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Tuesday, February 26, 2008

Latvia Employment Trade and Producer Prices

Unemployment in Latvia seems now to have started to rise steadily accoring to the latest data from the Latvian State Employment Agency (NVA). Although slight, the increase in unemployment in Jan 2008 to 5 pct points to qualitative economic and labor market change, NVA said. And I completely agree. The market seems to have turned in November.

The level of registered unemployment had declined steadily from 8.7 pct in late May 2004 to 4.8 pct in November 2007. Since November the tendency is now up again. This is yet more indication of the presence of an economic slowdown in Latvia.

The unemployment rate in Latvia at the end of 2007 was 4.9 pct of the economically active population, while at the end of 2006 it was 6.5 pct. The unemployment rate increased 0.1 percentage point in January 2008 over December and reached 5 pct of the economically active population. There were 53,325 unemployed registered with NVA in late January 2007.

So my feeling is that Latvia is now out of the "extreme overheating" stage - and probably came out around in May-June (which isn't to say there wasn't a lot of momentum left in the system at that point). If you look at the charts included in my December Retail Sales post earlier this month you will see that retail sales growth really peaked during the first quarter.

Also manuafacturing output has been in fierce retreat since July, while the property market seems to have turned around May-June. In part this exiting from overheating will have happened becuase a process as fierce the one which took place in Latvia almost has to choke itself out of its own accord, and also possibly because of the tightening of the credit conditions applied after April, and the impact of this tightening on the housing market.

Also if we look at this unemployment data, it is clear that the labour market turned in October/November, and employment is normally a lagged indicator, which means it only responds after the horse has started to bolt. So my feeling is the overheating situation is now dead and gone, and what people need to think about are cushions to try and soften the landing. Which is why I am not 100% opposed to the idea of fiscal loosening at this point.

Exports and Imports

According to the latest data from Latvijas Statistika:

Compared to November 2007, the value of exports in current prices in December 2007 decreased by 10.8% or 39.8 mln lats, but in comparison with December 2006 it increased by 12.9 % or 37.4 mln lats, reaching 328.0 mln lats, according to Central Statistical Bureau data.

However, the value of imports in current prices in December 2007 was 8.4% or 54.3 mln lats lower compared to November 2007, but in comparison with December 2006 the decrease comprised 6.2% or 39.5 mln lats, reaching 593.0 mln lats.

The total foreign trade turnover in December 2007 was 0.2% or 2.1 mln lats lower than in the corresponding period of the previous year and its value was as high as 921.0 mln lats.

The value of exports in current prices in 2007 reached 4025.2 mln lats – more by 732.0 lats or 22.2% compared to 2006.However, the value of imports in current prices in 2007 was more by 1342.5 lats or 21.0% compared to 2006 and reached 7721.0 mln lats.

So while year on year exports were still up by 12.9% year on year, they were DOWN by 10.8% on November, and indeed exports in November were down on those in October. And although the trade deficit reduced slightly, this is not the result of exports powering ahead to drive growth.

In fact the reduction in the trade deficit is basically a result of the fact that imports were falling even faster than exports, and indeed the year on year rate for imports is now negative. Which is a reflection I feel of the way in which internal demand in Latvia is now contracting rapidly. But if internal demand is contracting, and exports start to fall, then, if the governemnt go for a fiscal surplus, we should expect Latvian GDP to start to contract at some point, shouldn't we?

What we should note about the above chart is the slope of the imports chart. We should be getting used to seeing this in internal demand charts for the Baltic economies at the moment. We may also not that while year on year the rate of export growth was positive, the rate of increase is slowing by the month. One reason, apart from the slowdown in Germany, that this shouldn't surprise us is the degree of trade interlocking among the Baltic states. Latvia's two most important export destinations - and by quite a long way - are Estonia and Lithuania, and if internal demand is about to subside in these two countries, then so are Latvian exports.

Producer Prices
Latvian producer prices in January were up 10.9 pct year on year and 1.3 pct compared with December last year, according to the latest data from the country's central statistics office.

Obviously the rate of increase in the PPI is now slowing rapidly, although there is still some considerable distance to go. Perhaps the most noteworthy trend in January was that export prices reversed to downward trend of recent months, and were up 1.7% on December. This is not good news. It certainly won't help to reverse that downward trend in exports.

Bottom line, the Latvian economy is now cooling rapidly, and looks to be headed towards contraction at some point in the not too distant future.

Monday, February 25, 2008

Estonia Trade Deficit December 2008

Well, the only news we are receiving on the economic front from Estonia at the moment certainly seems to be bad news. At the end of last week we had the Q4 2007 wage increase data, while today we have the December trade data. I quote the statistics office release:

According to the preliminary data of Statistics Estonia, in December 2007 the Estonian foreign trade turnover made up 22.4 billion kroons.a Compared to December 2006, the foreign trade turnover decreased 6% and, compared to November 2007 it decreased 19%.In December 2007 the exports were 9.3 billion kroons (42%) and imports 13.1 billion kroons (58%). Compared to December 2006, the exports of goods decreased 8% and the imports of goods decreased 4%. Compared to November 2007, the exports of goods decreased 22% and the imports of goods decreased 16%. The trade deficit was 3.8 billion kroons. In December 2006 it was 3.6 billion kroons and in November 2007 it was 3.8 billion kroons.

