Latvia's government announced today that it has decided to take over the nation's second most important financial institution after the bank ran into liquidity difficulties. The Latvian government apparently decided late yesterday (Saturday) to take a 51 percent stake in Parex Bank, Latvia's second largest bank by total assets, following the preparation of data that indicated the bank was headed toward insolvency.
Prime Minister Ivars Godmanis stated that Parex was functional but in need of liquidity. He also said the government had faced a choice of either taking control of the bank or allowing it to enter bankruptcy. The government also suggested that there were no plans to rescue any of Latvia's other 25 banks at the moment, but that the possibility could not be excluded in the future.
The government bought the majority stake in Parex for 2 lats ($3.70). Another 34 percent stake in the bank will be held as collateral by the state-owned Hipoteku Bank. Obviously the fact that they have had to nationalize Parex bank was yet was another blow to Latvia's deteriorating economy, and to the governments present strategy for addressing the crisis. On Friday we learnt that gross domestic had fallen by an annual 4.2 percent in the third quarter.
Parex Bank was almost unique in both the Latvia and Baltic context in that it was homegrown. Founders Valery Kargin and Viktor Krasovitsky established the bank in 1992, one year after Latvia split from the Soviet Union and achieved independence.
A majority of the banking industry in the Baltic states of Estonia, Latvia and Lithuania are owned by Scandinavian financial institutions, and hence, up to now, have been somewhat shielded from the downturn.
This is obviously the first, and not the last, piece of news of this kind we are going to get during the present economic slump, and the nationalisation decision is sure to heat up the debate about whether or not to seek IMF protection, and indeed whether (or when) to break the Lat-Euro peg.
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Sunday, November 9, 2008
Friday, November 7, 2008
Estonia's Inflation Falls Back Again In October
Estonia's inflation rate fell to 9.8 percent in October, the lowest level in 10 months, as the growing recession cut consumer demand and excess capacity started to grow. The annual rate fell below 10 percent for the first time since January, (and down from 10.5 percent in September) according to data from the national statistics office. Prices rose a monthly 0.4 percent.
Everyone is agreed that the drop in domestic demand will help bring inflation down substantially, although some are still only focused on whether or not this will be enough to qualify for adopting the euro by the end of 2010. Unfortunaely much larger questions than this now loom on the agenda. Basically we will now start to follow a new chart for inflation purposes on this blog - the monthly index itself (see below). As can be see the monthly upward march is now quite small - and getting smaller. At some point it will peak, and then start turning down. At that point one of two things can happen (there really aren't too many choices at this point, it would have been better had we never gotten here, but then, to put the best interpretation on things, people were simply deaf): either the kroon-euro peg can be abandoned, or the index will start to march downwards and Estonia will simply fall deeper and deeper into deflation. I think I know which one of these I would prefer (coming off the peg), and neither is going to be easy - either people are going to have to start paying those euro mortgages in a much cheaper currency, or the value of their wages in euros is going to drop as wage deflation savages the whole economy. Which do you prefer, the devil or the deep blue sea?
EU Banks To Take the Hit
The other important detail here is the way in which banks based in other EU countries are going to be asked to get their home governments to step in and fork out to make up for all the inevitable defaults. I am not an avid Swedish bank watcher, but I have been following what has been going on in Austria, and especially the recent government decision to move and help the Austrian banks with state funds, since this move seems to be aimed less at shoring up troubled domestic lending and more at boosting credit and growth in emerging Europe, where Austrian banks dominate and the country could well lose heavily in the coming downturn.
Essentially, what used to be a lucrative grip on the financial markets of central and Eastern Europe - which contributed 42 percent of Austrian bank profits in 2007 - has now been transformed into a strong risk. The situation has even made it relatively more expensive for the Austrian government to borrow - since the spread over 10 year German bund has been sriven up - and has also driven up costs to insure against the seemingly unlikely even of an Austrian sovereign default.
Austrian banks are owed $290 billion by borrowers across the CEE, from Albania to Russia. Its exposure is much higher than that of Italy, Germany and France, and almost on par with what Spain has lent to Latin America, according to the Bank for International Settlements.
Relative to Austria's size, the exposure - roughly equal to its entire gross domestic product - is daunting.
Put another way, should the recent central European hiccup turn into a crisis of Asian or Latin American proportions, with currencies devaluing and debtors defaulting en masse, Austria would be in trouble, and more so than any other western country.
This underlying reality has evidently shaped how the Austrian government is using its 100 billion euro ($129 billion) banking package. The finance ministry last week agreed to boost the capital of Erste Group Bank by 2.7 billion euros, even though the bank, emerging Europe's third-biggest lender, is well-capitalized and funded.
