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Thursday, January 29, 2009

Message To Ilmars Rimsevics


"devaluation is a poison" and that "only pseudo-economists suggest Latvia devalue".

In this regard, it might be appropriate to consider the analogy with a pile of sand presented by the science journalist Mark Buchanan in his book Ubiquity: Why Catastrophes Happen. As a child, almost everybody has been building sand castles. We remember quite well that initially every single grain of sand which is added to the pile makes it bigger. In time, however, a certain point is reached, where the next grain causes a landslide instead of adding to the size of our edifice. Moreover, it is important to note that it is next to impossible to predict either which particular grain of sand will cause the landslide or how great and significant it will be. The author has a theory that this unpredictability is related to the instability that is unavoidable in the development process of any system. According to this theory then, even the most important events do not have special or extraordinary causes. These events can result from any, even the most insignificant of causes: a mere grain of sand that under different circumstances would probably be totally inconsequential and harmless.
Opening Remarks by the Governor of the Bank of Latvia Ilmars Rimsevics, Conference hosted by the Bank of Latvia - Latvia on Its Way to Prosperity: Growth Potential and Development Prospects, October 18, 2006.

I have one simple question. Given the latter, how can you be so sure of the former?

More opinions today.

Baltic Business News quotes economic analysts Hardo Pajula to the effect that the EEK has already effectively devalued, sinceit has lost its value since if a person loses half of income, "it’s the same as devaluation" (is this so hard to see, Edward).

“Devaluation is worsening of everyone’s standard of living at once and we have no escape from that in the near future. EEK has devalued for many of us since their incomes are smaller. Currently the devaluation moves from an individual to individual,” Pajula said.

Also Erkki Raasuke, Swedbank Baltic CEO has warned that "if the state cannot make the necessary cuts we’ll all go bankrupt".

“If Estonia can’t go necessary cuts, we’ll go bankrupt. There are examples to take and one should mostly look at Iceland. Problems are different, but it still should be terrifying enough to discipline us,” Raasuke said. “One option is devaluation here and not with all its destructive after-effects. Then we have that option politicians currently try to do – through deflation, decreasing the costs. Here the first question is discipline – are we capable of doing it? If we hesitate, we should pick the first option,” Raasuke said.

Please feel free to paste more "pseudo economic" opinions in comments if you find any.

Are Baltic labour markets really so "nimble", Maive Rute, SMEs’ competitiveness director at European Commission doesn't seem to think so:

“The relative inflexibility of the labour market is an issue that decreases the entrepreneurs’ readiness to create jobs and that especially affects the potential investors, who are interested in the attractiveness of the area. Our current legislations are rather inflexible compared to that of the EUs,” said Rute about the Commissions’ recommendations at that time.

Also Latvia's president Valdis Zatlers said on Tuesday that the country may fall deeper into recession than the 5 percent downturn currently forecast. If this is correct, then Latvia's situation would seem to be more critical with every passing day. Latvia's problems as a result of Parex (and related items) seem to be much more serious than Estonia's (ie it would be technically easier for Estonia to devalue), and the threat of credit downgrades and government debt which may be pushed over 60% of GDP put the eurozone 2012 exit strategy increasingly at risk. I think instead of talking about pseudo economists it would be better to come up with some practical solutions which have some hope of success. I think it reasonable to ask everyone to make sacrifices in a situation like this, but only sacrifices for a programme that can bring results.


Erkki Raasuke, head of Swedbank Baltic unit also said that Estonia needs to cut state spending by 30 percent or face “bankruptcy.

Wednesday, January 28, 2009

Why Latvia Needs To Devalue Soon - A Reply To Christoph Rosenberg

The IMF Senior Regional Representative For Central Europe and the Baltics, Christoph Rosenberg, recently took me to task on RGE Monitor about my Latvian devaluation proposal (as did RGE's own Mary Stokes), and I would like now to take a closer look at some of the points they raise.

In the first place, I would like to say that I obviously regard both Chrisoph and Mary as excellent economists, and I was in no way refering to them when I said that arguing in favour of sticking to the present currency peg constitutes trying to justify “virtually the unjustifiable” according to “the implicit consensus among thinking economists.” I do still hold that the consensus is with me, but that certainly does not mean I regard those who differ from me as "unthinking", and certainly hope I didn't give the impression that I was. And with that little "mea culpa", let combat begin.

And what better way to do this than by looking at Christoph's own arguments, (see below, and I hope I am being fair), although before I actually get into this part, let me "fast forward" to what I see as the three central issues involved: the timing and duration of the correction (that we all agree is needed), the role of Latvia's special demographics, and the distribution of the impact of the eventual debt restructuring between external stakeholders (the EU fiscal structure and the foreign banks) and Latvian state finances.

V Shaped or U Shaped?

As I see it, some of the force of Christoph and Mary's argument lies in the idea that there is little possibility of Latvia being able to succesfully carry out a V shaped correction at the present time due to the hostile global environment, thus it is better (my words not theirs') for Latvia to "mark time" to some extent between now and (say) 2012 (when possibly the external environment will be returning to some sort of normality, again my feeling, not theirs), and I understand the force of this point, I really do, it's just that I don't think Latvia's social fabric will be able to withstand the sort of pressure it is going to be put under (and Edward Harrison has already highlighted this part, as I have in my longer post on the difficulties associated with introducing generalised wage reductions). The IMF report on the Stand-By Arrangement stresses time and again that political consensus is vital to carrying through the proposed "fixed-peg correction", and yet it seems as if we are already running into difficulties on this front.

Also, and to try to keep this simple and as non-technical as possible, we are simply dealing here with trade offs, trade offs between the accumulation of bankruptcy and non-performing loans on the one hand, and the attraction of new FDI for manufacturing industry and getting growth through exports moving on the other. The trick is to get the balance right.

Now the U shaped recovery puts greater weight on the former, while the V shape one puts it on the latter, and I think the choice is as simple as that really. But I would also add in a further factor (to be explored a little more below), and this is the cost of waiting (there is always a cost to waiting) in terms of the demographic transition Latvia is living through (I am thinking about both out-migration and the impact of population ageing and Latvia's declining potential labour force). I suspect that part of the difference between us lies in the fact that Christoph and I attach different values to the cost of waiting in the Latvian case, and the roots of this difference lie, at least in part, on the differing theoretical frameworks we are using. To be blunt, I do not live in what I consider to be the rather timeless and abstract world of neo-classical steady-state growth and convergence theory (for all of which we have precious little meaningful empirical evidence across the EU27), but in the real historical time of ageing and shrinking populations, non-linear growth trajectories and windows of opportunity.

Latvia has between now and 2020 to get rich before it gets starts to accumulate so many age-dependency-related on-costs that it may, if it doesn't put in a well-founded spurt now, quite simply never close the gap. So Latvia is living in real historical time, and not an abstract theoretical one, and in the former, if you don't seize the opportunities you are offered with both hands, then you may well simply end up as tyre rubber on the highway of history, enjoying momentary fame only to end up as a historical irrelevance. So although history doesn't simply keep repeating itself in a simple circular (or Poincaréan) fashion, tragedy is always tragedy, whether it is the first, second, third or nth time round.

But perhaps "marking time" isn't really a fair analogy either, since obviously Christoph feels that the time in question can be put to good use - implementing structural reforms, rewriting the bankruptcy law to make debt restructuring easier, reducing wages and prices, etc, etc - but my worry is that all this will take place against a strongly contractionary atmosphere, with strong reductions not only in real GDP but also in nominal GDP - I mean if we are talking about a 5% plus contraction in real GDP, and (let's say, just as an example) a 3% reduction in the general price level, then we are talking about a drop of about 8% in the nominal value of GDP in 2009, and about another very large one in 2010, so let's be clear, these are contractions of a large order of magnitude (not far off the US 1930 - 33 ones) and my most serious doubt is about the ability of the Latvian social consensus to hold together through this, especially if there is no visible improvement in general conditions as a result. You need some sort of carrot, and not just good will.

Wage freezes Are more Palatable than Wage Cuts

Now it may seem strange to adduce arguments from evolutionary psychology (not Evolutionary Psychology, please note) in a debate about macro economic policy, but I do feel that years and years of evolution have left us with a kind of asymmetric bias which means while we definitely (always and everywhere) don't like to see our wages and salaries actually cut, we have much less resistance to them being eaten away by price inflation (again, this is the whole point of Keynes's little tract "How To Pay For The War" - its just that this war is an economic and not a military one). So politically, it is easier in principle to maintain consensus around a devaluation which followed by tight controls on income, than it is to cut people's salaries outright. Another example which illustrates my point here comes from the recent German experience, where real wage deflation was effected over a number of years (1995 - 2005), and export competitiveness restored, by maintaining a wage freeze, and getting people (during the most significant part of this process) to agree to work more hours for the same money. But to do this in Latvia you need to be able to expand output and add jobs, which is why devaluation is, in my opinion, highly desireable. You cannot expect people to work for the same money and longer hours, and agree to the chap working next to them being dispatched off to the employment offices, things just aren't that simple in the real world.

The bicycle is must easier to keep stable if you peddle forwards.

The Demographics Clinch It

So this brings me to the biggest problem I have to the whole U shaped correction idea in the Latvian context. I will readily agree with Christoph when he says that the Latvian labour force is extremely nimble, and indeed it is especially so when it comes to packing its bags and heading off in the direction of the frontier in search of work abroad. In fact it is so nimble that it manages to do this without the Latvian statistical office even noting that the people have gone, that's how nimble they are.

