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Friday, October 26, 2007

Lithuania's Economy Accelerates in Q3 2007

Lithuania's economy seems to have accelerated in the third quarter, expanding by 10.8 per cent according to a preliminary estimate from Statistics Lithuania. This is the fastest pace in four years, and the fact that the economy is gaining speed rather than slowing down must increase concern that Lithuania's economy may also be in danger of having a hard landing.

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

Catch Up Growth and Demographics - Evidence from Eastern Europe

by Claus Vistesen: Copenhagen

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.
Traditionally a rigorous economic analysis in the light of the immediate events would focus a lot on point 2 and 3 but in this note we shall look specifically at number 1 and the issues of labour capacity, its constraints, and what it means of the economic growth of less to medium developed countries. Now, the most obvious caveat in this entry is that I really don't have the time at this point to really lay out the whole theoretical framework of economic growth theory and as such the precise slot in which my argument should be inserted within the wider theoretical framework. This will be the topic of a more rigorous article not suited for the blog format. However, I still need to attach some comments to set the scene where I should also immediately note that my previous note here at DM about catch up growth in Eastern Europe serves as a good state of the game post for what comes next.

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!

In Summary

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

Estonia Construction Price Index Q3 2007

According to Statistics Estonia today, in the 3rd quarter of 2007 the percentage change of the construction price index was 1.6% compared to the 2nd quarter of 2007 and 12.1% compared to the 3rd quarter of 2006.

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.

Estonia Producer Prices September 2007

Statistics Estonia announced this morning that Estonian producer prices rose an annual 9 percent in September, the fastest pace in the last 10 years. In this post I asked the question as to whether Estonia was heading for a soft landing, looking at this data which is now coming in I think the answer can be quite unequivocal: it is not.

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

Translation Risk in the Baltics and other matters on Eastern Europe

by Claus Vistesen

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.

Wednesday, October 10, 2007

Latvia Industrial Output August 2007

According to data released this week by Latvijas Statistika, compared to July 2007, Latvian industrial production in August 2007 increased by 2.6%, according to seasonally adjusted data (seasonal and working day influence is taken into account). Within this total there was a rise of 12.9% in mining and quarrying, 2,4% in manufacturing, and 2.4% in electricity, gas and water supply.

Compared to August 2006, industrial production in August 2007 increased by 3.3% according to seasonally adjusted data. Within this total there was a rise of 1% in manufacturing, 6.2% in mining and quarrying, and 11% in electricity, gas and water.

So year on year manufacturing industry is barely moving, despite general overheating in the economy. This is not good news. Here is the movement in the total index:

And here is the chart for % change year on year. Remember the lions share of the increase is in electricity and other utilities.

Monday, October 8, 2007

Latvia Inflation September 2007

Well, Latvijas Statistika have just published the September inflation number, and the news is not good. Year on year inflation rose to 11.4%, the second highest rate in the EU (Bulgaria's annual inflation rate was 12 percent in August). I have just published an extensive post on the recent Estonia inflation data, and since the issues are essentially the same in both cases, I will simply report the data here.

Firstly here's the chart:

As can be seen, inflation is accelerating, and not reducing. On a year on year basis the big items are food and drink, entertainment, education and housing. As these are year on year data, the housing component may cool considerably as we move forward now, after several months of steady easing, although even on housing the statistics office record a month on month increase of 1.4% from August.

At the same time we have new data which shows that industrial output in August by 2.6% over July, and by 3.3% on a seasonally adjusted basis over August 2006.

Inflation Surge In Estonia Raises Questions About 'Soft Landing'

Estonian inflation surprisingly accelerated in September to reach a new nine-year high, largely on the back of rises in food, housing and services costs. The Estonian Finance Ministry has said it expects Estonia's inflation rate to remain near the current level for the immediate future. The annual rate rose in September to 7.2 percent, which was its highest level since October 1998, and was up from 5.7 percent in August, according to data released by the Estonian statistics office at the end of last week. Month on month, prices rose by 1.1 percent.

The largest increases were registered in food prices (7.8% annual rate), housing (16.1%) and services (hotels, cafes and restaurants, 12%). Here is the monthly inflation chart.

Now the Estonian central bank and Finance Ministry have been insistent in recent months that the Estonian economy remains on course for a ``soft landing'' as the property sector cools and credit growth slows. This outcome is far being a self evident one, however, as this and other recent data which will be reviewed in this note make clear.

