Facebook Blogging

Edward Hugh has a lively and enjoyable Facebook community where he publishes frequent breaking news economics links and short updates. If you would like to receive these updates on a regular basis and join the debate please invite Edward as a friend by clicking the Facebook link at the top of the right sidebar.

Friday, July 27, 2007

Lithuania to Balance Budget By 2009 to Adopt Euro

From Bloomberg Today:


Lithuania to Balance Budget By 2009 to Adopt Euro, PM Says


By Boris Cerni

Aug. 27 (Bloomberg) -- Lithuania, the only European Union nation to have its euro-adoption bid rejected, will balance the state budget as early as 2009 it to make the currency changeover, Prime Minister Gediminas Kirkilas said.

Lithuania, the largest of the EU's three former Soviet Baltic nations, reported on Aug. 10 that it collected more revenue than projected in the first seven months of the year on improved tax collection, while the shortfall amounted to 0.5 percent of gross domestic product in the first half, already within EU limits.

Lithuania and its Baltic neighbors Estonia and Latvia are struggling to slow inflation after their plans to be the first former communist countries to join the euro region were thwarted last year. Wiping out the budget gap in Lithuania would help quell government spending and inflation, giving it a second chance to take on Europe's common currency.

``The main point of our policies is that we will have a balanced budget in 2009 or the latest in 2010 and when that happens we will be ready to adopt the common currency,'' said Kirkilas in an interview at the Bled Strategic Forum in Slovenia yesterday.

Slovenia is the only eastern European nation that joined the EU in 2004 to have adopted the euro. Slovakia is due to be the second, in 2009.

Lithuania's annual inflation rate was 5.1 percent in July, the highest since 1998, as energy costs for households increased. All new EU members have to adopt the euro once they meet criteria on inflation, budgets, debts and stable exchange rates.

Adoption Rules

To do so, they must first bring inflation down to within a 1.5 percentage points of the 12-month average inflation rate of the three EU nations with the slowest annual consumer-price growth. That limit was 2.6 percent in July, while Lithuania's 12- month rate that month was 4.5 percent.

They also must keep debt to within 60 percent of gross GDP and deficits to within 3 percent of GDP.

``We had a pickup in inflation because of taxation and higher prices for alcohol and tobacco,'' Kirkilas said. ``Energy prices have been the main driver of inflation and have increased on average between 25 and 30 percent from the start of the year.''

The three Baltic states are under threat of an economic collapse because they their growth is among the fastest in the 27- nation EU.

Lithuania's economic growth slowed to a preliminary 8 percent in the second quarter from 8.3 percent in the first quarter. Estonia's growth rate was 7.3 percent in the period, while Latvia's expansion, at 11.3 percent, was the fastest in the EU. By comparison, the euro zone's growth rate was 2.5 percent.

Worsening Outlook

Standard & Poor's Ratings Services lowered Lithuania's rating outlook to negative from stable, citing a higher risk of a ``hard landing'' due to a wide current-account deficit and accelerating inflation. The current-account deficit shrank in June to 201.6 million euros ($276 million) from 383 million euros in May after imports slowed.

Kirkilas dismissed concerns about accelerating growth, predicting a steady slowdown.

``I do not see that danger as economic growth will slow to 6.5 percent next year, then 6 percent in 2009 and around 5 percent in 2010,'' Kirkilas said.

Thursday, July 26, 2007

Latvian Population Dynamics

I seem to be having a Latvia week. I gave a long post on Global Economy Matters analysing the current serious wage and price inflation problem the country is having, and a shorter summary post (more accessible if you are not an economist) on A Fistful of Euros which really tries to draw attention to why the problems this comparatively small country (population around 2 million) is having may be significant and interesting for people to think about in a much more general context.

The issue is labour supply and economic growth (what Claus and I call the "capacity problem"), and how a very tight labour supply in Latvia is producing an astronomical 33% annual increase in wages. The problem is basically how a society which has experienced strong out-migration and lowest-low fertility during an extended period can sustain strong economic "catch up" growth (which of course all the Eastern European societies need if they are to come anywhere near the per capita incomes of Western Europe) given the constraint that is produced on new labour market entrants.

Basically, economies can grow in one of two ways. They can either grow horizontally (by expanding economic activity in existing product categories) or the can grow vertically (by moving up the value chain). The problem is that it is a lot more difficult to achieve rapid vertical growth in a short period of time, since moving into new economic activities is, by its very nature, a comparatively slow process given that new human capital needs to be formed, experience needs to be gained, and learning-by-doing needs to take place. Thus bottlenecks inevitably arrive (Indian outsourcing growth would be one good current example of this issue). So during the initial periods of catch-up growth it is normal that horizontal growth plays an important part (this process is what economists tend to call the initial accumulation of inputs). This was clearly the experience, for example, in the classic case of the Asian tigers, were it is clear that strong productivity driven growth only took place at a later stage (China may now be about to become another example of this).

But the problem for countries like Latvia is they do not have the latent human resources to really get the benefits from this "inputs accumulation" process. At comparison of the Latvian projected population pyramid changes 2006-2025, and the Irish one 1986-2000 (which I have put up here) may help make this clearer.

What follows below is an edited version of the demographic component of my Global Economy Matters post. I think it is also important to note that - as Claus points out in this post - this tendency, which is now making its presence felt in Latvia will soon extend across Eastern Europe and Central Asia, (you can find a chart showing the labour force change projections for these countries between now and 2025 here). All of this takes on a certain importance when we think about the kinds of issues we were discussing in the Polish context (here), and if we look at the present rate of decrease in Polish unemployment. Poland's unemployment rate fell in May 2007 to 13 percent, and this was a decrease of 23% in one year (and Polands economy, remember is "only" growing by 6.5% a year). If this process continues, Poland will have an unemployment rate of 9% in May 2008, 7% in May 2009, 5% in May 2010, and 4% or below in 2011. So within 4 years Poland could hit a growth-constraint wall. This is all remarkably rapid indeed. Of course, growth may falter, but in which case it is hard to see how Poland can ever catch up with Western Europe. This is a race against time in some ways, before a window of opportunity closes.

Russia itself is already feeling the pinch, and out further East Azerbaijan's economy is growing at 35% a year. In the Russian case, John Litwack, the World Bank's chief economist in Moscow, estimates that Russia is going to need about a million migrants a year.

To compensate for this(the labour force decline, EH), Russia would need an annual inflow of 1 million immigrants, which is three times as the average official annual flowover the last 15 years, and five times the official flowin recent years.


Latvia, Fertility, Migration and the Labour Supply



So how big is Latvia's demographic problem? Well to try and get some sort of appreciation of the order of magnitude here we could think about the fact that during 2006 Latvian employment was increasing at an annual rate of around 70,000, while if we look at live births for a moment, we will see that since the early 1990s Latvia has been producing under 40,000 children annually (by 2006 this number is down to 21,000 (as the chart below makes clear).



Indeed ex-migrant flows, the Latvian population is now falling (by 0.648% annually according to the 2007 edition of the CIA World Factbook), and at a significant rate (the birth rate is at a very low level, 1.3TFR in 2006 according to the Population Reference Bureau). Taking into account uncertainties about out-migration (which is almost certainly greater then is reflected in the official statistics) in fact the rate of decline might be even greater.

At the same time the internal employment situation is becoming ever tighter, with unemployment levels becoming ever lower (see chart below, data 2005, and Q1 2005 through Q3 2006).

(please click over image for better viewing)


As can be seen in Q3 2006, employment was increasing at a rate of 7.2% (y-o-y), while the unemployment rate was down to 6.2%. Put another way, an increase in employment of some 75,000 had produced a reduction in the unemployment rate of 2.5% (or about 30% of the registered unemployed). It doesn't take sophisticated mathematics - or "robust" models - to see that this cannot last.

One solution is obviously to try and increase the level of labour market participation, but - and it is interesting that almost no-one here seems to be talking about the need for labour market reforms - it is hard to estimate just how much potential in reality there still is for this. According to the Latvia Statistical Agency Q2 2006 labour force report:


In Q2 2006 more than a half (63.8%) of residents in the age from 15 to 74 were economically active – this indicator was 68.9% amongst males, and 59.4% amongst females. in the 2nd quarter of 2006, the number of economically active population, in comparison with the corresponding period of 2005, increased by 2%.


