Three points about the Baltics

SEB MERCHANT BANKING – COUNTRY RISK ANALYSIS June 21, 2008

Analyst: Rolf Danielsen. Tel : +46 8 763 83 92. E-mail : rolf.danielsen@seb.se

May 27-29, 2008, we visited Tallinn, Vilnius and Riga to gather information about the three Baltic countries. Despite perfect weather, this trip was a rather chilling one.

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First: The turning point
New Car Registrations
(units per month) Changing winds: All three countries, but 10000 most so in Latvia and Estonia, are marked by 9000 changing winds. The salient feature of 8000 7000 people’s feel good factor, namely their new 6000 car purchases is a clear testament to changing 5000 sentiments in the two northern countries, with 4000 3000 drops in January 2008 of some 24% in Latvia 2000 and 3% in Estonia yoy while the 1000 2002 2003 2004 2005 2006 southernmost, Lithuania, is still continuing the binge with new registrations up 60%. As to Latvia, Total Estonia, New cars asset prices, however, the chill is prevailing in Lithuania, Total all three countries. Stock markets are down by 20-40% since the middle of 2007 – much more than the average emerging market index, and property prices are down by more than 10% all over. Credit growth peaked in 2006 and has since then fallen to 15-20% yoy. That, however is still not a credit crunch although rapidly rising inflation is eating into the real

2007

Source: Reuters EcoWin

Baltics Credit growth
80 70 60
70

60

50

values of new loans. Because, if anything is still increasing, and even accelerating, it is – unfortunately – prices. Gone are the days of optimistic projections when officials assured us of their steady path to price stability needed to achieve EMU entrance criteria. The overheating that became evident in 2007 has been further aggravated by a jump in

Percent

40 30 20 10

30

20

10

0

00

01

02

03

04

05

06

07

Estonia, Domestic credits to the private sector, EEK [ar 12 months] Latvia, Domestic credits to private enterprises, LVL [ + Latvia, Domestic credits to private person Source: Reuters EcoWin

important your attention is drawn to the statement on the back cover of this report which affects your rights.

Percent

50

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SEB Merchant Banking Country Risk Analysis June 21, 2008

excise taxes on tobacco and alcohol as required by their respective EU memberships, and also by higher utility 15 prices following new price hikes on 10 imported oil and gas mainly from Russia. Gas import prices have now 5 reached about $250/1000cm and will hit 0 2004 2005 2006 2007 2008 the consumers through the rest of the year in particular as the heating season Latvia, Total, 2000=100 [ar 12 Estonia, Total, 1997=100 [ar 12 kicks in after the summer. But $250 Lithuania, Total, CPPY=100 [a was the world-market price a year ago. Today Russia’s customers in Western Europe are paying $350, corresponding to some $300 for Baltic customers taking lower transportation costs into account. As could be expected, this has cooled consumer sentiment further with retail sales coming to a virtual standstill in Estonia, indicating a significant drop in constant prices – part of which is explained by the drop in new car sales. Reported GDP numbers for Q1 in the case of Estonia shows a sharp turn-around with to zero growth year-on-year (yoy). In Latvia and Lithuania the deceleration has so far been smoother with growth moderating to 3,6% and 6,9% respectively. (However, for Estonia the very weak number may have been influenced by stock-building before the new sin-taxes of January 1, complicating the assessment of the underlying situation without the 2nd quarter 2008 estimate.)
20
Source: Reuters EcoWin

But exports are still holding up reasonable well, correcting for Russia, electronics, textiles …
M erchandise exports
Annual growth in percent
Annual growth in percent
35 30 25 20 15 10 5 0 -5
35 30 25 20 15 10 5 0 -5

Annualized growth in percent

Consumer Prices, Index

Merchandise exports 2007-2008

2002

2003

2004

2005

2006

2007

Q1

Q2 2007

Q3

Q4

E ston ia, E xp orts, E E K [ar 12 m o n th s] Latvia, C urrent A cco u n t, G o o ds, C red it, LV L [ar Lith u ania , C urren t Ac co un t, G oo ds , C re d it, L TL
S ource: R euters E coWin

Q1 2008

Estonia, Exports, EEK [ar 12 months] Latvia, Current Account, Goods, Credit, LVL [ar Lithuania, Current Account, Goods, Credit, LTL
S ource: R euters EcoWin

