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.

Monday, May 26, 2008

Estonia External Trade March 2008

The rate of increase in Estonias exports fells back again in March, with exports rising at an annual 2 percent rate compared with an annual 8% increase in February. Not entirely unexpectedly imports plummeted over March 2007 (though they were running at the highest level since last November), falling at a 10 percent annual rate.

In March 2008 the share of the EU countries was 73% and the share of CIS countries accounted for 12% of the total exports (in the previous year 70% and 12%, respectively). Compared to the previous year, exports of goods to EU countries increased 7%, but to CIS countries decreased 4%. The main countries of destination were Finland, Sweden and Latvia.

In total imports the share of the EU countries was 81% and that of CIS countries 11% (in the previous year 76% and 16%, respectively). Imports from the EU countries decreased 3% and from CIS countries even 38% compared to March 2007. The biggest decrease was in the imports from Russia and Finland (by 1 and 0.3 billion kroons, respectively). The most important partners in imports were Finland, Germany and Sweden.

Estonia's trade deficit widened in March to 3.3 billion kroon ($330 million) compared with 3.0 billion krooni inFebruary, the first increase since December, although the deficit was down by 1.7 billion kroon on the 5 billion kroon deficit registered in March 2007.

Weakening exports will obviously compound the problems Estonia faces after GDP growth slowed to an annual 0.4 percent in the first quarter. With domestic demand shrinking, export strength is now the key issue. Since energy imports will remain a significant drag it is going to be hard work reducing the deficit while oil prices are so high, and GDP growth is really produced by the excess of exports over imports. So at the moment things look pretty difficult on all fronts.

Friday, May 23, 2008

Estonia Wage Increases in Q1 2008

Wages in Estonia, which has the fourth-fastest inflation in the European Union, rose by 19.5 percent in the first quarter, adding to concerns of about the hardness of the ``hard landing'' which is now underway. The increase is slightly less than the 20.1 percent wage growth recorded in the fourth quarter, but only slightly so, and the Estonian economy is certainly not correcting from its excesses anyhting like fast enough.

Wage growth in the central government sector rose 23.8 Percent, and 25.9 percent in local governments, reflecting growth in among other areas teachers' salaries. Wage growth was the slowest, at 10.7 percent, in transport, with property industry wages rising 15.7 percent and manufacturing wages up 16.3 percent, the statistics office said.

The inflation rate, which hit a 10-year high in April, and more conservative lending by banks have cut consumption and cooled the housing market, with economic expansion almost stalling to 0.4 percent annual growth in the first quarter, the slowest rate in the EU, compared with 4.8 percent in the fourth quarter and 10.1 percent a year earlier.

Rising wages, boosted by labor shortages during the economic boom from joining the EU in 2004, and an outflow of workers to wealthier member states are undermining the competitiveness of companies who sent products abroad. With domestic demand shrinking, export strength is a key to any future growth when it returns, the central bank and the International Monetary Fund warned this week, but I fear the tightness of the labour market may prevent any rapid and "natural" correction to this situation.

Of course real wages are now rising much less rapidly than previously due to the rapid increase in inflation, but that is scarcely a consolation in this situation.

Tuesday, May 20, 2008

Latvia Unemployment April 2008 - Where's The Correction Mechanism?

According to data from the Latvian State Labour Board, Latvian unemployment in April was at 52,897 (or an umployment rate of 4.8%) this was up from 52,806 in March, but only slightly (93 people to be exact, although obviously there are seasonal factors to take into account here. But this figure was still substantially down from the 67,154 (by about 14,350 people) registered in March 2007. Given that the Latvian economy is contracting I think this result is significant.

and the unemployment rate has been dropping steadily.

And the picture doesn't change substantially if you look at unemployment using the EU harmonised methodology. According to Eurostat unemployment in Latvia was running at 4.6% in March 2007 and 4.5% in March 2008, ie it is still down year on year, even though GDP was growing at a strong rate a year ago and is contracting now.

The economy has gone into recession without generating sugnificant unemployment. Of course the labour market does follow movements in GDP with a lag, and we still haven't had the "hard landing", but still, this is a surprising result.

It also helps explain why the rate of wage growth - according to the laytest data we have which is for the last quarter of last year - has't slowed dramatically, although it may now do so.