Overheating in the Baltics?

What is happening in Estonia may seem to be lacking in any great global significance, given the size of the country and its economy, and its lack of general importance at the global level. But such a conclusion might be over hasty, and premature, as I will try and argue here, given how representative what is happening in Estonia now is of processes at work in many EU10 economies (although not of course all, as the notable exception of Hungary shows).

In fact all three Baltic economies show clear signs of overheating, despite the fact that assessing the extent of the overheating in the Estonian case was initially complicated by an overly negative preliminary Q2 2007 GDP relase, which cited figures that were subsequently revised substantially upwards. I have addressed some of these questions in this post, and Claus had dealt with the external balance sheet position in this note here.

Slowing Down Nicely?

When we come to look at the details we can quickly appreciate that the Estonian economy certainly does show some clear signs of slowing, as can be seen from the GDP quarterly growth rates:

Also, and according to data from Statistics Estonia, industrial production increased in August 2007 when compared to August 2006 by only 4.4%, a pace which which was slightly down from the annual 5.2% increase recorded in July, and indeed the year on year rate of output growth has been slowing now since April, as can be seen from the chart.

But other data show if not a completely different picture, at least a more qualified one. If we look at retail sales for example, and again according to Statistics Estonia, we find that in August 2007 retail sales were up 13% year on year over August 2006. This rate is actually down on those registered earlier in the year, but it is still very high.

Actually, compared to July 2007, the level of retail sales in August was more or less stationary:

And again if we look at the monthly annual change figures, the rate of increase is clearly slowing.

Wage Push Inflation?

One big part of the underlying isssue here is undoubtedly strong wage-cost push inflation, of the old school kind. If we look at the quarterly chart we can see that though the rate of annual increase in wages and salaries has fallen back somewhat in the second quarter from the first, it is still very substantial:

Now if we move on to look at producer prices, which is where all the "cost-push" inflation shows up, we can see that these have been rising steadily over the last 18 months, and while they may well now have peaked in terms of the rate of increase, the pace is showing no real sign, up to now, of having eased off to any substantial extent.

The situation is even more problematic if we come to look at the rate of producer price increases in the export sector:

The reason this situation is so problematic is the impact that this sustained inflation on producer prices is bound to have on Estonia's ability to export, especially given that the kroon is effectively pegged to the euro, so prices cannot adjust via a downward movement in the currency.

We can perhaps get a point of comparison if we take a look at what has been happening in Hungary. The Hungarian economy has certainly been undergoing a "correction" since the autumn of last year, internal demand is down very sharply, and while domestic inflation remains stubbornly high - though not as high as Estonia's - export prices show a completely, and much more desirable pattern, since wage deflation has been very significant in Humgary.

Here is the chart for month-on-month changes in domestic sales prices and export prices in Hungary:

and below are the equivalent year on year changes. What we can observe is that there is now a very strong disinflationary process at work in Hungary, a disinflationary process which has yet to be seen in Estonia, or for that matter in the Baltics generally.

Now I think I need to be clear here, since I am certainly not recommending the kind of strong wage deflation they are having in Hungary as a preferred recipe for the Baltics. I am simply trying to suggest that this problem exists, and must eventually be addressed, either by coming off the peg, or by other means. There are even doubts in the Baltic acses that wage deflation as such could be operated, given that omnipresent danger of increased outward migration is bound to make wages and prices more "sticky" than in the Hungarian case (where among other things out-migration has not been present to any significant extent, at least to date it hasn't).

What I am suggesting is that there may well be other ways available to address the problem, even if they do involve "unconventional tools" and "out of the box" thinking. One of these unconventional measures would certainly be a flexibilising of the labour market through a significant and substantial opening to international migrant labour. In order to work this opening would have to be large scale, and should not simply be confined to skilled worker categories. At the end of the day, it is a question of which you prefer, to be flayed alive by systematic wage deflation (and all the problems of out migration that this might produce) or a rapid transition to a modern multi-cultural society. There are not many other options to play around with here I think. And time is pressing.

