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Thursday, September 27, 2007

World Bank Report on Labour Shortages in the EU10

The European Union's 10 eastern members must take concerted action to increase employment participation levels to avoid a serious short-term slowdown in economic growth and important supply-side structural problems in the longer term according to a report published today by the World Bank.

"Addressing the emerging skills shortages is particularly important, because failure to do so will constrain job creation and future economic growth"

You can find the report summarized here, or you can download direct here.

Claus and I will prepare a full summary and review over the weekend, but for now here are some revealing extracts.

The report in fact says the following:

In this atmosphere of short term turbulence it is important not to lose sight of the longer term trends and the fundamental challenges the EU8+2 continue to face. With the exception of Hungary, growth remains high throughout the EU8+2 and in the case of Latvia represents serious overheating. This growth is sustained largely by consumption and investment. With tightening labor markets, large increases in real wages and employment and very rapid credit expansion, a moderate slowdown in growth may in fact be desirable in the countries showing signs of overheating.

They also have this to say, which is IMHO very important, and to the point:

Unemployment has fallen substantially in virtually all EU8+2 countries since 2004 due to strong growth in labor demand. This has given rise to skill shortages and associated wage pressures, often amplified by out-migration of EU8+2 workers. However, employment/working age population ratios remain relatively low.

Really this is the very point that Claus and I have been making. They then continue:

In contrast to the earlier period of weak labor demand it is now the supply side of the labor market that constrains new job creation. Many persons of working age are economically inactive in EU8+2 either because they lack skills demanded by employers, or because of labor supply disincentives, such as early retirement benefits, generous disability schemes, high payroll taxes, and limited opportunities for flexible work arrangements. These effects are concentrated among the younger and older workers, while the participation rates for middle aged workers are similar to those of the EU15. Hence the main challenge facing now EU8+2 is to mobilize labor supply to meet the demand. Addressing the emerging skills shortages is particularly important, because failure to do so will constrain job creation and future economic growth. To increase the effective labor supply EU8+2 countries need to: (a) improve labor supply incentives through reforming the social security systems, (b) improve worker skills through reforming the educational systems and improving domestic mobility; and (c) import labor with skills that are in short supply by opening labor markets to foreign workers. The weights assigned to each policy depend on the nature of the most binding constraint to labor supply, which vary across countries.

also this is very important, even if I am nowhere near as optimistic as the World Bank is about the possibilities of Eastern Europe staying out of the firing line, especially as the eurozone itself is slowing fast.

The effects of deepening financial turbulence would potentially be more serious for the EU8+2, but are more difficult to predict. The greatest risk is that the countries that have large current account deficits – the Baltics, Romania and Bulgaria – are suddenly less able to finance them through capital inflows and are forced into an economic contraction. This is particularly true for countries like Hungary that are highly dependent on more volatile portfolio inflows than on FDI. Banking sector foreign borrowing which is the main financing source in the Baltics is generally less volatile than portfolio flows, but the extreme surge in the Latvian CAD (to 30% of GDP in the 12 months to end July ) clearly cannot be financed in this way in a sustained manner. There are other potential risks as well. A general retreat from mortgage lending provoked by US experience would lead to broad based credit tightening and weaken the booming construction sector in the EU8+2. Moreover, the increased risk sensitivity may cause the unwinding of carry trades making external finance more difficult for higher interest, carry trade destination countries.


In the latest quarters unemployment rates have either continued to fall or have remained fairly stable despite upward seasonal pressures. In several countries unemployment rates declined to historical minima (the Baltic States, the Czech Republic, and Poland). Employment rates in Latvia, and also in Estonia reached the highest levels since the start of transition and are around 68% for people aged between 15 and 64 years, which is close to the Lisbon strategy target of 70%. Nevertheless, further employment increases may be limited because of structural nature of joblessness due to skills mismatches and unwillingness to relocate or retrain, which is particularly relevant for those who stayed out of the labor market longer.

The recent trends have undoubtedly strengthened the power of employees in the wage bargaining process. Real wages have begun to grow rapidly in Poland where their expansion had been moderate so far. The highest growth is occurring in sectors which suffer most from shortages of workers (for example, construction). Rising employment and strong dynamics of real wages are pushing the growth of the wage bill into double digits. Nevertheless, demands of higher wages for public sector employees come into sight in most countries in the region. In Bulgaria and Poland, trade unions are prepared to resort to strikes or the threat of strikes in wage setting negotiations.