The position isn't that different in Estonia, since according to the latest data from the Estonian Labour Market board the rate of unemployment in April was still incredibly low there too - running at 2.7% - with only 17,098 people registered at the employment offices. Using the EU hrmonised methodology, the rate is rather higher - some 5.5% in March which is the latest data we have from Eurostat - but to get a comparison this is not up enormously from the 4.9% rate recorded in March 2007 using the same methodology. ie on whichever measure you use unemployment has risen, but not that much, at this point, which would explain in part why wage rises have been so stubborn in coming down in terms of their annual rate. There simply is not that much "surplus labour capacity" in Estonia, and this is of course part of the whole inflation - and now stagnation - issue.

Basically I hate to be a bore, or "party spoiler" at this point, but this is the issue that has been worrying me from the start about the whole Baltics situation, the absence of the ability of the labour market - due to years of very low fertility and substantial out-migration - to correct during a recession.

Without getting too theoretical here, there simply is no homeostatic mechanism to fall back on here to guarantee stability. Since the cohorts leaving the labour force at the upper end are going to be consistently bigger than those enetering at the bottom, there is no build up of surplus labour in the "deposit" during the slowdown.

Leaving aside the length of the present slowdown and its possible severity, we are left with the very unfortunate situation that when growth eventually does start to pick up again, there may be very little surplus labour capacity available to fuel the growth, and logically inflation would then simply start to shoot up yet one more time. Basically I would say that finding a longer term solution to this problem is now one of the most urgent questions facing the Latvian (and Estonian, and Lithuanian) government.

Estonia Producer Prices and Unemployment April 2008

The prices of goods leaving Estonian factories and mines rose at an annual 7.2 percent rate in April, which was the slowest rate in 13 months. Producer-price growth, which is an early indicator of future movements in consumer inflation, slowed from an 8 percent rate in March, according to data released by the Estonian statistics office earlier today. Prices rose a monthly 0.8 percent, which was up when compared with a 0.1 percent rise registered in March.

Looking at the above chart the downward trend is now clear. Declining domestic demand is undoubtedly forcing companies to tighten up on cost inflation and this is surely slowing down the rate of wage-cost growth from the more than 20 percent registered last year. The Estonian economy, which was the European Union's second fastest-growing in 2006, slowed to an annual rate of 0.4 percent in the first quarter, the EU's slowest, according to preliminary data, compared with 4.8 percent in the fourth quarter, as consumption shrank and the housing boom cooled.

In April 2008 the percentage change in the export price index was 0.4% compared to March 2008 and 5.2% compared to April 2007, while the percentage change in the import price index was 0.7% compared to March 2008 and 5.5% compared to April 2007.

In separate data - confirming the decline in domestic demand - the Estonian Statistics office reported that in the 1st quarter of 2008 8,900 purchase-sale transactions in real estate had a total value of 9.4 billion kroons and that the number and total value of transactions decreased compared to the previous quarter, as well as to the corresponding quarter of the previous year.

The recession that started on the real estate market in 2007 thus continued in the 1st quarter of 2008. The total number of notarised purchase-sale contracts decreased more than a third compared to the 1st quarter of the previous year and by about a fifth compared to the previous quarter. The total value of purchase-sale contracts decreased by about a half compared to the corresponding quarter of the previous year and by a quarter compared to the previous quarter.

According to the latest data from the Estonian Labour Market board the rate of unemployment in April was still incredibly low - running at 2.7% - with only 17,098 people registered at the employment offices. Using the EU hrmonised methodology, the rate is rather higher - some 5.5% in March which is the latest data we have from Eurostat - but to get a comparison this is not up enormously from the 4.9% rate recorded in March 2007 using the same methodology. ie on whichever measure you use unemployment has risen, but not that much, at this point, which would explain in part why wage rises have been so stubborn in coming down in terms of their annual rate. There simply is not that much "surplus labour capacity" in Estonia, and this is of course part of the whole inflation - and now stagnation - issue.

Monday, May 19, 2008

IMF Warn That The Estonian Economy May Contract In 2008

The IMF have this morning suggested in a report that the Estonian economy may in fact contract this year (whole year 2008) as consumption wanes and exports falter.

The report was presented at a conference held in the Estonian capital of Tallinn. The IMF have not yet posted the report on their website, but the conference is being covered by Bloomberg's Ott Ummelas.