The state money came cheaper and with fewer strings attached than similar deals in Germany or Belgium. There are few rules on how to use the capital - just enough to allow the government to present the measure as boosting domestic credit.
In reality, most of the capital is going to underpin lending in countries including Romania, where Erste owns the biggest bank, or Hungary, where it is number 6.
A number of emerging countries in Central and Eastern Europe share the problem of having a gaping hole in their current accounts - one which they currently fill to a considerable extent through the funding that Austrian, Italian, French, Belgian and Swedish parent banks provide. Fears that they were about to choke off this lending simply because the parents themselves had trouble refinancing played a big role when investors dumped Hungarian assets in droves last month.
By tapping their home governments, the banks effectively lean on taxpayers in their home countries for refinancing countries with large current account imbalances - countries which apart from Hungary also include Romania, Bulgaria and the Baltics.
Well, don't feel especially discriminated against in the CEE I would say, since there is no plan for Southern Europe either, and the problems in Italy, Greece and Spain are every bit as large. Indeed I would say that those responsible for policymaking across the CEE would do well to look at what happened to the Spanish economy after the external funding for the Spanish banks was effectively cut off in September 2007, or for that matter to what has happened in the Baltics. Canaries in the coalmine, anyone?
Incidentally, and quite coincidentally, Moody's Investors Service cut Latvia's credit ratings and lowered the outlook for both Lithuania and Estonia to negative, citing the worsening economic slowdown and the global liquidity crisis. Given what I have been saying above, it seems to me they might also like to take a long hard look at their Austrian and Italian sovereign ratings at this point too.
Everyone is agreed that the drop in domestic demand will help bring inflation down substantially, although some are still only focused on whether or not this will be enough to qualify for adopting the euro by the end of 2010. Unfortunaely much larger questions than this now loom on the agenda. Basically we will now start to follow a new chart for inflation purposes on this blog - the monthly index itself (see below). As can be see the monthly upward march is now quite small - and getting smaller. At some point it will peak, and then start turning down. At that point one of two things can happen (there really aren't too many choices at this point, it would have been better had we never gotten here, but then, to put the best interpretation on things, people were simply deaf): either the kroon-euro peg can be abandoned, or the index will start to march downwards and Estonia will simply fall deeper and deeper into deflation. I think I know which one of these I would prefer (coming off the peg), and neither is going to be easy - either people are going to have to start paying those euro mortgages in a much cheaper currency, or the value of their wages in euros is going to drop as wage deflation savages the whole economy. Which do you prefer, the devil or the deep blue sea?
EU Banks To Take the Hit
The other important detail here is the way in which banks based in other EU countries are going to be asked to get their home governments to step in and fork out to make up for all the inevitable defaults. I am not an avid Swedish bank watcher, but I have been following what has been going on in Austria, and especially the recent government decision to move and help the Austrian banks with state funds, since this move seems to be aimed less at shoring up troubled domestic lending and more at boosting credit and growth in emerging Europe, where Austrian banks dominate and the country could well lose heavily in the coming downturn.
Essentially, what used to be a lucrative grip on the financial markets of central and Eastern Europe - which contributed 42 percent of Austrian bank profits in 2007 - has now been transformed into a strong risk. The situation has even made it relatively more expensive for the Austrian government to borrow - since the spread over 10 year German bund has been sriven up - and has also driven up costs to insure against the seemingly unlikely even of an Austrian sovereign default.
Austrian banks are owed $290 billion by borrowers across the CEE, from Albania to Russia. Its exposure is much higher than that of Italy, Germany and France, and almost on par with what Spain has lent to Latin America, according to the Bank for International Settlements.
Relative to Austria's size, the exposure - roughly equal to its entire gross domestic product - is daunting.
Put another way, should the recent central European hiccup turn into a crisis of Asian or Latin American proportions, with currencies devaluing and debtors defaulting en masse, Austria would be in trouble, and more so than any other western country.
This underlying reality has evidently shaped how the Austrian government is using its 100 billion euro ($129 billion) banking package. The finance ministry last week agreed to boost the capital of Erste Group Bank by 2.7 billion euros, even though the bank, emerging Europe's third-biggest lender, is well-capitalized and funded.
The state money came cheaper and with fewer strings attached than similar deals in Germany or Belgium. There are few rules on how to use the capital - just enough to allow the government to present the measure as boosting domestic credit.
In reality, most of the capital is going to underpin lending in countries including Romania, where Erste owns the biggest bank, or Hungary, where it is number 6.
