Thursday, December 27, 2007
Import growth generally stalled in 2008 as Estonians spent less on cars, clothes and household goods due to rising interest costs and the weakening consumer sentiment. Export growth has also slowed as companies struggle with rising wage costs, which were up 20 percent in the third quarter.
Tuesday, December 25, 2007
Credit crunch, did someone use the expression credit crunch?
Thursday, December 13, 2007
Statistics Lithuania reports that, according to the labour force survey data, the number of the unemployed in the country in iii quarter 2007 was 63.5 thousand, i.e. The lowest over the recent 5 years. As compared to iii quarter 2006, the number of the unemployed decreased by 27.3 thousand persons, or by one-third. Over the year, the number of young unemployed persons (aged 15-24) decreased from 15.2 to 13.4 thousand.
The jobless rate dropped to 3.9 percent from 4.1 percent in the previous three-month period. The chart below shows the evolution in the Eurostat harmonised unemployment rate, which is calculated slightly differently, but the picture is broadly the same.
Lithuania's jobless rate has been falling since 2004. When the country joined the European Union the rate stood at 13 percent. Lack of available labor has forced employers to raise salaries, which accelerated an annual 18 percent in the third quarter. The unemployment rate has fallen steadily as people have emigrated to those European states that have opened their labor markets. Top destinations for Lithuania's migrants include the U.K., Ireland and the U.S., the statistics department said. Claus Vistesen has examined the Lituanian situation in some depth in "Lithuania Under the Loop" and "End of the Road in Lithuania". This twin pincer, of rapid economic growth plus large scale out migration is increasingly producing severe overheating, labour shortages and inflation all across the EU10 (with the honorable exception of Hungary which is spiraling downwards into recession). To the issue of migration must be added the long term presence of below replacement fertility, which means that new entrant cohorts are very small, and cannot compensate for the loss, and low male life expectancy, which means that poor health makes it very difficult to raise participation rates among older workers.
Tuesday, December 11, 2007
The slowdown in sales is much more rapid in Latvia, and on a rule of thumb reckoning - take a look at the chart and estimate for yourself - I guess in two or three months we will be looking at zero year on year growth and then contraction. So Latvia is now about to transit from the "Baltic Syndrome" to the Hungarian one.
And to help us see how we might get there, here is the next chart, the industrial producer prices one. As we can see, the rate of increase in producer prices has now peaked, and we are on the way down, but the decline is not rapid as it is in the case of retail sales.
Inflation has really wormed its way into the system, and it may well prove recalcitrant to being flushed out, again as we have seen in the Hungarian case. But there is one big difference with Hungary, and this can be seen in the next chart.
Waht we can see above is that Hungary is achieving, via an efficiency drive and substantial real wage deflation, a real reduction in export prices. Latvia has now peaked on this front, and the prices are coming down (while Estonia is still to correct really). Looking at the chart, I would say Latvia is about where Hungary was around 10 months ago. So this is likely to be a lengthy process, and remember that Hungary is still on a downard trail as far as GDP growth goes, with under 1% GDP growth this year, and my guess is a little less next year. And in Hungary they still have to decide what to do about the currency issue, and all those Swiss Franc mortgages people have. Since this is all going to become such an important problem, and since there is always safety in numbers, I think the governments of Latvia, Estonia and Lithuania should get together with the Hungarian one (and possibly Bulgaria and Romania) and have a high level meeting in Brussels to start to sort out the details of the inevitable bail out. I mean, how much of the "hit" are the Scandinavian, Austrian and Italian banks who are into this up to their eyes (and certainly over their heads) going to stand, and who else is going to come up to the plate and put money in when the inevitable correction on the book value of these debts comes. Call this the European Mega Conduit.
When compared with October 2006, in October 2007 total seasonally adjusted industrial production output fell by 1.6%. Output in manufacturing decreased by 6.7%, while in electricity, gas and water supply there was an increase of 15.4%, and output in mining and quarrying increased by 17.3%. I think the following chart makes the trend reasonably clear.
And then is we trun to the data for manufacturing only, well, here's your slowdown, or at least one part of it, clear for the eye to see I would say:
As we can see, the high point was reached in Q1 2006, and since that time ever so surely and ever so steadily the Latvian enconomy has been slowing down. Compared to the corresponding period of previous year, in the 3rd quarter of this year Latvian GDP increased by 10.9%, according to data released by Latvijas Statistika last Friday. Interestingly one of the parts of the economy which has slowed most is manufacturing indutry, which actually decreased by 0.3% y-o-y in Q3, and mining and quarrying only managed a measly 2.4%. Construction managed a 13.2% y-o-y growth, but this is undeoubtedly due to large base effects earlier in the year, and the execution of previously signed contracts - as we are noting in the US, you need to wait nearly a year to see the full effects of a slowdown in requests for new buildings to execute.
Unfortunately Latvijas Statistika do not have the Q3 breakdon in their database yet, and they only give annualised data in the press release, when what is most interesting at this point are the quarter on quater changes. Still they do produce this reasonably informative chart about movements in some of the key expenditure components over the last year, and some things are reasonably clear (please click over image for better viewing).