Now, returning to what I said above, the reason why all of this producer price inflation is so problematic for Estonia is the corrosive impact that it has on Estonia's ability to export its way out of difficulty. This impact is evident enough if we take a look at the recent evolution of the external balance in goods and services for Estonia:

Not a pretty picture, is it? And again, the dimension of this problem becomes even clearer when we come to look at this deficit as a share of GDP:

Well, according to Eesti Pank (Estonia's National Bank, see link above):

The average goods and services export growth rate has been fast, although the situation varies by groups of goods and by markets. Although the growth rate of merchandise exports slowed considerably at the end of 2006 and at the beginning of 2007, we are mainly speaking about the so-called transit goods. When we leave aside transit and the subcontracting sector, there are no reasons to assume the competitive ability of other sectors has substantially declined.

This assessment of the situation seems fairly reasonable when we take into account the impact of accelerating producer price inflation and its impact on competitivity. As we can see from the chart below, both exports and imports "peaked" back in May, and this peak in exports occured despite an extraordinarily favourable environment from an external point of view. This is not what should be happening in the case of a "correction". Domestic demand should, of course, be weakening, but exports should be beginning to play an increasing part in maintaining aggregate demand, otherwise this situation simply shows us that Estonia is moving steadily off into a recession, but since the currency cannot adjust, it is not clear where the actual correction to bring her out of the recession again is to come from here. Unless, of course, the recession produces a very sharp deflation in wages, but isn't that exactly what everyone would mean by a hard landing? (ie a strong recession accompanied by a long and sustained period of wage deflation). As I say in my original post I am simply not clear what kind of vocabulary register is being used by many of the participants here. Indeed, I would venture to say that the people who are using this vocabulary are themselves no more clear than I am.

Labour Shortages The Core of the Problem

Again according to Eesti Pank

In spite of slower economic growth, the number of jobs increased, although more sluggishly than before. In the second quarter of 2007, 1.3% more people worked in Estonia year-on-year. Employment increased to 62.9% of Estonia's workforce and the unemployment level fell to 5%.

This is precisely the problem. Even though the growth rate is slowing, the process of labour market tightening continues. This is due to the fact that there is no inbuilt correction mechanism in the labour market due to the shape of Estonia's population pyramid.

What do I mean by this? Well let's look at some more of those charts. Firstly annual unemployment rates in Estonia:

As we can see, these have been steadily coming down since 2000. Now lets look at the numbers of available unemployed:

As we can see the numbers of people registering as unemplyed and seeking work has dropped steadily since the end of 2000. At the same time the number of people working has steadily risen, as is only to be expected given the strong rate of economic growth.

So it is this path which is not sustainable, especially when we take into account that participation rates have also surged strongly.

As we can see the participation rates for older workers is now quite high by international standards, especially when we consider the compartaively low male life expectancy of around 67. Now if we come to look at youth unemployment:

We can again see that the rate of youth unemployment has been declining steadily since the start of 2005. And it is important to remember that these percentages are on a reducing total youth population as can be seen from this, the last chart in this series, which shows how the 0 to 14 age group - or if you like tomorrows young workers and labour market entrants - has been steadily declining as a proportion of the total population since the early 1990s and it is the impact of this steady reduction that is now about to make itself felt.

So there we have it. I basically don't see how - whether you talk in terms of hard landing or soft landing - the Estonian economy is ever going to "correct" unless this structural issue is addressed.

The macro imbalances we are refering to here are substantial, and as I have tried to argue at some length here, they stem from a virtually unique set of circumstances (historically unique I mean, at the present time the underlying dynamic across all the East European EU member states is remarkably similar, with the possible exception of Hungary). Estonia is facing, at one and the same time, a massive inflow of external funds, and a significant reduction in its potential labour supply after years and years of below replacement fertility. Put another way, demand side factors are increasing rapidly, while supply side capacity not only is unable to keep pace, it is actually shrinking (if we think about the number of people of working age).

So there are two problems to correct here, and they are both large and important. Essentially Estonia needs:

a) more labour supply, both skilled and unskilled
b) a lower rate of inflow of structurally distorting funds, whether these be bank credit, remittances, or even (possibly, this needs investigating further) EU funding for projects which Estonia cannot reasonably expect to carry through in the time horizon outlined, given the capacity constraints.
c) more Foreign Direct Investment to create value creating jobs, especially in manufacturing and services areas with export potential
d) increased spending on education and training projects to upgrade the human capital of the existing population

In this post I have been talking about Estonia, but we could just a well have been speaking about Latvia or Lithuania, about Romania and Bulgaria, and - if nothing is done of an international level to address the problem - in the not too distant future about Poland and Ukraine. If we simply sit back and wait for the crunch to come here, then quite frankly it will, and the end product of all that negligence will be much more significant than many seem to currently appreciate.