Imports are obviously decreasing as domestic demand (and reprocessing for export) declines. But crucially exports are down year on year by 8%, and the turnover decreased 6%.

Given the increased level of openness in the Estonian economy this is important. Basically if we can assume there will be no significant revival in domestic demand in the coming months (and if the Estonian government add to this by keeping a very tight reign on fiscal spending, then exports are the only possible growth area. But with relative prices as they are, it is hard to see how this can happen. Basically productivity increases and sector shifts cannot hope to compensate in any adequate degree for the erosion of price competitiveness we are currently seeing, and we may still be facing several more months - at least - of this. By that point the damage will effectively have been done (if it hasn't been already). I'm afraid ladies and gentlemen that the time for some very hard decisions on the currency peg front is fast approaching. I do hope that the IMF and the EU Commission/ECB are preparing some kind of contingency plan here. The big danger is that once all this breaks loose it can spread from one country to another like widlfire.

Many hold the view that since the Nordic banks have a strong stake in the Baltics’ economic future, a sudden Asian-style stop of funding would seem to be unlikely. The thing is, a sudden withdrawal of funding is not that likely, but what the countries in question need is a continuous injection of funding to cover the ongoing CA deficit. So even if the banks were willing to continue to increase lending, the question is what would the money be borrowed for? To pay for imports presumeably. And what would the Estonian banks offer as collateral if they are not creating loans to be securitised?

And anyway, since part of the adjustment programme involves a tightening of loan conditions inside Estonia, who is going to be able to do the necessary borrowing to attract in the funding needed to settle the monthly external account book? And if no one is able to borrow because the loan conditions are tightened, doesn't this in itself provoke a correction in the trade deficit, but in an extremely violent way?

I see Ott Ummelas in Bloomberg quotes Christoph Rosenberg this morning as saying that "risks of a 'hard landing' in Estonia, Latvia and Lithuania are 'real' due to rising trade imbalances in recent quarters". I couldn't agree more.

Incidentally, a piece of news is in this morning which is not devoid of significance for the future of Estonia's peg: the National Bank of Hungary today decided to remove the defended trading band and allow the forint to float freely.

Sunday, February 24, 2008

Cooling Down in Eastern Europe?

by Claus Vistesen

Just as we are nearing the transition from Winter to Spring here in Europe which traditionally promises to bring more pleasant and mild weather it seems as if Eastern Europe might just be getting a much welcome dose of cold air to quell its many overheated economies. This fresh breeze of cold air was inevitably coming in helped along from the breath of the illusive credit crunch and essentially it is also, in this respect, much welcome.

Yet, the issue which now confronts Eastern Europe and many of her economies is not so much the confusing sequence of seasonality but rather how not to freeze over completely and tumble into a hard landing. Here at Alpha.Sources and elsewhere I have been adamant in my description of the issues in Eastern Europe and how I think the situation may turn out worse than many observers think. None of us know of course; we can merely asses the facts as they are presented for us and follow closely the incoming data. Two recent very worthwhile contributions to the debate on Eastern Europe and more specifically the Baltics are presented to us in the context of RGE's Euromonitor where Christoph Rosenberg and Karsten Staehr posts separately on the topic at hand. Christoph and Karsten seems to more or less agree with respect to the main thrust of their arguments. Both authors write in the context of a recent conference organized by the IMF and Eesti Pank where the Baltic situation was discussed. Karsten also refers to his recent article in the monetary review from the Danish Central Bank.

Both the authors in question field arguments which are somewhat different from my own and my colleague Edward's and in this light I think it would be most interesting to go through some of the points and see whether we cannot learn something from each other?
Let us commence with the question of whether the Baltics will experience a hard or a soft landing? At this point in time it is very difficult to see. It is certain that we are now seeing signs of significant slowdowns not only in the Baltics but across the whole Eastern European edifice. The tricky question we all want to answer is the extent to which this slowdown will turn into a rout and a possible economic crisis of some sorts. In this entry I will focus on the Baltics as I try to scrutinize this question although I need to emphasise the need, in this context, to keep a weary eye on Hungary and Romania where especially the former is beginning to look increasingly shaky by the day. Regarding the Baltics Christoph makes the following important point ...

In particular, the financial sector is de facto owned and operated by Nordic banks. Since these banks have a strong stake in the Baltics’ economic future, a sudden Asian-style stop of funding seems unlikely. By the same token, however, these close ties put the fate of the Baltic banks into the hands of just a few Nordic parents and their ability to weather the global financial turmoil.
The dynamics here represent a very important point to take aboard. The past years' expansion and subsequent build-up of large negative external positions in the Baltics have mainly been driven by consumer and mortgage credit supplied by foreign (most notably Scandinavian) banks and credit institutions. In this way, the Baltic economies are very dependent on this link not only to keep the external position from not correcting too quickly which would happen if the foreign banks suddenly closed shop and retreated their fangs but also in order to keep and restore confidence in their economies and most importantly the currency boards tying their currencies to the Euro.