So this is the outcome I really fear most, the one which means that when Latvia does eventually start to recover, this recovery will only take place with a time lag, and in the wake of an expansion in some key West European (and especially Nordic) economies, which will mean that their will be another loss of workforce in the slipstream their take off will create, a loss which can become a very serious drag on future growth, and indeed may well restrict even further the inflation-free level of sustainable growth for the entire Latvian economy. The chart below, which compares the Irish and the Latvian wage distributions comes from an earlier period (and indeed was prepared by the IMF itself), but it does give some idea of the problem, since there is a clear wage slope running across Europe from east to West, and much needed Latvian workers have an unfortunate tendency of trying to climb their way up it.

(please click over image for better viewing)

So the situation envisaged in the "fixed-peg correction" - namely a period of negative economic growth and substantial wage contraction - will probably only produce yet another round of out-migration (although this time, in all probabity, it won't be to Ireland) which will in turn makes the domestic wage correction even more difficult to implement (another kind of 'vicious loop'). It is interesting to note that the IMF were raising this sort of issue with the Latvian authorities during the earlier overheating phase, but the Latvian solution (which prevailed at the time) was really to tolerate higher than desireable wage increases in order to disuade Latvians from leaving. So there is prior evidence that whatever the promises (and even, lets be generous, the good intentions) local governments find it very hard to stand in the path of their voters when these want social improvemnt, and indeed such vulnerability could come from the most compassionate and noble of motives, the problem is these are simply misplaced.

Debt Restructuring A key Problem

Here (see below) is the IMF Structural Roadmap as it appears in the latest report, and as can be seen, there is a heavy emphasis on the legislative changes needed to carry out the debt restructuring, which gives some idea of the important role this played in the decision making process.

• Cabinet of Ministers to adopt decision that reforms controls over budget execution (December 31, 2008).
• Adopt operational guidelines clarifying procedures for provision of emergency liquidity assistance (December 31, 2008).
• National Tripartite Co-operation Council will establish a Committee to Promote Wage Restraint (January 31, 2009).
• Review and, if necessary, revise regulations on emergency liquidity support (January 31, 2009)
• Complete focused examination of the banking system (March 31, 2009).
• Develop comprehensive debt restructuring strategy (April 30, 2009).
• Amend banking laws to give FCMC, BoL and Government powers to restore financial stability in case of systemic crisis (June 30, 2009).
• Adopt an amendment to the Budget and Financial Management law to strengthen financial responsibility, transparency and accountability (June 30, 2009).
• Amend insolvency law to facilitate orderly and efficient debt restructurings (June 30, 2009).

I have to say that I am really rather surprised at a numberof the things I found on reading the IMF report in detail. In particular I discovered that the true size of the 2009 annual fiscal deficit is going to be 17.3% and not the "mere" 4.9% that appears in the final budget accounts. This is not a problem of "massaging" (I am not suggesting that) but a by-product of the cost of bank restructuring - which involves recapitalisation and the acquisition of "troubled assets" - and these costs, under the new accounting rules, are classified as held to maturity, and not marked to market in terms of their valuation, nor, under the present convention do such liabilities appear as part of the headline fiscal deficit number.

Nonethless Latvia's gross public debt is now set to rise, and dramatically. It is set to go up from 8.3% of GDP in 2007, to 14.3% in 2008 and to an estimated 46% in 2010. And this is all basically to pay for the bank bailout (which is estimated by the IMF to be likely to cost of $1.868 billon in 2009) and not in order to address issues in the broader economic crisis.

The worrying part of all this is that if we don't get the best case scenario, and find ourselves, for example) not with a U- but with an L- shaped non-recovery, then this debt to GDP (and indeed even the annual fiscal deficit itself) may start to head above the EU 60% and 3% rules in 2011 or 2012, thus putting in jeopardy the IMF's own exit strategy for Latvia of eurozone membership. The IMF themselves go to some length to point out that the best case outcome critically depends on maintaining a political will which (as we are starting to see) may not be so strong as they were lead to believe at the time of making the agreement.

The problem is that Latvia, apart from the internal credit boom, and the consequent housing bust and real economy contraction which follows (and which all three Baltic states "enjoyed" actually stands out from its Baltic peers in that it also became something of an offshore financial centre during the boom years. That is to say, there are shades of the Iceland or UK problem in the Latvian situation. I quote the IMF document:

"Finally, standard debt sustainability analysis may not capture all of Latvia's characteristics, given its dependence on foreign bank borrowing for credit intermediation and its role as an offshore financial centre. First, Latvia's net foreign debt is much lower (around 70 percent of GDP), as it reinvests many of the non-resident deposits in assets overseas. The value and liquidity of these assets then becomes key. Second, much of its foreign borrowing is backed by domestic assets. Thus external debt sustainability will depend on whether these assets recover value and will be able to generate future returns to service the debt."

As I read it, this means that Latvia is a miniture version of Iceland or the UK, and that as well as a macro consumption boom/bust disaster there is a non-domestic-loan recovery problem inside the banking system of some magnitude. As the IMF itself says the value and liquidity of Latvia's overseas assets is one of the "keys" to the problem. The other "key" depends on whether or not domestic assets recover their earlier value, an outcome which given even the internal price deflation strategy proposed by the IMF seems fairly unlikely, at least over the relevant time horizon.

The bank restructuring component is so expensive largely because the Latvian owned Parex bank (assets equivalent to more than 20% of GDP) was taken over by the government following a run on deposits and the consequent need to avoid default on the 775 million euros ($1 billion) of syndicated credits due in 2009. In fact the problems at Parex were one of the main reasons Latvia went to the IMF and EU for financial help in the first place - since in theory the issuers of the syndicated credit had the right to demand repayment of the debt immediately following a change in ownership at the bank, and the government needed the institutional support to be able to renegotiate and rollover the debt.

As a result the Latvian authorities have been able to issue guarantee for the refinancing of isyndicated loans of EUR775 million due in 2009 (EUR275 million in February and EUR500 million in June). The credit ratings agencies, and in particular Fitch, believe that in the current global economic climate a rapid future sale of the bank difficult and that the government will have increasing difficulty in the future refinancing the syndicated loans. Moreover, the risk of further deposit withdrawals from Parex bank, especially by non-residents, will continue despite the effective nationalisation of the bank.

The new Parex chairman Nils Melngailis was quoted recently as saying that the bank's value was anywhere between 2 lats ($3.65), the price the state paid to buy out the two previous owners, and 600 million euros.

If all this is correct, then my guess is that we could even be eventually looking at the possibility of a Latvian sovereign default. I mean, personally speaking, I am pretty sure the medicine the IMF are administering just won't work (for the reasons I am putting forward) and that things will deteriorate. But sovereign default something I would never have imagined before I started digging a bit deeper into the whole situation. And the IMF should seriously be thinking about this. Latvia's level of public debt was previously very low, and then whooosh. Fitch seem to share this view, since they have maintained their negative outlook following last November's downgrade.

Fitch Ratings has today downgraded the Republic ofLatvia's long-term foreign currency Issuer Default Rating (IDR)to 'BBB-' (BBB minus) from 'BBB', Long-term local currency IDRto 'BBB' from 'BBB+' and Country Ceiling to 'A-' (A minus) from'A'. The Short-term foreign currency IDR is affirmed at 'F3'.In addition, Fitch has placed Latvia's sovereign ratings onRating Watch Negative (RWN).

Soon enough Latvia will have to face all the on-costs of pensions, health etc for the growing numbers of old people as the median age rises (see chart above). Claus Vistesen and I are busily trying to "calibrate" things here, since notionally Latvia's median age is a lot younger (41) than that of Japan, Italy or Germany (43). But then, on the other hand, Latvians live on average ten years less. So people stop working earlier, and since the really large health care costs are during the last 5 years of life, and this doesn't change substantially if those involved are between 65 and 70 or between 80 and 85. So there is an ageing "calibration" issue here - one which non of the multilateral agencies involved have yet taken on board as far as I can see. Also we need to move the saving and borrowing age ranges around a bit when we come to think about the life cycle (to adjust for shorter working lives etc).

And this "just where is all the money from the loans going" issue is a much bigger question than simply a Latvian one. The IMF original loan to Hungary, for example, included HUF 600 billion (about 20% of the total loan) to be allocated to bank bailout plans, 50% of which was earmarked for capital injections while the other 50% was to be used for state guarantees for commercial banks. The government later boosted this HUF 300 billion guarantee fund to HUF 1,500 billion, however today it has been announced that more of the IMF loan facility may be used to back loans right up to the 1,500 billion HUF level - which surely gives us an indication of the severity of the problems they are having. But what concerns us here is that as a result of these and other measures Hungarian debt to GDP is now projected to rise (Januarry 2009 EU Commission forecast) from approximately 65% in 2009 to 79% in 2010, and of course there can be downside (or if you prefer, upside) on this. So both Hungary and Latvia look dead set to me to receive further credit downgrades, downgrades which will only serve to materially worsen the situation. And thus there is a considerable danger of a self-perpetuating downward spiral, especially if due to the weighting towards the bank problems the present package of measures simply don't work. People are vastly overestimating the power of longer term structural reforms in the context of such a sharp downturn. All very troubling.

Deflation A Problem?

Also, there is another fundamental reason for devaluation, and that is the ability to regain control over an independent monetary policy, since handling a sharp and sudden deflationary shock may well be much harder with a fixed-wheel lock-in to the ECB benchmark rate. Ben Bernanke himself gave us a good example of how the sort of debt deflation process to which Latvia is going to be subjected works in practice, and why it is so dangerous in a modern economic context) in an early paper he wrote on Japan.