Sensibly the IMF saying that it is ``too early'' to make new ``numerical forecasts'' on the economy (this is my own personal position) but todays report already marks a substantial shift from April's WEO forecast, where the IMF said it expected economic growth to slow to 3 percent this year from last year's 7.1 percent, before accelerating to 3.7 percent in 2009. I think all these numbers just got scratched.

Estonian Finance Minister Ivari Padar is quoted as saying "In principle, we agree with the IMF's conclusions".

The core of the issue is summarised in the IMF view that a recovery will depend on the competitiveness of local industries, and a revival of exports or investment, adding that the slowdown will ``test'' the banking system. This is something I have been arguing from this blog for the last six months now. Basically It was always unrealistic given the pace of the slowdown to anticipate positive growth (let alone 3% plus growth) in Estonia this year (and it is far too early to start talking about 2009). Essentially continuing inflation (in the context of the currency peg to the euro) is eating away month by month at the vitals of Estonian export competitiveness.

Since Estonian domestic demand now looks to stay flat for the foreseeably future, the economy willneed to have export competitiveness to attract the inbound investment component. So everything now depends on getting relative prices straight, and without changing the peg quite frankly I don't see how Estonia is going to do this.

Basically when Estonia emerges from this crisis my feeling is that we will see an export driven economy on the pattern we can already see in some Scandinavian countries, and the reason for my holding this view is based on an appreciation of consumer demand dynamics in the context of a rapidly ageing population.

Wednesday, May 14, 2008

Estonia GDP Q1 2008 (preliminary)

In fact, we can only at this point say something decisive about Latvia and Lithuania since Estonia has not yet posted Q1 08 figures.
Claus Vistesen earlier this week in his Have the Baltics Entered a Recession? post

Well, now we can finally help Claus out, since today Estonia has posted its Q1 2008 GDP growth data, and it is pretty unambiguous: Estonia is in recession, which means that all three Baltic economies are now in all probability in recession.

In fact Estonia's economy more or less stalled in the firs t quarter , with the economy growing at a preliminary year on year rate of just0.4 percent. This was the weakest year on year number to be registered since a 1 percent contraction in the third quarter of 1999, and follows 4.8 percent growth in the previous quarter, according to data realeased by the Tallinn-based statistics office this morning.

And this isn't really the worst part, since seasonally adjusted GDP at constant prices decreased by 1.9% in the 1st quarter of 2008 compared to the 4th quarter of 2007. That is the economy clearly contracted in the fisrt quarter of 2008 and is, IMHO, now undoubtedly in recession.

Estonian consumer confidence fell in April to minus 16, matching the lowest level in 3 1/2 years that it hit in February on worsening expectations over national and personal finances, the Tallinn-based Institute of Economic Research said on April 28. Property sales fell to the lowest level in four years in the first quarter, the Tallinn-based Land Board said on April 9.

``With huge external imbalances, we believe that the Estonian economy faces a number of years of sub-trend growth to reduce these excesses,'' Violeta Klyviene, the senior Baltic analyst at Danske Bank A/S, said before the report.

Monday, May 12, 2008

Latvia Inflation April 2008

Well when it rains it really rains! Following close on the back of the news that Latvia's first quarter growth marked a strong slowdown, we now have Latvia's April inflation rate, which showed another strong uptick and rose to the highest level in nearly 12 years.

According to Latvijas Statistika the inflation rate, which is the highest in the 27-nation European Union, rose to 17.5 percent in April from 16.8 percent in March. Month on month, consumer prices rose 1.5 percent over March, the same level as registered in the previous month.

Electricity prices grew 39.2 percent in April on the month adding the most to inflation, the statistics office said. Food prices, which make up about a quarter of the consumer-price basket, rose about 20.8 percent from a year ago.

This now has all the signs of a very hard landing indeed scenario, with Latvia trapped in the vice of a pretty vicious form of what is generally known as stagflation.

Have the Baltics Entered a Recession?

by Claus Vistesen

As any mildly astute economist will know it is extremely difficult to call the exact turning point in an economic cycle and thus the point in time where a recession starts. Usually, such issues are resolved post mortem when the economic data has been firmly revised. Moreover, the actual determination of a slowdown's or a recession's starting point also quickly turns into a battle royal between economists as the alphabet soup of different national account measures easily ties up the discussion as we end up comparing apples and pairs. However, at this point in time I don't think we have the luxury to engage in such a battle among economic gentlemen. I don't think so because the Baltics' (and many of the other Eastern European countries') situation is a bit more complex than your average US type recession where a you clean up the mess with a couple of quarters of negative growth. What we consequently need to understand is that, depending on the turn of events and response from markets, the current slowdown may turn out to have quite far reaching consequences for the region. With these ominous remarks let us turn to the evidence suggesting that the tide is now finally turning in the Baltics.