Quite simply, the Baltics need these banks to now follow them down into whatever the current slowdown will bring. Will the banks be ready for this? So far, there has been no obvious signs of distress from the banks operating in the Baltics apart from words of warning from the rating agencies directed towards Hansa Bank and its operations in the Baltics. Some would even point to an upside in all of this. The recent 4th quarter results by two of Scandinavia's biggest banks Nordea and Danske Bank suggest, that they, contrary to their continental and transatlantic peers, have been dodging the incoming bullets from the credit market turmoil to such an extent that even Neo from the Matrix should be nodding approvingly. But the global credit market environment is only now waking up to the hangover from the past 5 years' exuberant credit expansion and we have already seen how the credit crunch has affected anything from regional cajas in Spain to indebted Hungarian households.

In this light I remain less sanguine but concur that each day passing without further signs of distress is a good one. It remains certain then that a lot of importance can be hinged on the extent to which the foreign banks are willing to continue their operations in the Baltics as well as the extent to which they are willing to let the credit taps stay open. Karsten seems to be rather optimistic in the face of the credit market turmoil.

The positive side effect of this [the subprime crisis] is that indebted borrowers in Estonia, Latvia and Lithuania will not face larger debt servicing payments, which again may reduce the likelihood of widespread bankruptcies. The global financial setback may thus have led to exactly the form of financial restraint that the overheating Baltic countries need.

This is kind of reverse causality relative to the way I have traditionally narrated the credit crunch in the context of the Baltics and Eastern Europe. However, this does not mean that Karsten is not right in the main. My main gripe would be that the slowdown was bound to come anyway as the labour market tightening and subsequent credit fuelled wage growth was bound to finish at some point entirely because of reasons endogenous to the Baltic situation. In this light, the credit crunch hardly comes at a convenient time since it may lead to the credit and financing of the external balance being pulled too quickly.

The second point I want to discuss is relates to the whole situation surrounding the currency pegs in the Baltics. Many commentators, including yours truly, have emphasised the risk of a run on one of the Baltic currencies which would take the form of a Asian crisis style test of the currency boards and thus ultimately by derivative the ECB's willingness to provide assurance. Christoph however seems to be lees convinced ...

These pegs have proven to be remarkably resilient, surviving the Russian crisis as well as recent attempts by outside market players to take positions. Speculators have not found a chink in the armor because the spot market is tiny and a forward market non-existent (contrary to the impression generated by those quotes on Bloomberg screens). From the Baltic governments’ point of view, abandoning the euro pegs, even in the face of mounting external pressures, would likely create more problems than it solves, given that many households and enterprises have borrowed in euros.

The illiquidity, or in the case of the forward market non-existence, of the FX market in the realm of the Baltic currencies is an important case in point. It is unlikely that the Baltics will be the first in line in connection with a potential currency run in the context of Eastern Europe. That dubious honor seems to have landed at the front step of Hungary and Romania. However, the fixed exchange rate regime represents another mounting problem for the Baltics in the current situation. How are they going to correct? This brings us into the heart of the predicament in my opinion and thus how the Baltics are in a bit of a bind. Consequently and as Christoph himself points out fiscal stimulus can not be used to counter the current downturn since in the end we are talking about a deficiency of external and not internal demand. Yet, this is also a textbook case of the ever recurrent trilemma often cited in the context of international economics. With free capital movement and a fixed exchange regime monetary policy is out as well as is de-valuation. Moreover and as noted, since fiscal policy also seems to be out of the question (some are even talking about a contraction) we are basically letting the reigns go hoping that the chariot won't fly off the cliff.

Those of you with Austrian inclinations would undoubtedly be cheering away at this point emphasising out that this is the one and only way that these economies can correct. This is a discussion for a separate post but suffice to say that there is a distinct possibility that all this will end in deflation since absent the adjustment mechanisms cited above this is the only conceivable way to break the vice. It is important to note that there is nothing deterministic about this scenario but it may in fact happen. And once we allow ourselves to consider the possibility we need to ask whether it wouldn't really be better to devalue in order to restore external competitiveness? However, this can hardly be seen as an ideal outcome either since as Christoph notes in a faint sentence, and as I have analysed extensively, Baltic enterprises and households would be severely exposed as a large part of the outstanding stock of loans are denominated in Euros. This brings us back to the question of deflation and whether the foreign banks would stay put in such an execrable macro environment and ever so important how such an environment would affect the tendency of net outward migration. I cannot say that the chain of events will play out as I am suggesting. But there is a risk. In the concrete context of Karsten and Christoph they both seem to end their analyses on a somewhat open note with a tendency to lean towards the soft landing scenario.

So, if this was the immediate cyclical perspective how might the longer term structural perspective aid us in the answer of whether in fact this will be a soft or hard landing. Following a graph of quarterly growth rates (y-o-y) in the Baltics Karsten makes the following noteworthy point ...