To take an admittedly extreme case, suppose that the borrower’s loan (taken out prior to 1992) was still outstanding in 1999 , and that at loan initiation he had expected a 2.5% annual rate of increase in the GDP deflator and a 5% annual rate of increase in land prices. Then by 1999 the real value of his principal obligation would be 22% higher, and the real value of his collateral some 42% lower, then he anticipated when he took out the loan. These adverse balance-sheet effects would certainly impede the borrower’s access to new credit and hence his ability to consume or make new investments. The lender, faced with a non-performing loan and the associated loss in financial capital, might also find her ability to make new loans to be adversely affected. This example illustrates why one might want to consider indicators other than the current real interest rate—-for example, the cumulative gap between the actual and the expected price level—-in assessing the effects of monetary policy. It also illustrates why zero inflation or mild deflation is potentially more dangerous in the modern environment than it was, say, in the classical gold standard era. The modern economy makes much heavier use of credit, especially longer term. Further, unlike the earlier period, rising prices are the norm and are reflected in nominal-interest-rate setting to a much greater degree. Although deflation was often associated with weak business conditions in the nineteenth century, the evidence favors the view that deflation or even zero inflation is far more dangerous today than it was a hundred years ago.

And it seems Lavia is now about to enter a sustained period of price and wage deflation (and thus loan to income inflation) with no monetary and no fiscal tools to attack the problem.

OK, Now for Christoph's points

1/ a devaluation in Latvia would have severe regional contagion effects. I think that on this point we are all in basic agreement. On my view, the EU and the IMF need a coherent common strategy to address the whole situation in the East (at least across those countries who form part of the EU), and I think we are rapidly getting past the point where problems can be dealt with on a piecemeal basis. I mean. clearly some of the points here post date our earlier debate, but part of the foundation of my initial argument was that the whole situation was at risk of becoming so serious that nothing less than a concerted regional initiative would have the credibility and the robustness to work. It may be that outright eurosisation of the entire group maybe the only viable way to go, but I need to argue this separately and substantially, so I will not go into this further here). But, be that as it may, the leading question is that even if eurosiation is to be contemplated, Latvia, Lithuania, Estonia and Bulgaria all need to come of their pegs and lower the parity at which they would enter, and even if the situation in each case is different, the problem is going to be the same, so my underlying point would be better to do this in a cordinated way, and indeed the decision by the Hungarian government to come off their band back in May could be seen as a first step in just this direction.

This is doubly the case since when we talk about regional consequences, we can also talk about the regional effects of a strong devaluation of the UK pound, the Swedish krona, the Russian ruble, the Ukrainian hryvnia, the Czech koruna, the Hungarian forint, and the Polish zloty. Basically the economies in all the aforementioned countries all face a similar problem - domestic demand is down and they need to export, and they are all addressing this by the application of a mixture of devaluation and price deflation, and basically I don't see why the Baltics should be so different, and why we (or at least the IMF, the WB and the EU) don't treat the three Baltic states as one single group here.

3/ Latvia’s preference for the peg is strongly supported by all foreign stakeholders, including the EU and its Nordic neighbors..........it seems unlikely that they will cut their losses and pull out, as Japanese banks did during the Asian crisis. Well, this is certainly the case, but it is not at all clear that these stakeholders could not be brought over to a devaluation strategy. There is currently a lively debate going on in Sweden about just how much responsibility the Swedish government and monetary authorities should accept in the context of what is happening in the Baltics (see here, and here), and more significantly, the Group Of Ten West European banks with most exposure to the CEE economies has started to lobby for an initiative from the ECB and the EU Commission to address the problem of the inevitable bank losses (since I take it we are agreed that the defaults will be no less on the internal deflation approach, and may well, as Krugman suggests, be greater as those who have borrowed in local currency are also forced into default).

4/ A devaluation would not significantly reduce Latvia’s external financing needs. I am not sure about this. Obviously a devaluation which was sharp enough to remove all further worries about future devaluations would take a lot of pressure off the country's reserves. The shrinkage in the CA deficit would also, as you say, help a little, as would the fact that internal saving would start to improve domestic liquidity.

While it would shrink the current account deficit further, private sector roll-over rates might not improve because the higher external debt to GDP ratio would likely result in credit agency downgrades to junk status and trigger the immediate repayment of most syndicated loans. I completely accept this point, but assume that the devaluation strategy would need to be accompanied by a loan restructuring package. Evidently this will be necessary in any event, on the devaluation variant they restructuring will come sooner, but against the difficulties this may present for a Latvian legal framework which is ill equipped to address the problems which will arise can be offset the advantages of getting all the bad news out of the way early.

5/ there are advantages to a U-shaped adjustment via factor price compression over the V-shaped recovery that is often associated with a devaluation.....Christoph makes the entirely valid point that Latvia’s banks (both domestic and foreign owned) and its legal system are at this point quite uprepared for the sort of stress a comprehensive debt restucturing process would put them under. By drawing the process of bankruptcies and nonperforming loan accumulation out a bit, Christoph argues, the authorities may well buy time to improve the country’s insolvency regime, strengthen banks’ capital base and allow private debt restructuring.

Well, this is essentially the same set of issues as in argument 4. There are advantages in drawing out the bankruptcy process, but against these advantages need to be offset the problems posed by reform fatigue, as people are asked to sacrifice over a long period with no visible benefits to see for their effort. And there is no guarantee that the towel won't simply have to be thrown in at the end of the day on the U shaped recession, with a hasty devaluation being carried out, and the U being converted into a UL, with the bounce back only coming much later.

6/ it is questionable whether a devaluation would quickly boost exports, given the global environment and the structure of its exports. Re-orienting the economy towards tradables will require structural reforms which are envisaged in the program. Basically, I think we are back to the "waiting room" approach again here. Export lead growth is not really a credible option at the moment, so the argument goes, given that the external conditions are extremely unfavourable, and that Latvia's economy is dominated by non-tradeables, financial services and construction. All of this is undoubtedly true, but my argument is that you have to start somewhere, and may own view is that it is better to start tomorrow, rather than the day after, and I think the key to breaking the logjam is attracting greenfield site FDI, but to do this you need to get your operating costs down, and the V shape correction achieves this outcome quicker than the U shaped one.

7/ Latvia has a very flexible economy, especially a quite nimble labor market. Really I don't know what to make of this argument, since if this is the case, why was it not more evident during the years of dramatic wage inflation. Wage cuts of up to 25 percent do seem, as Christoph says, large, but so does the tripling of nominal wages between 2001-07 (doubling in real terms), and unless we get to grips with why all that happened in the first place (that is we take a good look at what may be the real Latvian capacity growth rate without inward migration) then I feel I remain unconvinced that we are suddenly about to see a newborn agility in the Latvian labour market. What I see are rather labour market rigidities, and a resistance to change.

Some analysts called for expanding inward migration to alleviate shortages and dampen wage pressures. However, policymakers generally considered that this would have the effect of replacing domestic low-cost workers with imported ones, thereby holding down wages and promoting further emigration. The government argues that rapid wage convergence with western Europe is needed to check emigration. - IMF Staff Report, 2006
Conclusions And Exit Strategy

So where does all this leave us? Well basically that what we have on our hands is one hell of a mess, and that here there are no easy solutions. Did anyone tell you we lived in an imperfect world? Well what is going on in Latvia is surely as good an illustration that you are likely to find that this is the indeed the case. There are no easy, quickfix, policy solutions, and I fully understand Christoph's dilemma, and the difficulty associated with decision taking in this case.

But, while nothing is guaranteed to work, some approaches may turn out to be better placed than others, and it is my considered opinion that the best way of addressing the Latvian problem is by trying to kick-start the economy via devaluation, and to then tackle the wage increase problem by explicitly opening Latvia's frontiers to external migrant labour (as, for example, the Czech Republic have, to some extent, done). Such devaluation, backed by imaginative enough greenfield site support from the government, could attract the FDI, and alongside it the migrants to provide the manpower for unskilled positions, with better educated Latvians being able to get involved in some of the higher value work. If something is not done to break the population vicious circle, and the meltdown in internal demand and property prices as young Latvians seek work elsewhere then the outcome is all too clear, although not for that any less tragic, as Krugman suggests.

Of course, some may wish to object at this point that devaluation has the same effect on wages as wage cuts do, and they would be right, but the point is the overall level of economic activity is greater on the V shaped approach (this was Keynes', and is today Bernanke's, basic insight). Latvian GDP is about to be thrown, from a period of trying to operate above capacity, to one where for an extended period of time it will operate below capacity. This can never be a good solution. On the V shaped recovery scenario the time path of GDP is higher, and the possibility of finding remunerative employment for each and every individual Latvian is to that extent greater. More idle resources will be put to work at a time when there is huge slack in the global system, and energy and material costs are at very low levels. Investment (building factories etc, buying machinery and equipment) simply couldn't be cheaper . Putting the resources to work to make this possible quite simply can't be a bad thing, or so I contend, and certainly not if the alternative may be sitting back and waiting till you have a sovereign default coming crashing in on top of you.

I see plenty of work for Latvian parliamentarians (passing much needed laws etc) in the current proposals but I see comparatively few initiatives which will keep the idle hands of Latvia's valuable human resource base from freezing over.

Let us be clear, of course there is no single clear "cure all" remedy here, but I think we need to say strongly that the earlier attempt to stem the migrant out-flow by being lax on the wage inflation front was to invite disaster (and the disaster of course came), whereas now, excessively compressing wages as the solution will have the impact which was previously feared.

Export Defeatism?

