World Bank Report on EU10

by Claus Vistesen

cross posted from Alpha Sources

As my regular readers no doubt will have noticed I have been very preoccupied with Eastern Europe and the Baltics recently in the light of the rather peculiar and unique situation some of these countries might end up finding themselves in given the ongoing uncertainty in financial markets and in fact also the global economy. Now, I intend to stay preoccupied as it were and e.g. at some point soon I will be expanding my ongoing analysis of Lithuania. However, this time around I am not presenting my own analysis but rather pointing towards a recent report by the World Bank on EU10 (get main points in PDF here) which also takes on the recent economic development in the Baltics and Eastern Europe both from the point of view their own individual developments but also in the light of recent events in financial markets which, as I have argued, have tended to bring the region's issues rather more quickly to the front end of the debate than perhaps could have been expected.

The report progresses with great vigour and data sampling although of course I feel tempted to launch my traditional reservation regarding the fallacy of not, even with the faintest sentence, mentioning the underlying demographic dynamic of the region. This is especially odd given that, at least, part of the report's emphasis is on the region's labour market dynamics. On this, the report does not add much to the general story we get from the media and other economic analysis sources save perhaps one important point which relates to the underlying (un)sustainability of the growth in wages on the back of dwindling capacity as labour markets tighten not only overall but also crucially in key sectors. In this way the report puts numbers and words on something which I guess we all knew but have rarely emphasised ...

In all countries apart from Slovakia and Slovenia, wages are growing faster than labor productivity. Rising unit labor costs (see Chart 28) provoke central bankers in the region to tighten monetary policies (Poland and the Czech Republic). Apart from inflationary pressures, excessive ULC growth may undermine competitiveness and prospects for sustained long-term output growth and further labor market improvement.

Apart from this and as a general qualifier to the general discourse on the labour market I would clearly also add that we need to factor in demographic trends in the form of a sustained drop in fertility since the beginning of the 1990s which is now taking its toll as well as a sustained process of outward migration from many countries to Western Europe.

There are of course a lot of other interesting points and charts and I can widely recommend you to visit the report for a closer look. However, before I leave you I want to point one more interesting point from the report which relates to the financing of the current account deficits of some of the countries in question in Eastern Europe. Now, I know that this might seem to be a technical detail but in fact it is not in this case but rather pretty important. Here is the key quote ...

External positions in 2Q 07 in most EU8+2 were financed by FDI. In the Baltic countries they were financed by foreign borrowing through the banking sector. In most countries current account deficits remain largely covered by FDI – fully in the Czech Republic and Poland, in 90% in Bulgaria and 2/3 in Slovakia and Romania. Meanwhile in the Baltic countries, which have the largest imbalances, FDI cover 1/3 of CAD in Latvia and Estonia and slightly more (58%) in Lithuania with banking sector foreign borrowing remaining the primary source of financing.

This point links up quite well with my recent analysis of the risk of so-called balance sheet exposure in Lithuania in connection with the risk that the currency peg could come under pressure. The main venue of my analysis is of course the stock of credit expansion to households and cooperations and not so much a flow analysis as is the case with the World Bank's report. However, as we can see these two things (stocks and flows) are of course related and as such we see that especially in the Baltics the hefty increase of the stock of credit/loans outstanding (using Lithuania as a proxy) is closely tied to the flow composition which finances the three countries' current account deficit. Coupled with the exchange rate exposure which could potentially emerge if the pegs were tested the Baltic countries seem to be harboring a rather nasty mix of fundamentals in the context of the external financing. Finally, it should never escape your attention that all this of course is closely tied to the ongoing turmoil in financial markets since, as per definition given the situation described above, a substantial part of the increase in credit stocks has been supplied by foreign banks and as we have all witnessed in recent weeks risk aversion is set to rise significantly among those banks who have been most aggressive in the cycle which now seems to be ending. In the case of Lithuania the first shot already seems to have been fired across the bow as Swedish owned Hansabank for example already seems to be seriously contemplating its positions in the Baltics ...

(Quote Bloomberg)

AS Hansapank, the biggest Baltic lender, will diversify its credit portfolio in Lithuania after an economic boom in neighboring Estonia and Latvia caused credit to soar dangerously high, Chief Executive Officer Erkki Raasuke said.

Hansapank, owned by Stockholm-based Swedbank AB, will ``at some point'' have to set credit growth restrictions in Lithuania, the biggest of the three Baltic countries, Raasuke said in an interview in Tallinn yesterday. It has not done so yet because Lithuania's expansion trails growth in Latvia and Estonia.

The economies of Lithuania, Latvia and Estonia are among fastest growing in the 27-member European Union, creating a boom in credit and raising warnings that growth may be overheating. The global credit crisis adds to concerns about a Baltic regional ``meltdown,'' prompting banks to take steps to limit lending.

