IS EASTERN EUROPE READY FOR RECESSION? T-Bills, Only An Illusion Of Safety

Do you remember, dear readers, the famous theory about decoupling emergent economies from developed economies? Just a few months ago, the authorities of developing countries were still fooling themselves that they would manage to avoid the effects of the crisis. Now they waiting in fear, in horror maybe, to see what the next year is going to bring about. Yesterday"s leaders of the transition process in Eastern Europe, such as Hungary or the Baltic countries, have already gone into recession and are expecting an even deeper recession in 2009. How was such decay possible? A decay that is threatening to nullify any progress made in the last 18 years? The answer is quite simple: the mirage of cheap money replaced reformist zeal upon the dawn of the new millennium. The fundamental need to accumulate basic capital to allow the reorganization of the former socialist economies became second priority. Cheap lending encouraged debt-funded consumption and discouraged savings. The consumption-driven approach deepened foreign imbalances, which were "generously" financed by foreign investors until 2008. The statistical artifices employed by authorities are a major cause of the citizens" reaction to the crisis. In Latvia, people are "alarmed and confused" by the sudden economic collapse, as Reuters describes it. The confusion is easily understandable, considering that, early last year, the prime minister was heralding the beginning of a new age of prosperity. While the matter of the recession in the Baltic countries is quite clear, analysts are now trying to assess the impact that a decrease in industrial orders from Germany may have on Poland and Hungary. The historical correlation between industrial orders from Germany and the industrial production in Hungary and Poland indicates that we should expect a rapid deterioration of the latter, according to an article in the Financial Times. Bank of America analysts estimate that Poland and Hungary can no longer count on foreign direct investments to finance current account deficits and recommend investing in local t-bills, even though they expect further depreciation of national currencies. Such recommendations are increasingly frequent in Romania"s case, too, because the general impression is that such investments are not risky. Is that so? The way risk is perceived by the markets points to the contrary, including for t-bills issued by the developed countries. The yield offered by U.S. bonds collapsed in the last two months (see the chart), but this development has all the characteristics of a speculative bubble about to implode. Investors are desperately seeking safety and are ready to pay anything for it. James Grant, from Grant"s Interest Rate Observer, believes that the investors" confidence in bonds, regarded as the flagship of risk-free investments, will change radically, as soon as they wake up and see that the "risk-free yield" becomes "yield-free risk."

Those hoping for some economic revival through infrastructure projects had better study Japan"s case. "Airport Without Planes Shows Japan Hooked on "Useless Projects"." This is the headline of a recent Bloomberg article on this topic. All this effort financed by the State has caused an unprecedented increase in the public debt, which is now equal to 170% of Japan"s GDP. Because raising taxes is not considered a viable option in the developed economies, governments are trying to make sure that there will be buyers for the new t-bill issuances. Britain has already found a solution to this: banks will be forced to hold important t-bills portfolios through a reorganization of their asset portfolio, in line with a recent proposal by the Financial Services Authority. The motivation, a noble one, of course, is to ensure a high level of liquidity to help them withstand financial shockwaves. This approach, plus programmes to stimulate consumption, will inevitably increase pressure on Eastern Europe currencies. The effect of financing crisis rescue plans through bonds will be the contrary to the expected one, because financing costs will increase. Only the United States can still afford, for now, the luxury of increasing the budget deficit and financing it with bonds, but things will probably change by the end of next year.

Confronted with a crisis they ignored until the last moment, authorities are appealing to the consumers" patriotism. According to an article in Aftonbladet, Swedish Prime Minister Fredrik Reinfeldt said: "If you open your Christmas present and it says "Made in China" then you haven"t done much to secure Swedish jobs." The Irish Government made a similar appeal, and the trend is not about to stop here. It"s quite obvious that "these magnificent politicians in their fantasies" do not remember the words of the English writer, Samuel Johnson: "Patriotism is the last refuge of a scoundrel." The next appeal will be to buy state bonds. Citizens do have a patriotic duty to finance the incompetence of their elected leaders, don"t they?

The Romanian Government still manages to maintain the yield on state bonds around the Lombard rate of the National Bank, but they only secure financing on very short term and far below the planned volume. The situation is clearly unsustainable. On top of everything, a recent study by an OECD official indicates that the forex reserves of the emergent economies should not be a reason to relax in front of the crisis either. Helmut Reisen from the OECD Development Center believes that the loss of confidence among foreign and local investors can rapidly burn even the most impressive forex reserves. Reisen also believes that the ratio between the public debt and the GDP can create a feeling of false safety during a period of economic growth, but it can also explode during a crisis. Our authorities, who recently criticized the rating agencies also for this reason, are confronting precisely the described situation, as indicated by a deepening budget deficit. The increasing need to finance it will cause a larger public debt and Romania is close to closing a vicious circle in which debts will follow the financing costs and take a huge toll on the long-term development prospects.