In all countries apart from Slovakia and Slovenia, wages are growing faster than labor productivity. Rising unit labor costs provoke central bankers in the region to tighten monetary policies (Poland and the Czech Republic). Apart from inflationary pressures, excessive ULC growth may undermine competitiveness and prospects for sustained long-term output growth and further labor market improvement.

Hansapank Announces Lithuania Portfolio Diversification

AS Hansapank, effectively the biggest Baltic lender, has announced that it is going to diversify its credit portfolio in Lithuania.

Hansapank, which is owned by Stockholm-based Swedbank AB, will ``at some point'' have to set credit growth restrictions in Lithuania, the biggest of the three Baltic countries, Chief Executive Officer Erkki Raasuke said in an interview in Tallinn yesterday (reported by Bloomberg here). According to Raasuke the only reason Hansapank haf not previously done this was because Lithuania's problems have been longer in coming than those in Latvia and Estonia.

"We don't have any signs or confidence at this point that in Lithuania we would avoid the need for credit restrictions, but we would do it differently there" Raasuke said. "Instead of setting internal limits for absolute credit growth, we should rather set targets on diversifying the credit portfolio. These are the steps we didn't take in Estonia and Latvia."

Hansapank predicted in April that Baltic loan growth will slow to around 35 percent this year from 59 percent last year, helped by lending restrictions it set to lower credit growth to more sustainable levels.

Raasuke did however admit that Hansapank could have acted earlier to cool loan growth in the light of its own forecasts in the second half of 2006.

``We were probably talking more and doing less, there was kind of a frozen state,'' Raasuke said. ``But we are only a part of the market and it seemed that the critical mass was achieved only in February-March so that all market players could start moving in the same direction.''

In April, Hansapank's Estonian unit raised the minimum monthly income requirement for granting a mortgage to 7,000 krooni ($607) from 5,000 krooni, compared with the average gross monthly salary of 11,549 krooni in the second quarter.

Raasuke also said that it was obvious from Hansapank's business that lending behavior had changed within the last four to five months in Latvia and Estonia, and cited a "clear decline" in new loans, compared with peak monthly levels and the average levels of the last three to four years.

Raasuke also said that the recent decline in consumer confidence in the Baltics was not affecting the peoples confidence in the banks, since the Baltic market is small compared with the size of the banking groups involved. (Estonian consumer confidence fell during August to its lowest level in almost two years because of worsening expectations about household and state finances).

Estonian investment gold seller AS Tavid is reported to have tripled its weekly sales to about 60 kilograms in recent months, according to the newspaper the Postimees yesterday, and the paper also cites reports that people are increasingly converting their bank deposits from krooni into foreign currency.

Raasuke however was confident that there was no `"big" risk of a Baltic property sector collapse as the problems of oversupply are only affecting residential property business, with demand expected to remain strong for commercial property and especially civil engineering.

Raasuke is undoubtedly right to point out that the Baltic States for only a small part of their total business, but it is also true to say that the US sub-prime liabilities of many European banks were also only a small part of their total portfolio, and look what a mess that has caused. So I think we need to be rather careful before reaching any strong conclusions here.

Monday, September 24, 2007

Estonia Q2 2007 Current Account Deficit

Estonia's current-account deficit narrowed in the second quarter from a 14-year high as slower consumer spending and credit growth cut imports, suggesting the Baltic economy is cooling somewha. The deficit, which offers a braod measure of the evolution of trade in goods and services, fell to 8.5 billion krooni ($770 million) or 14 percent of gross domestic product in Q2 2007, from a revised 21.9 percent of GDP in the first quarter and 15.2 percent in Q2 2006, according to data released by the central bank today.

Estonians it seems spent less on imported cars, clothes and household goods last quarter as interest costs rose and stricter lending requirements by banks took their toll. Lower domestic demand also slowed manufacturing and construction growth, reducing the rate of GDP growth in Q2 to the lowest level in 2 1/2 years.