In fact, we can only at this point say something decisive about Latvia and Lithuania since Estonia has not yet posted Q1 08 figures. The pace of growth however has been consistently lower in Estonia throughout 2007 compared to 2006 and in Q4 Estonia posted a growth rate of 0.9% q-o-q which is of course more than respectable but a significant slowdown in relative terms. What remains to be seen now is whether Estonia will kick off 2008 with negative growth rates or just eek out a positive showing. Indicators for retail sales suggest that Estonia may be lagging Latvia so I would not be surprised if Estonian Q1 is positive on a q-o-q basis. In the context of Latvia my colleague Edward Hugh has been keeping a watchful eye. Back in March he asked the question of whether we were heading into a recession in Q4 2007? At the time, strong circumstantial suggested that this was the case and now with the recent flash estimate from Q1 it is safe to say the coffin has now been supplied the final nails;

(...) in constant price terms - Latvian GDP hit a peak at some point between Q2 and Q3 2007 (lets say August 2007) and since that time has been steadily CONTRACTING. Now I know there are probably hundreds of different ways of skinning a chicken, and of course you can read data everywhichway you want to, and there are seasonal factors to take into account, but as far as I am concerned there is no getting away from it, on any reasonable criterion the Latvian economy is now in recession, and has been since the middle of last year.

This leaves us with Lithuania. Since we just recently got Q1 2008 GDP figures (provisional estimates too) we should have a fairly strong picture of what is going on. First, we will have the visual inspection;

As can be observed in the figure above Lithuania stalled sharply from Q3 to Q4 and now posting a contraction in Q1 08 on a q-o-q basis. On a y-o-y basis the economy is still growing but this figure is basically pointless in so far as goes the determination of where the economy is at in the present time. The first graph speaks for itself and in this context the two additional graphs plotting the indexed values of GDP do not really add much to the general picture. I still think they have merit though. Especially the last one is interesting as it shows the 'momentum' of the slowdown. Basically the chart shows the rate of expansion relative to the previous period without saying anything about the level of growth (which is shown in graph number two).

In Summary

I have been very cautious in pulling out the R-word in connection with the Baltics let alone Eastern European in general. I still am. However, what is clear at this point is that we are now observing a hard landing. The rate of the slowdown since it began in the middle of 2007 leaves no other conclusion I think. What happens next then? This question is not at all insignificant. What we now have on our hands in the Baltics is, in macroeconomic terms, quite a predicament. Basically, the economic momentum now seems to be unwinding far too fast relative to the pace by which the inherent imbalances present in these economies can be expected to respond. Large external deficits and pegging currencies here are important since it means that the latter cannot adjust. The only possible alternative if the rout continues is consequently a transition into price and wage deflation. It is still early to say whether this will materialize but it is now a real risk rather than a theoretical possibility. Additionally, we now need to watch all those foreign banks who have set up shop across the Baltics helping to finance all those credit inflows. Will they stay or more specifically can they afford to? This is also now a question which must be considered as more than an academic question.

I am really sorry to start this week on such a nasty note but I do think that the genie is out of the bottle in the context of the Baltics. Now we need to watch carefully where it goes from here. If economic momentum (or lack thereof) continues to linger in the current territory we should be a prepared for a rapid change of fundamentals in the Baltics.

Friday, May 9, 2008

Latvia GDP 2008 Q1 GDP Flash Estimate

Latvijas Statistika published the following 2008 Q1 GDP flash estimate on its website this morning:

In accordance with flash estimate published the CSB, which is based on currently available statistical data and econometric models, the Gross Domestic Product (GDP) increased by 3.6%, compared to first quarter of 2007.

More precise data and more extenive analysis of first quarter 2008 GDP will be published on June 9, 2008. In the meantime we are rather left guessing again. First of here is the year on year chart:

If we look at the rate of decline indicated by the slope of the line over the last three quarters one thing is clear: this is now that long feared "hard landing". I think though that had already been clear for some time from the data we had been seeing from retail sales and industrial output.