As is obvious, final household demand peaked in the 4th quarter of 2006, and is now falling steadily. It is not clear when (ot whether) this component will ever recover to the extent of being able to drive growth, since we get into age related elements (which I know not many people agree with me on at this stage, but still) as Latvia's median age is climbing steadily, and calibrating all of this for Eastern Europe's comparatively low male life expectancy (ie calibrating how domestic constumption loses its relative strength as median age rises, in the way we have seen in Germany, Japan and Italy) is something noone has done at this point to my knowledge. In fact most people you talk to don't imagine that this is important, but then most of them didn't imagine that Hungary would fall into the hole it is currently falling into.
Now as we can see, these two countries (Latvia and Hungary) are pretty similar in the evolution of the relative population median ages. And if we come to male life expectancy, here is a comparison of Hungary, Latvia and Germany.
As we can see, male life expectancy is considerably lower in both Hungary and Latvia, than it is in Germany, and this must have consequences for economic behaviour and performance. Increasing the working life to 67 and beyond as they have in Germany is just not the same proposition at all in a lower life expectancy society like the other two, nor is the issue of getting employment participation rates among the over 60s comparable given the evident health problems of one part of the population.
So while we would not normally expect domestic consumption to run out of steam until the median age reaches 41/42 (this is the sort of lesson we can garner from Germany, Italy and Japan) there may be good reasons for imagining that this median age needs rounding down somewhat in the Latvian and Hungarian contexts. I will certainly stick my head out and say that this property boom, like the 1992 one in Japan, and the 1995 one in Germany is very likely to be the last of its kind we will see in Latvia, high median age societies just don't work like this. They do not ride on the backs of credit driven booms, and I would have thought that the reasons why would be obvious.
Monday, December 10, 2007
In January–October 2007 against January–October 2006, exports and imports increased by, respectively, 10.3 and 14.5 per cent.
The value of imports in September 2007 was 1.3% or 8.4 mln lats lower than in August 2007, and 8.5% or 49.7 mln lats higher than September 2006, reaching a total of 633.3 mln lats.
The total foreign trade turnover in September 2007 was 11.1% or 96.7 mln lats higher than in the corresponding period of the previous year and its value was 970.0 mln lats.
As can be seen in the chart, many of the lines in Latvia are down at the moment, including the trade deficit one, which is basically still as bad as it ever was.
The small positive change we can observe in the second chart is that the rate of increase in imports has slowed down dramatically since July basically (on the back of the slowdown in domestic demand growth presumably), while the rate of growth in exports is now no longer slowing, and we can see a small increase in the pace.
Monthly inflation in November was 1.4 percent, led by food prices, which increased 3.4 percent, Latvian Statistics said. Bread prices alone soared 16.3 percent over the month. The result is another blow for the outgoing government, which in March passed a series of anti-inflation measures to curb bank lending and speculation on the real estate market. The four-party ruling coalition resigned on Wednesday after having lost its credibility over the sacking of a popular anti-corruption chief in October.
The coalition, however, still maintains a majority in the 100-seat parliament and will likely form the next government. Outgoing Prime Minister Aigars Kalvitis said the next head of government would have to tackle economic issues immediately as Latvia's economy continues to face macroeconomic imbalances. I agree. Immediately!
Lithuania is struggling to contain consumer-price growth as the economy expands at the second-fastest pace in the European Union after Latvia. Gross domestic product rose 10.8 percent in the third quarter. On Dec. 7 Fitch Ratings followed Standard & Poor's in cutting Lithuania's credit rating outlook, citing the growing risk of an abrupt slowdown triggered by inflation.
Gas prices are scheduled to rise 69 percent for Lithuanian citizens next year.
Food costs, the biggest item in the consumer basket with a 25.9 percent weighting, rose an annual 15.4 percent in November. Household expenses such as gas, water and electricity, the second biggest category in the index, rose 11.3 percent.
Sunday, December 9, 2007
The total number of notarised purchase-sale contracts decreased by 25% as compared to the 3rd quarter of the previous year, and by 17% as compared to the previous quarter. The last time that less than 12,000 contracts were notarised was in the 1st quarter of 2004.
Also the total value of contracts decreased 25% when compared to the previous quarter and to the corresponding quarter of the previous year. Although the average value of contracts has decreased during last quarters as well, the decline has not been as drastic as in case of the number and total value of contracts.
The recession in the number of contracts is mainly caused by the decrease in the number of contracts for dwellings. Compared to the 3rd quarter of 2006 the number of contracts for dwellings decreased by a quarter and compared to the previous quarter by a fifth. In the 3rd quarter of 2007, 55% of the purchase-sale contracts were concluded for the transfer of dwellings, 23% for unimproved registered buildings, 14%for residential buildings and 7% for non-residential buildings. The decrease in the number of contracts notarised in Tallinn was greater than in the rest of Estonia. A dead fish, as they say, starts to stink from the head.
50% of real estate contracts were notarised in Tallinn in Q3 2007. The value of these contracts accounted for almost three quarters of the total value of purchase-sale contracts. The share of the number and the total value of contracts notarised in Tallinn has been decreasing since the beginning of 2006.