One of the biggest obstacles facing countries like Latvia at the present time (of course Latvia is far from being unique, Latvia is simply the "canary in the coalmine") is a kind of passive defeatism about exports. Of course, Christoph is completely right, the global environment coundn't be more unfavourable, but there really is plenty to be done, so why not keep warm during those long dark winters doing some of it. The EU Commission points out the problem in its latest forecast:

Exports are still dominated by commodity products and re exports, with only limited evidence of moving up the technology ladder. Hence, export revenues are exposed to volatile global commodity price developments (mainly prices of wood and metals). Furthermore, unfavourable real exchange rate developments (based e.g. on unit wage costs in manufacturing) had a negative effect on the external competitiveness of the economy. However, a recovery of exports in the first part of 2007 was driven by manufactured goods which stood at odds not only with the above described problems of the supply side, but also with the reportedly very low increase in manufacturing output in the same period. The overall conclusion on progress in strengthening the supply side is therefore mixed, but it can be concluded that the current domestic cost developments pose serious challenges to producers of tradeable goods and services. EU Commission, January 2009 Latvia Forecast

Finally Christoph has one additional point which really serves as a conclusion and a monument to all this, and that is the idea that Latvia has a clear exit strategy from its currency predicament: euro adoption.

As Christoph says, the Latvian authorities are determined to work to meet the Maastricht criteria in 2012. Certainly entering the euro zone will not do away - at a click of the finger - with the hard lifting necessary to address the competitiveness and high external debt problems (as he suggests in his avoiding the Portuguese trap article, and I go through in my Portugal Sustains post here). But it would offer support to a struggling Latvia and help bring back investor confidence. The point is, at which exchange rate should Latvia enter ERM2? Indeed, it is now apparent - if you read the IMF staff report on the standby arrangement, on their website, that they favoured an expansion of the band to 15% (which basically means 15% devaluation) and it was the EU itself who objected and pushed to retain the peg (see appendix below). It is not difficult to see the problems a Latvian devaluation might face in the light of the Parex related issues without direct euroisation (or EU fiscal support), but the thrust of my argument here has been that these difficulties (credit rating downgrades, sovereign default vulnerability) are going to come anyway. Indeed Latvia had its foreign-credit rating cut to Baa1 by Moodys on January 7 2009, the second such downgrade in three months, with the agency citing increased risks of a prolonged economic decline (read L shaped recession).

“The downgrade reflects the further intensification of the economic adjustment in Latvia since October 2008,” said Kenneth Orchard, an analyst with Moody’s, in the statement. “The economic downturn is now expected to be deeper and more prolonged than previously assumed.” The risk of a “disorderly correction” to economic imbalances remains even after securing the 7.5 billion-euro ($10.2 billion) international aid package. “Government borrowing will rise significantly over the next few years to smooth the adjustment and prevent a major economic crisis,”

Basically, the EU objected to the IMF proposal for emergency eurozone membership on the grounds that this would sat a precedent in other cases. But I really do feel that the Commission (and the ECB presumeably) are being ridiculously pig-headed here. We have an emergency on our hands, and exceptional measures are called for.

It is impossible for me to go here into all the issues involved in collective membership of the eurozone for the EU12 states that are not already in, but let me just say we need a substantial rethink allround, involving:

a) Issuing EU bonds to collectively fund bank bailouts across the Union (East and West)
b) Collective membership of the eurozone for those EU member states who want it
c) A new Lisbon Strategy and Stability and Growth Pact code involving much stricter conditions and stronger Commission powers and sanctions.

c) is the necessary and prior condition for giving consideration to (a) and (b) and not the other way round.

Finally, thank you, one and all, who have struggled forward and reached this point. In particular thank you for being so patient with my verbal largesse. I am trying to contain it, I really am.

Appendix: Extracts From IMF Staff Report On Latvian Request for Stand-By Arrangement

The authorities and staff examined the merits of alternative exchange rate regimes. A widening of the exchange rate band to ±15 percent (as permitted under ERM2; currently Latvia has unilaterally adopted a ±1 percent band) would result in a larger initial output decline, since adverse balance sheet effects would reduce domestic demand. However, competitiveness would improve more quickly, reducing the current account deficit and fostering a more rapid economic recovery. The case for changing the parity would be stronger if it could be accompanied by immediate euro adoption. Technically, this would address many of the risks described above, and give Latvia deeper access to capital markets. With its negligible public sector debt, the government would also find it easier to borrow in euros on international capital markets. However, the EU authorities have firmly ruled out this option, given its inconsistency with the Maastricht Treaty and the precedents it would set for other potential euro area entrants.

The main advantage of widening the bands is that it should eventually deliver a faster economic recovery. Although growth would be depressed in the short run by balance-sheet effects (see below), the economy might then bounce back more sharply, and a Vshaped recovery would likely start in 2010. This reflects a faster improvement in competitiveness since high pass-through (reflecting Latvia’s openness to trade and liberalized movement of labor within the European Union) would be dampened by the negative output gap. Enhanced competitiveness would also reduce the current account deficit more quickly. This would come mainly from import compression, with a relatively slow response of Latvia’s underdeveloped export sector, especially as the external environment is not as supportive as in previous devaluation-induced recoveries as Argentina, Russia or East Asia.

However, balance-sheet effects would cause a sharp drop in domestic demand. The net foreign currency exposure of Latvia’s private sector is around 70 percent of GDP, with the corporate sector’s foreign currency open position roughly double that of the household sector’s. A 15 percent devaluation against the euro would increase private sector net foreign currency exposure by 11 percent of GDP, two thirds in the corporate sector and one third in the household sector. Mismatches between owners of foreign currency assets and liabilities suggest that devaluation may cause substantial redistribution effects. Private consumption would fall by around 6 percentage points due to negative wealth effect as net foreign debt increases, house prices decline, debt service costs increase, and consumer confidence deteriorates. Experience of other countries suggests that a devaluation of this magnitude would lead to a 5 percentage point decline in private sector investment.

Euroization with EU and ECB concurrence would also help address liquidity strains in the banking system. If Latvian banks could access ECB facilities, then those that are both solvent and hold adequate collateral could access sufficient liquidity. The increase in confidence should dampen concerns of resident depositors and also help stem non resident deposit outflows.

However, this policy option would not address solvency concerns and has been ruled out by the European authorities. If combined with a large upfront devaluation, there would be an immediate deterioration in private-sector solvency, which could slow recovery. Privatesector debt restructuring would likely be necessary. Finally, the European Union strongly objects to accelerated euro adoption, as this would be inconsistent with treaty obligations of member governments, so this option is infeasible.

Friday, January 23, 2009

Estonia's Exports Down Again In November

Well, there is nothing really surprising here. The people who advocated keeping the peg knew what they were getting into, didn't they? Exports and imports were down sharply in November, and there is obviously a lot more to come. So we should expect to see some pretty shocking GDP numbers in the coming quarters. The only surprising thing, perhaps, is that Estonia’s trade deficit still widened in November (from October) as exports fell to their lowest level in the whole year due to waning foreign demand for cars and fuel. The deficit ballooned to 3.08 billion krooni, which compared with a revised 2.58 billion krooni in October. Exports fell an annual 19 percent, and imports declined 20 percent.

Estonian PM Andrus Ansip also acknowledged in a press conference yesterday (Thursday) that one of the reasons for the deterioration of the current crisis in the country is that some of the governments in some export markets such as Ukraine, Russia, Sweden and UK have gone for allowing their currencies to weaken against the euro.

“Before our very eyes, some of Estonia’s export markets practically have ceased to exist for us,” Prime Minister Andrus Ansip told a news conference yesterday. “The crisis and difficult times have reached Estonia.”

Estonia’s economy contracted an annual 3.5 percent in the third quarter, the second-weakest performance in the European Union behind Latvia. Exports of cars, which are shipped from western Europe for re-exports to neighboring Latvia, Lithuania and Russia, fell an annual 32 percent. Fuel exports, mainly of Russian oil products, declined 30 percent. Exports to Latvia and Lithuania fell 36 percent, and 21 percent, correspondingly.

The UK Shows Latvia The Way

Well, this morning I am taking the rather unusual step of putting a whole article from the Financial Times online. Even more unusually, the article ostensibly has nothing to do with Latvia. I say ostensibly, because in reality it has everything to do with Latvia. It is basically about how a country which has been dependent on financial services and construction for a ridiculous boom can go to work on correcting that. I don't think I am saying anything very constroversial if I say that the UK has a rather more substantial economic tradition than Latvia does, so it could be interesting to listen to what UK economists have to say, and how they are going about trying to straighten things out there.

Also, it only struck me this week how ridiculous it is to have all these Swedish banks giving the advice to stay on the peg, when Sweden itself is not pegged to the euro, and is able to "correct" in a way which Latvia isn't. Sweden again is a country with a substantial economic tradition. There is now quite a debate going on inside Sweden itself about the extent of that country's responsibility for what is going on in the Baltics. It also now seems clear (from the IMF staff report on the Latvia loan available on the IMF website) that it was pressure from the EU - who didn't want Latvia to throw itself at the mercy of the euro - which has created this ridiculous situation. The IMF seem to have favoured widening the band to + or - 15%, as a first step to entry into ERM2.

The latest person to start to complain has been Neivelt, chairperson of the Estonian Development Fund is saying that Estonia isn’t competitive with its current cost base, and the only option that faces the country is lowering prices and cutting salaries.

“Our main problem after this consumption party is competitiveness. The money has been devalued in many export markets. With our expense base and prices we are no longer competitive. Polish food is going to Lithuania and it’ll be here soon. Soon we might not be able to produce food competitively,” Neivelt said. “Today is the situation that shopping in the UK is cheaper, sitting into the taxi is cheaper than in Tallinn, eating out is cheaper than in Tallinn – with our prices we aren’t competitive,”

Estonian PM Andrus Ansip also acknowledged in a press conference yesterday (Thursday) that one of the reasons for the deterioration of the current crisis in the country is that some the governments in some export markets such as Ukraine, Russia, Sweden and UK had gone for allowing their currencies to weaken against the euro.

And one thing they realise in the UK - and that people in Latvia seem to be struggling with - is that the slump won't last forever - but that since the internal market will be low growth, then exports will be crucial in raising living standards. So even if you can't export much in 2009 and 2010, this is no reason not to get ready to start exporting in 2011 and 2012.