I will try and put something more extensive up either later this afternoon or early tomorrow, but if we take into account that quarter on quarter growth over the 3 previous quarters had been at a rate of 2.4, 2.5 and 1.2% respectively, and that this added up amounts to 6.1% growth in 3 quarters it is pretty clear that we must have seen quite a strong contraction (in seasonally adjusted terms, since the other numbers are seasonally adjusted) in Q1 2008. More later.


What a chump I am sometimes. Basically the easiest thing to miss is the blindingly obvious. Now what we do know - according to the flash estimate, which can be revised of course, but as one commenter (see below) astutely notices normally the revisions have been downwards of late - we do "know" that GDP probably rose by 3.6% year on year, and we do know that GDP in Q1 2007 was 2058.156 million lats (i just looked it up at Lavijas statistikas). So if we increase this number by 3.6% we get 2132.249 million lats (since I just did the calculation), and that puts us at a level lying below the 2,192.109 million lats of Q2 2007 and below the 2,240.902 million lats of Q3 2007 (all at constant, inflation adjusted, prices).

That is to say that - in constant price terms - Latvian GDP hit a peak at some point bewteen Q2 and Q3 2007 (lets say August 2007) and since that time has been steadily CONTRACTING. Now I know there are probably hundreds of different ways of skinning a chicken, and of course you can read data everywhichway you want to, but as far as I am concerned there is no getting away from it, on any reasonable criterion the Latvian economy is now in recession, and has been since the middle of last year, and as a result I am now more than happy to stick with my original recession call which I made when I first had site of the detailed Q4 2007 data.

As I say the Latvian economy is contracting, and I see no sign (or jutification for thinking) that it is going to start expanding again in the immediate future. So I really don't see where people are getting all those positive GDP growth numbers for 2008 from at this point, I really don't.

Thursday, May 8, 2008

Estonia Inflation April 2008

Estonia's inflation rate rose to a 10-year high in April as food and housing costs jumped, showing Baltic countries may face spiraling inflation even as their economic expansion slows. Consumer prices rose an annual 11.4 percent, the most since April 1998, after a 10.9 percent increase in March, according to the statistics office in Tallinn.

In April 2008 compared to April of the previous year, the prices of goods changed by 10.4%, of which the prices of food by 15.3% and the prices of manufactured goods by 6.5%. The prices of services increased 13.4%. Regulated prices of goods and services changed by 21.4% and non-regulated prices by 8.7%. The index was mainly influenced by the price increase of food and by the increase in the expenditures on housing. The prices of motor fuel also increased, accompanied by the increase in the prices of transport services. Dairy-, cereal- and meat products gave more than two thirds of the price increase of food. The biggest impact on the increase of expenditures on housing had the price increase of heat energy.

On average, the prices of goods and services in April were 1.0% higher than in March.
The consumer price index was mainly influenced by the increase in the prices of food and heat energy. Fresh vegetables and cereal- and meat products gave 80% of the price increase of food.

If we weren't in a stagflationary scenario before, we certainly seem to be in one now . Today's data shows just how difficult it'll be for the authorities to bring inflation back down, despite a rapidly slowing economy.

The finance ministry has sais that it expects double-digit inflation to continue ``in the coming months,'' citing external pressures from rising global food and fuel prices.

Estonia's central bank last month forecast 2008 economic expansion of 2 percent, expecting a contraction at the end of the year, after lower spending and property investment pushed growth to 4.8 percent in the fourth quarter, the lowest in almost six years.

The central bank said today that April price increases were caused by rising prices of food, raw materials and heating charges in several regions due to higher global oil prices. Price increases are potentially in line with the central bank's forecast of 9.8 percent average inflation in 2008.

Wednesday, May 7, 2008

Latvia Industrial Output March 2008

In March 2008, industrial output in Latvia fell 5.5 percent on a working day adjusted basis and at constant prices when compared with March 2007, according to the latest data from Latvijas Statistika. Output in mining and quarrying shrunk 21.1 percent, and output in the manufacturing industry was down by 9.2 percent. Only output in power, gas and water supply increased - by 3.6 percent.

Compared to February, this March, Latvia's industrial output contracted by 1.5 percent on a seasonally and working day adjusted basis. This composite figure included a 10.8 percent drop in mining and quarrying, a 4.3 percent decrease in manufacturing and a 4.3 percent growth in power, gas and water supply.