These numbers, since they include everyone up to 74, and many under 20 - an age where education may still be taking place in many cases - are really very hard to interpret. But whichever way you look at it there is certainly a problem, since wage increases of this order would normally be considered to motivate more labour to come into the market, were it available. However, before going into this labour market structural bind in greater depth, let's take a look at some more of the details of the general economic dilemma.


Migration As A Solution?

Well given that a strategy of relying exclusively on fiscal tightening and strong deflation (as is being recommended to the Latvian government by a variety of sources) is fraught with risk, another possibility which should be seriously considered would be to apply a determined policy mix of both decreasing the rate of economic expansion and increasing capacity by loosening labour market constraints somewhat via an open-the-doors policy towards inward migration and with the active promotion and encouragement of an inward flow of migrants from elsewhere in Eastern Europe (or further afield). This would seem sensible, and even viable given the fact that Latvia is a pretty small country. However, as Claus Vistesen notes here, this can only be thought of as an interim measure, since, as the World Bank has recently argued, all the countries in Eastern Europe and Central Asia are effectively condemned to face growing difficulties with labour supply between now and 2020 (so in this sense what is now happening in Latvia may be an extreme harbinger of the shape of things to come). But given this proviso it is clear that a short-term inward migration policy may help Latvia escape from the short-term vice it seems to be in the grip of. This short term advantage may be important, since longer term solutions like increasing the human capital component in the economy and moving up to higher value activity need much more time, and what is at issue here is transiting a fairly small economy from an unsustainable path to a sustainable one.

However Latvia certainly faces difficulties in introducing a pro-migrant policy. One of these is that such a process may ultimately put downward pressure on unskilled Latvian workers wages in a way which only sends even more of the scarce potential labour Latvia has out to Ireland or the UK. A recent report by the US Council of Economic Advisers made some of the issues involved relatively clear. The report cited research showing immigrants in the US on average have a “slightly positive” impact on economic growth and government finances, but at the same time conceded that unskilled immigrants might put downward pressure on the position of unskilled native workers. Now in the US cases these US workers are unlikely to emigrate, but in Latvia they may do.

A further difficulty is the lack of availability of accurate data on the actual scale of either inward or outward migration in Latvia (this difficulty is noted by both the IMF staff team and the Economist Intelligence Unit). On the latest estimate from the Bank of Latvia some 70,000 Latvians, or around 6% of the labour force, are currently working abroad - mostly in the UK and Ireland - but the true number is very likely considerably higher (IMF Selected Issues Latvia 2006, for example, puts the figure at nearer 100,000).

Several recent surveys also suggest that the potential for outward migration remains substantial. For example, a survey conducted by SKDS (Public Opinion on Manpower Migration: Opinion Poll of Latvia’s Population) in January 2006 revealed that about 22 percent of Latvian residents see themselves as being either “very likely” or “somewhat likely” to go to another country for work “in the next two years”. Based on the current estimated population, this translates into between 350 and 450 thousand residents (between 15 and 20 percent of the 2005 population). The survey also indicated that these respondents were significantly skewed toward the relatively young (15-35), which would significantly reduce the working-age population and labor force in the near future. These respondents were also slightly more likely to be male, less educated, low-income, employed in the private sector, or non-Latvian.

But there is a second issue which immediately arises in the context of projected in-migration into Latvia, and that is the situation vis-a-vis the presence of large numbers of Russophone Latvian residents who are non-citizens. The issue can be seen in the table below.

(please click over image for better viewing)




Essentially out of a total population of 2,280,000, only 1,850,000 are citizens. Of the remainder the majority (some 280,000) are Russians. And these Russians are not recent arrivals, but they are a part of a historic Russophone population which build up inside Latvia during the period that the country formed part of the Soviet Union.

In fact, if we look at the chart below, we will see that during 2003 the rate of out migration from Latvia seems to have dropped substantially, and given what we know about the post 2004 out migration boom, this, on the surface, seems strange.

(please click over image for better viewing)



The answer to this puzzle is to do with the Russophone population who are not Latvian citizens (and therefore logically at this point not EU citizens either). The majority of the pre 2004 out-migration was actually towards the CIS, and it is reasonable to assume that many of these migrants came from the Russian speaking population. And this process is not over as this recent article from Itar-Tass about a joint project to settle Russian speaking Latvian residents in Kaliningrad makes clear.

So clearly the fact that the Latvian authorities may still be actively considering encouraging the resettlement of Russian speaking Latvian citizens elsewhere gives an indication of just how unprepared the collective mindset in Latvia is for all that is now about to come upon them.

Yet one more time the difference with Estonia couldn't be clearer. According to the Baltic Times this week, Estonian Economy Minister Juhan Parts is busy working on a set of proposals - which before Parliament by November - which will attempt to address Estonia’s growing shortage of skilled workers. The quota of foreign workers will be doubled to about 1,300 and the bureaucratic paperwork slashed . Now it is true that Parts is still to bite the bullet of accepting the need for unskilled workers too, but in the present situation a start is a start, and it is one that Latvia has yet to make.

Wednesday, July 25, 2007

The Latvian Economy

Something is afoot in Latvia. Being alerted by reports which have appeared in the press in recent days to the very rapid rate of wage increases they have been experiencing there I decided to dig a little deeper, and in the process I came across this recent IMF statement on Latvia, where I read the following:


"Latvia, like other recent EU entrants, has benefited from an accession-related boost to income convergence....."Recently, however, fast credit and wage growth has caused the economy to diverge from a balanced and sustainable growth path, with domestic demand outstripping Latvia's supply capacity. As a result, overheating has intensified, bringing higher price and wage inflation, a sharply wider current account deficit, and greater external indebtedness. Rapid credit growth in euros has left large currency mismatches on the balance sheets of households and corporates and a boom in housing prices that has diverted resources from the tradable sector. A pervasive "buy now-pay later" mindset has settled in and is heightening systemic risk. These developments, if not tackled firmly, will thwart a recovery of export growth."


"There is an urgent need for decisive action to unwind overheating pressures and narrow external imbalances by sharply curtailing domestic demand. Notwithstanding actions by the Bank of Latvia to raise risk awareness, recent pressure on the lats signals growing investor impatience with the limited policy response so far. A comprehensive strategy is therefore needed to curb domestic spending and wage growth, and moderate real estate prices to rebalance incentives for investing in tradables sectors."



What now follows is a long (very long, even by my recent standards) post which examines the core features of Latvia's current economic malaise. It is generally recognised by most external observers that this malaise has its origins in structural problems in the Latvian labour market, and it will be argued here that these structural problems have their roots in recent characteristics of Latvian demography (namely high out-migration and a sustained low birth rate). As such there is no easy solution. Even in the longer run the position will inevitably be difficult, since demography almost inevitably casts a long shadow. This does not mean, however, that we should be complacent. There are steps which can be taken to address the issues which Latvia faces in the short term, and it is important that such appropriate measures are enacted. These measures clearly include policies to reduce the dramatic overheating which is taking place, but they also should include policies to loosen the labour supply, not only by encouraging increased labour market participation and mobility, but also by actively encourage inward migration. Such policies may be seen as short term measures which are vital to move Latvia away from an unsustainable and towards a sustainable economic path.


The Measure of the Problem

As I have said, and previously noted in this post, according to the latest Eurostat data, wages and salaries in Latvia rose in Q1 (as compared with a year earlier) by an astonishing 32.7%. This rate of increase is, in and of itself a symptom of something important, and is clearly unsustainable.

For a simple coverage of recent developments this recent Bloomberg article gives a useful summary of the underlying dynamic involved.

According to Alf Vanags, director of the Baltic International Centre for Economic Policy Studies, and Morten Hansen, an economist at the Stockholm School of Economics (in this BICEPS report) "Latvia's inflation, the fastest in the European Union, will continue to erode the competitiveness of the country's' exports as it shows no sign of slowing"

In fact Latvia's inflation rate (CPI, see Graph below) reached a 10-year high of 8.9 percent in April 2007, largely driven by growth in wages and producer-prices.