The figure clearly shows the very high trend growth in the Baltic countries, only interrupted by the downturn in 1999 as fallout from the Russian crisis. Given the low initial income levels, part of the impressive growth performance can probably be explained by ‘catch up’, where import of technology and organisational knowledge speed up growth. In 2006, the purchasing power adjusted GDP per capita in the Baltic countries still amount to approximately 50-60% of the EU27 average.

The important point here is the idea of catch-up growth and more specifically how catch up growth is related to the demographic profile of almost all Eastern European countries. You see, the very impressive growth spurt we have observed since the Baltics' accession into EU has not come without a cost. Two stylised facts are important to tune into here. Firstly, there is the steady trickle of labour out of the CEE and Baltic economies into Western Europe. All these 'Polish plumbers' which has become the catch-all phrase for the east-west migration have undoubtedly aided in amending supply side issues in the receiving countries and in some cases even boosted trend growth (e.g. in the UK). However, it has also intensified the pressure on wages and thus inflation in Eastern Europe not only because of their physical numerical absence but also because of the human capital component as many of these workers are those in the highest end of the value chain (i.e. most productive) relative to the countries they are leaving.

The second point we need to remember is quite simply the point that the Baltics and their Eastern European peers have moved through the demographic transition far more quickly than economic development has had time to really sink in. Notable and important differences clearly exist between the Baltics and many Eastern European countries but the stylised facts remain. So, this is, in fact, not a question of being right or wrong in terms of calling the immediate cyclical outcome of the slowdown but about a deeply structural problem. In this specific light it would be most severe if the Baltics and/or Eastern European countries tumble into deflation since this would potentially intensify the emigration as well as make it much harder to accomplish that much allured catch up growth. In essence, I agree then with Christoph when he concludes ...

The lesson for the governments and citizens in the Baltics is that they should lower their expectations, be it with respect to income growth, large-scale public investment projects or speedy euro adoption. Modesty and prudence are the best insurance against falling into the Portuguese slow growth trap—or experiencing a sudden Asian-style output contraction.
This is indeed the case but take note. The lowering of these expectations may be much more permanent and enduring than you might imagine and as such it is rather important that the tumble is not too rough. I guess that my main addition to Christoph's list of solutions as he presents them is quite simply that we take a look at the demographic edifice of the region and individual country since if we don't, the situation is not likely to improve much in the long run.

In Summary

In this note I have reviewed a number of arguments recently made on the Baltics from Karsten Staerh and Christoph Rosenberg over at RGE's Euromonitor. I think the two authors' analyses are very solid but I do have a few objections and niggles when it comes to the main conclusions. I concur that the extent to which the Baltics or one of three will experience a hard landing is a difficult question to answer at present. It is clear that Q4 2007 marked the beginning of a notable slowdown across most parts of the Baltics and Eastern Europe and now we will see how 'bad' it turns out. Above, I have highlighted reasons as to why I tend to lean towards the pessimist narrative but also realise that both Christoph and Karsten field arguments to the contrary. There are three main reasons why I am on the pessimistic side of the median ...
The risk of contagion. Events in Hungary and Romania point to a deterioration of economic fundamentals by the day. The laws of economics do not as such prescribe that this need to affect the Baltics but since the underlying issues are much the same I do think that the risk of contagion is there. The most important potential transmission channel of such contagion would be the extent to which a debt crisis and subsequent withdrawal of foreign credit in one country could lead to similar events in another country.

The lack of adjustment mechanism due to a fixed exchange regime and translation risk due to unhedged cross-currency liabilities of households and corporations. The main risk as I see it is that one or more of the Baltic countries will slip into deflation on the back of the current slowdown. The alternative which would be to un-shackle from the Euro hardly seems positive for two overall reasons. Firstly, the ensuing debt burden levied on economic agents in possession of Euro denominated loans would be quite severe and secondly there would be political issues as the prospect of future entry into the EMU would be seriously dimmed.

Finally, I tend to assign a rather strong weight to demographics as a variable in this whole situation. In my opinion a large part of debacle many Eastern European countries now find themselves in is due to their unique demographic situation. Focus is needed here I believe and especially we need focus on attempts to raise fertility and to keep people from leaving. As a Dane I see how those Polish plumbers have been a most welcome addition to an overheated Danish construction industry and I can also see how Ireland and the UK have benefited from Eastern European labour. But, we need a more balanced focal point on this and one which also takes into account the impact on the sending country. Remittances are fine indeed and so are claims that migration is temporary but this is also part of the whole edifice. In this way, the degree to which Eastern Europeans choose to stay in their current country of residence seems to be somewhat proportional to the potential severity of the current slowdown.

Friday, February 22, 2008

Estonian Wages Q4 2007 and The Growing Credit Squeeze

Christoph Rosenberg has a post up on the RGE Europe EconMonitor where he argues he thinks a soft landing for Estonia is both possible and likely, always given, as he says, that the right policy options are adopted.

In fact Christoph is reporting on an academics and policy makers seminar on Baltic Convergence recently held in Brussels. The seminar was jointly organized by the IMF and Eesti Pank, and both he and his fellow blogger Karsten Staehr attended.