Exports of goods rose 6 percent from a year earlier, increasing slightly more rapidly than imports which rose 5 percent increase. Services exports climbed 19 percent, while imports went up 18 percent.

Latvia's current-account gap, which is the widest in the European Union, narrowed to 23.5 percent of GDP in Q2 2007 as economic growth there slowed too.

Wednesday, September 19, 2007

The "New" Latvian Stabilisation Plan: Too Little Too Late?

Bloomberg reports that Latvian Prime Minister Aigars Kalvitis was on the Latvian Independent Television program 900 Seconds last night. His message, that "new government measures to slow inflation and cut the current account deficit will mean ministries must trim spending and plan for larger surpluses". Ministries, he said, will have to ``tighten their belts'' and the budget surplus will have to be ``much bigger'' than the planned 0.5 percent for next year.

The government is apparently planning to introduce a (another) stabilization plan. At the end of the day, I cannot help having a certain sympathy for the Latvian politicians and bankers concerned. Not that they couldn't have been doing more, but this situation - which is way beyond the "know how" of even the IMF and the EU commission - it seems, certainly can only find them wanting before the challenge. They are, at the end of the day, only human, and they should not be blamed for that fragility.

No one could really have anticipated the extent of the problems Latvia was destined to face back in 1990 when the wall came down and fertility suddenly plummeted. Now we all know better. There will be a lot to be learnt from what happens next, unfortunately the on-cost of the education process will be paid for by the Latvian and other East European peoples, who, lord knows, have already suffered enough.

History is far from kind in this case. In fact it seldom is.

Saturday, September 15, 2007

Latvia Wages and Salaries Q2 2007

Well Latvijas Statistika had the latest wages and salary data up last week, and they don't make especially pleasant reading, even if you do consider that Latvians are basically much poorer than their Western European counterparts, and that wage (and productivity) convergence in the longer run would be a thoroughly good think. The question is, can we get from here to there, and if so, how? Since one thing is plain enough, the present situation just isn't sustainable.

According to Latvijas Statistika compared to 2nd quarter of 2006, in the 2nd quarter of 2007 the average hourly labour costs increased by 31.6%. Hourly labour costs in this period increased from 2.46 lats to 3.23 lats or by 78 santims per hour.Quarter on quarter this was a rise of 6.2%.

Here are the charts. First the development of the annual rate, which is, quite simply, horrific.

Now here is the quarter on quarter rate. And we can, of course, notice some very slight slowdown in the second quarter, and this is consistent with other data - GDP, housing - that we have been seeing. The question is now how rapidly and how far this will slow.

Clearly these wages increases subsequently have a knock-on impact on costs, and this impact can be seen in the producer price index. This can be seen in the charts that follow. First the index itself.

Now the annual rate of increase each month. This has now been accelerating since about July 2005, although the rate of acceleration has slowed recently.

Then we have the rate of increase in export prices component. As we can see these prices have also risen considerably, although the rate has now, fortunately, been slowing down since April. The damage, however, is being done, and it is considerable.

The impact of all of this is reasonably predictable, Latvia is finding it harder and harder to export:

as we can see, since May the value of Latvia's exports each month has been falling. If we look at the monthly trade balance we get a similar picture:

As we can see, the deficit is not reducing in any systematic way, and indeed deteriorated a little in July, which is the last month for which we currently have data.

So all of this is unsustainable, and the end result will probably be an impact on the peg. Why?

Well economics isn't such a difficult subject as it sometimes seems really. Basically you have two key drivers of economic growth, domestic consumption and exports (in this sense both government spending and investment are secondary variables). Now if at some stage domestic demand is going to be reduced - as it has to be - then Latvia will have to live from export growth. But if you can't increase exports because your prices are too high, then the only real move left is to change the value of your currency. Its as simple, or as hard, as that really.