In 2007, Latvian exports rose by 20%, accelerating from 14% the year before, while Lithuanian exports moderated to 12% and Estonian to only 4%, the latter down from 25% in 2006. Re-routing of Russian transit trade from Estonia to Latvia may explain a part of these uneven performances, but also specific developments, such as the temporary closing of the Mazheiku oil refinery in Lithuania in 2007, played its role. The mid-year downscaling of Nokia’s assembly plant for handsets also cut Estonia’s export growth as did the continuing problems for the country’s textile industries. So far in 2008, the numbers change the picture of relative performances somewhat to the benefit of Lithuania on behalf of Latvia. It should be noted, however, that about half of the Lithuanian export boom reflected oil products since the upstart of Mazheiku following its reconstruction in 2007.
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SEB Merchant Banking Country Risk Analysis June 21, 2008

Annual growth in percent

Imports are moderating. In 2007, imports to Latvia and Lithuania decelerated from the stratospheric M erchandise im ports 2007-2008 growth levels of recent years but were 40 still moving up at quite a rapid clip. In the case of Estonia, by contrast, 30 imports slowed sharply in part 20 reflecting reduced Russian transit trade. 10
Merchandise imports
Annual growth in percent
30

0 -10 Q1 Q2 2007 Q3 Q4 Q1 2008

20

Estonia, EEK [ar 12 m onths] Latvia, LVL [ar 12 m onths] Lithuania, LTL [ar 12 m onths]
S ource: R euters EcoW in

10

0

2002

2003

2004

2005

2006

2007

Estonia, EEK [ar 12 months] Latvia, LVL [ar 12 months] Lithuania, LTL [ar 12 months]
Source: Reuters EcoWin

In the first quarter of 2008, Estonian imports actually shrunk, while the Latvian slowed to a meager 2% yoy growth likely indicating a drop in real terms. Lithuanian imports, by contrast, rose 30% boosted by new feed-stock to the Mazheiku refinery.

Current account deficits peaked in 2007, but the external balances still remain very weak. Continued export growth and moderating imports provide little comfort, however, given Current account balance the large trade deficits in the first place. In 2007, these deficits reached 17%, 25% and 14% relative to GDP in -5 Estonia, Latvia and Lithuania respectively. The positive balances on the income and services accounts of all -15 three countries have traditionally mitigated the concerns of the trade -25 deficits but that effect seems to be 2001 2002 2003 2004 2005 2006 2007 fading. Tourism, which dominates Lithuania Estonia Latvia services revenues, has grown at a healthy pace since the beginning of the Tourism decade, but last year the growth rates Arrivals, overnight stays dipped into negative territory. There is 60 hope that new hotels now nearing their completion in 2008 and 2009 will help Latvia 40 attract more visitors, but it may also be the case that prices have become too high. In 20 both countries prices for hospitality and Estonia entertainment services 1 have risen even 0 faster than average consumer prices. In the case of Estonia, they rose 10% in 2007. In -20 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 the case of Latvia, they were up by more 2004 2005 2006 2007 than 20%.
percent/GDP
Source: Reuters EcoWin

Annual growth in percent

Latvia, ByCountry of Residence, Total

Estonia, Overall, Nights spent, total

Latvia, ByCountry of Residence, Total

Source: Reuters EcoWin

1

Subcategory ”Hotels and restaurants” in the Consumer Price Index.
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SEB Merchant Banking Country Risk Analysis June 21, 2008

That means large current account deficits are here to stay although 2007 likely marked their peaks at least for Estonia and Latvia. As such, the deficits could remain at exceptionally high levels for coming years, perhaps making investors increasingly wary of the three countries solvency. In the case of Latvia and Estonia external debt has already passed the 100%/GDP milestone by a wide margin, while in Lithuania it was still less than 80%/GDP in 2007. However, in the case of Latvia, high debt ratios reflect in part non-residential deposits representing some 46% of total bank deposits of which about half are kept in highly liquid foreign assets by the deposit taking banks 2 . Correcting for this reduces Latvia’s external debt to around 120% of GDP, which is still an unusual high number by any comparison. But the government’s financial position is still strong. The large external debt ratios are mirror images of the high indebtedness of the private sectors -households and companies, as a consequence of the very rapid credit growth over the last four years mostly funded by foreign parent banks. The governments, in contrast, have much stronger financial positions thanks to overall balanced budget policies. Government debt levels are reported at around 4% for Estonia, 8% for Latvia and 17% for Lithuania. Estonia’s net asset position is even positive at more than 6% of GDP representing the accumulation of recent years’ budget surpluses. This gives the three countries and enviable position to cushion economic shocks by letting automatic stabilizers function.