(please click over image for better viewing)




As a consequence of this wage and price growth the competitiveness of Latvia's exporters has been so eroded, and the trade balance so negatively affected (see graph below), that the economy is now destined either to go through a very long period of deflation, or to undergo a substantial devaluation of the currency in order to put the ship back on an even keel. But if the Latvian government were to opt for the latter course we would hit a problem, since the traditional route for correcting such a deficit - letting a currency freely float (the Lats has been loosely pegged* to the Euro since early 2005) and raising interest rates - is not so obviously open here. In today's perverse world of global liquidity and international capital flows it could well be that any increase in central bank interest rates would simply suck-in even more funds in a steady and ongoing search for yield. Appetite for risk might not be reduced by the appearance of non-sustainability since - and this would be the big initial difference from say Turkey in 2006 - the EU and the ECB are ultimately seen as guarantors of the last resort for the Latvian economy. So effectively the situation could turn into a battle of wills between speculators looking for yield and the EU institutional structure.

( *The Latvian currency, the Lats, is allowed to move by plus or minus 1 percent around a midpoint against the euro. The lats is currently worth somewhere around 1.43 euro).

As can be seen from the graph below, Latvia's current-account deficit has more than doubled over the last two years, and the quarterly current-account deficit, for example, grew from around 10% of GDP in Q1 2005 to 26% of GDP in Q1 2006.

(please click over image for better viewing)



Thus Latvia now has the somewhat dubious merit of having the fastest growing economy, the highest inflation, and largest current-account deficit in the 27-nation EU. Since the country has a fixed exchange rate (which could be made more flexible, although, as we will, doing this in itself raises as many problems as it could solve, since the currency could just as easily be lead to float up as down), and raising interest rates may well only draw even more liquidity into an economy where the majority of consumer credit expansion is now in non-Lats denominated loans (70% of domestic credit is now denominated in euros), the Latvian government is really only left with fiscal policy as the major instrument with which to try to correct the growing internal and external imbalances.

As Lars Christensen, senior economist at A/S Danske Bank (who is quoted by Bloomberg) says: "Money supply and credit growth have created a property bubble. What has fueled growth and credit has been cheap liquidity, globally rather than locally."


An Anti Inflation Programme?

So what do we have here? Well, despite considerable talk and concern, the inflation problem in Latvia has not gone away in recent months, if anything has intensified. The Latvian government do seem to be as concerned as anyone, and on the back of the problem have set up a working group on inflation, which published its current anti-inflation plan in March, and which, according to the Bank of Lavia, "continues to monitor the situation". Despite strong prodding from the IMF, the aims of Latvian government policy as contained in the report - and summarized by the Finance Ministry here - are surprisingly modest given the severity of the situation, namely:

i) to maintain a balanced budget (ie, neither deficit nor surplus) for 2007, and attempt to attain a surplus by 2009/10.
ii) to impose a real estate tax on properties sold which have been owned for less than 3 years;
iii) to attempt to make it more difficult to obtain credit by, for example, requiring commercial banks and leasing companies to better determine the purchasing power of customers and to make loans available exclusively on the legal income of clients;
iv) to exercise better control over energy prices
v) to introduce measures aimed at increasing labour market participation and increasing productivity, as well as product-market-competition reforms. As the summary says, these last items are by their very nature long term, and as such hardly appear to form a core part of the "crisis" short term package.

All in all then, an extraordinarily relaxed programme it would seem under the circumstances.

Now (as indicated above) both wages (32.8% growth y-o-y in Q1 2007) and producer prices (16% - 18% growth y-o-y in early 2007) have been accelerating recently with wage growth being estimated to feed into producer prices with a lag of approximately 15 months. This increase in producer prices in turn then feeds into export prices, and the consequence is a continuing and sustained loss of international competitiveness.

Now the existence of this evident feed through between wages and producer prices means that there is now a wide consensus (both inside Latvia itself and among international observers) that the inflation problem cannot be addressed separately from the imbalances which exist in Latvia's internal labour market (imbalances to which outward migration in the early years of this century and many years of below replacement fertility - see below - have contributed in no small way). Since the recent surges in producer prices and wages point to further inflation in the pipeline, and no easy end in sight the BICEPS report authors referred to above conclude that we face the possibility "that the Latvian economy has shifted from a position of simple overheating to something more serious in structural terms".


Monetary Policy

Nowhere are the difficulties facing the Latvian authorities better illustrated than in the field of monetary policy. The Bank of Latvia has been steadily raising the refinancing rate, especially after it became apparent that Latvian economy was continuing to grow very rapidly, and that part, at least, of the reason for this was the boom in bank lending,. The rate was raised to 4.5% in July 2006 and to 5% last November. As of May 2007 the rate is 6%. At the same time the ECB has also been lifting its refinancing rate, from 2.25% to 3.5% in 2006, to the current (June 2007) rate of 4%, and this level now appears to be not too far from the peak. What this effectively means is that there will not be too much further room for increases from the BoL without taking the risk of precipitating substantial speculative inward capital flows, and in the process putting upward pressure on the euro peg (an indication of how this might work can be found in the fact that in the week of 18 June 2007 the Bank of Latvia found itself forced to intervene and sell Lat to buy Euros (28 million euro worth in that week) to try and take some of the upward pressure of the peg. This process has effectively been taking place off and on all year).

Of course, since Latvia's new inflation targets now lie well above the ECB criteria for some time to come (see the chart below, which comes from the Ministry of Finance summary of the anti-inflation package), the close alignment with the euro could be considered to be unnecessary at this point, and indeed a substantial devaluation in the currency might be thought to be a more palatable alternative to a hefty dose of deflation, were such a devaluation possible.


(please click over image for better viewing)

Now I say were such a devaluation to be possible, since it isn't exactly clear whether, as long as the EU institutional structure and the ECB maintain their effective underwrite guarantee of Latvian solvency, the funds inflows which followed any loosening of the peg (or even hint of its possibility) might not well have the counter-productive effect of pushing the Lat even higher. In this situation what would effectively result would be a battle of wills between EU institutions and the international financial community, and I imagine that everyone (at least at this point) would rather avoid this eventuality.

Given the clear difficulties which the Latvian government face in using currency and interest rate measures many observers have reached the conclusion that, at the end of the day, the only measures which are now available to the them effectively boil down to fiscal ones. What this implies is that the Government's inflation plan can only generate a larger or smaller contraction of domestic demand depending on the severity of the fiscal contraction introduced. This whole position was more or less explicitly accepted by the IMF staff team who visited Latvia in April 2007 (see full reference below):

"Against the balanced budget targeted in the anti-inflation plan, we consider that a headline general government surplus of 2.25 percent of GDP in 2007 and 4 percent of GDP in 2008 is appropriate. This could be achieved by saving in full revenue overperformance, restraining current and capital expenditures, and abstaining from cuts in taxes, including the personal income tax."

So what the IMF are effectively recommending is a budget surplus of between 2.25% and 4% of GDP. This is pretty hefty, but, even if it were to be implemented, would it be enough? This I think is very hard to say at this stage, but there are reasons for thinking it may well not be, in particular given the strength of consumer demand for credit from external sources (to give some idea of the strength of this, it may be worth noting that M2 was increasing at an annual rate of around 38.5% in 2006). At the same time if it is sufficient to give the shock which is evidently required, is there not the danger at the other extreme of overshoot, and that the impact of administering this non-lethal dose might still render the patient unconscious semi-permanently?

I ask the "would it be enough" question in a somewhat obtuse way above, since it is apparent that the Latvian government, which is hardly keen on inducing large scale unpopularity for itself by curtailing the perceived benefits of a booming economy by using deflation to - even temporarily - sharply lower living standards, remains reluctant to tighten fiscal policy in the way the IMF recommends. This I think would be the key point to note about the "anti-inflation" programme mentioned above. For the time being they are content to settle for a neutral balance budget, and this almost certainly will not be enough to quench the fire.

Thus it is not clear at this stage what institutional architecture there is in place to constrain any Latvian government at this point. Certainly the IMF itself no longer carries any real clout, and the EU Commission may also have cut Latvia adrift in a way they never intended when they pushed back over the horizon Latvia's euro membership (and here). Devil-may-care heterodox policies it seems are not only possible in Brazil and Thailand these days.

Government Spending and the Consumer Boom


An examination of the following chart may well help us put things in perspective insofar as the ability of a fiscal surplus of the magnitude being recommended by the IMF to achieve it's intended result.

