was no comparable borrowing binge “largely because Czech interest rates were lower than in the euro zone and there was no point in borrowing in foreign currencies.”


One source of pressure, particularly for Poland, is the exposure of the local corporate sector to FX options and structures. Firms are betting on the continuing appreciation of the zloty. Now, with depreciation, losses could affect a number of local companies, though it is uncertain which companies could suffer and whether any will go bankrupt as a result. “This could perhaps happen across the region as we see very large deprecia- tion in CEE currencies which people were not expecting, and that could have an effect on banks and corporates as well,” said Jon Harrison, emerging markets strategist at Dresdner Kleinwort. The Polish national regulator disclosed PZL18bn worth of unrealised losses in the corporate sector due to FX options. If these were to be exercised or closed to limit potential further losses, BNP Paribas’ Vallee forecasts the corporate sector would need about US$5bn to close outstanding FX positions. “This could become a real issue in Poland and also presents higher risk to


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