Second: The point of no return
Solvency The external debt ratios, even after correcting for specific factors such as non-residential deposits matched by very liquid assets of the deposit taking banks, stick out as unusually high in the Baltic countries, in External debt/GDP particular in Estonia and Latvia. 150 Debt at these high levels raises Estonia concern about solvency. In theory, the debt ratio will eventually 100 Latvia stabilize as long as there is positive Lithuania GDP growth and the annual increase 50 in the net debt (i.e. the current account balance, ignoring valuation changes) is a constant fraction of 0 GDP. But such a debt level may be too high for comfort for most 1992 1997 2002 investors. Compared to other large emerging markets there are only two instances of higher debt/GDP levels in the period since 1994: Argentina and Indonesia. In those cases, however the high debt ratios were reached after deep economic crises during which their currencies had been in almost free fall following many years of dollar

p e rc e n t

2007

2

Latvija Bankas will in a forthcoming Financial Stability Report publish estimates that show Latvian banks able to withstand a run on their deposit base from non-residents equal to 10% of total non-residential deposits each day for five consecutive days without the banks themselves running into liquidity problems.
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SEB Merchant Banking Country Risk Analysis June 21, 2008

targeting and finally undershot their true values 3 . The future path of these debt ratios in the Baltic countries over the next few years is likely to be crucial. A back on the envelope calculation with a halving of the current account deficits and GDP growth in nominal (euro-terms) terms to an average of 10% and 5% respectively, shows debt to GDP not leveling off before having reached 200%. For the debt ratio to stabilize at present levels, the current account deficits would have to be reduced to only 5-7%, or more generally to the same level as expected GDP growth. That is not likely to happen unless more resources are redirected swiftly to export activities, which depends on wages and other production costs. The Baltic economies pride themselves of flexible labor markets with few restrictions on hiring and firing and low unionization. Wages are also more flexible than in most Western European countries. In the flagging construction industry, for instance, salaries are already being slashed to the half of last year’s levels according to some observers. In the first quarter of this year, growth rates moderated in Estonia and Latvia but overall wage levels were still up by healthy numbers compared to the same period of 2007. In Lithuania, by contrast, wage growth took a rather brisk jump in the first quarter of 2008. We accept the official argument that some of the recent wage growth may reflect improved statistical recording, and that underlying wage trends is smaller. In the case of Latvia, this statistical effect has been estimated to about 7%, leaving actual Latvian wage growth in the first quarter at about 20%. That is still almost certainly much higher than underlying productivity growth. The Baltic economies started the decade with strong labor cost competitiveness and for several Debt/GDP years high productivity 160% growth compensated 120% rapid wages. 80% Large scale 40% emigration to the 0% EU as that opportunity opened following the EU accession in 2004, was evidence of a significant wage gap, but more recent reports talk of a reversal of this emigration and there has been some anecdotal evidence of workers from “old” Europe finding interesting employment opportunities in the Baltic countries as well, in particularly in the construction industry. That may indicate that recent years’ wage hikes have eroded much of the original Baltic cost competitiveness. Any further wage development out of line with competitors would increase the pressure of finding new opportunities and niches for

3

Argentina had a dollar peg and currency board arrangement from 1993-2001. Indonesia had a crawling peg to the dollar from 1991 to 1997.
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Argentina Brazil Chile China Czech Estonia Hungary India Indonesia Korea Latvia Lithuania Malaysia Mexico Philippines Poland Russia SouthAfric Taiwan Thailand Turkey

SEB Merchant Banking Country Risk Analysis June 21, 2008

production of commodities and services that can be exported beyond the scope of what can reasonably be expected in the near future. The IMF recently calculated various measures of competitiveness for Lithuania and concluded that the exchange rate was overall in line with underlying competitiveness of that country. By contrast, in its latest report on Latvia of late 2006, the IMF did not make a specific estimate of competitiveness at the present exchange rate level for that country, but noted that “..until recently Latvia enjoyed a modest competitiveness premium, but recent wage and price developments had absorbed much of this initial advantage.” As wages have risen by some 50% since then it is hard to believe that the organization would have repeated its comment on competitiveness in a similar soft language were it to make a new assessment today. 4 We fear that the IMF might have concluded that labor costs in Latvia have grown too much and that significant devaluation or deep cost cuts are needed to restore competitiveness. The situation in Estonia appears more similar to Latvia than Lithuania and the same concerns for that country might seem justified, although perhaps somewhat less acute. How long will markets support the imbalances? If the development already has 30 gone too far at least in Estonia and Latvia, markets will at one point in time begin to make a 20 new bet on devaluation, which in the case of the existing 10 pegs: a currency board arrangement in Estonia or a currency peg with narrow 0 2004 2005 2006 2007 margins in Latvia (both countries peg to the euro) Latvia, Gross, LVL [ar 4 quarters] Estonia, Gross, EEK [ar 4 quarters] would be a one way bet Lithuania, Gross, employees in the whole e ignoring the temporary loss on the likely higher interest rate margin on local currency deposits.