According to Statistics Estonia, the more conservative loan policies of the banks and the increase in interest rates (ie the credit crunch) have been the main factor influencing the slowdown of real estate market. If at the beginning of 2006 the interest rates on housing loans granted to individuals were still below 4% (these loans are largely, remember, denominated in euros), by September 2007 they had already reached 5.9% (although please note, if we look at the inflation rate - 9.1% in November - these are still extraordinarily negative), and of course, in Estonia, unlike the United States, there is no mega-conduit rescue proposal on the table to come to the aid of those paying the interest. If (or rather when) the value of the currency moves (as it surely has to if Estonian GDP is not to go into straight decline at some point) and more realistic interest rates (ie ones which bear some relation to the level of risk involved) come into effect, then distress among households will become severe. Basically a rescue package will need to be put together, and the capital (book) value of all these outstanding loans will have to be adjusted down according to the actual level of distress produced. Essentially, all those who from the sidelines - the EU Commission, the IMF, the ECB, the World Bank, the Economist, etc - have had a hand in all this with their constant stream of policy recommendations, recommendations which have been by-and-large followed (ie leaving out the odd 'detail' of excess here, too much government spending there, I mean here that policy needs to be realistic, humans, and even more to the point governments, are never perfect, so this part should be factored in from the start, by allowing a margin.....) - will need to accept their share of the responsibility for the mess which has been produced as a result. As Oscar Widle put it "to lose one parent might be considered a misfortune, but losing two, that has to be carelessness". Well the ECB has lost three plus (The Baltics, Bulgaria, Romania, possibly now Poland, and Russia is now definitely wobbling- this latter is not the direct responibility of the ECB I know, but is certainly is in the policy sphere of the World Bank and the IMF).
These institutions cannot, like Pontius Pilate, simply wash their hands of all this (well they can, but they should at least be ashamed of themselves if they do), having aided and abetted it during the upswing by recommending policy proposals which quite simply failed to take account of the quite unique demographic characteristics of this whole region. You cab incant the mantra that Demography Doesn't Matter till you are blue in the face, but unfortunately it does, and I will tell you how we know it does, we know it does by looking at the macroeconomic data, in which (plagiarising Solow's famous dictum) we may not be able to discern the presence of the computer, but we can certainly see the impact of fertility, and especially of decades of below replacement fertility. As I say in my recent analysis of Russia's burgeoning inflation problem:
Well it seems to be the case that this sudden acceleration in growth and inflation is intimately related to the very specific and unusual demographic profile which most of Eastern Europe has inherited from its recent past. So one of my central arguments is that what we have here is certain a kind of mis-match. A mis-match between a basically third world. “developing-country-type” income level (for this reason they tend to be called “emerging economies”) and a very-first-world-type age structure - in the sense that many of these societies have now had below replacement fertility for decades, and in some cases several decades, with the working age group entry level cohorts (15 to 24) down to around 65% of their earlier high point, and the key 25 to 49 age group peaking nearly everywhere as a proportion of the total population, before the total working age population finally enters terminal decline. This is very different from the sort of demographic dividend driven growth we are seeing across most of the other strong growth emerging economies, and the economic consequences of this difference are now becoming all too evident.
Of course, we are still waiting for an adequate Mea Culpa for the Argentine case, but at least people have generally lined up and accepted their "haircut" with dignity. Now it will be the turn of all those who piled in and fuelled all this madness. It is easy to get things wrong, we all do, the important thing is to know how to accept when you have been wrong, to recognise mistakes, and to be "big" enough to take the necessary remedial steps.
We should note however, that in month on month terms there was a slight recovery in September, since sales were actually up 3% on September, when they were down 6% on August.
In October the largest increase continued to be in stores selling manufactured goods (13%), although compared with previous months the growth rate continued its decline. The growth rate in grocery stores was also slightly less in October compared with previous months, with the increase in these stores being 6% when compared with October 2006. Due to a large their share, grocery stores were responsible for about half of the total increase in the sales of the retail trade enterprises.
Among manufactured goods the fastest growth was in specialized stores (28%), with strong demand in stores selling textiles, clothing and footwear (all of which, please note, are subject to strong competition from ex-eurozone sources), and sales in this group increased by 20% year on year. Stores selling household goods and appliances, hardware and building materials also grew by a fairly strong 13% y-o-y.
Saturday, December 8, 2007
In October 2007, when compared with October 2006, the production of electricity increased by 28%, and the production of heat by 14%. The growth in the production of energy is partly the result of an increased demand for exports via Estlink’s submarine cable.
The underlying point is that growth in the manufacturing sector continued to be weak in October, although it did rebound somewhat from September, posting a 4.4% year on year growth. The industrial sector with the largest share - food production - increased output by 3%.
Compared to October 2006, the output growth was highest in the manufacture of precision instruments (39%). Output also increased in the manufacturing of chemicals, building materials and furniture, mainly due to increase in exports. In October the smallest growth was to be found in the manufacture of textiles, where there was an increase in sewn textile products, but the production of yarn and fabric continued to decline.
The downward trend in wood manufacture also continued, while the production of metal products decreased as well. The rise in the prices of raw materials now constitutes a serious problem in these sectors. The production of plastic products also decreased in October, the decline was mainly being influenced by the decline in production for export.
All in all, and little by little, we can see that the continuing increase in prices is having its corrosive effect on the manufacturing sector.
The largest impact on the price change was made by a 4.5 per cent leap in prices for food products and beverages, a 0.6 per cent rise in the cost of refined petroleum products and 0.7 per cent rise in electricity, gas and water supply. There was a 2.7 per cent fall in price of radio, television and communications equipment and apparatus, a 1.2 per cent fall in wearing apparel and a 2.5 per cent fall in machinery and equipment. Refined petroleum products excluded, prices for total industrial output sold grew by 1.3 per cent.