Certainly if we look at the charts we will see that the slowdown is now pretty dramatic.

Over the entire first quarter of 2008, industrial output in Latvia declined by 3.1 percent, compared to the same period a year ago.Over the three-month period, output decreased by 4.7 percent in manufacturing and by 0.3 percent in power, gas and water supply, but rose 4.6 percent in mining and quarrying.

Now when we saw the GDP data for the last quarter of 2007 I was arguing at that point that Latvia had quite probably already entered recession (ie quarterly negative growth), and when we come to look at this industrial output data for Q1 2008and put it up against the retail sales data (see chart below) it is very difficult not to think that the Latvian economy is now well mired in recession, especially if we take into account the fact thgat at this point the Latvian government was still trying to run a fiscal surplus, so there is no relief on that front either. So Latvia has now almost certainly got itself well bogged down in recession (even while the inflation fire continues to roar). The only really big remaining question is just how long it will have to wait to come out of this recession, and just what the Latvian economy will look like (in a structural sense) when we get to that point.

A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.
John Maynard Keynes

Monday, May 5, 2008

EU Economic Sentiment Index For the Baltic Countries

Economic confidence across the eurozone is eroding rapidly, with increasing signs that the growth slowdown is hitting the region’s labour market, a closely-watched survey has shown.

The European Commission’s eurozone “economic sentiment” index has fallen sharply from 99.6 in March to 97.1 in April – the lowest level since August 2005. With the indicator regarded as good guide to growth trends, the unexpectedly steep decline pointed to a marked deceleration in economic activity.

The latest data could fuel speculation that the European Central Bank will cut interest rates later this year. Eurozone inflation data showed eurozone prices rising at an annual rate of 3.3 per cent this month – down from 3.6 per cent in March – suggesting that the worse may be over in terms of price pressures.

If we turn to the Baltic countries we can see that Latvia and Lithuania continue their steady downward course, while Estonia begins to decline again after a few months of seemingly marking time. The deterioration in Estonian sentiment in April is pretty consistent I would say with the other data we have been receiving lately, like the industrial output for March.

Basically I think the Baltic countries should pay attention to what is happening across the rest of the EU , and in particular to the eurozone (although the UK economy is also clearly losing speed fast). The fortune of these countries is now of particular interest to Baltic citizens since the Baltic economies are now all export dependent given the boom bust cycle which domestic demand has just passed through. So really now what happens to your potential customers really does matter to you.

As can be seen from the above chart, Italy's economy continues - like Venice - to sink steadily, while the two eurozone economies which had the strongest housing booms - Spain and Ireland - head steadily off the cliff, with Spain having poll position, and by quite a long margin. My basic guess is that the mechanism for a slowdown in central and eastern europe will operate through Germany. basically the German economy is very heavily dependent on exports, and German GDP growth is now very sensitive to export volume growth. The slowdown in the UK, Italy and Spain - which are all important German customers will in all likelihood have a significant negative impact on the German industrial output dynamic, and we saw an indication of this in the relatively weak employment growth in April in Germany. Since most of the CEE is locked into the German economy quite strongly this loss of momentum in the German economy will be felt across the zone, and in a sort of negative lose-lose dynamic this impact on output in the CEE will work its way back home to Germany again. That is to say I would be expecting to see quite a significant slowdown in Germany in the second half of 2008.

Estonia Industrial Output March 2008

Estonia's industrial production fell year on year in March, the first decline in more than eight years, and just one more sign that the country's economic downturn is now continuing its course after having a brief respite in January/February. On the worst case scenario (which does seem to be unfolding) Estonia's economy may actually contract in 2008 after expanding an average of 8.7 percent every year since 2000.

Output, adjusted for working days, decreased an annual 4.9 percent, the first fall since August 1999, after a revised 5.5 percent increase in February, the Tallinn-based statistics office said today. Production fell 5.3 percent in the month on a seasonally adjusted basis.

The March decline was led by wood production and processing, the second biggest component of manufacturing with a 14 percent share. The industry's output shrank a work-day adjusted 18 percent, with the production of building materials falling 19 percent.

Food production, the biggest manufacturing industry with a 17.5 percent weighting, declined 7 percent as rising prices deterred consumers, the fourth straight month of shrinking output. Manufacturing made up 88 percent of total industrial production in March.