The gist of the argument presented by the participants was with the right policy mix a hard landing can be avoided in the Baltics. I have serious doubts about this, and in particular due to the relative time scales of the remedies being proposed and the rate at which the slowdown is taking place. That is, most of the remedies being offered appear to be longer term in their horizon of operation, whilst the crunch is actually coming in the Baltics over the next six months or so, ie in the comparatively short term.

What I feel for the "soft landing" argument to be more convincing is that we would need to be seeing more evidence for it in the data. But if we look at what we have, we can see that the deterioration is continuing, and at a pretty rapid pace.

Noone seems to be addressing head-on the central issue which would seem to be whether or not what we had in the Baltics was a demand bubble inspired by the designation of certain categories of property lending as worthy of investment grade, and a low interest inward flow of funds and loans in non-local currencies which appeared to be underpinned and guaranteed by the condition (ie not the option) of euro membership for all the new EU10 accession countries. What noone seems to have thought about was the impact on the macro economic dynamics in the short run of a rapid transition from win-win to loose-loose as the door has been steadily closed in the applicants face. Slovenia seems to have been the last one in before the door was temporarily closed, with Slovakia poised perilously like a man on a ledge half way up a cliff face, not knowing whether to continue climbing tenaciously upwards (or to jump now before he gets any higher), even as the ever stronger inflation-driven-gusts of wind and rain make his footing weaker and more tenuous with every passing step.

And if the whole thing was a bubble, what can we ultimately expect from the reversal of fortune, and the schocking grip of debt deflation? Obviously any such thing seems a long way away at the present moment, as what we are faced with is an exceedingly hard to eradicate bout of inflation. Just how serious this position is in the face of the continuing slowdown is brought home by the last set of inflation figures, and todays announcement from the statistics office that wages actually rose in Q4 2007 at a year on year rate of 20.1%. Estonia's inflation rate rose to almost a 10-year high of 11 % in January (see chart below) following a 9.6% annual rate in December. So while domestic demand is rapidly slowing, inflation is still accelerating.

This process will not, of course, continue indefinitely, and at some point we will see the reverse face of this, as price deflation gets its grip when demand falls below capacity, as it obviously is going to do. We have two lines moving in opposite directions and at some point they will cross. What we can say is that given the major suplly side capacity constraint has been labour, it should not surprise us if we find the phenomenon of extremely "sticky wages" in the Baltic context. And so, it is, indeed, wage growth in Estonia, as I have said above, remained virtually unchanged in the fourth quarter from the previous one. The average monthly gross salary rose 20.1 percent from a year earlier to 12,270 krooni ($1,161), compared with an increase of 20.2 percent in the third quarter, accdoring to the statistics office in Tallinn earlier today.

Wages have risen due to labor shortages as Estonia's ageing population and an outflow of workers to wealthier countries have steadily pushed unemployment to a 15-year low of 4.1 percent in the fourth quarter. The impact of these ongoing increses in wages can be seen in the continuing high inflation in producer prices , and even more importantly in the continuing increase in export prices. Since domestic demand (ex government spending, and EU fund transfers) may well start to contract at some point, exports are the only real hope for the Estonian economy in sustaining GDP growth in positive territory, but just how far Estonia has to go in putting things into line to do this can be seen from the comparison between export producer prices in Hungary and Estonia shown in the chart below. Export prices have been falling in Hungary for nearly a year now, and as a result Hungary now has a small goods trade surplus. Estonia has still to really start this process.

And remember, with each month that passes and producer prices continue to rise (ie the PPI index remains above zero price growth), the more pressure there is on the competitivity of Estonian exports and logically the more pressure there is on the kroon peg. Enough said, I think.

Strong Growth Slowdown

Estonian economic growth more than halved last year reaching a year on year rate of 4.5 percent in the 4th quarter (according to preliminary data), and this was an eight-year low, in the fourth quarter. A rapid decline in the rate of wage growth is crucial if Estonia is to avoid a sharp slowdown as even central bank Vice Governor Marten Ross admitted earlier this week. If we look at the quarter on quarter growth rate chart, the dramatic nature of the decline is evident. As I keep saying, I don't know what sort of charts the people who argue the soft landing view are accustomed to looking at, but I humbly suggest that the sloe is a lot softer than the one we are looking at here. And the fact that year on year Estonia is still growing at 4.5% is hardly reassuring, since we are only in the early throes of the slowdown at this point, and there is no sign in the line of any significant slackening of pace. When we get to see some "bottoming" then we will be able to make some initial damage assessment, but the airplane is still loosing height, and fast, at the moment.

More evidence of the way things are slowing down comes from industrial output data. Output is in free fall downwards (see chart below, as are retail sales which is showed in a chart above), until we can see some sign that this rapid rate of deterioration is slowing it is far too premature for people to start arguing they have evidence of a soft slowdown (rather than expressing their hope that his will be the case, but here as ever, hope is one thing, and evidence to justify the hope quite another).