Prices for products sold on the domestic market over a month increased by 1.2 per cent. The largest impact on prices here again was a 3.5 per cent increase in prices for food products and beverages, 0.7 per cent for electricity, gas, steam and hot water, 1.1 per cent for refined petroleum products. There was a 17.0 per cent decrease in prices for wearing apparel, a 5.1 per cent decrease in machinery and equipment, a 2.9 per cent one in radio, television and communication equipment prices, as well as 2.0 per cent decrease in the prices of electrical machinery and apparatus.
Among food products and beverages, the most noticeable increase in prices was observed for grain mill products – 30.8 per cent, dairy products – 9.7 per cent, feed-stuff – 5.8 per cent, bread and fresh confectionery – 3.0 per cent; mineral water and soft drinks went down in price by 2.8 per cent, fish and fish products – 0.4 per cent, meat and meat products – 0.3 per cent. Refined petroleum products industry excluded, prices for products sold on the domestic market increased by 1.2 per cent.
Prices for exported products in September 2007 against August increased by 1.1 per cent. The biggest factor was a 6.6 per cent increase in prices for food products and beverages, 0.5 per cent – refined petroleum products, 1.6 per cent – wearing apparel, as well as a 2.7 per cent decrease in prices for radio, television and communication equipment and apparatus, 0.7 per cent – electrical machinery and apparatus, 1.6 per cent – base metals.
I think if we look at the chart for the evolution of producer prices for the export sector, then the situation and the outlook is pretty clear.
Compared to the 3rd quarter of 2006, the average monthly gross wages and salaries increased the most in agriculture and hunting (28.6%) and the least in real estate, renting and business activities (7.2%).
Compared to the 3rd quarter of 2006, the average hourly gross wages and salaries increased the most in public administration and defence; compulsory social security (30.7%) and the least in real estate, renting and business activities (10.0%).
In October 2007 the percentage change in the export price index was -0.1% compared to September 2007 and 8.5% compared to October 2006. In October 2007 the percentage change in the import price index was 0.7% compared to September 2007 and 3.8% compared to October 2006. This is all now totally unsustainable, and two graphs tell it all.
Hungary, it should be remembered, still has a long hard road out there in front of it, with no easy answers readily to hand, but at least it is one year on into addressing this particular problem. Estonia is yet to start.
Compared to September 2006, total foreign trade turnover decreased 7% and compared to August 2007 it decreased 5%. The trade deficit was 3.7 billion kroons (4 billion kroons in September 2006 and 3.8 billion kroons in August 2007).
What all this means in simple language is that Estonia has been running a consistant foreign trade deficit.
and both exports and imports have been in decline of late, imports due to the slowdown in domestic demand, and exports due to the lack of price competitiveness of Estonian products. If we look at the year on year movements of the two, the downward trend is horribly clear I'm afraid.
And unfortunately, that August surge in exports looks rather like the last surge of something, at least until the issue of relative export prices is resolved, one way or another.
Friday, December 7, 2007
Well, now back to matters in hand, inflation in Estonia. According to Statistics Estonia, the percentage change of the consumer price index in November 2007 compared to November 2006 was 9.1%. On average, the prices of goods and services in November 2007 were 1.4% higher than in October 2007. The broke down into a 15.1% increase in food and non-alcoholic beverages, 13.4% for housing, 9.2% for health, and only 3.3% on household goods. Put another way, the rise in the nontradeable sector (apart from agriculture and fuel, where global prices do play a big role) carried the weight of the increase. In other sectors pressures for import substitution keep some sort of a lid on prices. As we will see in the chart, in recent months inflation - as in many other parts of the EU10 as well as in Russia and Ukraine - is now starting to climb up towards the roof.
What happens next? Well this is a difficult question to answer. Prices will obviously keep rising until they no longer can (dragged down by and inability to export and by falling domestic demand), but at the present time there is much less evidence of this in Estonia than there is in, say, Latvia, where the slowdown seems to be gathering momentum rather more rapidly.
Initiated by the dominant Swedish banks and encouraged by recent government restrictions, a supply-led credit slowdown is slowly but steadily developing into a demand-led slowdown. Private sector credit growth in Estonia slowed to 39% Y-o-Y in October, down from a 66% rate in mid-2006. In Latvia, the same measure was down to 42%Y-o-Y from 61% Y-o-Y.
The number of real estate transactions in Estonia has also fallen by 25% between Q2 and Q3 2007 to reach its lowest level for three years. So things are moving. But where? Well, watch out for more posting which should now come thick and fast over the next week, as little by little I try to work out what I myself really think about the answer to that question.
Friday, October 26, 2007
Statistics Lithuania informs that based on available statistical data and econometric models, estimated GDP for 3 quarters of 2007 totalled LTL 69946.9 million at current prices and as compared to 3 quarters of 2006 grew by 9.1 per cent (estimated using a chain-linking method in volumes of value added).