(please click over image for better viewing)




As can be seen government expenditure was running at something just under 900 million Lats per quarter in 2006, while GDP was running at something just over 2000 million Lats per quarter, which gives us a figure of around 45% of GDP for government spending. As such a 4% GDP surplus is large, since it amounts to either a tax increase of 8 to 10% of total revenue, or a reduction in spending of an equivalent order, or a combination of the two. This constitutes a relatively large shock to the economy. In addition, in the short term continuing producer price inflation will reduce exports, which constituted 48.1% of GDP in 2006 (so Lavia is relatively open and exposed in this sense) and this can also be expected to slow growth. In the opposite corner, and pushing the other way as it were, we have the future path of remittance flows and bank lending.

Taking remittances first, the World Bank Development Group estimates that remittances into Latvia were flowing at an annual rate of 381 million US dollars in 2005 (or 2.4% of GDP, see table below), but as they note the real numbers are likely to be significantly larger, and looking at growth across 2003-2005 the 2006 and 2007 numbers are most likely up (an estimate of a share of between 4% and 5% of GDP seems not unreasonable).


(please click over image for better viewing)

So this push will continue, and indeed it is even not unreasonable to imagine that if "bursting" the overheating starts to have serious consequences in terms of distress at the individual level in Latvia, then we may well see more money coming in to try and help out family members.

On bank flows, bank’ borrowing from abroad remains by far the largest source of foreign financing for Latvia. If we look the current account deficit we will see it has been growing rapidly (see chart below, data 2004and Q1 2005 through Q3 2006).


(please click over image for better viewing)



By Q3 2006 it was running at a negative rate of 1,269 US$ million, but as can be seen this is effectively covered by other items in the capital and financial account. During the first three quarters of 2006, “for example, other investment” (which is predominantly bank borrowing) arriving in Latvia came to US$3.3bn, which was some US$560m more than the entire current-account deficit for the period.

Evidently such foreign borrowing by Latvian banks ’has increased the external debt position substantially, and at the end June 2006, Latvia'’s net international investment position was some US$11.1bn in deficit, a quantity equivalent to around 80% of nominal GDP. Obviously an inward funds flow running at this level puts a significant cap on the ability of the fiscal measures to achieve their desired effect, and hence the emphasis from the IMF on institutional measures to get the levels of bank lending under control. According to the Bank of Latvia "parent banks of Latvian major commercial banks in Scandinavia have expressed their readiness to reduce the lending growth gradually", however, in Q1 2007 "net loans to Latvian banks reached 23.9% of GDP, a 4.2 percentage point increase over the average of 2006". Well, as they say, it is early days yet.


One of the implications of the structural diagnosis that is being offered (both here, and at the IMF, and by the BICEPS authors) is that implementing the anti-inflation plan will not allow Latvia to simultaneously achieve acceptable inflation, acceptable growth and a positive external balance. It would appear that Latvia has become strapped on the horns of a what is called in the literature a Tinbergen policy dilemma, simply put, and with or without the existing peg to the euro, it simply has too few instruments available with which to achieve its policy targets. (A classic explanation of the Tinbergen dilemma from none other than euro-intellectual father Robert A Mundell - I don't know whether to laugh or to cry at this point - can be found here, while another, and now rather outdated, version of the underlying idea - and one which became pretty fashionable in economic circles in the 1990s - is Krugman's eternal triangle. Obviously in the light of recent developments in the global financial and migration systems this whole literature is now badly in need of an update).


Interestingly - and again according to the BICEPS authors - the latest surge in inflation can neither be blamed on a low initial price base, on EU accession, or on unfavourable exchange rate developments, but is rather the direct result of overheating in the labour market coupled with an ongoing cycle of ever-higher inflation expectations. What the expectations problem means in the present context is that Latvia has become a country with very high (and rising) continuing inflation and Lavia's citizens are now fully aware of this and factor-it-in to wage demands, which in turn add to the production costs of firms and end up in higher prices, which of course then fuel higher wage demands. This is the classic wage-price spiral.


The East-West Wages Gap

Latvia's employment continues to rise, and unemployment remains on a downward path. Employment has been boosted by strong economic growth, and in the third quarter of 2006 the number of people employed reached 1,118,800, up by 7.2% compared with the same period a year before. Employment growth has accelerated, from 4.2% in the second quarter, and currently almost 62% of Latvians between the ages of 15 and 74 are employed"the highest level of employment since 1991. Conversely, the unemployment rate has continued to fall. In the third quarter of 2006 the unemployment rate"calculated according to International Labour Organisation (ILO) methodology"was 6.2%, down from 8.7% in the same period of 2005. Labour shortages are most acute in the capital, Riga, where registered unemployment is below 4%.

In the Latvian case there is one additional dilemma that is not current to the normal Tinbergen policy debate: the wage differential with say the UK or Ireland, and the problem of out-migration. The chart below, which compares the Irish and the Latvian wage distributions may be helpful in seeing the problem:

(please click over image for better viewing)



Now this situation - namely that a period of restrained wage growth may produce yet more out-migration which in turn makes the domestic wage pressure even greater (another kind of 'vicious loop') - is by no means easy to address and as the October 2006 IMF staff report authors note:

Some analysts called for expanding inward migration to alleviate shortages and dampen wage pressures. However, policymakers generally considered that this would have the effect of replacing domestic low-cost workers with imported ones, thereby holding down wages and promoting further emigration.


That is, one solution to the wage increase problem might be to open the frontiers to some extent to migrant labour, but policymakers worry that any resulting flow - being possibly mainly of unskilled workers - might only serve to push down unskilled wage rates and push more Latvian nationals over towards the UK and Ireland. Certainly the Economist Intelligence Unit in its most recent report also noted this issue (January 2007):

The government argues that rapid wage convergence with western Europe is needed to check emigration. On the latest estimate from the Bank of Latvia (BoL, the central bank), some 70,000 Latvians, or around 6% of the labour force, are currently working abroad, mostly in the UK and Ireland.

Of course there is no single clear remedy here, but I think we need to say strongly that this attempt to stem the migrant out-flow by being lax on the wage inflation front is to invite disaster, serious disaster.


Fertility, Migration and the Labour Supply


So the Latvian government is yet one more time here on the horns of a dilemma, and one this time which means they need to run, and keep running, in an ongoing chase to try and catch their own shadow. But how big is their demographic problem? Well to try and get some sort of appreciation we could think about the fact that during 2006 Latvian employment was increasing at an annual rate of around 70,000, while if we look at live births for a moment, we will see that since the early 1990s Latvia has been producing under 40,000 children annually (by 2006 this number is down to 21,000 (as the chart below makes clear).



Indeed ex-migrant flows, the Latvian population is now falling (by 0.648% annually according to the 2007 edition of the CIA World Factbook), and at a significant rate (the birth rate is at a very low level, 1.3TFR in 2006 according to the Population Reference Bureau). Taking into account uncertainties about out-migration (which is almost certainly greater then is reflected in the official statistics) in fact the rate of decline might be even greater.

At the same time the internal employment situation is becoming ever tighter, with unemployment levels becoming ever lower (see chart below, data 2005, and Q1 2005 through Q3 2006).

(please click over image for better viewing)


As can be seen in Q3 2006, employment was increasing at a rate of 7.2% (y-o-y), while the unemployment rate was down to 6.2%. Put another way, an increase in employment of some 75,000 had produced a reduction in the unemployment rate of 2.5% (or about 30% of the registered unemployed). It doesn't take sophisticated mathematics - or "robust" models - to see that this cannot last.

One solution is obviously to try and increase the level of labour market participation, but - and it is interesting that almost no-one here seems to be talking about the need for labour market reforms - it is hard to estimate just how much potential in reality there still is for this. According to the Latvia Statistical Agency Q2 2006 labour force report:


In Q2 2006 more than a half (63.8%) of residents in the age from 15 to 74 were economically active – this indicator was 68.9% amongst males, and 59.4% amongst females. in the 2nd quarter of 2006, the number of economically active population, in comparison with the corresponding period of 2005, increased by 2%.


These numbers, since they include everyone up to 74, and many under 20 - an age where education may still be taking place in many cases - are really very hard to interpret. But whichever way you look at it there is certainly a problem, since wage increases of this order would normally be considered to motivate more labour to come into the market, were it available. However, before going into this labour market structural bind in greater depth, let's take a look at some more of the details of the general economic dilemma.


