I was expecting this article to come sooner or later but when I read it this morning in FT I cannot say that I’m happy because for the time being I’m still living in Eastern Europe.
Not so long ago the consensus about Eastern Europe economies was that they are FUNDAMENTALY sound and those economies should decouple from global slowdown. At that time I wrote that this is not sustainable process and that the decoupling will be followed by the recouping to the rest of the world . Now after the first wave of debt/currency crises went through the Eastern Europe the consensus story has been changed somehow into more doom and gloom story. But now some say that Eastern Europe is almost FUNDAMENTALY cheep (i.e. here)
I think this way of thinking is FUNDAMENTALY wrong as markets are not efficient pricing machines Some/Most market participants believe that the markets tend toward equilibrium but equilibrium is just only first approximation how the market works.
My critique is not new. Milton Friedman said that idea of fully efficient market is inherently contradictory. In order to remove market inefficiencies we must have traders who are motivated to exploit them. But if the market is perfectly efficient there is no possibility to make excess profits. While efficiency might be true at first order, it cannot be true at second order: There must be on-going violations of efficiency that are sufficiency large to keep traders motivated. The misconception of efficient market is even obvious now than ever before, because it was the intervention of the authorities that prevented financial market from the total meltdown, not the market themselves. Indeed non-equilibrium nature of the markets is especially visible in the sharp price movements occurring at the booms and (especially) crashes which are accompanied with massive price jumps. Question is how in first place the market gets to “critical” point. The Eastern Europe decoupling story was based on the fact that economic growth in recent years was strongly based on domestic demand. Domestic demand was continuously stimulated by credit growth and budget deficits. At the beginning of the process the credit growth was limited and its impact on the price assets was limited. However lending usually stimulates economy. A strong economy tends to enhance the asset values, increases country creditworthiness and also often tigers local currency appreciation. As the asset prices grows the banks are more willing to lend because (i.e.) the value of the collaterals is growing the more credit is available the stronger economy grows. This positive feedback process continues until a point is reached where credit cannot grow fast enough to stimulate economy. By that time the asset value strongly depends on the credit growth and as the credit growth fails to accelerate further the asset values starts to decline. At the “critical” point the process reverses. Declining prices of assets/collaterals decreases the banks willingness to lend which has depressing impact on economy. Since creditworthiness/collateral has been pretty fully utilized at that point, a decline may precipitate the liquidation of loans which in turn may make the decline more precipitous.
This is very, very simplified vision of the process which leads to asset bubbles. However one of the features of the process is that Economic FUNDAMENTALS ARE NOT EXOGENOUS to the process. Unfortunately is not my idea but George Soros reflexivity which he defines as a “two-way feedback loop, between the participants’ views and the actual state of affairs. People base their decisions not on the actual situation that confronts them, but on their perception or interpretation of the situation. Their decisions make an impact on the situation and changes in the situation are liable to change their perceptions”
(Unfortunately Soros is not good at math but it’s easy to show that his reflexivity idea is a system of differential equations. More formal model definition and solution to the systems of “Reflexivity” differential equations you can find here in excellent V.I. Yukalov D.Sornete paper).
But let’s come back to the main subject and let’s try to find out what may come next. Financial linkages/Interlinkages in Eastern Europe are very tight. With the increase in the foreign ownership of the banking system in Eastern Europe the degree of financial interlinkages among Western Europe and Eastern Europe has also grown substantially i.e. Austria’s lending exposure to Eastern European countries top 80% of GDP ( IMF Paper with the statistics you can find here). As the economy slows the processes which lift asset prices is in full reverse as investors starts to withdraw the money. The liquidation of the loans takes time: the faster it has to be accomplished, the grater the effect on the value of the collateral . In the bust the reflective interaction of the loans between collateral becomes compressed within very short time of period the consequences can be catastrophic (reflexivity works both ways)
For several years Ukraine economy was flying on cheep credit and high steel prices now both engines has been lost which is not only the case of Ukraine but also for several countries in the region (i.e. Romania, Bulgaria). And now we are in self reinforcing process of loans liquidation which reinforces the drop of asset prices. Because of the size of Ukraine and close financial interlinkages acrros the Europe the comparison of Ukraine potential default to Lehman Brothers bankruptcy and its implications for the whole financial system makes sense for me
End of Part ONE
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