This year, the increase in the gross value added (GVA) was conditioned by the value added created by enterprises engaging in agricultural, construction, wholesale and retail trade, real estate, renting and other business, as well as transport, storage and communication activities. In III quarter 2007, GDP reached LTL 26473.5 million at current prices and, as compared to III quarter 2006, increased by 10.8 per cent. In the third, as in the second, quarter, the increase in GVA was conditioned by construction, wholesale and retail trade, transport, storage and communication, real estate, renting and other business, as well as manufacturing and agricultural activities. Value added created by agriculture reached the level of 2005 (in III quarter 2006, a 22.8 per cent decrease in value added was recorded).
Wednesday, October 24, 2007
Performing a simple series of adept Googling exercises around various sources on the internet you can easily discover that certain species of the lynx are able to travel at speeds of up to 50 kph (31 mph). Wikipedia informs us that the Eurasian lynx, on average, commands a hunting area of between 20-60 square kilometers in which the lynx is able to walk and run about 20 kilometers in one single night. All in all, a pretty rugged and constitutional little thing this lynx.
In this way, and perhaps because, at that particular point in time, the Eastern European Economies looked as if nothing could come in their way of economic prosperity and growth they were paired, by the Economist, with the region's sturdy feline coining the notion of 'Lynx Economies.' Thus, 'that particular point in time' was sometime back in the spring of 2006 where the Economist's (and my own) coverage of the CEE and Baltic economies came in hot on the heels of publications by the World Bank and and the Vienna Institute of Comparative Economic Studies speaking favorably of the future prospects of economic prosperity and thus 'catch-up' growth in the CEE and Baltic Economics.
Yet, merely 1 year and a tad later things seem to have changed quite significantly with respect to the discourse on the economic situation in Eastern Europe. Many of the contributors to this blog has been pitching on the change in discourse but also some of major institutional actors have been flagging the red banner. Not least the World Bank seems to have changed their attitude somewhat with most notably a recent report on the demographics of Eastern Europe entitled From Red to Gray - The Third Transition of Ageing Populations in Eastern Europe and the former Soviet Union as well as a recent writ with specific focus on the macroeconomic risks prevailing in the region. Yet, also the IMF in their latest World Economic Outlook devotes a chapter to the managing of large capital inflows where Eastern European economies also take center stage of the general tone of warning; in essence this note of warning concerning Eastern Europe seems to be the general talk of the day amongst economic analysts and journalists. As such, perhaps even the lynxes roaming the forests and planes of Eastern Europe are beginning to feel that the otherwise catchy notion conjured by journalists at the Economist is becoming something of a stretch according to the reality of the situation. Sure, things are moving fast now but it is what happens next which might finally serve to make the allegory rather unrealistic. In this entry I set out to explicitly investigate an issue which in fact has been treated several times on this blog and perhaps most often in the context of the CEE and Baltic Economies. Simply put and in the form of one simple question;
- How do changing demographics and more specifically the final and ongoing stages of the demographic transition affect the notion and principle of economic catch up growth and thus economic convergence as it is stipulated by (neo-classical) economic growth theory?
As I have hinted above in the introduction my main subject of analysis on which the general theoretical argument is based is the current and ongoing situation in the CEE and Baltic economies. A lot has been written about this recently not least from the hands of the contributors to this blog (see also above). As a one-stop overview of the concrete issues at hand this recent note by Edward over at Global.Economy.Matters should provide you with suitable ammunition to get you started. In particular, the following three point overview of the current economic situation in Eastern Europe should always be in the back of your mind as we move forward from this point ...
Basically the principal outstanding issues confronting the EU10 countries are threefold:
- Labour capacity constraints (which are normally a by product of long-term low fertility and large scale recent migration flows) are producing significant wage inflation and strong overheating.
- A structural dependence on external financing - which is in part a by-product of the effect of low levels of internal saving, and which is another factor which separates the EU 10 from those like India or China who are benefiting from a typical demographic dividend driven catch up, is leading to large current account deficits, and potentially high levels of financial instability.
- A loss of control over domestic monetary policy due to eurozone convergence processes which - with or without the presence of formal pegs - make gradual downward adjustment in currency values as a alternative to strong wage deflation virtually impossible. This issue is compounded by the likely private "balance sheet consequences" of any sustained downward movement in the domestic currency given the widespread use of mortgages which are not denominated in the local currency.
Apart from my studies of selected pieces of the economic growth literature one of the best overviews of the concept of economic convergence as a function of the theoretical and practical assumptions vested in the growth models is to be found in an article by Norbert Fiess and Marco Fugazza on economic integration in Europe (PDF). As such it is important to note that convergence of GDP per capita levels is not a holy grail within the fields of economic growth theory. Rather, the process of convergence should be seen as an inbuilt consequence of the fact that as economies mature returns to production inputs decrease; that is to say that this discussion essentially revolves around the concept of increasing v. decreasing returns to scale in our economic model. If we think about decreasing returns to scale and introduce the concept of marginal productivity to production inputs we can then see that less developed countries are likely to exhibit higher rates of growth than their more mature counterparts in the sense that their marginal productivity is higher which then leads to a process of convergence. Now, this argument in its most strict sense is usually applied in the context of capital as a production input and coupled with the properties of an open economy and subsequent free flow of production factors this would lead to a rather rapid process of convergence or absolute convergence as the technical term. As regards to labour as a production input is has also been argued that the universal transition from an agricultural to manufacturing over to service (?) based economy produces a mechanism of convergence in the sense that this process implies a move up the value chain and thus that every unit of labour becomes more productive. Of course and even though we are talking about stylised facts here, this is also where the whole debacle begins in the context of my immediate argument because how certain is this process? Also, we need to take into account the distinction between stocks and flows (of labour) which is a crucial issue to consider when talking about ageing economies.