Producer Prices and Wages


The Producer Price Index measures changes in the price level of most of the manufactured goods produced in a country. The major difference for present purposes between the CPI and the PPI is that the latter excludes imported goods. The recent dramatic upward path which the PPI has followed can be seen in the following graph (Source Biceps report):

(please click over image for better viewing)

In the Latvian case imported goods constitute an important component in CPI since imports account for over half of Latvia’s GDP. Now as we know, inflation in domestically produced goods is very high indeed - currently approaching 20% - while CPI inflation, even though it is now at the highest level for the last decade, is significantly lower due to the low inflation component for imported goods (which is naturally eased, of course, by the way the Lat has been tending to rise in tandem with the euro). The difference in trend for CPI and PPI can be seen in the figure below (source: Biceps report), and it is clear that PPI inflation has been surging much more dramatically than CPI inflation since January 2006.

(please click over image for better viewing)




Now all of this presents rather a large problem when thought of in terms of the international competitiveness of the Latvian economy since a position where the price path of externally produced goods is considerably lower than the price path of Latvian produced goods is evidently not sustainable. And if, as seems reasonable to assume, inflation is being affected by higher expected inflation which workers factor-in to their wage demands, aided and abetted by a perceived tolerance from the Latvian authorities given the migration constraints mentioned above, then the key to all this is clearly the structural issue of the presence of a very tight labour market, and the constraint which this puts on capacity growth moving forward. The result is again very evident: a strong upward pressure on wages which can be seen in the following chart (Source Biceps report):

(please click over image for better viewing)



As the BICEPS authors note, the high degree of similarity (correlation) in the movement of the two graphs (wages and PPI) is striking and suggests that wage growth "is passed on in the form of price increases with a time lag of around 15 months". Again as the BICEPS authors conclude:

"The implication is quite sinister: The current surge in wages has still not shown up fully in inflation but we should expect it to do so later i.e. PPI inflation is very likely to increase and with it to some extent CPI inflation, too. If this is believable, inflation will thus rise before the government’s antiinflation plan may kick in and dampen inflation......The recent surges in wage growth, PPI growth and CPI growth are also worrying in the sense that they seem to indicate a shift in the economy from simply overheated to potentially structurally imbalanced."

So a relatively simple analysis is all that is needed to see clearly that the Latvian inflation problem cannot be addressed separately from the current imbalances in the labour market. As the next section will demonstrate the inflation problem cannot be addressed separately from the imbalance in the external sector either.


Recent Latvian Current Account Deficits


Moving on now to the external position, many things might be said, but one thing is for sure: Latvia’s current account deficit at 21.3% of GDP in 2006 is not a sustainable position. Only 10 countries in the world had higher current account deficits in 2006 than Latvia, and most of these were small island economies with populations of less than 1m (and some of them even as low as 40 000). So it is clear that Latvia’s deficit has become excessive, even by EU8 standards (see chart below).


(please click over image for better viewing)



Latvia in fact was running fairly high current-account deficits throughout the late 1990s (at an annual average of 6.8% of GDP in 1996-2000), but these were mainly financed by inflows of foreign direct investment (FDI) as Latvia steadily sold-off most of its state-owned assets. Since 2001, however, the burden of financing the deficit has moved increasingly towards borrowing (FDI covered 84% of the current-account deficit in 1996-2000, but just 30% in 2001-05), and Latvia's external debt has soared from just 22% of GDP in 1996 to an estimated 112% of GDP in 2006.

But what lies behind the recent substantial deterioration in the current account? The figure below shows developments in the real effective exchange rate (REER) in terms of producer prices against Latvia’s main trading partners:

(please click over image for better viewing)


The key point to note here is the rapid and seemingly accelerating loss of competitiveness which has been taking place in Latvia since mid-2005. This loss of competitiveness is dramatically reflected in the most recent developments in export and import volumes as can be seen in the chart below.

(please click over image for better viewing)



The disconnect that is being produced here is pretty clear even at a simple glance. What is not so clear are the mid term consequences of this evolution.

In the fourth quarter of 2006 the current-account deficit seems to have momentarily peaked at 26.3% of GDP, with the very high reading being mainly the result of a deterioration in the trade balance. According to the Bank of Latvia, the current account deficit in Q1 2007 was running at 25.7% of GDP (see chart below).


(please click over image for better viewing)

Again, as the Bank of Latvia note:

"In the first quarter, total direct investment in Latvia grew by 7.3% year-on-year, covering one third of the current account deficit. The largest part of the current account deficit was financed by borrowing from foreign banks. Reserve assets increased by 45.5 million lats."


Internal Consumption and the Housing Dimension


As we are seeing the Latvian economy is currently expanding at a breathtaking rate, driven by a variety of mechanisms, including negative real interest rates, EU grants, and strong real wage increases. GDP growth averaged just under 12% during 2006, up from just over 10% in 2005. In particular the trend reflects the very rapid increase in household credit as well as sizable spending on EU-related projects and transfers (which nearly doubled to 3.25% of GDP in the first full year of EU membership in 2005). While external demand did contribute positively to growth in 2005, this was really a one-off, with the subsequent strengthening of imports and weakening of exports producing a negative net exports balance from early 2006 onwards.

Rapid financial deepening continues, and with it increasing bank exposures to credit and market risk. Credit to private sector residents grew nearly 65 percent in 2005, and the loan to GDP ratio reached 70 percent, triple the level in 2000, becoming in the process the highest in the EU8. New loans are disproportionately skewed towards household mortgages - which have almost doubled to constitute 20 percent of GDP (although this is still well below the EU15 average of 48 percent) - and such mortgages are increasingly denominated in euros. As a result, housing prices have grown sharply (at an annual rate of about 50 percent through mid-2006: see graph below) and are now at very high levels.


(please click over image for better viewing)


At the end of September 2006 lending to households was up by 80% year on year. It is entirely possible that a housing price bubble has now developed, and one interesting comparison is that while in Estonia and Lithuania house prices did start to stabilise somewhat in late 2006, in Latvia they have continued to rise by about 2% a month. According to the Q1 2007 y-o-y Knight Frank Global House Index, Riga (Latvia's capital) was the global price increase champion, with a staggering 61.2% increase over Q1 2006.

So while the financial soundness indicators for the banking sector remain strong - there are for example very few nonperforming loans (NPLs) and high levels of profitability are being maintained - these measures are in-essence backward looking. With the real estate sector now accounting for around half of total loans, and direct and indirect euro exposure having risen sharply (reflecting both the lifting of limits on open euro positions following the repeg of the lats to the euro and the rapid expansion in euro-denominated loans to mostly-unhedged households) risks have obviously increased.


Migration As A Solution?

Well given that a strategy of relying exclusively on fiscal tightening and strong deflation is fraught with risk, another possibility which should be seriously considered would be to apply a determined policy mix of both decreasing the rate of economic expansion and increasing capacity by loosening labour market constraints somewhat via an open-the-doors policy towards inward migration and with the active promotion and encouragement of an inward flow of migrants from elsewhere in Eastern Europe (or further afield). This would seem sensible, and even viable given the fact that Latvia is a pretty small country. However, as Claus Vistesen notes here, this can only be thought of as an interim measure, since, as the World Bank has recently argued, all the countries in Eastern Europe and Central Asia are effectively condemned to face growing difficulties with labour supply between now and 2020 (so in this sense what is now happening in Latvia may be an extreme harbinger of the shape of things to come). But given this proviso it is clear that a short-term inward migration policy may help Latvia escape from the short-term vice it seems to be in the grip of. This short term advantage may be important, since longer term solutions like increasing the human capital component in the economy and moving up to higher value activity need much more time, and what is at issue here is transiting a fairly small economy from an unsustainable path to a sustainable one.

However Latvia certainly faces difficulties in introducing a pro-migrant policy. One of these has already been mentioned: that this may ultimately put downward pressure on unskilled workers wages in a way which only sends even more of the scarce potential labour Latvia has out to Ireland or the UK. A recent report by the US Council of Economic Advisers made some of the issues involved relatively clear. The report cited research showing immigrants in the US on average have a “slightly positive” impact on economic growth and government finances, but at the same time conceded that unskilled immigrants might put downward pressure on the position of unskilled native workers. Now in the US cases these US workers are unlikely to emigrate, but in Latvia they may do.