Gross wages

Annual growth in percent

Source: Reuters EcoWin

One can identify five groups of market participants in the Baltic foreign exchange and money markets of importance when considering the short to medium term stability of the exchange rate arrangements in the Baltics. o Foreign parent banks with large exposures. They may go at lengths to support the exchange rate in order to ring-fence their local subsidiaries o Tycoons of former Soviet block countries, who see Latvia in particular as a safe haven for their money.

4

Latvia is on a ”regular 12 month consultation cycle” with the IMF but no new report has been issued since October 2006. Such delays often indicate deep disagreements between the national authorities and the IMF over how to describe the present situation and future prospects.
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SEB Merchant Banking Country Risk Analysis June 21, 2008

o Foreign companies and local individuals, who do not seek speculative positions, but enter the foreign exchange market when they want to hedge positions against negative exchange rate changes. o Carry traders who seek higher returns from weak currencies as the local authorities have to hike interest rates (or use other means to tighten monetary conditions in the case of currency boards) to defend their exchange rates. o Foreign parent banks with small exposures in the Baltics. The first two groups have for several years been the steady supporters of the money markets in the Baltic countries. The foreign banks, at least those with large subsidiaries in the Baltics, are unlikely to leave the markets “voluntarily” and should have an interest in as little turbulence as possible to give the countries a chance to restructure in a smooth manner. The CIS-tycoons, in contrast, have little choice but to stay put, but could leave in an extreme situation. They may be willing to take risk, but not any risks. The noted investigation of the Latvija Bankas, however, may indicate that the relevant Latvian banks have taken reasonable safeguards against a possible run from non-residential depositors should it occur. That mitigates this source of risk but does not eliminate it keeping in mind that these nonresidential deposits represent 46% of banks’ total deposit base and that the relevant banks may have changed their portfolio since the central bank investigation. 5
Interbank rates

Hedgers were apparently the guys who stirred the markets in Latvia about a year ago. They were scared by rumors over a weekend of individuals changing their local currency cash at hand into euros and dollars in forex bureaus which, in itself had only marginal impact on market conditions. Hedgers are likely to stay alert and may react swiftly again.

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Latvia
Estonia
ECB Lombard (ceiling) rate

% p.a.

ECB Minimum bid rate

Carry traders are a new type of market participants for the Baltic countries. In other countries they have often represented a positive speculative force, supporting currencies that other -“professional” -- investors would have left long ago. However, they may be scared by factors far outside the control of the Baltic countries, such as increased volatility in their funding currencies. As such they represent a significant vulnerability to market stability, as has indeed been the experience of Iceland. The importance of carry trade for the Baltics is hard to assess as this is apparently a rather recent phenomena, but they can probably be thanked for some of the renewed stability of the local inter-bank markets. The rapid expansion of some local Baltic banks into main Western European capitals could be a part of a strategy to attract such deposits.
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jan maj sep 2005 Latvia, RIGIBOR, LVL

jan maj sep jan maj sep jan maj 2006 2007 2008 Lithuania, VILIBOR, LTL
Source: Reuters EcoWin

The report was published last week in Riga but as yet only in Latvian. We await the English version before judging the results of this examination. One sticking point is if the test relates to the banking system in aggegate or, preferably, to each individual bank with non-residential deposits.
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SEB Merchant Banking Country Risk Analysis June 21, 2008