However and it does not take much of an economist to see that empirical facts do not support the idea of absolute convergence or at least it seems as if the process takes much longer to materialize than predicted by the theory. This has lead, among other factors, to a 'new' strand of economic growth models which allows for persistent growth divergence to exist between countries. The crucial aspect to understand here is the mechanism through which persistent divergences can occur. In this way, one of the widest contributions by economist to this thesis has dealt with the possibility that technological processes and thus accumulation of technological advances exhibits increasing returns to scale. The fundamental brilliancy of this notion is that it allows for a model where there is indeed decreasing returns to labour and capital but where different levels of technological effort leads to internal positive feedback mechanisms and thus explains persistent divergences in growth and 'prosperity' across countries.
Ok, I think that I have already said enough at this point and in order to get us back to track one crucial assumption and conceptual idea needs to be pinned down. As such and if we look at the rudimentary description of the economic growth process above it is not wholly unreasonable to argue that the growth process of an economy is somewhat directly related to the process of the demographic transition. Or as Robert Lucas puts it in a widely cited article ...
That is, the industrial revolution is invariably associated with the reduction in fertility known as the demographic transition.
As such, why don't we take a look at Eastern Europe where the economies have experienced, quite as expected by the conventional theory of economic growth, economic dynamics tantamount to catch-up or convergence. Especially the economic data since the expansion from EU15 to EU25/27 and, for some countries, the subsequent anchoring to the Euro has been very impressive indeed. Yet as Edward and I have been at pains (see link above) to explain again and again these countries are not your average emerging markets. This follows from the fact that their demographic structures have been fundamentally distorted due to a collapse of fertility in the beginning of the 1990s which has been aggravated by a persistent net outflow of migrants serving to further speed up the decline in the working and essentially also most productive cohorts. In order to capture this development and in order to frame the current situation the following point I made in a previous note is worthwhile to repeat.
In short, we are dealing with countries where the demographic transition by far, and indeed worryingly, has out paced the traditional economic process of economic convergence.
This is exactly what we are talking about here and apart from going to the heart of the imminent issues in Eastern Europe it also strikes right smack into the concept of economic growth theory and how to deal with the fact that the demographic transition does not occur the way it was originally anticipated. Most emphatically, we can see in the context of the Eastern European countries that the final stages of the transition have arrived far before and quicker than the twists and turns of history allowed for these economies to really get on with business. Yet, the general argument can just as easily be expanded into a discussion of the ageing part of OECD where it is painfully clear at this point that conventional economic theories are wholly incapable of explaining what is likely to happen next. In fact, we could stretch it so far as to say that modern economic growth theory is not able to explain what happens when fertility drops to a level below replacement level and stays there!
Even though that a lot words have been written in this entry I am afraid that only superficial contributions have been made to the final answer of the proposed question. This entry principally had one main task, namely to initiate a line of reasoning which ultimately and hopefully can lead to a better understanding of modern economic growth processes in a context of the current demographic profile of many developed and developing economies. Specifically, this entry revolved around the concept of catch-up growth/convergence where the countries in Eastern Europe were suggested as an example to demonstrate how demographics can fundamentally alter the principles by which the economic growth process is likely to conform. In this way, the message is not that modern economic growth theory and growth accounting methods are rendered obsolete in the face of changing demographics but rather that considerable adjustment needs to be made; especially in the context of catch up growth/convergence but also crucially in the context of the notion of a steady state of economic growth. Returning briefly to the real world before we sign off it could seem as if the branding of the lynx economies never was more than a quick and essentially expensive make-up which is set to quickly wear off as we venture on. Specifically, recent signs coming out of the ECB and the European commission suggest that expectations are aligning towards an outlook where the process of convergence effectively risks grinding to a halt. My advice would then be not to exchange the carrot too swiftly into a stick since this would only serve to kick those who are already on the ground.
Monday, October 22, 2007
The construction price index was primarily influenced by the increase in the labour costs compared to the previous quarter and also the same quarter of the previous year.
In the 3rd quarter of 2007 the percentage change in the repair and reconstruction work price index was 1.7% compared to the 2nd quarter of 2007 and 12.1% compared to the 3rd quarter of 2006.
The calculation of the construction price index covers four groups of buildings — detached houses, blocks of flats, industrial buildings and office buildings, as well as office buildings covered by the repair and reconstruction work price index. The index expresses the change in the expenditures on construction taking into consideration the price changes of basic inputs (labour force, building materials and building machines).
As can be seen from the charts, while the rate of increases in these prices may have pulled back slightly in Q3, it is still very large indeed.
As I said in this post about Latvia's August trade statistics:
"The key question to now follow will be the evolution of producer prices in the export sector, since the only way to get out of this mess in the longer term will be to export your way out of it - since all those capital inflows one day or another have to be paid back - and the only way to be able to export is to be competitive."
So why don't we do just that, take a look at producer prices in the Estonian export sector. Here is a comparison of the recent inflation in the export and import sectors.