A further difficulty is the lack of availability of accurate data on the actual scale of either inward or outward migration in Latvia (this difficulty is noted by both the IMF staff team and the Economist Intelligence Unit). On the latest estimate from the Bank of Latvia some 70,000 Latvians, or around 6% of the labour force, are currently working abroad - mostly in the UK and Ireland - but the true number is very likely considerably higher (IMF Selected Issues Latvia 2006, for example, puts the figure at nearer 100,000).

Several recent surveys also suggest that the potential for outward migration remains substantial. For example, a survey conducted by SKDS (Public Opinion on Manpower Migration: Opinion Poll of Latvia’s Population) in January 2006 revealed that about 22 percent of Latvian residents see themselves as being either “very likely” or “somewhat likely” to go to another country for work “in the next two years”. Based on the current estimated population, this translates into between 350 and 450 thousand residents (between 15 and 20 percent of the 2005 population). The survey also indicated that these respondents were significantly skewed toward the relatively young (15-35), which would significantly reduce the working-age population and labor force in the near future. These respondents were also slightly more likely to be male, less educated, low-income, employed in the private sector, or non-Latvian.

But there is a second issue which immediately arises in the context of projected in-migration into Latvia, and that is the situation vis-a-vis the presence of large numbers of Russophone Latvian residents who are non-citizens. The issue can be seen in the table below.

(please click over image for better viewing)




Essentially out of a total population of 2,280,000, only 1,850,000 are citizens. Of the remainder the majority (some 280,000) are Russians. And these Russians are not recent arrivals, but they are a part of a historic Russophone population which build up inside Latvia during the period that the country formed part of the Soviet Union.

In fact, if we look at the chart below, we will see that during 2003 the rate of out migration from Latvia seems to have dropped substantially, and given what we know about the post 2004 out migration boom, this, on the surface, seems strange.

(please click over image for better viewing)



The answer to this puzzle is to do with the Russophone population who are not Latvian citizens (and therefore logically at this point not EU citizens either). The majority of the pre 2004 out-migration was actually towards the CIS, and it is reasonable to assume that many of these migrants came from the Russian speaking population. And this process is not over as this recent article from Itar-Tass about a joint project to settle Russian speaking Latvian residents in Kaliningrad makes clear.

So clearly the fact that the Latvian authorities may still be actively considering encouraging the resettlement of Russian speaking Latvian citizens elsewhere gives an indication of just how unprepared the collective mindset in Latvia is for all that is now about to come upon them.

Yet one more time the difference with Estonia couldn't be clearer. According to the Baltic Times this week, Estonian Economy Minister Juhan Parts is busy working on a set of proposals - which before Parliament by November - which will attempt to address Estonia’s growing shortage of skilled workers. The quota of foreign workers will be doubled to about 1,300 and the bureaucratic paperwork slashed . Now it is true that Parts is still to bite the bullet of accepting the need for unskilled workers too, but in the present situation a start is a start.


Towards A Policy Driven Exit


So what is the remedy? Well, lets look again at the IMF proposals:

a) Fiscal policy: Against the balanced budget targeted in the anti-inflation plan, we consider that a headline general government surplus of 2¼ percent of GDP in 2007 and 4 percent of GDP in 2008 is appropriate. This could be achieved by saving in full revenue overperformance, restraining current and capital expenditures, and abstaining from cuts in taxes, including the personal income tax.

b) Credit and prudential policies: Sharply curtailing and improving the risk profile of new lending is essential to mitigating macroeconomic and financial stability risks. Rebalancing incentives governing credit growth is therefore essential. The mission supports the effective implementation of the credit-restraining measures in the anti-inflation plan, including fully documenting legal income to secure a loan, establishing a comprehensive register of all loans, and requiring a 10 percent minimum downpayment. We also welcome the recent reimposition of limits on banks' open positions in euros. Additional regulatory measures are also needed to slow credit growth and induce banks to internalize systemic risk in real estate and currency markets. The FCMC, working with the Bank of Latvia, should increase its emphasis on monitoring systemic risk through more frequent on-site inspections of large banks and ensuring that foreign banks tailor their credit-risk models to the Latvian context.

c) Real estate policies: Rebalancing the structure of the economy away from the nontradables sector, especially real estate, is essential to underpin needed current account adjustment. The mission welcomes the increase in real estate taxation envisaged in the anti-inflation plan, as well as the periodic reassessment of cadastral values, beginning in 2007. To be effective, however, enforcement of real-estate related taxation should be stepped up. To further relieve overheating in the construction sector, it will be necessary to significantly scale back government capital expenditure (planned at 5 percent of GDP for 2007)."

d) Labor market policies: Efficient labor utilization is critical to expand aggregate supply and contain surging wage costs, which are contributing to overheating and undermining Latvia's competitiveness. The greater flexibility allowed in the use of fixed-term employment contracts introduced in the 2006 Amendment to the Labor Law is welcome, and further steps to facilitate mobility between jobs and regions are needed. The recent decision to allow unfettered labor market access to the newest EU members may help relieve bottlenecks, and wider temporary access should also be considered.


The above IMF package is clearly a big move in the right direction. My principal worry is that the severity of the shock produced may have a significant longer term impact in a negative direction than is desirable, especially if the package is followed by a bursting of the housing bubble which could in itself precipatate yet another outward stream of migrants. However, as we have seen above, the Latvian government is itself far from accepting the need for the totality of the package, and in particular as regards the fiscal dimension. But I think the big missing issue which is not being addressed here is the labour supply one. A systematic move to apply the fiscal braek, to tighten lending conditions and to facilitate an increased supply of labour would seem to offer a better possibility of bringing about the necessary correction without completely upsetting the apple cart in the process, so I therefore think that such labour supply measures should now be considered as a matter of urgency.

Hard landing?

Of course debating the niceties of the policies we would like to see is one thing, and addressing the economic realities of the policies we have is another. If domestic demand does not abate steadily now, a hard landing could well result. Under this kind of scenario, one or two more years of GDP growth in excess of an annual 10% rate would probably lead to such pressure on the labour market (remember the unemployment rate was dropping in 2006 by about 2.5% a year) and thus to such an acceleration in inflation that the impact on competitiveness and external liabilities would become unbearable. Under these circumstances attracting the necessary external financing would become increasingly difficult, and a sharp slowdown would probably result as the underlying accumulated output gap was corrected in an unduly short space of time. The most worrying point about such a scenario is that we really don't know the long term consequences it might induce. Latvia - like many East European and Central Asian societies is about to experience a severe demographic challenge, and it would be better to face that challenge with the wind behind you rather than the wind in your face, and certainly better to try and chart your own course than head off in the direction of "destination unknown".


References


Inflation in Latvia: Causes, Prospects and Consequences, by Alf Vanags, director of the Baltic International Centre for Economic Policy Studies, and Morten Hansen, an economist at the Stockholm School of Economics.


Statement by IMF Mission to Latvia on 2007 Article IV Consultation Discussions
, May 2007.

Republic of Latvia: 2006 Article IV Consultation - Staff Report
; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for the Republic of Latvia, October 2006

Republic of Latvia: Selected Issues, IMF October 2006


Language Use and Intercultural Communication in Latvia

Inese Ozolina

"Changes of Ethnic Structure and Characteristics of Minorities in Latvia"
by Peteris Zvidrins

'Exit' in deeply divided societies : regimes of discrimination in Estonia and Latvia and the potential for Russophone migration. Hughes, James (2005) Journal of common market studies, 43 (4). pp. 739-762. ISSN 1747-5244

Estonian Report on Russian Minority

Aksel Kirch

Latvian Naturalization Board, Statistical Information on Acquisition of the Citizenship of Latvia as at May 31, 2007.

Sunday, July 22, 2007

Lithuania Under the Loop

by Claus Vistesen

Cross posted from Alpha Sources



As promised below in my brief note on my continuous coverage of the CEE economies I am going to take a close look at Lithunia's economy and as such try to give a solid picture of what the risks are of a hard landing. More specifically, I will be looking at the labour market and the formation of price and employment expectations. My immediate impetus to do this is the amount of attention I got regarding my last in-depth look at Lithuania where I asked the timely of whether in fact Lithuania was running fast out of capacity relative to the sizzling growth rates. In short, I want all my bases covered on this one.

In this way, this entry will be pretty data intensive so be sure to load up on the caffeine for this one.