The important point to grasp here is that this is now all about timing, the whole drama looks likely to be played out over the coming six months, and unfortunately many of the remedies being advocated by Brussels and the IMF, including facilitating the switch of production and investment from non-tradable sectors to tradable sectors, and the strengthening financial supervision are longer term measures. And in any event are so obviously commendable (I mean, who at the end of the day would disagree that the violent husband SHOUL stop beating his wife) that they risk being platitudes: the question is the how.

And one of the recommendations, that "wages should be flexible and remain in line with companies’ competitiveness and productivity conditions, just went out of the window, at least as far as this downturn is concerned".

Which leaves us with the fourth recommendation, that "fiscal policy should not seek to offset a contraction in demand, even if the Baltic economies enter a period of slow growth". Being very contrarian, even here I have my doubts. We need to take into account that the recommendation to increase the fiscal surplus was issued in one situation, and we are now very rapidly entering another one. Before the problem was excess demand, and now the problem is going to be lack of it (again in the short term). Unless the Estonian authorities plan to do something more radical than I am contemplating they will do in the short term about the peg, Estonia will effectively be without conventional monetary policy tools in this situation (as it was in the situation which lead up to it). To deny the Baltic economies fiscal alternatives given the gravity of the sitiuation they face would, to my mind, be unduly conservative. Demand management is about just that, slackening demand when there is too much of it, and increasing demand when there is insufficient. So for exactly the same reasons the IMF were argeuing for fiscal tightening one year ago (that there was no effective monetary policy tool available) I would suggest we could consider the opposite policy now, especially since the global credit crunch is now steadily tightening its vice across Eastern Europe. Basically if it makes sense to brake at the end of the straight as you enter the curve, it also makes sense to accelerate and not hit the brake even harder as you go round it. You don't have to be Fernando Alonso to know that. And of course we are only talking about short term stimulus here, not long term structural policies, but since the Baltic economies - unlikely Hungary and Portugal, have comparatively low levels of debt to GDP, then they could well permit themselves this option I feel (according to Eurostat data, accumulated government debt as a % of GDP - ie not the annual deficit, the entire sovereign debt - for Estonia in 2006 was only 4.1% of GDP, for Latvia it was 10% and for Lithuania it was 18.2%, ie this is a pittance, and there is leeway for demand management cushioning, which is why I did not look so negatively on the proposal from the Latvian government to change tack at this point, of course they should have been braking hard six months to a year back, but we are now past that point, and it really isn't useful at this stage to be simply crying over spilt milk. There will be plenty of time for post-mortem's later).

And doubly so, since one of the other favoured arguments about why the Baltic countries can avoid a sharp slowdown - namely that the Scandinavian Bakns will help them manage the situation - is looking wobblier by the day. Cristoph advances what is a very common argument:

In particular, the financial sector is de facto owned and operated by Nordic banks. Since these banks have a strong stake in the Baltics’ economic future, a sudden Asian-style stop of funding seems unlikely. By the same token, however, these close ties put the fate of the Baltic banks into the hands of just a few Nordic parents and their ability to weather the global financial turmoil.

What this argument tends to forget, however, is that these banks themselves are not charitable institutions, but have their own balance sheets and credit ratings to think about. This point was brought home ealrier this week by Moody's Investors Service that it is cutting its ratings for Estonian banks on concerns of weakening asset quality due to high exposure to the cooling property market. Moody's assigned a negative outlook to Estonian banks, including AS Sampo Pank, fully owned by Danske Bank A/S, and Balti Investeeringute Grupi Pank AS.

Virginie Merlin, senior analyst with Moody's in London and author of the report, is quoted as saying that the move ``naturally'' follows the decision on Jan. 18 to lower the outlook of AS Hansapank, the top Baltic lender and a fully owned unit of Swedbank AB, to ``negative'' from ``stable.'' Hansapank accounts for more than half of Estonia's banking industry assets.

According to the report "Moody's primary concern is that the rapid loan growth has led to unseasoned portfolios with high concentration on the mortgage and real estate sectors....We therefore see a growing risk of a deterioration in the banks' asset quality if the economic outlook continues to soften"

And I think this is hardly unsurprising news, these banks cannot simply sit bank and watch their credit rating and asset quality deteriorate simply because it would be the "politically correct" thing to do.

Wednesday, February 20, 2008

Estonia Producer Prices January 2008

According to data released by the Estonia Statistics Office in January 2008 the percentage change in the producer price index was 1.3% compared to December 2007 and 8.3% compared to January 2007. In January compared to December 2007 the producer price index was mainly influenced by the increase in prices in energy and in the manufacture of food and beverages.

In January 2008 the percentage change in the export price index was 1.1% compared to December 2007 and 6.7% compared to January 2007, while the percentage change in the import price index was 0.5% compared to December 2007 and 5.6% compared to January 2007.

For those of you who are interested to see a chart which I would term having "bottomed out" - or in this case "topped out" - the above chart should serve the purpose, since a lot of the impetus has now gone out of the wave of increase in producer prices. But please remember they are still increasing, it is only that the rate of increase is slowing, but obviously with each month that passes and producer prices continue to rise (ie remains above zero price growth), the more pressure there is on the competitivity of Estonian exports and logically the more pressure there is on the kroon peg. The rate of increase in export prices, as can be seen from the chart below, is now slowing even more quickly, but still, unfortunately a lot of the damage has already been done.