While exporters have benefited from the cheaper pound in higher profits rather than higher market share, he feels that will change as business conditions become more challenging and when the global economy recovers. “There will come a time when British exporters will have to compete on price,” as well as on quality.

With the pound more competitive than in years, Sir Andrew (Cahn, chief executive of UK Trade & Investment) feels the time is ripe to “market Britain as never before” so the economy can benefit from export-led growth once the global recession is over.

New look UK economy to emerge from gloom
By Chris Giles, Economics Editor

A slimmer financial services industry, lower house prices, higher borrowing costs, fewer migrants and lower growth rates: these are the features that will distinguish the economy forged in the crucible of recession, according to an FT analysis.

But, according to the research, the years of downturn will also boost exports and see the private sector start to regain some of the ground lost to the public sector over the past decade.

Gross domestic product data covering the final three months of 2008 will on Friday provide the latest evidence of the depth of the recession which has been under way since the late summer. Economists believe output is unlikely to climb back to last year’s levels until late 2011 or 2012.

So where should businesses invest and graduates seek employment if they aim to surf the wave of recovery?

Even when output recovers to its 2008 levels, unemployment will be higher than it is now. Malcolm Barr of JP Morgan forecasts the economy will grow more slowly as east European migrants find the UK a less attractive place to work.

On the output front, the most likely change is a relative decline in financial services. Ray Barrell, of the National Institute of Economic and Social Research, predicts that sector will fall back to 6 per cent of national income, its level in 2000, down from the high of 8 per cent reached in 2007. “The country, or at least London and Edinburgh, will be poorer than we had thought it would be.”

In contrast, the public sector will be playing a bigger part in the economy, as the government reluctantly compensates for reduced private sector activity.

Mr Barr adds: “To the extent the state is more involved [in the economy], it is by dint of decisions it would have preferred not to have taken.” This is likely to be the sector’s high watermark, however, given planned cuts in public spending.

By 2012, the big winner – strikingly, given the decline in the industrial base over many decades – may be manufacturing. Although the sector is taking a hammering, the pound’s continuing weakness should encourage longer term investment and increase output. Simon Hayes of Barclays Capital says: “In a complete change to the past eight to 12 years, there is every reason to expect exports will be, relatively speaking, thriving.”

Expenditure patterns are likely to alter markedly as a result of the downturn. The fall in house prices, which are likely to wind up about 30 per cent below their peak, will almost certainly permanently reduce consumption as a share of national income, raising saving levels as well as net exports.

Wages will form a bigger share of national income, reflecting the drop in income and profit that will be suffered by companies. But once the recovery is under way, profits are likely to rise strongly again.

Carl Emmerson, deputy director of the Institute for Fiscal Studies, rejects the notion that any real benefit can be reaped from the downturn. “It is difficult to think of winners,” he says, arguing that by 2012 a large amount of expected economic output will have been lost for ever.

He concedes that among the better-protected groups are those who have retired on secure incomes who should not lose out provided they do not want to trade down in the housing market. Younger people will also have the chance to pay less for housing once credit constraints ease.

But the big losers are those who bought property at the height of the market or are close to retirement without final salary pensions, the newly unemployed and the very rich, whose incomes tend to be correlated with the stock market.

Will the British model of capitalism have undergone a lasting shift by the time the nation emerges fully from the downturn? Ross Walker, of the Royal Bank of Scotland, warns the private sector’s contraction in contrast to the public realm means “we are likely to end up losing entrepreneurial spirit”.

But that, he suggests, reflects the true nature of the economy over the past decade. “The credit boom went a long way to disguising the mediocrity of the UK,” he says.

Cheerleader in good spirits

The pound is plummeting, the once booming financial services sector has never been weaker and some investors are losing confidence in the UK. It has rarely been a more difficult time to be Britain’s chief cheerleader abroad but Sir Andrew Cahn, chief executive of UK Trade & Investment, is in good spirits.

“There is no doubt we’ve taken some damage to our image,” he told the Financial Times after speaking on Thursday to the Whitehall & Industry Group, a charity that wants greater collaboration between bureaucrats and business.

“But one of the important things is to acknowledge mistakes and we do that well in Britain,” he said, referring to the feverish activity across the public sector aimed at improving financial regulation.

But at the heart of Sir Andrew’s confidence is the fall in sterling. “The most important benefit is that our exports are more competitive and we are continuing to attract inward investment as [UK] assets are cheaper to buy.”

While exporters have benefited from the cheaper pound in higher profits rather than higher market share, he feels that will change as business conditions become more challenging and when the global economy recovers. “There will come a time when British exporters will have to compete on price,” as well as on quality.

Sir Andrew feels export success will come from some unlikely sectors. “We have doubled our staff on security because it is a growth area,” he says, insisting that security is not just defence equipment but airport protection systems, protective clothing, and security advice and services at sporting venues.

With the pound more competitive than in years, Sir Andrew feels the time is ripe to “market Britain as never before” so the economy can benefit from export-led growth once the global recession is over.

Wednesday, January 21, 2009

Freezing Yourself Out In Lithuania And Latvia

This very short piece of news in Bloomberg this morning is straight to the point, how the hell are you going to export to countries (whenyou now need to live from exports) if those countries are having massive devaluations while you mark time. Oh, I know, the Ukraine and Russia represent only a small fraction of Baltica exports, but they aren't the only ones falling, the Romanian Leu, the Polish Zloty, the Hungarian Forint, the Czech Koruna are all falling, and all these countries are direct rivals for market share in the rest of the EU.

AB Snaige, the only refrigerator maker in the Baltic states, will cut about 300 jobs in its Lithuanian factory, citing lower demand in Russia and Ukraine as both the ruble and hryvnia lose value against Lithuanian litas. Sales in Russia and Ukraine have “stopped” and “there is no evidence these markets will revive” during the first quarter, the Alytus, Lithuania-based company said in a statement to the Vilnius Stock Exchange today. The company employs “more than” 2,300 workers in its two factories in Lithuania and Kaliningrad, Russia, according to its Web page.

Basically as I say, it also matters which currency you are pegged to. One commenter has made this point.

Regarding Latvia, I'm working for industrial company in Latvia, with most customers from Sweden or Russia and latest SEK and ruble rate changes have really eaten up business both for export and import. From SEK/LVL we lose in funny sequence, more you sell - more you lose. Today, here are a lot and a lot of industries closed, closing or planning to close.

Evidently there is a lot of "restructuring" going on, but is it the kind of restructuring Latvia and Lthuania need, I ask you?

Euro To Swedish Krona

Here's the chart of the Euro with the Swedish Krona.

Euro To Russian Ruble

Here's the Euro/Ruble chart:

Euro To Polish Zloty

Finally, here's Latvian industrial output for November, anyone spot the trend?

And incidentally, Latvian exports were down 19.7% between October and November 2008. And incidentally, Latvian exports were down 19.7% between October and November 2008. Oh, I know, I know, not only doesn't Latvia need exports, it doesn't need industry either. Meanwhile, onwards and downwards we go.

Monday, January 19, 2009

The Long And Difficult Road To Wage Cuts As An Alternative To Devaluation

Well it's pretty clear to me at least that there is now one, and only one, major and outsanding topic towering head and shoulders above all those other pressing and important problems those of us following the EU economies currently find lying in our macro-policy in-trays: the issue of wage cuts. Not since the 1930s has the possibility of such a generalised reduction in wages and living standards loomed out there before policymakers, and doubly so if we now hit - as I fear we may well for reasons to be explained at the end of this post - systematic price deflation in a number of core European economies.

The issue that has suddenly and even violently erupted onto the European macro horizon over the last week (as if we didn't already have sufficient problems to be getting on with) is, quite simply, how, if they either don't want to, or can't, devalue, do politicians successfully go about the business of persuading the people who, at the end of the day, vote them into office (or don't) to swallow a series of large and significant wage cuts? And this is no idle and abstract theoretical problem, since in the space of the last week alone the issue has raised its ugly head in at least four EU member states - Ireland, Greece, Latvia and Hungary.

In the case of the first two of these devaluation simply isn't an option, since there is no a local currency to devalue, while in the case of the latter two the presence of prior large scale foreign currency borrowing means that authorities are nervous about anything that smacks of devaluation (since the providing banks would take large losses following the inevitable defaults, and the cooperation of these providing banks is necessary in the future if the economies in question are ever to recover). This latter view (no devaluation) prevails even though many economists, (including myself), would argue that is a highly questionable one, since wage deflation on a sufficient scale will ultimately produce those very same defaults (with the added schadenfreude, as Paul Krugman points out, that even those who have borrowed in the domestic currency are also pushed into default).

War of the Sicilian Vespers Part II

Now, there is already quite a debate going the rounds on the merits or otherwise of devaluation in the Latvian case (see IMF Central European representative Christoph Rosenberg here or RGE Monitor analyst Mary Stokes here), but what I want to focus on in this post is the acute difficulty faced by any elected politician when it comes to enforcing wage cuts. This has to be one of the most important arguments in favour of devaluation, at least from the practical policy point of view. And this is also why, in my humble opinion, the IMF constantly ends up being the whipping boy, since the easiest way for any local politician to try to side step the responsibility for taking difficult decisions is to throw the country to the mercy of the "dreaded" fund (or at least, as seems to have happened in last weeks Irish case, threaten to do so), and then tell everyone that there simply is no alternative, as "they" will accept nothing less.