If we turn first to the general economic indicators I already noted in my last post how growth measured by GDP was powering ahead. An important part of this picture is of course to look at the external balance as where Lithuania as well as Latvia has seen its external balance deteriorate somewhat lately. This is visualised in the two figures below ...

lithuania.GDPQuart.jpg

lithuania.current.account.jpg

If we turn to various measures of prices we also see a secular increase in price levels which is a clear sign that capacity issues are mounting. Note especially the soaring labour costs as well as the ever creeping CPI. Regarding the PPI I have to say that I cannot account for its rather dodgy course as of late (feel free to illuminate this in the comments section). In general, we should also note (as a reference) that while the figures indeed look sizzling in Lithuania they are not at the level of Latvia's where both the CPI measure as well as labour costs are demonstrating higher growth rates than in Lithuania.

prices1.lithuania.jpg

prices2.lithuania.jpg

As should be readily clear through the numbers Lithuania is very much thundering ahead at the moment and given the underlying capacity issues I have already drawn somewhat attention to, the question still remains as to how far this can go without a correction. Yet what is it with that Lithuanian labour market then and what are indeed the underlying capacity issues? In order to shed light on these questions we need first to get a grip on the latest developments in the Lithuanian labour market as well as to gauge the future expectations of prices and employment from the point of view of producers (and YES, I do have data on this :)). As we go through the following figures it is important to keep the long term development in mind as it was sketched out in my previous post on Lithuania linked above. The two main points to watch out when we gauge future trends is the secular decline in the labour force as well as the annual net outward migration (see the two graphs in the previous post linked above). Now, if we look at the unemployment rate first as I cited it at 2.7% we need to be aware of a fundamental downward bias in this figure relative to the figures cited at Eurostat and the Department of Statistics in Lithuania. As such the figure cited by Bloomberg both in terms of unemployed people in total as well as the official unemployment rate comes from the Vilnius-based Labor Exchange office. Now, this small detail is important since it appears as if there is some discrepancy between the figures released under the seal of the official statistics department and the labor exchange office (Eurostat seem to cite from the former). This might of course be due to methodological issues but in the case of Lithuania the difference is not so trivial. At this point, the confusion might of course seem total but the figures below should aid you with the big picture (note the difference in time perspective of the graph sets).

lithuania.unemployment.eurostat.jpg

lithuania.unemployment.litstatistics.jpg

lithuania.unemployed.eurostat.jpg

lithuania.unemployed.litstatistics.jpg

Before moving further I would like to point towards the last graph which also shows the rise of vacancies. As can be seen the trends in vacancies and unemployed people are now moving in opposite direction which is of course a de-facto proxy for declining capacity. Now for somebody not trained in economics it might seem a bit overdone all this since there is clearly still enough unemployed persons relative to vacancies. However, here we need to think about two things. First off is the general trend. As the economy keeps growing new jobs will be created which will put a pinch on the labour supply as vacancies rise relative to dwindling capacity. However, more worrying is the fact that that there are also structural factors at play here such as the general demographic profile and net outward migration. In short, these two curves are moving rapidly closer. Secondly, and this is where your economic wit is tested, only in a very perfect world can we expect a perfect match between demand and supply on the labour market. In fact, there are bound to be notable mismatches on the labour market already given the very low unemployment rate and as vacancies rise this will exacerbate the situation through rising labour costs and inflation which is clearly not warranted given the economy's ability to absorb the activity. Moreover, the prospect of raising participation as well as to ameliorate the structural mismatches (often sectoral) is very dim in this environment since the gap is closing really fast.

Lastly and before I leave you to digest all this I present two very graphs which sort of nails this whole idea of how capacity is not able to match current and in this case expected growth rates. The graphs themselves are informative but not, as it were, very logical and a bit messy too (which BTW is my doing entirely). Any value over 0 indicates that optimists outweigh pessimists. The value itself indicate the amount of percentage points which one group outweigh the other. A small value close to 0 thus indicate a close even balance between the two groups but it does not tell us whether this is because the two groups are very large (i.e. a polarized distribution) or whether the amount of respondents who take the middle position (i.e. status quo) is large which would indicate a centered distribution. Pff, let us look at the graphs shall we?

lithuania.employment.expectations1.jpg

lithuania.selling.expectations1.jpg

So, what the heck are we looking at here then? Well, in fact it is not that complicated and quite frankly graph number one does not make me any more calm about the general economic prospects. As such, the employment expectations in all key industries not only show a clear, but also in some of the cases, substantial level of expectation to hire more workers in the next 2-3 months. In fact the propensity to hire more workers has shot up lately in the first part of 2007 with the exception of the industrial sector. Once again this is sign that expectations are still running high relative to what seems to be the economic fundamentals. Especially, if the relative propensity to hire more workers across a wide selection of sectors stay at this level it is hard to see how this cannot end with some kind of correction since it will only make worse the run on capacity. Moving to second graph it seems as if inflation expectations on the push side seems to somewhat better anchored than for example is the case in Latvia. The notable exception here of course is the construction sector where both employment and price expectations seem to be rather elevated although we can't of course say anything about the actual expected price level from these indicators.

In Summary

With the graphs and notes above I hope that I have now delivered a sufficiently comprehensive account as regards to my general thesis that many CEE economies are in for some kind of correction. In Lithuania, we should be able to take some comfort in the fact that inflation expectations and pressures seem to be somewhat milder than in e.g. Latvia but still the labour costs indicator is, for all intent and purposes, in red hot territory. The most alarming signs of a potential correction comes from the labour market where (whatever indices you abide by) expectations of future and able capacity clearly seems out sync with current and future levels given the well known structural driving forces. In this way, it won't take long after expectations of future employment has corrected before the effect trickles down to confidence and demand measures and thus economic activity. As I previously argued, Lithuania needs to stop and preferably reverse the migration flow and this needs to happen in 2007. Moreover, efforts need to be taken to improve labour market participation rates. As regards to the external balance which is also getting much attention the relative decline in competitiveness is of course also an important aspect to watch out. In this respect the recent sharp drop in the PPI measure surprises me a bit.

Lithuania's Population

From the Baltic Times:


Hands up if you’re Lithuanian

Aug 16, 2007
From wire reports
VILNIUS - Lithuania's state institutions do not know how many residents there are in the country, it has been revealed, with different bodies giving significantly differing estimates of the population.

There are two offices subordinate to the Interior Ministry of Lithuania - the Migration Department and the Residents' Register Service.

The names of the departments may give the impression that they keep track of population levels and how many passports have been issued, but this is not in fact the case, reports the Lietuvos Zinios newspaper.

The Head of the Passport Division of the Migration Department,Danute Matareviciene,told the paper that she had no statistics on how many passports have been issued. The Residents' Register Service drew a balnk when asked as well.

The closest thing to an official figure can be found at the Department of Statistics.

During the second quarter of 2007, 3,338,000 residents were registered in Lithuania, but only 3,162,879 have citizenship.

Further confusion is created by data on official and unofficial emigration levels. Officially the number who left the country between 2003-2006 was 54,400. Unofficially the department puts the figure at 76,700, though other institutions suggest the number is actually as high as 500,000.

Given the large number of Lithuanians working in other parts of Europe, and particularly the UK and Eire, this last figure seems far more realistic.

Tuesday, July 10, 2007

Running out of Capacity in Central and Eastern Europe

by Claus Vistesen

Cross posted from Alpha Sources


Well, it is pretty much official now I think that some countries in Eastern Europe might be heading for an economic crash. As such, both the FT and the Economist recently ran articles on this topic in which warnings were duly handed out. On the record, I am pretty convinced myself that some countries might crash very soon among those the most notable candidates being Latvia and Lithuania. Behind this doom and gloom call is a very simple hypothesis that demographics matter for economic growth and that this fact is now hitting home big time in the CEE countries proxied by dwindling capacity to match expectations of economic growth and prosperity. Of course I am sad to say, the mainstream coverage cited above did not have the faintest squeak about demographics and the unique population regime in which the CEE countries are situated. For that reason I recommend you to read Edward Hugh's recent post at AFOE in which he pins the Economist, his note on Latvia as well as my own analysis on Lithuania. In this entry I am looking at Poland in much the same way that I have been looking recently at Lithuania. Clearly, Poland are Lithuania are different not only because of the differences in size but also because Poland seems to be equipped with much more spare capacity than is presently the case in Lithuania and the other Baltic countries for that matter. I have marked 'seems' in italic since whereas Poland's unemployment rate is still in double digit territory accounts of substantial labour shortages are mounting which suggests that high growth regions in Poland are fast running out of qualified labour. In this way, the trend in the labour force is very similar to Lithuania but where Lithuania represents a small single deck frigate which is set to quickly succumb to any water intake Poland perhaps resembles more the Titanic. However, as I will demonstrate below, through graphs, the tendency is the same which only further substantiates the claim that when it comes to the CEE economies it is in fact, at this point, all about demographics and even though I realize that I am biased in my view here from the offset I just cannot see how any reasonable economist would be able to argue otherwise.

