Emerging Markets and Safe Havens

Danske Bank's Lars Christiansen had another research note last week which is of some interest for Latvia's current situation (see this post for his earlier research note). Entitled "Emerging Markets: Looking for the safe haven" (watch out pdf), and published last Thursday, Christiansen accepts that there is a global credit crunch, and that it is now spreading to Emerging Markets (EM), with many of the high-risk EM currencies (the Turkish Lira, the Hungarian Forint, etc) now coming under heavy fire. As to the question what countries may be most at risk, he answers the following:

In a situation where liquidity is tightening there is no doubt that the most liquidity-“hungry” countries are those with large current account deficits and large external debt. In this category we find Turkey, South Africa, Hungary, and Iceland. Furthermore, risks are heightened in the Baltic states, Romania, and Bulgaria.

That would seem to put Eastern Europe pretty generally on the map I would have thought. Chrisiansen seems to accept the arrival of the credit crunch as now a fact:

For the last couple of weeks, we have warned that the global credit crunch could spread to Emerging Markets. This has now clearly happened, but given the major moves in the global credit and equity markets there clearly is potential for even more contagion to Emerging Markets. Therefore, there is also reason to start looking for safe havens within Emerging Markets. Here external funding needs will be the key.

Furthermore:

The credit crunch has triggered a strengthening of the yen and to a lesser extent, the Swiss franc. We would in particular watch the Swiss franc as many households in Central and Eastern Europe have funded their property investments with Swiss franc loans. Hence, if the Swiss franc strengthens further then it could put additional pressures on the CEE markets mostly exposed tothe Swiss franc.

This is really code language for speaking about Hungary (although there may be more) since in Hungary around 80% of the mortgages which have been taken out in recent times have been Swiss Franc denominated (via Austrian banks I should mention, so the Austrian banking sector is also partially at risk, although the Austrian Central Bank think they can withstand the shock if you look at the "Stress Testing the Exposure of Austrian Banks in Central and Eastern Europe" paper presented here.

So here are Danske Banks recommendations. The countries you are told to avoid are in red:



One bright spot - or potential safe haven - does exist in Eastern Europe however: the Czech Republic:

Finally it should be noted that the Czech koruna (CZK) – unlike most other CEE currencies – should be expected to strengthen in the present environment due to unwinding of CZK-funded carry trades. That said, the CZK is fundamentally not undervalued and the Czech central bank should be expected to keep interest rates below the ECB rate – especially if the CZK strengthening accelerates. That will limit the potential for strengthening of the CZK.

In case any of you notice some inconsistency in this view of the Czech Republic, since of course Czechia is also one of the "reds" (though to a much lesser extent than some of the others), I think it needs to be pointed out that other factors beyond the CA deficit need to be taken into account when evaluating the situation (the value content of exports would be one of these, what the deficit is based on would be another - ie are you importing machinery and equipment which can subsequently be used for exports - and the openness of the labour market to immigration would be another - there is of course an acute labour shortage in the Czechia , but they are they are actively attempting to address this and they are even out trying to recruit in Vietnam). Essentially the Czech economy seems to be on pretty solid ground (as may also be the Slovenian one), and you do need islands of tranquility in Oceans of tempest. So some countires will for this very reason prove to be win-win, while others may well, by the same token, prove to be lose-lose. Unfortunately historic reality is seldom just.

I also would be much more cautious than Christiansen is about Russia, political instability is evident, as are labour shortages. We need to see what happens next to oil and other commodity prices before sticking our necks out on Russia I think.

Is Estonia Heading For A Soft Landing?

Earlier in the week I read a number of reports in the press which seemed to be suggesting that the recent (2nd quarter 2007) decline in the Estonian growth rate was an indication of the fact that a "soft landing" was now to be expected there. This article from Bloomberg more or less typical of the reception with which the data release was greeted:

Estonia's economy grew at its slowest pace in two and a half years in the second quarter, as manufacturing output ebbed and oil shipments from Russia declined.

The $15.1 billion economy grew an annual 7.3 percent, compared with 9.8 percent in the first three months of the year, the Tallinn-based statistics office said on its Web site today. ``The number takes out the worst fears about overheating,'' said Mika Erkkila, a senior analyst with Nordea Bank in Helsinki in an e-mailed comment.``However, 7.3 percent is still above the long-run sustainable rate and hence it will still take a quarter or two with further slowing growth before we can conclude that we are out of the woods.''

The central bank said the data was in line with its previous forecasts the economy will make a ``soft landing.'' Trade data also indicated the current-account deficit has stopped growing, it said in an e-mailed statement.

The finance ministry said growth should slow further in the third quarter, citing weaker business and consumer confidence. The slowdown in the second quarter was more than expected, but still ``welcome'' after prolonged growth above potential, the ministry said in an e-mailed statement.