All this puts me in mind of the popular urban legend according to which mothers in Naples put the fear of god into their recalcitrant offspring by warning them that they'd better darn well behave since otherwise "the Catalans will come" (in reference to an infamous incident in the aftermath of the War of the Sicilian Vespers in which Catalan Commander Roger de Flor allegedly massacred 3000 Italian soldiers on his arrival in Constantinople - for default on a debt as it happens - simply because his mercenary troops had not been paid). Now mothers all over Europe are apparently telling their children "lock the front daw, Dominique Strauss Kahn is Coming".

The Irish Gaffe, Or Just Another Load Of Old Blarney?

First Up this week was Irish Prime Minister Brian Cowen, whose alleged threat to call in the IMF if the trade unions did not agree there an then to all overall 5% wage cut for public sector workers (a threat which was subsequently denied) made quite a few waves in the press and even got as far as producing an official denial on the part of the Fund.

Prime Minister Brian Cowen, while at an investment conference in Tokyo on Wednesday, was reported to have endorsed the view of an Irish union leader that the parlous state of Ireland's public finances could lead to the IMF ordering mass dismissals of public sector workers. Dan Murphy, the general secretary of the Public Service Executive Union, had previously told his branch members that the Fund could intervene if public spending was not curtailed, according to the Irish Times......As for public sector wages, the prime minister's comments may simply have been an attempt to scare unions into agreeing to public sector wage cuts. That ploy "may have backfired somewhat," for all the attention it has now received, remarked Rossa White, chief economist at Davy stockbrokers.

Around 20.0% of Ireland's 1.2 million-strong workforce get their salaries from the state. While that proportion is not unusual in Europe, wages are unusually high, as are their accompanying pension benefits. The Irish government is now working to scrap a 6.0% pay increase it announced last September--badly timed to have launched around the time of Lehman Brothers Holdings' collapse--and White believes another 10.0% cut is needed.

Lightening Trip To Hungary

Cowen was swiftly followed out of the starters box by IMF Managing Director Dominique Strauss-Kahn who must certainly have been the highest profile vistor to pass through the VIP lounge at Budapest Ferihegy's airport last week as he found himself having to take time out to fly-in and offer a spine-stiffener to a government who were giving every indication of backtracking on the 8% public sector wage cut they had agreed to as one of the conditions for the 20 billion euro IMF-lead rescue loan. Strauss-Kahn arrived amidst a notable weakening in the value of the forint, and all manner of speculation about whether or not the fund was set to withhold the second tranche of the loan.

At the heart of last week's visit were concerns about the size of Hungary's 2009 budget deficit, since while Hungary has been steadily reducing the size of the deficit as part of the austerity programme agreed to in the summer of 2006 and the deficit was down to around 3.3% of GDP last year, according to Finance Minister János Veres last Tuesday, it is not clear what impact the recession will have on the 2009 target number of 2.6%. And we still need to say "about" 3.3% for the 2008 deficit since we evidently don't have a final figure for Hungary's 2008 GDP on which to make a more precise calculation.

The days before Strauss-Kahn's visit were rife with speculation that Hungary might be forced to adopt new austerity measures in order to stay on track with its deficit target, with analysts estimating Hungary could be set to overshoot the target by something in the region of HUF 200 billion-HUF 250 billion, due to the recession being deeper than expected and a sudden drop in inflation. Lower than anticipated GDP growth is important since Hungary currently has an estimated 0.9% contraction pencilled-in for its fiscal calculations, while in reality the final outcome may be anywhere between minus three and minus five percent, depending on the view you take (in fact the EU Commission Hungary 2009 Forecast - out today has -1.9, but this is almost certainly too optimistic). Also the sudden drop in inflation is also taking everyone by surprise, since if prices are lower than expected then VAT returns etc will be down accordingly, too. Hungary's inflation stats will likely undershoot the current forecast, Veres emphasized, confirming analyst expectations for a significantly lower inflation path for Hungary (the current market consensus for annual inflation in December 2009 is 2.6%, but again personally I think this is way too high).

"Currency traders in London took a sentence out of context in last night's media reports (which included Portfolio.hu coverage) which said the International Monetary Fund might cancel October's credit agreement with Hungary. This was the main reason for extreme pressure on the forint this morning," a Budapest-based trader told Portfolio.hu. After this morning's statement by Finance Minister János Veres, who claimed it was “impossible" for Hungary not to meet fiscal targets (or else the government was ready to take further austerity measures), market players began to see that the panic was unsubstantiated. As a result, we have seen an intense correction towards midday, the trader argued.
Portfolio Hungary Report

So Hungary's 2009 budget is in trouble, and this is partly due to exaggerated inflation and growth forecasts, and partly due to some hefty government compensation for state employees who lost their “13th month" bonus at the end of 2008. Arguably it was this latter point which was the main reason for the IMF Managing Director's visit. Strauss-Kahn met with Prime Minister Ferenc Gyurcsány, Finance Minister János Veres and National Bank of Hungary Governor András Simor, President of opposition party Fidesz Viktor Orbán, and a number of MPs, according to the IMF press release.

Apart from putting a stop to any kind of "back door" compensation for wage cuts, the tangible outcome of the meeting was a battery of agreed measures intended to bring the budget deficit back into line with targets.

“In order to partially offset the loss of budget revenues, we do not want to rule out the possibility of tax hikes," Hungary's Finance Minister János Veres told a morning talk show on Hungarian TV channel ATV. Veres did not make direct reference to a VAT hike, but recent press leaks and comments from analysts suggest that this may well be in pipeline.

Naturally Strauss-Kahn explained at his post meeting press conference that the International Monetary Fund was generally satisfied with Hungary's efforts to meet the conditions for the IMF loan (he was, of course, hardly likely to say otherwise in public), and he even dangled out the possibility that the loan might be extended beyond 2010 if economic condititions made it necessary. We will return in the future to this point, since as I personally cannot see the present plan working as anticipated, I cannot help asking myself when it will be (if ever) that Hungary is able to be discharged and certfied as fit to stand on its own by the fund. Or are we about to see the creation of a new set of Fund Economic Protectorates, a possibility which I'm sure was never envisaged by the institution's founders.

How To Dangle Your Government On The End Of A Very Thin Thread Latvian Style

But things were obviously a lot hotter under the collar (despite the snow) in Riga round about the same time, since according to the Financial Times Latvia’s president threatened to call early elections last Wednesday after anti-government protests led to the Baltic country’s worst rioting since independence in 1991.

“It’s going to bring down the Parliament, and through that the government,” said Krisjanis Karins, a member of Parliament and former leader of the opposition New Era party. “It’s already happening, and the pace is such that nobody really understands.”

Such demonstrations - and similar ones in Bulgaria and Lituania (shown in photo) - raise doubts over whether Latvia’s government actually has enough political and social capital to implement the painful austerity plan agreed with the International Monetary Fund last month as an alternative to devaluation.

“Trust in the government and in government officials has collapsed catastrophically,” President Valdis Zatlers told a news conference. “The Saeima [parliament] and the cabinet of ministers have lost links with the voters.”

About 10,000 Latvians demonstrated in Riga’s Dome Square on Tuesday night in a rally called by opposition parties, trade unions and civic organisations. The demonstrators accused the government of corruption and of economic mismanagement and demanded that elections – not due until 2010 – be brought forward. The government now forecasts that the economy will contract 5 per cent this year and unemployment will soar to 10 per cent.

The Latvian government is well aware that strong adjustment will be needed to ensure success. In fact, most of the tough measures—including a nominal wage cut in the public sector of no less than 25 percent—was proposed by the Latvian government itself. This shows that the economy—including the labor market and the wage-setting mechanism—is very flexible, much more flexible than in most other countries, even outside Europe. The IMF is supporting the government's policy package through a $2.4 billion loan, with the EU, the World Bank, and a number of bilateral creditors providing additional financing.
Marek Belka, Current Head of IMF's European Department, quoted in IMF Helping Counter Crisis Fallout in Emerging Europe, IMF Survey Magazine.

What really seems to have angered people are the conditions attached to the €7.5bn stabilisation package agreed last month with the International Monetary Fund and the EU after the nationalisation of the country’s second largest bank shook confidence in the country’s fixed exchange rate. In particular Latvian citizens seem to have been upset by the stringency of the austerity package since in the letter of intent Latvia undertakes to limit budget spending to under 40% of GDP, and this in the context of a sharp contraction in GDP is not an easy thing to do- Clearly not of the envisaged measures are popular - cutting wages in the government sector by about 15%, freezing pensions as well as cutting back government spending on goods and services. And in addition to the cut in provision an increase in VAT is also being contemplated. All this contrasts, however, with the measures envisaged for restructuring the banking sector, including recapitalization of banks, honoring liabilities via the deposit guarantee fund and ensuring the maintenance of confidence in the various liquidity instruments, all of these areas of spending where increases in spending will be permitted. Of course, once you decide to stay on the peg there is no avoiding this, but it is hard for ordinary people to understand that this is not simply favouring Nordic banks at the expensive of Latvia's pensioners and unemployed.

Its All Greek To Me

Greece, as ever, is steering a rather different course. In the Greek case it is not the IMF who is waving the big stick, but the credit rating agencies, in the shape of Standard & Poor's who last week cut its credit ratings on Greece's sovereign debt, already the lowest in the 16-nation euro zone, to A- with a stable outlook from A. Greece was only one of four euro zone countries who have been warned by S&P recently that they may have their ratings cut, and ideed Spain has only today had its rating cut too.

"The ongoing global financial and economic crisis has in our opinion exacerbated an underlying loss of competitiveness in the Greek economy," S&P credit analyst Marko Mrsnik said. "In our opinion, the ongoing slowdown in credit growth will likely lead to a deceleration in domestic demand, thus increasing the risk of a recession and a possibly protracted adjustment."