Electricity output fell 24 percent as domestic production was replaced by cheaper imports, which covered almost 30 percent of local consumption, the statistics office said.

Saturday, May 3, 2008

Foreign Credit in Lithuania

by Claus Vistesen

As my regular readers will know a part of my analysis on Eastern Europe and the Baltics has been to look at the Eastern European edifice through the lens of Lithuania. Last time I did that I showed an update in terms of the labour market as well as I did a more thorough analysis of Lithuania's external position. At this point I probably should move in with a lot of updated graphs on the labour market and economic activity. However, I won't since we have not gotten a lot of new data and what we have got confirms what we already knows. Inflation continued its upward increase in the first months of 2008 where the HICP index touched nearly 12% y-o-y. This is not at all good news. As we can currently observe across a wide range of Eastern European countries inflation is lingering even as economic growth slows down considerably. Meanwhile of course Lithuania's capacity to work its way out of this seems quite shaky since unemployment is at all times low which means that the structural pressures for wage increases and productivity eroding inflation is now a fundamental part of the economic structure. A combination of rapid economic growth as per expected on the basis of the convergence hypothesis and a structurally broken population pyramid and net outward migration is now taking its visible toll. Provisional estimates for Q1 GDP suggests that Lithuania expanded at 8% y-o-y which is still way too fast given the underlying capacity constraints. Official authorities in Lithuania narrate this as if the economy is on track towards a soft landing. I can only hope they are right but I am not confident. Signs of a slowdown are beginning to emerge ever so slightly in the labour market where unemployment has risen a tad going into 2008. Obviously, as Lithuania slows further this development should increase. As ever though, the risk is of a rapid reversal of economic conditions loom on the horizon in the context of the global financial and now also food crisis thundering along with all the increased risks that such events bring with it in the context of a small emerging market such as Lithuania.

What risks we should watch out for is what I will investigate further here.

Better late than never an old adage goes. In this way, IMF's recent World Economic Outlook as well as its Global Financial Stability Report comes with a timely warning in the context of the current financial and food/energy related crisis (the latter point which I will deal with later and where you, in the meantime, could do a lot worse than read Macro Man's recent tale of the 800 lb gorilla). As per usual, IMF's center piece publications are littered with information but the part of it I most noticeably latched on to was the chapter about emerging markets and their resilience. More specifically, I took note of the part dealing with the resilience of the CEE and Baltic economies' external position. Now, this story has already been well summarised by RGE's Mary Stokes in her excellent investigation of foreign banks' presence and exposure to the Eastern European markets and thus, by derivative, Eastern's Europe dependence on credit inflows to finance external borrowing (often done in foreign currency just to make it a bit more complicated). Since I have also sketched this situation many times before I am going to quote myself from a previous note in which the stylised facts are laid out ...

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?

Especially, the last question is important to be aware off and essentially this is also at the heart of the inquiry Mary and IMF are making. In the context of Lithuania the dependence on foreign loans reveals itself on two accounts. Firstly, we have the composition of the external balance where we can see how the liabilities (i.e. the break up of the negative net investment position) is made up disproportionately much of bank loans compared to the more traditional components of portfolio flows and direct investments. Secondly, we have also seen how, as a result of the pegged Litas to the Euro, many of these loans are denominated in Euros. This is about balance sheet risks then in the context of translation risk which basically arise in connection with loans denominated in Euros and cash-flow/deposits where an overweight is in Litas. Obviously, this works well as long as the peg holds but in light of the discussion sketched above the risk is of course that the foreign banks suddenly retreat and/or that the Lithuanian currency is subjected to a pressure to depreciate as the external position becomes unsustainable. Quite clearly, any kind of market moves here would require the ECB to shield the peg since the currency board itself cannot be expected to keep the peg if the unwind really begins.

The main question I am asking here is what actually provided the build-up of foreign denominated loans in the first place and what the main driver is? Well, we are finally getting to the visual part of this note. As the first set of of graphs we have the formal illustration of what translation risk potentially means. Note that the graphs are updated with the latter part of 2007, a rather important point for the rest of the analysis (click on the pictures for better viewing).