Tuesday, October 2, 2007

World Bank Report on EU10

by Claus Vistesen

cross posted from Alpha Sources

As my regular readers no doubt will have noticed I have been very preoccupied with Eastern Europe and the Baltics recently in the light of the rather peculiar and unique situation some of these countries might end up finding themselves in given the ongoing uncertainty in financial markets and in fact also the global economy. Now, I intend to stay preoccupied as it were and e.g. at some point soon I will be expanding my ongoing analysis of Lithuania. However, this time around I am not presenting my own analysis but rather pointing towards a recent report by the World Bank on EU10 (get main points in PDF here) which also takes on the recent economic development in the Baltics and Eastern Europe both from the point of view their own individual developments but also in the light of recent events in financial markets which, as I have argued, have tended to bring the region's issues rather more quickly to the front end of the debate than perhaps could have been expected.

The report progresses with great vigour and data sampling although of course I feel tempted to launch my traditional reservation regarding the fallacy of not, even with the faintest sentence, mentioning the underlying demographic dynamic of the region. This is especially odd given that, at least, part of the report's emphasis is on the region's labour market dynamics. On this, the report does not add much to the general story we get from the media and other economic analysis sources save perhaps one important point which relates to the underlying (un)sustainability of the growth in wages on the back of dwindling capacity as labour markets tighten not only overall but also crucially in key sectors. In this way the report puts numbers and words on something which I guess we all knew but have rarely emphasised ...

In all countries apart from Slovakia and Slovenia, wages are growing faster than labor productivity. Rising unit labor costs (see Chart 28) 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.

Apart from this and as a general qualifier to the general discourse on the labour market I would clearly also add that we need to factor in demographic trends in the form of a sustained drop in fertility since the beginning of the 1990s which is now taking its toll as well as a sustained process of outward migration from many countries to Western Europe.

There are of course a lot of other interesting points and charts and I can widely recommend you to visit the report for a closer look. However, before I leave you I want to point one more interesting point from the report which relates to the financing of the current account deficits of some of the countries in question in Eastern Europe. Now, I know that this might seem to be a technical detail but in fact it is not in this case but rather pretty important. Here is the key quote ...

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 point links up quite well with my recent analysis of the risk of so-called balance sheet exposure in Lithuania in connection with the risk that the currency peg could come under pressure. The main venue of my analysis is of course the stock of credit expansion to households and cooperations and not so much a flow analysis as is the case with the World Bank's report. However, as we can see these two things (stocks and flows) are of course related and as such we see that especially in the Baltics the hefty increase of the stock of credit/loans outstanding (using Lithuania as a proxy) is closely tied to the flow composition which finances the three countries' current account deficit. Coupled with the exchange rate exposure which could potentially emerge if the pegs were tested the Baltic countries seem to be harboring a rather nasty mix of fundamentals in the context of the external financing. Finally, it should never escape your attention that all this of course is closely tied to the ongoing turmoil in financial markets since, as per definition given the situation described above, a substantial part of the increase in credit stocks has been supplied by foreign banks and as we have all witnessed in recent weeks risk aversion is set to rise significantly among those banks who have been most aggressive in the cycle which now seems to be ending. In the case of Lithuania the first shot already seems to have been fired across the bow as Swedish owned Hansabank for example already seems to be seriously contemplating its positions in the Baltics ...

(Quote Bloomberg)

AS Hansapank, the biggest Baltic lender, will diversify its credit portfolio in Lithuania after an economic boom in neighboring Estonia and Latvia caused credit to soar dangerously high, Chief Executive Officer Erkki Raasuke said.

Hansapank, 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, Raasuke said in an interview in Tallinn yesterday. It has not done so yet because Lithuania's expansion trails growth in Latvia and Estonia.

The economies of Lithuania, Latvia and Estonia are among fastest growing in the 27-member European Union, creating a boom in credit and raising warnings that growth may be overheating. The global credit crisis adds to concerns about a Baltic regional ``meltdown,'' prompting banks to take steps to limit lending.

``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, 36, 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.''


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.

Two joint applicants would need a combined income of 10,000 krooni, compared with 7,500 krooni required previously. The bank last changed the requirements four years ago.

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

So, the lemon is getting squeezed as I type; let us hope indeed that the wring won't suck out all the juice.