S&P said Greece was entering the downturn with a fiscal deficit of around 3.5 percent of GDP, after repeated government failures to bring expenditure under control and reduce high debt levels despite years of economic growth averaging four percent. Following the announcement, spreads in Greek 10-year government bonds over benchmark German Bunds widened by about 10 basis points to a session high of 246.9 basis points.

The extra interest Greece must pay to borrow money for 10 years as compared with Germany stands at 246 basis points, while for Ireland the figure hit 180 basis points, also a record, and spreads have widened too for Spain and Portugal.

Wage moderation and enhancing wage flexibility are important challenges. The authorities will continue with the policy of containing increases in basic wages of government employees and are hoping for a favorable signaling effect on private sector wage settlements. However, in recent years, wage increases in the private sector have been relatively large and often exceeded productivity growth.
Greece: 2007 Article IV Consultation - IMF Staff Report On Greece

It should not surprise us then to learn that one of the key areas of controversy behind the recent Greek protests was a law which effectively ended the employees' right to collective wage contracts - a law which won approval in the Greek parliament last August. The government justified the move by saying that it wanted to clean-up debt-ridden state companies and overhaul protective employment laws in an attempt to attract more foreign investment. The now-dismisssed Greek Finance Minister Alogoskoufis recently told parliament the reform should be pushed ahead "for the sake of the Greek economy and society," since higher wages have added to state companies' debts, which ordinary Greeks had to cover with their taxes.

A much fuller review of the Greek problem can be found in my "Why We All Need To Keep A Watchful Eye On What Is Happening In Greece" post.

So What Are The Options?

IMF Survey Online: The IMF appears to be advocating fiscal restraint in all of its loan programs in Europe. Wouldn't these countries recover faster with fiscal stimulus packages?

Marek Belka: The answer is obvious: can a country finance its borrowing requirements or not? If only these countries could afford a larger budget deficit, fiscal stimulus would have been fine. But when a country is already in crisis, the main problem is usually to come up with enough liquidity. In these cases, fiscal restraint is necessary. Choices in a financial crisis are very constrained.

Well really there are no very easy solutions here, and anyone who suggests there are is kidding you. In all the countries we are talking about above (and a good few more) the citizens, and the corporates (and in some, but not all, cases the governments) are very highly leveraged (indebted in relation to their realistic future income expectations) and the debt accumulation process has pushed living standards to a level which is higher than sustainable. Just think of your own household. If you push all the available credit to its limit during the first half of a year, its clear you can't live on the same level in the second half unless you keep borrowing, but when the lenders not only won't allow you to do this, but even have the nerve to ask you to pay some of your borrowings back, well then your standard of living in the second half is bound to drop, and this, of course, is what is happening across all these countries.

There is an additional problem here, however, since all that "over-the-top" borrowing drove these countries forward above their normal "capacity" level, and that is also what all the above four economies have in common. This driving-forward beyond capacity is what is called "overheating", and this overheating is normally reflected in above average inflation, which is again what we have seen in these countries. The end product is that they have not only an indebtedness problem but also a competitiveness one, and that is what the IMF packages are intended to address.

Of course, the problem is if you get your salary cut it becomes harder to pay back the money you owe (loan defaults) and you can't spend as much on consumption (demand slump). And on top of this, as these first two lock-in, government revenue falls (less VAT) while expenditure rises (unemployment payments and bank bailouts), so we get fiscal deficit problems. So not only do you have banks lending less, households spending less, and companies investing less (as demand drops), we also have governments finally forced to cut back (at least in the more vulnerable economies), as the ratings agencies get to work. So you get a downward spiral of falling wages, and falling prices as GDP just comes down and down. And this process can become systematic (deflation) meaning that nominal GDP starts falling even faster than real GDP, making for a car that becomes increasingly "wobbly" and difficult to steer.

In this environment, there really is only one way to halt the spiral, and to jump start the economy, and that is to export, and to try and encourage export directed investment. But to get going with exports you need to recover competitiveness. You can achieve some of this restoration via productivity improvements, but not enough, and not quickly enough, especially if the distortion is large, and has been going on over a number of years (see the real exchange rate chart for Hungary above). So you can either do one of two things, devalue, or cut wages and prices. Neither is easy, but as we are now seeing the second is hardly universally popular either.

Friday, January 9, 2009

Estonian Consumer Inflation Slows As Industrial Output Collapses

Well, there doesn't seem to much room for doubt at this point does there, the Baltic Economies are in the van of the European economic slowdown for 2009, just as they were leading the charge up in 2007, and all that debate about whether we were going to get a hard landing or a soft one seems now so out of date and and old hat as we watch how Estonia's economy contracts almost faster than the body of the incredible shrinking man (by an annual 3.5% in the third quarter of 2008), while Latvia's seems to be rivalling Harry Houdini in the expert art of staged disappearance (dropping as it did by an annual 4.6% in Q3). Even Lithuania's economy - which like a half drunken man still manages to stagger forward before it finally gets to fall over - is now expected by IMF regional representative Christoph Rosenberg to be set to contract an annual 2% in 2009. As Rosenberg so pointedly says "Latvia had the highest growth rate in the EU for several years, but it was a bubble."

The only slightly worrying thing about all the belated acceptance that the Baltics are going to have one of the hardest landings in the global economy this time round is the apparent collective failure to do the ritual "soul searching", and address the tricky issue of just what it was in the original analyses which lead so many to place such trust in the good intentions of the Nordic Banks and in the consequent probability of a soft landing, since the danger is now that we simply get misplaced policy piled upon well-meaning but misplaced policy in an attempt to address problems whose roots (which I am convinced are located to some extent at least in the regions rather peculiar demography) are quite simply left untackled. That is, we remain stuck on the currency pegs, we continue to count on the goodwill of the Nordic Banks, we expect wages and prices to exhibit a downward flexibility not seen, for example, in a comparable country like Portugal, whilst over at Eesti Pank (the Estonian National Bank) they still expect the recovery to begin in 2010 (in rather stark contrast to the much more realistic assessment for the US economy from the Congressional Budget Office - who don't expect the US recovery to really get underway till 2012, and don't see trend growth being reached till 2015). If they were serious about seeing through the correction in terms of allowing a long and painful downward adjustment in living standards to take place as the favoured alternative to devaluation, then they would realise that this process would really only be getting itself going in 2010, let alone be over - so why, oh why, I ask myself, do people in the Baltics insist on trying to view things through such rosy tinted spectacles? The main ones hurt by all this at the end of the day are those very people we are all, I am sure, trying so hard to help.

The Estonian economy should start to recover by 2010, according to the nation's central bank.Although Eesti Pank expects the country's gross domestic product to fall by 4.48 per cent in 2009, growth could be experienced in as little as 12 months, reports Baltic Business News.

The Future is In Exports

Basically the future outlook for the Estonian economy lies in exports. This simple point should not be so hard to grasp, since it can be easily deduced from one fundamental structural aspect of the Estonian economy: the presence of a fairly large current account deficit (which admittedly is not as large as the Latvian one, but the fact that others are even worse off is somehow cold comfort here) which now needs correcting. In fact, as we can see in the chart below, the correction has already started.

But what the correction means is that domestic demand will have to contract - to make space for the export oriented activity - since it has basically been the excess of domestic demand in relation to the economy's capacity to meet it which has been at the heart of the process which has produced the deficit. Effectively Estonian's need to consume less, or pay for more of what they consume by exporting, there really is no third alternative here, and the reality is that the way to "correct" the current account imbalance problem is more than likely going to be by a combination of these two paths, Estonians are going to consume less and they are going to export more, as the latest economic forecast from Eesti Pank timidly admits:

A new upward cycle highly depends on the reallocation of labour to sectors with stronger productivity growth...........Possibly, the new cycle will require part of the workforce currently serving domestic demand to be reallocated to export oriented sectors. Otherwise Estonia’s economy might be facing a long period of slow growth. It should also be said that in some cases a new job may entail smaller wages, although households are not really prepared for that.

I think it is possible to be a bit more specific and explicit than Eesti Pank on all of this: the new cycle will (certainly, definitely) require part of the workforce currently serving domestic demand to be reallocated to export oriented sectors, and in almost all cases a new job will entail smaller wages (and indeed existing jobs will have to accept wage reductions), since this is quite simply what maintaining the krona-euro peg entails - if you don't devalue, then you need to reduce wages and prices to achieve the same result. Of course, as the bank notes, "households are not really prepared for that".

Basically Estonia (and most other CEE economies) have been running large CA deficits due to the insufficiency of domestic savings to meet the principal lending and borrowing needs, so the first thing Estonians are going to need to do (and not for one year, or two years, for several years, I hardly see the structural position of the Estonian economy being better than the US one at this point, so we are talking about a correction which can run all the way through to 2015, and while we may have some sort of idea what US trend growth may be in 2015 - the famous 2% - we have no idea at all what trend growth could be in Estonia at that point, but certainly a lower than many imagine).

Another reason Estonians need to save can be seen in the chart blow, and that is the divergence between the evolution of the trade balance (which is improving) and the income balance, which continues to deteriorate. Basically the income balance reflects the difference in interest paid on loans (and dividends paid on equities) between outsiders investing in Estonia, and Estonians investing externally. This balance is deteriorating, and this steady deterioration needs to be arrested, since otherwise the achievement of a simple goods and services trade surplus will be of no avail, if all the proceeds are simply sucked out in a negative income stream.

This ongoing correction in the CA deficit is, of course, easily visible in household consumption, which is now year on year negative (see chart), where it will remain as far ahead as the eye can see (this is a simple deduction which comes from the need to save).

At the same time the trade balance is going to have to be turned round, and exports begin to take a leading role, something that they were conspicuously unable to do for many, many quarters, although there is a little evidence from Q3 2008 that the position may have begun to improve. However, as Eesti Panki themselves note, with the worsening external environment this improvement is going to be hard to maintain in the short term.