Wednesday, February 13, 2008

Sharp Decline in Q4 2007 Estonia GDP Growth

Estonia's economy in the fourth quarter certainly grew at its slowest pace in eight years in Q4 as both investment and consumer spending drpooed dramatically. At annual rate (ie total economic growth over Q4 2006) Estonia's GDP grew at 4.5 percent, down from 6.4 percent in the third quarter, according to the Tallinn-based statistics office today. As can be seen in the chart, the slowdown is now evident and significant.

Well, nothing wrong with that people may say. 11% growth was obviously too high, so 4.5% may be a positive improvement. The thing is the Estonian economy is unlikely simply to reduce speed to 4.5% and stay there. If we look at growth quarter on quarter, and on a seasonally adjusted basis, the economy grew by 0.6% in the 4th quarter over the third. That's an annualised rate of just 2.4% and dropping, as we can see from the chart.

So this slowdown isn't suddenly going to come to a halt. At some point it will "bottom out", but we aren't there yet, and may not be for some few more quarters. When we actually get to the end of the drop we will be able to see the extent of the damage, but at the present time all I can say is that there doesn't seem to be anything "soft" about this landing at all.

Tuesday, February 12, 2008

Lithuania Current Account Deficit December 2007

Lithuania's current-account deficit narrowed by 38 percent in December when compared with November, but before we get too excited about this we need to examine what may be driving this improvement. Clearly exports continue to expand, and grew by 4.7% over November, but the change in the trade deficit - which is what really lies behind this data - was produced by a sharp drop in imports - 7.1% month on month - which was really a result of a movement back from the very high levels registered in November.

In fact imports increased to million LTL in November - up from million LTL in October - and then fell back again to million LTL in December. Thus a large part of the change was due to this movement in imports, although it is also the case that exports accelerated in December, as can be seen in the above chart.The effect of the correction in imports on the trade deficit can be seen in the chart below.

The current account deficit, which measures the difference between money flowing into and out of the country, narrowed to 254.5 million euros ($370 million) from 408.9 million euros in November, according to the central bank today.

But there is some slight longer term improvement taking place, since the gap narrowed in the fourth quarter to 11.3 percent of gross domestic product, compared with 12.3 percent in the third quarter, the bank said. The full-year deficit was 13.2 percent of GDP in 2007, compared with 10.8 percent in the previous year.

Sunday, February 10, 2008

Estonia Unemployment January 2008

According to data released last week by the Estonian Labor Market Board there were 15,758 people registered unemployed in Estonia in January, and this was a rise of 11.7 pct compared with December. Now looking at the data for last year it is not unusual that unemployment should rise from December to January, but if you look at the chart you can see that unemployment touched a low in June, and since then has been steadily rising. In fact there is a 27% rise on the level of January last year.

Of course, as the Estonian economy slows this increase in unemployment is hardly surprising, but if we follow it as the slowdown deepens it should give us another measure of the extent of things. The difficulty is - in macroeconomic rather than human terms - that due to the very constrained Estonian labour market, and the low level of arrival of young people into the market, registered unemployment may not rise anything like as rapidly as demand collapses. This presents a difficulty, since it means that prices may not be able to adjust as quickly as they should (in the literature this is called "sticky prices"), thus making it difficult for the economy to adjust, and hard to "bleed" inflation out of the system. This is a technical problem, but its impact is real enough. The consequence would be the the recession would be longer and deeper than necessary (as we are beginning to see in Hungary) as domestic prices deflate back - by whichever is the preferred method of the Estonian authorities, real wage reductions or currency adjustment - to internationally competitive levels. This is important, since given the extent of the recent "excesses" and the impact of the correction on domestic demand when coupled with the population ageing component, it seems pretty clear that there will be a "before" and an "after" here, and Estonia will need to re-invent itself as an export driven economy on the Swedish or Finnish model. Anyway, we will keep following unemployment as we move forward here as there is a lot we can learn from Estonian labour market dynamics.

Friday, February 8, 2008

Latvia's GDP Q4 2007

Latvikas Statistika have just released a flash estimate for GDP growth in the 4th quarter of 2007. According to this data Latvia's economy expanded in the fourth quarter at the slowest pace since March 2005 growing by 9.6 percent. Still since this is still probably the fastest rate of expansion in the European Union, - and compares with 10.9 percent in the third quarter - it is not an especially useful data point for those of you who are interested in the finer details of things, and in particular for those of you who want to know whether or not the Latvian economy is going to "enjoy" a hard or a soft landing.

Another approach to this process would be to look at the quarter on quarter changes in GDP. During the 3 quarters prior to Q4 Latvian GDP has grown at 2.4, 2.7 and 2.8% respectively. That is, in Q3 growth was still accelerating slightly. Now we have no figure for Q4 yet, but doing some quick mental arithmetic, my guess is that q-o-q growth will come in around 1.5/1.6%, provided the original flash estimate is confirmed. Now this deceleration is quite fast, but it still isn't enough to tell us what kind of landing we will have with any high degree of certainty (as opposed to what my guts tell me). Look at the chart a moment.