Wednesday, September 12, 2007

Balance Sheet Exposure in Eastern Europe - The Case of Lithuania

by Claus Vistesen

cross posted from Alpha Sources

As a part of my general assessment of the current financial market turmoil which has lead me to conclude that especially Eastern Europe should be carefully watched Lithuania in particular has commanded a lot of attention here at Alpha.Sources. Of course, my general attention directed towards Eastern Europe has been shared by my colleague Edward Hugh who is shadowing the day-to-day economic development in the Baltic and CEE economies on the following three blogs; Baltic Economy Watch, Eastern Europe Economy Watch and Latvia Economy Watch. This is then to say that if you want to do a bit of catch-up as it were on what is actually going on the links provided above should provide you with plenty of ammunition. In general and as we home in on today's topic, the Baltic economies are interesting for three main reasons ...

  • All three countries have pegged their exchange rates to the Euro. Apart from being a simple fact we need to understand the perfect logic in this regime since these countries are shaping up to become a full fledged member of the Eurozone. Ironically of course this may now seem to be one of those events subject to eternal postponement as inflation remains at very high levels well above the comfort level for Trichet and his cabal in Frankfurt. The situation is well epitomized in the following headline carried this morning in Bloomberg; Baltic Inflation Leaves Slovakia as Only Viable Euro Candidate. Another aspect which is then intimately tied to the choice of a pegged exchange rate regime in the Baltic economies relates to the potential risk of a sudden abrupt unschackling of the exchange regime as a result of the inability to maintain the peg. Many events can course such a process and as the US economy seems set for sub-trend growth and as the financial market turmoil muddles along the risk is increasing given the rather unsustainable growth path of the Baltic economies. In this note I will focus on Lithuania. I will predominantly try to treat two topics. Firstly I will try to quantity the recent build up of credit in Lithuania in the current (very expansory) cycle and secondly I shall look at the balance sheet exposure towards a potential correction of the exchange rate.
  • The second reason why the Baltic economies is interesting is quite simply derived from the fact that all three countries seem to have been somewhat on the forefront of the overall credit expansion in Eastern Europe. At this point I would not try to give any kind of explanation to illuminate this but my intuition suggests that perhaps the very nature of the Baltic economies' institutional environment, of which the currency peg and subsequent expectation of Euro membership is certainly an important factor, as well as the relative proximity to the competitive Nordic economies have created a solid base for the recent economic expansion.
  • The third stylised fact attached to the interest of the Baltic economies is quite simply their difference. In this way we could as a rough and ready approximation group the Baltic economies according to potential risk relative to the current environment. As the most exposed economy Latvia seems to hold this ill favored position as the build up of credit and subsequent inflation has been somewhat more severe in this country. Secondly, we have Lithuania which I shall examine today where it seems as if growth is not as sizzling as in Latvia. Lastly, we have Estonia then and although the expansion indeed has not passed Estonia in its wake Estonia has not seen such a rapid exodus of workers as its neighbours and this together with other factors (see below) may render Estonia to be able to weather the storm just a wee bit more effectively than its Baltic counterparts should push come to shove. For a more thorough assessment of Estonia I recommend this GEM note authored by Edward Hugh and Aapo Markkanen. Clearly, this juxtaposition is not by any means exhaustive but it should act as a fair initial guidance line for the economic situation in the Baltics.
Now, let us turn to the real subject at hand which revolves around two main analytical segments where we will firstly look at the development of household and corporate credit in Lithuania and secondly examine the extent to which the overall Lithuanian balance sheet is exposed to a potential pressure on the peg.

As a first approximation to the topic in question let us look at the evolution of total amounts of outstanding loans to households and non-financial corporation since October 2004 (monthly data). As a qualifying note the notice of (non-cumulative) might seem a bit odd but it originates from the fact that the data set includes loans with between 1-5 year maturity which means of course that, given the time span in question, non linear overlappings will be present as a result of the term structure of the data set.

Putting methodological issues aside we can easily see the extent of the expansion as it took off especially in the middle of 2005. In order to substantiate the figure above we can see from the two figures below that particularly loans to households have seen a steady increase through what seems clearly to be housing loans (+5 year maturity) and consumer credit loans.

A hefty and steady increase of credit to households and non-financial corporations does of course not indicate that ill tidings are in store for the economy. However, as is so often the case we need to consider the overall quantity as well as the subsequent effects on wages and inflation. In this way as it has been noted several times (see links above) Lithuania now finds itself with a rather large and growing current account deficit as well as it is almost certain that labour productivity has been wholly unable to follow the increase in wage costs which has then eroded the external competitiveness and thus probability for an endogenous correction of the external balance. It is in this context and with what seems to be an evolving state of uncertainty in financial markets that the next aspect of this analysis becomes important.