Let us look at the data then and more specifically the short term indicators on economic growth which show how growth and wage costs have been picking up the pace lately which also shows itself in a widening current account deficit. The first graph plots (in % y-o-y) growth in GDP, wage costs and industrial production, the second plots retail sales and the third plots the evolution of the current account deficit. Note that while the graphs for GDP(etc) and the current account share time perspective in the form of quarterly indicators the graph for retail sales plots monthly y-o-y % growth rates.

Poland.GDP.etc.jpg

Poland.retail.sales.jpg

Poland.current.account.jpg

As can readily be seen, growth in Poland had been indeed picking up the pace in the past year. This has naturally pushed up the demand for labour with an ensuing rather dramatic tightening of the labour market to follow. Also wage costs are beginning to rise rapidly and as the Economist Intelligence Unit reports (sorry, no link available) labour productivity is not able to follow the speeds of wage increases which of course questions the sustainability of this brisk growth spurt. This is accentuated in the following quote which cites the view of JPMorgan ...

In Poland, JPMorgan expects the dataflow over the next two weeks to confirm that “the labour market continues to tighten fast and that the labor productivity-wage relationship is deteriorating."

Curiously, wage costs are yet to show up in core inflation and producer price inflation where growth is still very moderate relative to the overall economic growth rate. It serves to remember here that the Polish unemployment rate is still in double digit territory which indicates that capacity needs to be a bit more strained for pressures in CPI and PPI indices to take hold.

Like I argued with Lithuania I believe it is important to take a long hard look at the Polish labour market and population dynamics in order to see what is really going on. Regarding the latter, Poland is inhabited by about 39 million people and as almost all other CEE countries Poland is set to age very rapid as a result of a severe stagnation in fertility from 1990 and onwards still lingering today. This is a very important point to remember as we move through the graphs below. Let us begin with a long term indicator of migration flows which demonstrate that Poland has suffered from a net-outflow since 2001. The numbers might seem puny in relation to the general population size but remember two things. Firstly, Poland's demographic profile is already damaged as a result of the fertility decline and secondly that all evidence suggests the skill component of the net outflow results in a loss of net value added from the point of view of the Polish economy. In short, even if the numbers are small Poland can hardly afford to lose these people if catch-up growth is to be sustained.

Poland.net.migration.jpg

This brings us to the general labour market dynamics which are presented below in terms of short-term indicators which share the time perspective as the economic data above. Essentially, two identical time series for unemployment are presented with the first being in real numbers and the second in percentage of the workforce.

Poland.unemploy.thousands.jpg

Poland.unemploy.percent.jpg

Clearly, the situation in Poland is very different from Lithuania and as such unemployment in Poland still linger in double digit territory. However, this will not go on for much longer if the current growth rates are sustained and this is where the problems begin to emerge. As such, you could choose to flag optimism in Poland on the basis of what is after all very impressive economic momentum which at this point is even welcomely deviating from nudging up core inflation rates. However, this is also at the core of the problem with almost all CEE countries in the midst of what is currently an unprecedented spurt of global growth. These economies are thus growing briskly, quite naturally, as emerging economies but with the important qualifier that they have extremely mature and essentially loop sided demographic profiles. This means that given the underlying capacity constraints these economies are faced with they are quite simply growing much faster than is sustainable in any meaningful sense of the word. This has then, at this point, obviously caught up with market participants and financial commentators but my guess is that it is moving way faster than many seem to think. Clearly, Poland is not Lithuania where the time span is already under one year but it still raises the question of just how much further this can go given the underlying structural capacity issues. Also remember here that while structural remedies such as raising labour force participation rates as well to address the skill mismatch on the domestic labour market should be strongly advised this is just moving so fast in some countries that this really does not seem to be a viable solution to address what is clearly becoming a short term issue with long term and structural drivers. In the end, what we have now regarding the CEE economies is evidence that a demographic profile wholly out of sync with the economic stage of development effectively can halt the process of catch-up growth. In order to ram this point home here at the end we need to look at productivity and how brisk productivity needs to grow in order follow suit. And this is just the point; catch-up growth and productivity increase as an economy moves up the value chain takes time and time is exactly what the CEE countries do not have at this point with the current growth rates.

Appendix

This was really the end of this entry but if you want to catch a glimpse of how fast this might be moving I invite you to read on. However, beware ... dodgy empirical methods and math will follow! Let us try then to do a thought experiment and ask the question, how far will it take for the Polish economy to reach a 'critical' level of unemployment rate where 'critical' here is defined as either a 3% or 5% unemployment rate?

Well, before we move I need to attach some important qualifiers.

Firstly, the following thought experiment does very little to represent sound empirical economics but the general approach is still worth while I think. As such, we know that rapidly ageing societies, especially those growing rapidly as is the case here, will tend to face a structural decline in the unemployment rate and/or the labour force as more people leave the labour force compared to entrants. Add to this, in the Polish case, the trend of net outward migration as well as the high economic growth rates and suddenly an unemployment rate of 10% becomes a rather small buffer. Secondly, be aware since math will now follow. I rarely do this at Alpha.Sources and I promise you that it will not turn into a habit but I think that it is important in this case.

Regarding the method I have already hedged my bets above and please do note that the underlying assumption of trend perpetuity in the following experiment makes the predictive power virtually useless, at least at the time horizon we will be looking at. So, what are we in fact looking at?

Well, based on rough and ready calculations the average monthly decline in the unemployment rate in Poland between July-06 and May-07 stood at a monthly decline of 2.4% (i.e. in absolute terms). Based on an all things equal approach, assuming trend perpetuity, how far would it take for Poland to reach an unemployment rate of 3% and 5% respectively? To answer this we use the common expression for time value of money as an imperfect yet useful approximation:

FV = PV(1+r)n (in our case -n but that is of little matter)

where FV denotes future value at time n, PV the present value at time 0, r is the compound rate at each period, and finally n denotes the periods. In our little experiment we approximate the expression to our need by assigning the values as follows;

FV: 3% and 5%

PV 10,5% (unemployment in May 07)

r: 2.4% (average monthly decline)

n: ? (i.e. this is what we want to find out)

Calculating for 3% ...

3 = 10,5(1.024)n

solving for n ... (a bit complicated but Excel delivers in a heartbeat)

In(3/10,5)/In(1.024) = -52.8

Which translates into about 53 months to reach an unemployment rate of 3% or 53/12 = 4.4 years assuming trend perpetuity.

Calculating for 5% ...

5 = 10,5(1.024)n

solving for n ...

In(5/10,5)/In(1.024) = -31.2

Which translates into about 31 months to reach an unemployment rate of 5% or 31/12 = 2.6 years assuming trend perpetuity.

So, was this useful at all? Well, perhaps not but do note that the assumption of 'perpetuity' as regards to a structural decline in the labour force/unemployment rate is not entirely voodoo magic when we think about the CEE societies. Clearly however, the process will be subject to notable nonlinearities as we approach ever lower levels and furthermore it is not certain that the current cyclical economic boost will continue. But the point is that, at the pace with which this is moving it is difficult to see how structural mechanisms such as improving labour market institutions, raising participation rates, and addressing the skill mismatch can keep up with the structural and cyclical run on the level of capacity if it continues much longer. Especially, the fact that these countries are now targets for a substantial part of new global credit suggests that the pressure is very high indeed. Note also that many central banks in the region would be effectively unable to act as a lot credit is denominated in foreign currency. As such, an aggressive turn of monetary policy to the loose side would entail severe balance sheet issues as the countries' domestic currencies most likely would plummet. Effectively this would mean strong appreciation of the liability side (denominated in e.g. Euro) relative to the asset side (denominated in the domestic currency).

In the end, whatever rate of decline we assign in our little pet model here we are looking at a horizon in most CEE countries where labour markets are set to tighten significantly in the next 2 years and in some countries it will move much faster than this.