Now I was intrigued by all of this since in the first place I don't think any decision on hard and soft landings is something you can take on the basis of a simple quarterly GDP reading (leaving aside for the present time the question of what exactly we mean by hard and soft landings in this context, a topic which I have attempted to address in this post), and in the second place I don't think you can even begin to address the issue in an emerging markets context (and yes, the Eastern Europe EU 10 are in the sense that counts here still "emerging markets")without taking some account of the final landing the financial markets will have when the current bout of turmoil ends. But still, as I say, I am intrigued by the way people can make such assertions, and what they think the grounds for making them are. So I started to dig a little deeper. And here is what I found.

In the first place it may be useful to take the arguments as they are being presented one at a time, since the way people justify their opinions is important, and I do think there is some confusion abroad about is being talked about here.

What is being asserted is:

1) That the year on year growth as measured by quarters has slowed in Estonia (this is certainly true, it has).

2) That the growth rate needs to slow further to "get out of the woods".

3) The Finance Ministry consider the slowdown greater than expected, but still "welcome".

4) The data is consistent with the possibility of Estonia having a soft landing.

Points (2) to (4) seem to me to be misleading, and now I'll try and explain why. (Incidentally, here is the original Estonia statistical office release which lies behind the report. It is worth noting that what we have here is only a "flash release", the complete initial data will only be available in September, together with what promises to be a complete overhaul of recent Estonian GDP data, so we well may be in for some surprises yet awhile, but still, if we want to decide whether or not we face a possible hard or soft landing at this point we have to work with the data we have, such as it is).

One of the difficulties about measuring economic growth is that you are never sure just which numbers to look at. You could look at GDP evolution (by quarters, lets stay with quarters here) in straight current money terms, a process which for some strange reason we economists refer to as viewing the data in "nominal" terms. So lets start here, and to do this here's a chart for Estonian GDP at current prices and non-seasonally adjusted since the start of 2006.





Well this chart is reasonably easy to interpret, and there is no big mystery here, in the sense that it is clear that the Estonian economy is, and has been, growing. So, lets dig-down a little deeper: here's a chart for Estonian GDP at current prices and non-seasonally adjusted since 2000.



Now the interesting thing to notice, is that in these "raw", non-adjusted, figures, you can see a clear decline in GDP in Q1 each year when compared with Q4 in the previous one. So the annual data have a rather irregular flavor, and this will be important when we get to what is happening in 2007.


Ok, so now let's look at the data from 2005 on a seasonally adjusted and constant (2000) price basis, ie what we economists call in "real GDP growth" terms.



Here what we can see here is that while the Estonian economy has been growing, the rate of growth has been slowing for some quarters now. This slowing becomes even clearer if we look at the quarterly growth in real terms.




Here it becomes apparent that the Estonian economy probably peaked somewhere between the 3rd quarter of 2005 and the 1st quarter of 2006. But what stands out even more is what happened in Q2 2007 (with a quarterly growth rate of only 0.2% according to my calculations). This is almost - in Baltic economy terms - to grind to a halt. Indeed since the Q1 2007 figures are seasonally corrected, and it is not clear to what extent the "correction" being used is valid during such a sudden slowdown, the deceleration may be more equally distributed over the two quarters than it seems, but still, the drop is real and evident enough.

The issue is however compounded by one additional factor, which only adds to our difficulties: the bronze soldier factor. Back in April Estonian authorities exhumed the remains of 12 Soviet soldiers and moved the associated bronze statue to a military cemetery on the outskirts of Tallinn. This move provoked significant protests in Tallinn and other Estonian cities, disturbances which lead to the detention of over 1,000 people, to dozens injured and to the death of one Russian national.

Predictably the Russians have responded in kind, by taking administrative economic measures against Estonia.

Tiit Vahi, Estonia's former prime minister and owner of the Silmet plant, is quoted in the Estonian press as saying the downturn was predictable, given that the economy was bound to be negatively affected by any worsening in relations with Russia.

"Russia has used administrative measures, scaling down rail service and limiting exports to Estonia and imports from Estonia," he is quoted as saying.

This view is also shared by Tiit Tammsaar, head of Baltic Panel Group, who said his company, which produces plywood, has been experiencing a shortage of raw materials from Russia.

The state-controlled railway Eesti Raudtee has also indicated that the volume of rail shipments fell 35% in July, year-on-year, to 2.5 million metric tons, while the volume of oil shipments in July fell 34%, year-on-year, to 1.55 million metric tons, and coal shipments declined 60% in July, year-on-year.

As a result of this Eesti Raudtee has had to lay off 200 employees due to a fall in the volume of freight traffic to Russia.

So what can we conclude from all this? Well in the first place the obvious point would be that it is very important when you enter a critical economic period as Estonia has, not to shoot yourself in the foot. But then this is exactly what Estonia seems to have done.