Now we can see straight away here that there is no significant productivity differential being achieved in the tradeables sector, and rising costs are being pushed straight on through to exports. This now can only end badly, and the only question left is when. My guess is when the Eesti Pank finally bite the bullet and break the euro peg. The situation is impossible, and like this it simply cannot correct. In addition the euro has been trading earlier this morning at over $1.43 per euro, and the Kroon is of course being dragged up with the euro. We are all hoisted on our own petard.
Last months producer price growth compares with an increase of 8.5 percent in August, and 6.4% back in January.
Estonia's export industry has struggled this year to adjust to rising wages, which were up 21 percent year on year in the second quarter, stoked by labor shortages which have been produced by rapid economic growth following a large drop in ferility some 20 odd years ago. The problem - which would exist in any event - is only being added to by Estonian workers leaving to earn the higher wages which are on offer elsewhere in Europe, although it must be said that this end of the problem is much less severe in Estonia than it is in other parts of the Baltics, Bulgaria, Romania and Poland.
Clearly the Baltic countries are being hit by the fact that no-one saw this coming and thus structural reforms of the kind which might make the countries more attractive to immigrants (like multi culturalism) have not been extensively introduced.
Meantime the foreign companies are steadily begining to draw the inevitable conclusions and pack their bags. The latest example, as reported by Eesti Paeevaleht last week is Boras Wafveri AB, a Swedish textile producer, which is now busily seeking a partner for its unprofitable Estonian unit, Kreenholmi Valduse AS. Rumours have it it they are even contemplating selling the whole plant as losses mount due to competition from lower-cost producers in Asia and elsewhere.
Tuesday, October 16, 2007
cross-posted from Alpha Sources
Work is piling on my desk at the moment and I fear that events might even overtake my efforts to keep up with them but here is to trying. Basically and if this was not clear back in the beginning of September it should now be readily clear everybody that Baltic and CEE economies now need serious watching and attention. As my regular readers will know I have been slowly and steadily chipping away together with my colleague Edward Hugh. My own catalogue of posts on the subject can be found here and you might also want to check the following three blogs; Baltic Economy Watch, Eastern Europe Economy Watch and Latvia Economy Watch. Also, the group blog Global.Economy.Matters has been the venue lately of some very interesting posts on the issue at hand. In fact, Edward's recent entry over at GEM offers an excellent introdution to the issues in Eastern Europe as they have been dealt with and indeed described regularly in the past months here at this blog. As such and in order not to repeat myself, I reproduce a key quote by Edward below which sums up the current situation quite well and also allows me to get down to business in this post ...
Basically the principal outstanding issues confronting the EU10 countries are threefold:
1/. Labour capacity constraints (which are normally a by product of long-term low fertility and large scale recent migration flows) are producing significant wage inflation and strong overheating.
2/. A structural dependence on external financing - which is in part a by-product of the effect of low levels of internal saving, and which is another factor which separates the EU 10 from those like India or China who are benefiting from a typical demographic dividend driven catch up, is leading to large current account deficits, and potentially high levels of financial instability.
3/. A loss of control over domestic monetary policy due to eurozone convergence processes which - with or without the presence of formal pegs - make gradual downward adjustment in currency values as a alternative to strong wage deflation virtually impossible. This issue is compounded by the likely private "balance sheet consequences" of any sustained downward movement in the domestic currency given the widespread use of mortgages which are not denominated in the local currency.
Now the worrying part about all three of these is that they are not simply cyclical in character. As such they are not problems which will "self correct" as a result of a recessionary slowdown, whether this be of the "soft-" or "hard-landing" variety.
And business, as it were, in this post is basically an extension of the analysis I did a couple of weeks ago regarding the balance sheet exposure of (primarily) Lithuanian households towards a potential rattling of the pegs to the Euro carried by a currency board. To put it more directly, this post will deal with aspects of the topic at hand which ties up to point 2 and 3 above.
In order to frame the discussion a bit before we move into the data I want to emphasize that the risk of a rapid currency unwind somewhere in Eastern Europe is most emphatically not some kind of odd suggestion. The risk is very real indeed! You just need to take a brief look at what has happened the past weeks to see how things are now set in motion towards what seems to be an inevitable loosening of the tight strings attached between the Eurozone and the pegging and also floating currencies in Eastern Europe. Exhibit one is found in two recent publications from the World Bank and the IMF in which specifically Eastern Europe is singled out as a cluster of countries where the economic development as epitomized by the three points above have put these economies in a situation where not only the general macroeconomic environment is in risk of taking a serious blow. However, this is also a situation where the process of convergence with the Eurozone countries as well as of course the final carrot of Eurozone membership have become events subject to eternal postponement for the majority of the countries in the region. Now, this raises obvious questions surrounding political reactions and while I can understand the overall political and economic dynamics which are now set in motion I also need to emphasize why these countries should not be handed the stick at this point since this would not help at all. Yet, this is an issue for another post. What I am really getting at here, and this would be exhibit two, is quite simply the fact that people which in this case mean policy makers and opinion makers at the ECB as well as of course investors seem to be positioning themselves for a collapse of the de-facto fixed exchange rate regime which ties together the Eurozone and most of the CEE and Baltic economies. A notable example of this would then be Danske Bank's Lars Christensen who is also shadowing the unfolding events in Eastern Europe and who recently suggested in a note that the ECB might be growing rather un fond of the close ties to the economies in Eastern Europe with respect to the fixed exchange rate relationships.