Quite simply, translation risk can be measured by the extent to which these two figures are not alike. As we can see the loan composition does not match domestic deposit composition thus making the servicing of the debt vulnerable to potential currency movements. Moreover, these figures tend to underestimate the real translation risk since one thing is deposits another thing is the cash flow itself used to service the loans. In this light, one of the questions that has haunted me a bit lately when I looked at the charts is what exactly drives the fluctuations and general discrepancy between these charts.. One obvious explanation is that, per function of the strong foreign bank presence, the liquidity of the Euro credit market is a lot deeper than the corresponding market for Litas denominated loans. And as we shall see below this seems to correspond to reality since a deeper more liquid market quite simply translates into lower funding costs.

The three graphs above tell an important story about the market for credit in Lithuania and thus I imagine in the Baltics. As can be immediately observed borrowing in Euros is substantially cheaper than borrowing in Litas. Over the sample period in question the average interest rate spread in favor of Euro denominated loans has been 123 basis points (sd: 35 basis points) which should be more than enough to induce a considerable cross-price demand effect. Another interesting observation is that the trend in loan taking now seem to be parting ways with respect to currency denomination. In this way, the volume of outstanding loans denominated in LTL is beginning to decline where as it seems as if steam is still left in the Euro credit flows. Obviously, there may be both stock and flow effects where the latter would be how Litas loans were simply rolled over into Euro loans or, in the context of flows, simply that the amount of Litas loans were falling.

So, what on earth is all this good for?

Well, I think there are two main issues to note. First of all I should thoroughly try to formalize the connection between the interes rate spread and the composition of Litas vs. Euro denominated loans. As can be seen it seems as if the hump of the interest rate spread is indeed reproduced in the graph of the currency composition of the total loan portfolio. In order to investigate this I developed a small rudimentary regression model with the change in the differnce between Litas and Euro loans as a dependent variable and the change in the interest rate spread as an indepedent variable. This produces the following relationship (R-sq = 0.147, F: 6,20 (p; 0.0176).

If you really want the equation just drop me a note in the comments. The formal interpretation of the model is that a 1 basis point increase in the interest rate spread in favor of the Euro translates into a 32 basis point change in the difference between Euro and Litas denominated loans. E.g. if the interest rate spread widened .25% (25 basis points) in favor of the Euro (i.e. Euro loans got .25% cheaper relative to Litas loans) the change in the difference between Euro and Litas denominated loans would be 8% (800 basis points) in favor of Euro loans. Please note that this is not a very strong model in statistical terms but it does show that a relationship exists.

The second issue which is more pertinent in our present context is just what we can expect from interest rates going forward. Clearly, as Mary shows above (and as is widely detailed in the IMF report) foreign banks are now visibly beginning to wobble. As an appetizer of this we learned recently that a batch of Swedish banks recently suffered a dent in their Q1 profits on the back of the slowdown in the Baltics. We need to understand that this is just adding further to the perils of these banks since they are obviously already under attack on several other fronts not least in the context of securing financing for their operations in the interbank market. All this points to higher borrowing costs for those Euro denominated loans. Should that be a problem then? Well, not necessarily since as long as the credit market and currency peg is there the denomination of the loan is in fact all about where the low interest rate is. However, as I stressed above Lithuania need those foreign bank loans to finance their external position and if these suddenly dry up because the banks reduce activity and/or borrowing costs rise so much as to make them unattractive we are getting into trouble. In this context I don't see a major move out of Euro denominated loans at this point but that does not mean that the costs of servicing these won't increase. Basically, the banks can do two things. Follow the economy down raising rates and curbing lending or they can write off their losses. In reality it seems as if a process of 'a bit of both' has already begun and now it remains to be seen whether the squeeze becomes so tight elsewhere that some of these banks opt to significantly reduce activity. In this light, Lithuania in itself can hardly bring down any but perhaps a local bank but as Mary warns the contagion risk is not insignificant. Moreover, the issue of the inflows themselves are important since Lithuania, and the rest of the Eastern European gang, has an external deficit to cover. If suddenly, the inflows in the form of foreign bank loans retreat (and they will to some extent) there will be a short fall and since the Litas cannot correct we could see a rather rapid transition from rapid inflation into deflation as this would be the only way to correct the external position.

Ultimately, I am not trying to pull another doom and gloom rabbit out of the hat here. The risks I have pointed to here represent nothing new in the general discourse. What we do need to understand though is that; if the inter-relationship between the foreign banks and Eastern European and Baltic consumers/corporations hitherto was in a honeymoon stage with plenty of mutual benefits for both it is now set to become a dance macabre (or a tango if you will) and we know that this takes two to tread.