But I really do think it is important not to fall into fatalism on the export question at this point. Simply because doing anything is hard is not a good reason for sitting there with folded arms and doing nothing. The first step towards recovery will come not from the exports themselves, but from the fixed capital investment (machinery, plant and equipment) which will be undertaken in order to make exports subsequently possible. But to attract the FDI you need to get relative wages and prices competitive, you need to convince would be investors that you are a better destination than your rivals. Sorry, but capitalism is just like that, this is how it runs, and you can't take one part (the bit you like), and ignore the other (the bit you definitely don't like). There is, for better or for worse, a competitive process at the heart of all our economies, and not every situation can be straightforwardly win-win (would that!). So basically, if there do have to be winners and losers here, are you happy for your country and your economy to stay in the second group, and wait and see if eventually a rising tide can lift all boats.

At the present time, as we can see in the chart below, Estonian fixed capital formation is also running at a pretty constant year on year negative, and this is the part Estonia needs to turn round, since without this turnaround the economy will simply not get that productivity boost which again almost everyone agrees forms part of the solution recipe.

So with private consumption falling and investment falling, it isn't hard to understand that even the small increase in govenment spending that Estonia can permit itself is insufficient to stop total domestic demand from falling.

Industrial Output Plummets In November

All of this "macro" level data is of course also reflected in the day-to-day data releases we are seeing, and as might only be expected Estonia’s industrial production fell the most in at least 14 years in November. Output fell 21.7 percent, the most since at least 1995 when the Tallinn-based statistics office started compiling data in this series. This compared with a revised 11.7 percent drop in October.

“The real crisis in its real extent is starting to arrive,” according to Ruta
Eier, an economist with SEB AB in Tallinn. “The slump in demand has been
enormous and is continuing. Such a big fall probably means that export orders
also declined a lot.” Gross domestic product will decline “significantly more”
than the 3.5 percent fall in the third quarter.

Output adjusted for working days was down by an annual 17.7 percent, while manufacturing industry, which is the second-biggest contributor to GDP (second only to the property sector and construction industry) fell a working-day adjusted 25.5 percent, led by a 40 percent fall in the output of building materials and a 30 percent decline in textiles’ production.

Forty-nine percent of Estonias industrial companies said they are planning job cuts in the next three months, according to a recent survey by the Eesti Konjunktuuriinstituut research institute. Company order books were down to 3.4 months of future output in December compared with historic average of 5 months. Capacity usage was down to 67 percent, compared with an 81 percent-average for the European Union as a whole. As we can see in the chart below, it isn't only the year on year readings in recent months which indicate deterioration, the output index peaked around the start of 2008, and is now heading sharply down even below the levels of early 2006.

Companies like seatbelt manufacturer the Swedish subsidiary AS Norma (who have announced plans to cut 52 jobs, or about 6 percent of the workforce) or Dutch office equipment manufacturer Atlanta Office Products BV, a Dutch office supplies maker (who planto close their factory in Kohila, northern Estonia, with the loss of more than 200 jobs) are steadily reducing jobs, possibly the numbers seem small, but do remember Estonia really is a small open economy.

As a result Estonia’s seasonally adjusted unemployment rate rose to 8.3 percent in November from 4.1 percent a year ago, the second- biggest jump in the EU following Spain, according to the latest data release from the EU statistics office, Eurostat. The unemployment rate may rise to 10 percent by next year, according to a worst-case scenario proposed by The Estonian Finance Ministry in November, but it now seem that even that level may now be a significant underestimate, although it really does depend on whether we are referring to the unemployment rate as measured by the Estonia Labour Board methodology or the one the Estonian statistics office supply to Eurostat using the EU harmonised methodology (the Estonian Labour Board number is significantly lower).

Inflation Falling

At the same time Estonia’s inflation rate is falling (if still far to slowly) and hit its lowest level in 16 months in December - 7 percent, the lowest since August 2007 down from 8 percent in November.

So inflation is falling quite fast and is likely to significantly undershoot the central bank forecast of 3.7 percent in 2009. In fact prices fell on the month by 0.2 percent from November. This was largely the result of a sharp fall in fuel prices - down 8.1 percent from the previous month - but food (up 0.5 percent) and administered prices still continue to rise. However, as we can see in the chart below, the general index has now been more or less stable since the summer.

Retail Sales Also Falling Sharply

Estonian retail sales also posted a record decline in November - dropping by an annual 9 percent (the most since the start of the present time series in 1994, following a revised 7 percent drop in October. This drop includes an annual fall in car sales of nearly 50%, while the value of food sales is already falling in prices not adjusted for inflation.

The constant price sales index also peaked at the start of 2008, and it will be a very very long time before we see domestic retail sales hitting this sort of level again, which is another good reason why employment needs to be steadily displaced out of the domestic sector and into the export one.

Exports Still Holding Up In October

According to the latest data we have from Statistics Estonia, October goods exports were up by 13% year on year while imports declined by 3%. Goods to the value of 13.2 billion kroons were exported, 1.5 billion kroons more than in October 2007 - however the growth in exports was largely caused by the increase in the re-exports of fuels - up by nearly one billion kroons.

Imported were down to 15.7 billion kroons - 0.4 billion kroons less than in October 2007. The decline was the result of a decrease in domestic demand with the biggest falls being in the transport equipment and in machinery and equipment sections. As a result of the increase in exports and the decrease in imports the Estonian foreign trade deficit fell to 2.5 billion kroons - 1.9 billion kroons less than in October 2007. If we take account of the increase in re-exports it is evident that the reduction in imports for the domestic market was much sharper than the aggregate 3%.

63% of October exports went to the EU and 17% to CIS countries accounted for 17% of the total exports. The main destination countries were Finland, Russia and Sweden.

The Outlook On The IMF View

"The major policy challenge is the budget. The 2009 budget incorporates a welcome adjustment that required difficult decisions. However, given the deteriorating global outlook, our assessment is that the deficit will likely exceed 3 percent of GDP in 2009 and beyond. This does not present a near-term financing risk given the prudent accumulation of fiscal reserves via surpluses in recent years. But the current fiscal posture is not sustainable going forward. Moreover, it risks breaching the Maastricht fiscal threshold just when inflation is receding. This could delay euro entry, which the authorities rightly consider to be their highest priority. What is needed now is early action to achieve fiscal consolidation.
IMF Staff Mission Statement, December 2008

This is the IMF conclusion as to the short term outlook for Estonia, and the view was confirmed only last week by IMF representative Christophe Rosenberg who said in a Bloomberg interview last week that “Estonia is the least vulnerable of the Baltics because it has big buffers, it’s been running a budget surplus for a number of years now and so there are fiscal assets.”

This view is not entirely confirmed by the latest EU economic sentiment index reading (see chart above) which shows Lithuania still in an apparently better position than Latvia or Estonia, but Christoph's reasoning here is based on his assessment that Lithuania’s economy is about to “decline sharply” and I am hardly in any position to dispute his view here (nor would I wish to, I simply have not been following Lithuania closely enough). In fact the IMF forecasts that Lithuania's economy may well contract by “at least” 2 percent in 2009, even though Lithuania's central bank’s suggested an expansion of 1.2 percent in their October outlook. But on the one had we all know that the economic outlook in the CEE economies has deteriorated significantly since October - as domestic demand has waned and banks have tightened lending - while "at least" means simply that, the number could well be a lot worse.

“Lithuania is in a more difficult position as GDP growth is predicted to decline
sharply this year and this may create fiscal problems,” Rosenberg said in an
interview conducted on Tuesday in Warsaw.

What the IMF is referring to basically is the fiscal reserve which Estonia has, there is no accumumulated national debt, and indeed the government as net assets to the tune of something like 5% of GDP, so there is a certain leeway to use this money to soften the impact of the correction, although it is important that the country's savings are spent on facilitating the necessary correction and not on postponing it.

As Christoph Rosenberg points out the Baltic problems were created by a soaring wages and a credit boom which saw funds channeled into non-tradable sectors like real estate, retail and banking. As a result these economies became structurally distorted and they didn't diversify enough since insufficient was done to curtail rapid credit growth and to use counter-cyclical fiscal policies to cool the economy off before it was much too late. The danger is that if in the downturn we get the same inability to translate sound economic sense into practical economic policy that we saw during the upcycle, then problems can become worse, a lot worse, without getting any better. That is Estonia's challenge, and if it isn't grasped fully and with both hands then it can just as easily turn into Estonia's tragedy. 12 years from now (ie come 2020) Estonia's population will be much older, and the elderly dependency ratio will be much higher, than it is now. It is also to be imagined that the potential annual GDP growth rate will be comparatively lower, even as the needs for social spending rise and rise. So while Estonia still has a window of opportunity, it is not an indefinite one, and once it closes it won't come back. I think Estonia's citizens would do well to dwell on this point.

Update Wednesday 14 January

Baltic Business News reports that Estonia’s 25 bln Kroon in state reserves dropped by 20% during 2008, according to the Ministry of Finance. Government spending exceeded incomes by 5.2 bln Kroon. The budget deficit was bigger than the Ministry had estimated, Piret Seeman, the spokesperson for the Ministry of Finance said.

Seeman said the state collected less VAT and social tax than expected. Part of the reason for this was that people had postponed paying the social tax. Seeman was not able to say how much of that tax will never be recovered for the state budget.

“There is a possibility of tax debts, some debts might be for a short period,” Seeman said.

Estonia will need to keep eating up its state reserves this year, and very likely in 2010 too. More than 4 bln of Estonia’s 25 bln Krona reserves are in the Health Insurance Fund, the Unemployment Fund and Kredex. EEK 7.2 bln is in the stabilizing reserve. The rest of it is so-called cash reserve managed by the government.