The increasing and clear signs of overheating in a number of Central and Eastern European countries especially the Baltic States and South East Europe are drawing attention not only from the financial markets, but also from international institutions. Recently the IMF has warned of the dangers of overheating in the CEE and the World Bank has on numerous occasions raised the same concerns. Now the ECB is also stepping up the rhetoric. At a conference earlier this week ECB officials expressed their concern about the in-creasing imbalances in the Central and Eastern European economies.
Now, some of my readers with a special interest in ECB affairs will recognize that Christensen is a keen ECB watcher by his mentioning of a recent conference on Eastern Europe which indeed produced some rather spectacular contributions related to the economic situation in Eastern Europe. The most cited speech from this conference is consequently one held by Lorenzo Bini Smaghi who is a member of the executive board about the risks which pertain to the process of convergence in Eastern Europe. Of course, mentions of the currency pegs were not made explicitly but as Christensen also homes in on, Bini Smaghi did note that there is a clear tradeoff between keeping the pegs and continuing the process of convergence. I will devote more time later to discuss this speech as well as another one along the same lines made by another member of the executive board Jürgen Stark but for now and in connection with the immediate topic at hand we need to understand that the scene is now effectively set for an (potential) economic correction triggered by either/or both an unwind of one of the pegs and an 'attack' one of the floaters.
Moving on to the Baltics
It is thus in this immediate light that I am going to present a slew of graphs below on the Baltics which, as noted picks, up on one of my recent posts on Lithuania which deals with the concept of crossover currency balance sheet exposure or as it has been coined in the literature; translation risk. The following definition is from investopedia.com:
The exchange rate risk associated with companies that deal in foreign currencies or list foreign assets on their balance sheets. The greater the proportion of asset, liability and equity classes denominated in a foreign currency, the greater the translation risk.
Now, the first interesting thing which should be noted in the quote above is of course the notion of how 'companies' are emphasised. Now, I don't have a very broad overview of the literature on this topic but on the back of a superficial glance it seems clear to me that most of the words on this subject has been devoted to the description of companies' exchange rate risk of operating in foreign countries under insecure exchange rate systems and obviously subsequently how this risk can be hedged using derivatives or just by calibrating the denomination of the stock of liquid assets held on the balance sheets. In this way, we need to look at another kind of translation risk and one which is especially important in the case of the Baltic countries and in fact also in many other countries in Eastern Europe. Simply put and as an inbuilt and strongly influential factor in connection to the general economic situation these countries have, as mentioned above, seen a very rapid increase in credit/capital inflows in the past years to cover a ballooning negative external balance helped on its way by boom in domestic demand. The point is moreover that the majority of this credit has been extended to households through loans intermediated by foreign financial institutions and thus in foreign currency (mostly Euros). As an overall point the following point as quoted by a recent report by the World Bank (linked above) is important:
External positions in 2Q 07 in most EU8+2 were financed by FDI. In the Baltic countries they were financed by foreign borrowing through the banking sector. In most countries current account deficits remain largely covered by FDI – fully in the Czech Republic and Poland, in 90% in Bulgaria and 2/3 in Slovakia and Romania. Meanwhile in the Baltic countries, which have the largest imbalances, FDI cover 1/3 of CAD in Latvia and Estonia and slightly more (58%) in Lithuania with banking sector foreign borrowing remaining the primary source of financing.
This last part is rather important for the analysis at hand which basically seeks to present comparable charts for the three Baltic countries according to the following overall analytical principles.
- The charts will show three things. Firstly, charts will be presented on the evolution of the external balances in order to show the magnitude of the problem. Secondly, a set of charts will seek to show the overall build up of credit measured as the evolution of the total stock of loans with special focus on the households' contribution. Thirdly and as a direct measure for the potential translation risk associated with an unwind of the fixed exchange rate regimes in the Baltics charts will be presented which compares the denomination of loans with the denomination of deposits in financial institutions. In this way it is important to note that we are not comparing the stock of loans with the stock of deposits according to a criterion of how much the latter can cover the former in absolute terms but, as it were, solely with a focus on cross-currency denomination.
- The charts, which will be presented without many words, denotes what you could call a static analysis of the issue of translation risk. The point is that the charts solely show stocks and not flows. It is thus assumed that in the case of households in particular the cash flows used to service the loans are denominated in local currency (i.e. salaries) as well as it is assumed that households have limited acces to intruments used to hedge cash flows at different points in time.
Now, and if I have been able to hold on to you until this point why don't take a look at the charts. We will begin with the charts showing the evolution of the external balances before moving on to charts showing the evolution of the stock of loans and finally finishing off with charts comparing the denomination of loans with the denomination of deposits in financial institutions. The charts which cuts across all the Baltic countries have been made with the explicit goal that they are comparable. It has not been a complete success but it works.
Current Account (Estonia, Latvia, and Lithuania)
Evolution of total stock of loans (Estonia (million EEK), Latvia, and Lithuania)
Stock of loans and deposits by currency denomination (Estonia, Latvia, and Lithuania)
(Please click on images for better viewing)
As promised I won't say a whole much at this point save of course to point out that the charts above do indicate that a considerable amount of translation risk is present which also conforms with the rather large amount of anecdotal evidence.