The foreign banks with smaller exposures on the Baltic markets may represent some kind of a wild-card. Until recently they were certainly attracted by what seemed to be very good investments by the two major Swedish banks first to enter the markets. In the present situation, however, as the fortunes appear to change, they could use their positions to put spanner in the works for attempts of the larger banks to manage overall credit growth. Having relatively small exposures such behavior may not present much risk to their own finances, while their positions in the Baltic markets are large enough to make a difference, including in local money and currency markets. All in all, the situation in the Baltic countries has become more complex with new participants entering the market including carry traders. That may be a new source of instability, but may also for a while support market equilibrium provided calm returns to international financial markets and the three Baltic countries are willing to pay a price attractive to the carry traders. The danger is for this calm to delay ultimately needed restructurings of the Baltic economies – i.e. to let the party go on for too long. But there is also a chance this can give the authorities a respite to restructure without the duress of financial market turbulence. The latter may still be a bit optimistic. As has been the recent experience of other countries such hot money can leave as quickly, or more quickly, than it comes leaving market equilibrium on shaky grounds. Market turmoil triggers. The market turmoil beginning February 2007 in Latvia was followed by disturbances in Lithuania and Estonia toward the end of the year. However, it is difficult to discern any common pattern through these cases, and it may appear that these events were triggered by rather erratic behavior from various categories of market participants. More fundamental fear could arise if markets were to perceive a threat of one of the larger foreign banks heading for the exit. The recent report from the Swedish central bank, Riksbanken, should help lay such concerns to rest. It stated that none of them faced any serious damage to their balance sheets even in the case of severe shocks hitting the Baltic economies. Judged by the share prices of the two banks, by contrast, the Riksbank report did not seem to have much immediate positive effect on local investors. That could be because it did little to allay investors concern over a new issue, namely statistics from the Latvian banking association which shows a rapid increase in overdue loans in recent months reaching 9% by the end of the first quarter. So far this development in the total delinquency ratio has not affected the level of non-performing loans (NPL), which is loan payments overdue more than 60 days and the official measure of “bad“ loans. At 0,5% of total assets NPLs still remain low by any standard. The point is that any increase in “light” delinquencies could have a lagged effect on real delinquencies, i.e. “NPL”, some months down the road. In Latvia the total delinquency ratio reached about 9% at the end of the first quarter of 2008. The equivalent number for Estonia was 5%. The latter is reportedly dominated by a few large
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SEB Merchant Banking Country Risk Analysis June 21, 2008

loans that could have turned sour regardless of the circumstances. The sheer size of the Latvian numbers for Q1 seems to preclude such an explanation.

Third: Where does this point?
Having adopted pegged exchange rates and even combined with currency boards in two of the three Baltic countries, until quite recently many market participants believed that nothing could go wrong, even though the memory of Argentina should not yet have faded completely. Unfortunately the rigors of such kind of exchange and monetary policy regimes were forgotten in the ebullient environment that reigned in the first few years after the Baltic countries’ EU accession in 2004 and in global financial capital markets in general. For these policies to succeed, fiscal policy would have had to be kept much tighter than was the case, even though by normal standards, including the Maastricht criteria, fiscal policies were prudent. Tighter fiscal policies would have helped reduce overheating, kept wage and price inflation in check and enabled governments to accumulate larger reserves to meet shocks should they occur anyway. Unfortunately, politicians of these countries seem to have been beset with the notion of “convergence”, that is to bring living standards up to Western European levels at a pace that disregarded any speed limits. For Latvia and Estonia many observers seem to agree that a soft landing scenario is no longer an option, and the discussion is about degrees of hard landing. The question is if Lithuania has been a quick learner and is now able to slam the breaks in time. With a general election waiting this fall these may not be the best of times for telling people to stop spending. The danger is therefore growing by the day that Lithuania will follow in the footsteps of its two northern neighbors within the next year or so. A hard landing scenario will most certainly include some kind of a devaluation. In a best case scenario that could be a so-called internal devaluation, meaning severe wage restraint, increased labor market flexibility and labor productivity. Many people will have to accept longer work hours and wage cuts, not least in the government sector where groups of employees apparently have received excessive salary raises. Such have been the bitter medicine swallowed by other countries including Hong Kong and Germany in the recent decade, but eventually these policies have succeeded. This means a gradual process that could take up to a decade to complete and which would require a significant and immediate reduction of peoples’ income expectations. The other option is an external devaluation, which again has two sub-options: • Controlled devaluation • Devaluation enforced by markets The first would be the preferred choice if combined with economic adjustment programs for example under the auspices of the IMF. The second would more likely than not ensue excessive overshooting. In the case of Argentina the pesos fell by more than 70% when the currency peg to the dollar broke in 2001, much more than the 25% overvaluation estimated by many observers prior to the event. A similar scenario for the Baltic countries could spell disaster. Most bank loans -- on average some 80% of the total, are in euros, more than was the case in Argentina. A steep devaluation could force many
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SEB Merchant Banking Country Risk Analysis June 21, 2008

debtors to default, reducing the stigma of doing so. At the end the Baltic countries might come to carry the stigma of unreliable debtors for years to come. We think that the Baltic countries should realize that they have come to the end of the road and that they need to engage a new strategy. For one thing: “fast-track conversion” should be abandoned as any operational policy goal. Second: It should be realized that in the absence of tough policies to maintain competitiveness and if needed to restore competitiveness through internal devaluations, the pegs have outplayed their roles as policy instruments and it may be a matter of time before they loose credibility. Effort should also be directed at designing policies that can cushion any economic downturn. In this sense it is important that policy makers refrain from dogmatism and allow automatic stabilizers of fiscal policy to function within reason.

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SEB Merchant Banking Country Risk Analysis June 21, 2008

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