``We don't have any signs or confidence at this point that in Lithuania we would avoid the need for credit restrictions, but we would do it differently there,'' Raasuke, 36, said. ``Instead of setting internal limits for absolute credit growth, we should rather set targets on diversifying the credit portfolio. These are the steps we didn't take in Estonia and Latvia.''

(...)

In April, Hansapank's Estonian unit raised the minimum monthly income requirement for granting a mortgage to 7,000 krooni ($607) from 5,000 krooni, compared with the average gross monthly salary of 11,549 krooni in the second quarter.

Two joint applicants would need a combined income of 10,000 krooni, compared with 7,500 krooni required previously. The bank last changed the requirements four years ago.

Raasuke said it was ``obvious'' from Hansapank's business that lending behavior had changed within the last four to five months in Latvia and Estonia, citing a ``clear decline'' in new loans, compared with peak monthly levels and the average levels of the last three to four years.

So, the lemon is getting squeezed as I type; let us hope indeed that the wring won't suck out all the juice.

World Bank Report on Labour Shortages in the EU10

The European Union's 10 eastern members must take concerted action to increase employment participation levels to avoid a serious short-term slowdown in economic growth and important supply-side structural problems in the longer term according to a report published today by the World Bank.

"Addressing the emerging skills shortages is particularly important, because failure to do so will constrain job creation and future economic growth"

You can find the report summarized here, or you can download direct here.

Claus and I will prepare a full summary and review over the weekend, but for now here are some revealing extracts.

The report in fact says the following:

In this atmosphere of short term turbulence it is important not to lose sight of the longer term trends and the fundamental challenges the EU8+2 continue to face. With the exception of Hungary, growth remains high throughout the EU8+2 and in the case of Latvia represents serious overheating. This growth is sustained largely by consumption and investment. With tightening labor markets, large increases in real wages and employment and very rapid credit expansion, a moderate slowdown in growth may in fact be desirable in the countries showing signs of overheating.

They also have this to say, which is IMHO very important, and to the point:

Unemployment has fallen substantially in virtually all EU8+2 countries since 2004 due to strong growth in labor demand. This has given rise to skill shortages and associated wage pressures, often amplified by out-migration of EU8+2 workers. However, employment/working age population ratios remain relatively low.

Really this is the very point that Claus and I have been making. They then continue:

In contrast to the earlier period of weak labor demand it is now the supply side of the labor market that constrains new job creation. Many persons of working age are economically inactive in EU8+2 either because they lack skills demanded by employers, or because of labor supply disincentives, such as early retirement benefits, generous disability schemes, high payroll taxes, and limited opportunities for flexible work arrangements. These effects are concentrated among the younger and older workers, while the participation rates for middle aged workers are similar to those of the EU15. Hence the main challenge facing now EU8+2 is to mobilize labor supply to meet the demand. Addressing the emerging skills shortages is particularly important, because failure to do so will constrain job creation and future economic growth. To increase the effective labor supply EU8+2 countries need to: (a) improve labor supply incentives through reforming the social security systems, (b) improve worker skills through reforming the educational systems and improving domestic mobility; and (c) import labor with skills that are in short supply by opening labor markets to foreign workers. The weights assigned to each policy depend on the nature of the most binding constraint to labor supply, which vary across countries.

also this is very important, even if I am nowhere near as optimistic as the World Bank is about the possibilities of Eastern Europe staying out of the firing line, especially as the eurozone itself is slowing fast.

The effects of deepening financial turbulence would potentially be more serious for the EU8+2, but are more difficult to predict. The greatest risk is that the countries that have large current account deficits – the Baltics, Romania and Bulgaria – are suddenly less able to finance them through capital inflows and are forced into an economic contraction. This is particularly true for countries like Hungary that are highly dependent on more volatile portfolio inflows than on FDI. Banking sector foreign borrowing which is the main financing source in the Baltics is generally less volatile than portfolio flows, but the extreme surge in the Latvian CAD (to 30% of GDP in the 12 months to end July ) clearly cannot be financed in this way in a sustained manner. There are other potential risks as well. A general retreat from mortgage lending provoked by US experience would lead to broad based credit tightening and weaken the booming construction sector in the EU8+2. Moreover, the increased risk sensitivity may cause the unwinding of carry trades making external finance more difficult for higher interest, carry trade destination countries.

Finally:

In the latest quarters unemployment rates have either continued to fall or have remained fairly stable despite upward seasonal pressures. In several countries unemployment rates declined to historical minima (the Baltic States, the Czech Republic, and Poland). Employment rates in Latvia, and also in Estonia reached the highest levels since the start of transition and are around 68% for people aged between 15 and 64 years, which is close to the Lisbon strategy target of 70%. Nevertheless, further employment increases may be limited because of structural nature of joblessness due to skills mismatches and unwillingness to relocate or retrain, which is particularly relevant for those who stayed out of the labor market longer.