Clearly the dispute with Russia has produced a dramatic screech of the brakes in Estonia. Does this mean that a hard landing is now inevitable? Well, not necessarily, since to know the answer to this question we need to know what happens next in the financial markets, but what we can say is that the possibility of a hard landing has risen considerably, while what we most definitely can't say is that this slowdown is positive (or "welcome" even, given its scale) or that it provides evidence of a soft landing. Au contraire and caveat emptor.


Update

Someone who seems to have some clear idea about what happens in the world is Danske Bank Senior Analyst Lars Christensen. Last week he published a research report (pdf link) which I pretty much agree with, and in particular he says this:

It is still too early to say whether there will be a hard or a soft landing in the economy – and we will probably not know this for a couple of quarters yet. The signs of overheating in the Estonian economy have been very clear, and therefore it should not be any great surprise that growth is beginning to slow now.

By-the-by he also makes this point:

The breakdown of the national accounts numbers for GDP has not yet been published, but other data indicate that the slowdown in the economy is fairly broad-based. The major change is probably that consumer and investor sentiment have turned more negative, and private consumption and particularly fixed capital investment – mostly in the construction sector – is now beginning to slow decisively. That said, the numbers are still mixed, but overall we do not think there is any doubt that growth has peaked and a slowdown in the economy is under way. Anecdotal evidence seems to indicate that a slowdown in construction activity, in particular, is leading the general slowdown in the economy.

Latvian Fertility

Well, while we are looking at the economic straights which Latvia is now in, it may also be useful to see how we got to where we are. Basically the Latvian economy is growing very rapidly, in all probability too rapidly even in the best of cases. But Latvia does not have the best of cases. If there were a plentiful and adequate supply of fresh labour, growth rates near the present one might not be unthinkable (remember China's GDP is currently growing at around the 11% annual rate, and India may well soon overtake this - over say a 5 to 10 year window). So why not Latvia? Well you have to look at the fertility and migration situation, that is why not.

Latvian Abroad had a post over the weekend which gave some details of the numbers of Latvians in the UK and Ireland (which must surely be the principal destinations since 2005), while Latvijas Statistika offered us some useful information on Latvian fertility earlier in the week.

But before we get into some of the more recent details, I've compared a simple chart showing live births in Latvia since the late 1980s (and in the process, documented the natural population decline by making a comparison with deaths, as can be seen the crossover point is around 1992).



And before going any further I think it important to point out that, from an economic point of view, it is live births and not the Total Fertility Rate statistic which matters, since these births are what regulate the actual flow of new people into the working age groups. As can be see there was a very dramatic decline after 1987 (ie 20 years ago). The decline steadied after 1999, and the number of births has risen slightly, but it is important to point out here (and even forgetting for the moment about the impact of migration) that the number of births will surely soon start to fall again.

This is principally for two reasons:

In the first place there is the fact that the median age of first birth for Latvian mothers at around 25.5 is still comparatively low by West European standards (in Western Europe the numbers normally are approaching the 30 mark). Let's have a look at a chart from Latvijas Statistika:



So we can see that mean ages at first birth have been steadily rising. This process is known as birth postponement, and produces what is known as a "birth dearth" as women delay having children. This process also produces artificially low readings on period based fertility indicators (like the standard Total Fertility Rate), but this, as I say, is largely irrelevant from an economic point of view, since what we are interested in is how many people will be arriving in the labour market in the years ahead. And as I say, since postponement has only run approximately half its probable course, we should expect more from the "birth dearth effect".

But there is a second reason why births are likely to go down with time rather than up, and this is known as the population momentum effect. If we look at the number of children born in 1999 (just under 20,000), then even assuming that Latvia achieved that magical 2.1 perfect reproduction fertility number, they would only produce 20,000 children, not the old level of 40,000 or so. And we can be pretty sure that these 20,000 children born in 1999 won't do this even under the best of circumstances (which, of course, we aren't) since even being optimistic they are only likely to have completed cohort fertility of somewhere in the 1.5 - 1.7 region if other countries examples are anything to go by. So these 20,000 children will produce say 16,000 or 17,000 children.

July 2007 Latvia Inflation

Well, not unexpectedly the July inflation reading came in on the high side (9.5% year on year). This is not especially surprising given all the inflation there must be in the pipeline after all the wage rises. Things will have to get worse before they get better on this front. The first sign that inflation pressures are easing would come from the Q2 wages data, assuming these have improved.

Of course coupled with the Q2 GDP data (see next post), there are few signs that Latvia is slowing anything like quickly enough (in order to avoid having a very dramatic deceleration later), so this must raise question marks about the effectiveness of the policy measures introduced so far.

For the record, here are the time series graphs for the consumer price index and the yaer on year inflation rate.