Well, we can certainly see that the cycle has peaked, and the slowdown is certainly sharp, but look at the chart a bit harder, and you will see that after Q4 2002 there was another sharp slowdown, but in Q3 2003 there was a rebound. That is what the people who argue there will be a soft landing this type hope will be repeated. My view is that I don't see how this can happen with the Lat at its current high values, since to get export let growth, export prices in euros will need to be brought back down from where they will be once all that inflation is effectively "bled" out of the system.

What I do think though is that we need to see the reading on GDP for the next quarter. Unless there is a complete fudge in the data, my guess is that we will be able to say definitively at that point.

Which means we should know definitely one way or another on or around 8 May 2008. Those of you of a nervous disposition might like to take up knitting or crochet in the meantime.

Thursday, February 7, 2008

Estonia Inflation 2008

Estonia's inflation rate rose to almost a 10-year high in January, led by an increase in taxes on fuel, alcohol and tobacco. Inflation accelerated to 11 percent, the highest since April, 1998, from 9.6 percent in December, according to the statistics office in Tallinn today. Month on month, prices rose 2.2 percent.

Continued high inflation triggered by rapid economic growth, a consumer spending boom and growing labour shorgages now increases the risk of an abrupt slowdown in Estonia, and puts mounting pressure to do something about the high value of the currency which makes exporting increasingly difficult.

Wednesday, February 6, 2008

Latvia Industrial Output December 2007

According to preliminary data from Latvijas Statistika total seasonally adjusted industrial production decreased by an annual 5.4% in December 2007. Manufacturing output decreased by 7.5%, while in electricity, gas and water supply there was an annual increase of 2%, and mining and quarrying the increase was 7.8%.

However if we look at the trend, month on month from November industrial output at constant prices decreased in December 2007 by 3.2% on the month, on a seasonally adjusted basis (seasonal and working day influence is taken into account). There was a monthly 1.7% decrease in mining and quarrying, a 1.8% one in manufacturing, and a 7.3% one in electricity, gas and water supply. So the picture is that manufacturing continues to decline, while the novelty is that output in mining, quarrying, electricity, gas and water are now also falling.If we add to this the likelihood of negative growth in retail sales, and no significant increase in government spending (ex EU grants) then it is hard to see where GDP growth is likely to come from as we move forward. Certainly we are a long way away from an export lead growth process at this point, and something will need to be done about relative prices if this is to become possible.

Looking at the charts we are still in the process of falling steadily off the roof, and if the degree of slope is anything to go by, we aren't falling slowly, in fact our rate of descent has just accelerated.

The details below which come from the statistics office are interesting since they give some idea of the distribution of the slowdown.

Compared to December 2006 industrial output in manufacturing of food products and beverages decreased by 14.8%, of which in manufacture of other food products (bread, confectionery, sugar) – by 36.1%, dairy products – by 11.2%, meat and meat products – by 6.8%, beverages – by 5%. Within the food product group only production in processing and preserving of fruit and vegetables and in processing and preserving of fish and fish products grew, by 28.8% and 11.8%, respectively.

Compared to December 2006 output increased in manufacturing fabricated metal products (except machinery and equipment) – by 56.1%, in manufacture of motor vehicles, trailers and semi-trailers – by 11.1%, in manufacturing of basic metals – by 5.9% and in manufacture of pulp, paper and paper products – by 5%, but the most notable industrial production output decrease was recorded in manufacturing of rubber and plastic products – by 19.3%, in manufacture of non-metallic mineral products (manufacture of glass, ceramics, cement, concrete, brick, etc.) – by 18.6%, in manufacturing of chemicals, chemical products and man-made fibres – by 18.2%, in manufacturing of furniture; manufacturing not classified otherwise – by 15.5%, in manufacture of radio, television and communication equipment and apparatus – by 15.1%, in manufacturing of wearing apparel – by 14.9%, in publishing, printing and reproduction of recorded media – by 13.2%, in manufacturing of other transport equipment (repairing and construction of ships and boats) – by 10.9%, in manufacture of machinery and equipment – by 10.7%.

On an annual basis - compared to 2006 - industrial output in 2007 increased by 0.5%, of which mining and quarrying by 13.7%, electricity, gas and water supply by 4.2%, while industrial output in manufacturing decreased by 1%.

In 2007 increases were recorded in the manufacture of fabricated metal products, (except machinery and equipment) —by 19.4%, in manufacturing of rubber and plastic products – by – 13.6%, in manufacture of electrical machinery and apparatus - by 10.6%, in manufacture of pulp, paper and paper products – by 9.5%.

The most significant industrial output decreases were recorded in the manufacture of radio, television and communication equipment and apparatus – by 19.9%, in manufacture of wood and wood products – by 5.8%, in manufacture of machinery and equipment – by 6.8%, in manufacturing of furniture; manufacturing not classified otherwise – by 5.1%, n manufacturing of wearing apparel – by 4.5%.