The recent trends have undoubtedly strengthened the power of employees in the wage bargaining process. Real wages have begun to grow rapidly in Poland where their expansion had been moderate so far. The highest growth is occurring in sectors which suffer most from shortages of workers (for example, construction). Rising employment and strong dynamics of real wages are pushing the growth of the wage bill into double digits. Nevertheless, demands of higher wages for public sector employees come into sight in most countries in the region. In Bulgaria and Poland, trade unions are prepared to resort to strikes or the threat of strikes in wage setting negotiations.

In all countries apart from Slovakia and Slovenia, wages are growing faster than labor productivity. Rising unit labor costs provoke central bankers in the region to tighten monetary policies (Poland and the Czech Republic). Apart from inflationary pressures, excessive ULC growth may undermine competitiveness and prospects for sustained long-term output growth and further labor market improvement.

Hansapank Announces Lithuania Portfolio Diversification

AS Hansapank, effectively the biggest Baltic lender, has announced that it is going to diversify its credit portfolio in Lithuania.

Hansapank, which is owned by Stockholm-based Swedbank AB, will ``at some point'' have to set credit growth restrictions in Lithuania, the biggest of the three Baltic countries, Chief Executive Officer Erkki Raasuke said in an interview in Tallinn yesterday (reported by Bloomberg here). According to Raasuke the only reason Hansapank haf not previously done this was because Lithuania's problems have been longer in coming than those in Latvia and Estonia.

"We don't have any signs or confidence at this point that in Lithuania we would avoid the need for credit restrictions, but we would do it differently there" Raasuke said. "Instead of setting internal limits for absolute credit growth, we should rather set targets on diversifying the credit portfolio. These are the steps we didn't take in Estonia and Latvia."

Hansapank predicted in April that Baltic loan growth will slow to around 35 percent this year from 59 percent last year, helped by lending restrictions it set to lower credit growth to more sustainable levels.

Raasuke did however admit that Hansapank could have acted earlier to cool loan growth in the light of its own forecasts in the second half of 2006.

``We were probably talking more and doing less, there was kind of a frozen state,'' Raasuke said. ``But we are only a part of the market and it seemed that the critical mass was achieved only in February-March so that all market players could start moving in the same direction.''

In April, Hansapank's Estonian unit raised the minimum monthly income requirement for granting a mortgage to 7,000 krooni ($607) from 5,000 krooni, compared with the average gross monthly salary of 11,549 krooni in the second quarter.

Raasuke also said that it was obvious from Hansapank's business that lending behavior had changed within the last four to five months in Latvia and Estonia, and cited a "clear decline" in new loans, compared with peak monthly levels and the average levels of the last three to four years.

Raasuke also said that the recent decline in consumer confidence in the Baltics was not affecting the peoples confidence in the banks, since the Baltic market is small compared with the size of the banking groups involved. (Estonian consumer confidence fell during August to its lowest level in almost two years because of worsening expectations about household and state finances).

Estonian investment gold seller AS Tavid is reported to have tripled its weekly sales to about 60 kilograms in recent months, according to the newspaper the Postimees yesterday, and the paper also cites reports that people are increasingly converting their bank deposits from krooni into foreign currency.

Raasuke however was confident that there was no `"big" risk of a Baltic property sector collapse as the problems of oversupply are only affecting residential property business, with demand expected to remain strong for commercial property and especially civil engineering.

Raasuke is undoubtedly right to point out that the Baltic States for only a small part of their total business, but it is also true to say that the US sub-prime liabilities of many European banks were also only a small part of their total portfolio, and look what a mess that has caused. So I think we need to be rather careful before reaching any strong conclusions here.

Estonia Q2 2007 Current Account Deficit

Estonia's current-account deficit narrowed in the second quarter from a 14-year high as slower consumer spending and credit growth cut imports, suggesting the Baltic economy is cooling somewha. The deficit, which offers a braod measure of the evolution of trade in goods and services, fell to 8.5 billion krooni ($770 million) or 14 percent of gross domestic product in Q2 2007, from a revised 21.9 percent of GDP in the first quarter and 15.2 percent in Q2 2006, according to data released by the central bank today.

Estonians it seems spent less on imported cars, clothes and household goods last quarter as interest costs rose and stricter lending requirements by banks took their toll. Lower domestic demand also slowed manufacturing and construction growth, reducing the rate of GDP growth in Q2 to the lowest level in 2 1/2 years.

Exports of goods rose 6 percent from a year earlier, increasing slightly more rapidly than imports which rose 5 percent increase. Services exports climbed 19 percent, while imports went up 18 percent.

Latvia's current-account gap, which is the widest in the European Union, narrowed to 23.5 percent of GDP in Q2 2007 as economic growth there slowed too.