Consequently, what really matters in Lithuania's situation is the hypothetical risk associated with a potential run on the currency and subsequent testing of the peg (for a general assessment of this issue in Eastern Europe see this piece from the WSJ). In order to illuminate and gauge this risk we will look a bit more closely at the denomination of all those loans which have been provided to Lithuanian households and corporations. This will in turn be compared to the overall currency denomination of residents' deposits in order to essentially create a proxy for the risk associated with a sudden appreciation of the book value of loans outstanding relative to a depreciation of the deposits and essentially income cash flow used to service these loans*. The following two graphs seek to shed light on exactly this aspect. The first shows overall denomination of loans whereas the second shows denomination of resident deposits. What we are obviously looking for is a mismatch which might lead to an increased risk as a result of a sudden appreciation of the Euro with respect to the Litas.

As we can see quite obviously from a comparison of the graphs above the potential exposure is rather large. However, we should note that whereas the relative ratio of deposits remain the same over the time period in question the ratio of Euro denominated loans to Litas denominated loans has declined steadily from around March 2006. This does not however mean that the exposure has evaporated and there seems indeed to be notable balance sheet issues present in the situation of run on the Litas peg. As a general qualifier we of course have no idea regarding the extent of currency hedging and thus how many of these positions are backed in the derivative markets. In the perfect world it would clearly have been optimal to gauge especially households' currency exposure in order to assess the potential for very rapid contaigon to the real economy.

As a final note it is of course most relevant to actually gauge the risk of a breakdown of the peg which could lead to the balance sheet issues sketched somewhat above. Given the small size of Lithuania and indeed the Baltic economies in general it would seem as if ample opportunities would exist for a potential bailout; surely the ECB would be able to cover the Lithuanian balance sheet. But then we also move in muddy territory since there would be no precedent for such a move (right?) and at the end of the day the future prospect of Euro membership does not work as a pull process from the point of view of the ECB but rather as a push process from the point of view of outside economies. All in all, the peg might very well remain for some time but given the obvious unsustainability of the current growth rate relative to deteriorating capacity constraints on the labour market I am looking into the future with some anxiety.

* At some point I will provide a comprehensive list of literature regarding currency crises and balance sheet issues.

Monday, September 10, 2007

Estonia Revises (Slightly) Q2 2007 Growth Estimate

Estonia has revised up its second quarter economic growth estimate which was originally released on Aug. 14. the Tallinn-based statistics office, Statistikaamet, in data released today have revised the rate up to 7.6 percent, a pace which is ever so slightly higher than the preliminary estimate of 7.3 percent.

as can be seen from the quarter by quarter chart the rate of decline is now much softer than originally thought, which is basically good news, as it reduces the chances of a hard landing in the shorter term, as discussed here, although clearly this does nothing to alter the level of risk in the longer term.

Latvia Inflation August 2007

Latvia's CPI inflation year on year in August reached 10.1% according to data out today from Latvijas Statistika. Since this was largely expected there is little more to add, it is however an extremely preoccupying number.

Here's the chart showing annualized rates by month:

and here's the chart for month on month changes, which doesn't really give much comfort, since while the August increase is not especially high, there is no clear evidence of trend. Since the whole phenomenon is being driven by wage push,we need to see some more evidence of trend in wage and salary growth, and some data on export prices and volumes would no be useful to see how GDP growth is likely to evolve.

Lithuanian Inflation August 2007

According to data just out from Statistics Lithuania, Lithuania's annual inflation rate accelerated in August to the fastest pace in almost a decade. The rate jumped to 5.5 percent from 5.1 percent in July, the highest since June 1998. Month on month prices rose by 0.3 percent.

Lithuania, it will be rmembered, was the first country to have its application to adopt the euro rejected, since it failed the inflation test. Since that time consumer-price growth has steadily accelerate from 4 percent at the start of this year. This being said, Lithuania is at the present time well short of the inflation performance in neighboring Latvia, where they have just posted a year on year inflation rate of 10.1 percent for August.