"That this is about providing credit to Austrian companies is just a pretense," said Matthias Siller, who manages emerging market funds at Baring Asset Management. "This move is a clear commitment to eastern Europe......But this has nothing to do with charity. Those (Austrian) banks are system-relevant banks in central and Eastern Europe, and if they had to withdraw capital from there, this would set off a landslide," he said.
A number of emerging countries in Central and Eastern Europe share the problem of having a gaping hole in their current accounts - one which they currently fill to a considerable extent through the funding that Austrian, Italian, French, Belgian and Swedish parent banks provide. Fears that they were about to choke off this lending simply because the parents themselves had trouble refinancing played a big role when investors dumped Hungarian assets in droves last month.
By tapping their home governments, the banks effectively lean on taxpayers in their home countries for refinancing countries with large current account imbalances - countries which apart from Hungary also include Romania, Bulgaria and the Baltics.
"If there is no EU-wide plan then it will be left to Sweden (in the Baltics) and Austria (on the Balkans) to take care of this," said Lars Christensen, an analyst at Danske Bank. "Obviously you can't have the Austrian government bailing out central and Eastern Europe," he added. "The problem in this situation is a lack of coordination between European Union governments about a stabilization plan for Eastern Europe."
Well, don't feel especially discriminated against in the CEE I would say, since there is no plan for Southern Europe either, and the problems in Italy, Greece and Spain are every bit as large. Indeed I would say that those responsible for policymaking across the CEE would do well to look at what happened to the Spanish economy after the external funding for the Spanish banks was effectively cut off in September 2007, or for that matter to what has happened in the Baltics. Canaries in the coalmine, anyone?
Incidentally, and quite coincidentally, Moody's Investors Service cut Latvia's credit ratings and lowered the outlook for both Lithuania and Estonia to negative, citing the worsening economic slowdown and the global liquidity crisis. Given what I have been saying above, it seems to me they might also like to take a long hard look at their Austrian and Italian sovereign ratings at this point too.
Latvia's Economy Contracts By 4.2% in Q3 As Moody's Downgrades The Credit Rating
Latvia's economy shrank an annual 4.2 percent in the third quarter, the fastest drop since at least 1994, according to today's flash estimate from the Riga-based statistics office (Friday). This follows a 0.1% year on year expansion in the second quarter.
We do not have quarter on quarter statistics at this point, but if we apply the minus 4.2% calculation over last years Q3 2007 constant price number, then what we get is 2.147 billion Lati, and a GDP graph which looks like this:
Which may have little analytic value (since the data is not seasonally corrected), but does enable us to form a pretty rough and ready visual impression of what is going on, where the annual contraction data remains rather abstract. The economy definitely peaked and started to enter contraction mode after the summer of 2007, and now we need to keep watching and waiting to see just how far it is we go.
The statistics office will release constant price and seasonally adjusted data for the third quarter on Dec. 9. The last time Latvia's economy contracted on a year on year basis (by 2.2 percent) was in 1994, according to data from the Latvian central bank.
Coincidentally Moody's Investors Service today downgraded Latvia's credit rating to A3 from A2, the third-lowest investment grade level, citing a worsening global liquidity crunch and economic slowdown.Moody's warned today that tighter global liquidity could affect some of Latvia's 26 banks, many of whom rely on syndicated loans to finance operations.
We do not have quarter on quarter statistics at this point, but if we apply the minus 4.2% calculation over last years Q3 2007 constant price number, then what we get is 2.147 billion Lati, and a GDP graph which looks like this:
Which may have little analytic value (since the data is not seasonally corrected), but does enable us to form a pretty rough and ready visual impression of what is going on, where the annual contraction data remains rather abstract. The economy definitely peaked and started to enter contraction mode after the summer of 2007, and now we need to keep watching and waiting to see just how far it is we go.
The statistics office will release constant price and seasonally adjusted data for the third quarter on Dec. 9. The last time Latvia's economy contracted on a year on year basis (by 2.2 percent) was in 1994, according to data from the Latvian central bank.
Coincidentally Moody's Investors Service today downgraded Latvia's credit rating to A3 from A2, the third-lowest investment grade level, citing a worsening global liquidity crunch and economic slowdown.Moody's warned today that tighter global liquidity could affect some of Latvia's 26 banks, many of whom rely on syndicated loans to finance operations.
``The global liquidity crisis will probably cause a shock to the Latvian banking system, which will reverberate throughout the rest of the economy,'' Kenneth Orchard, a senior analyst at Moody's, said before the report. ``Unless there are major improvements in the European syndicated loan market by early 2009, the government and central bank will be forced to take remedial action.''
Friday, October 31, 2008
In Search Of The Bottom - Estonia's Economy Continues To Drift Aimlessly
The Estonian recession continues to deepen, month by month. The most recent evidence comes to us in the form of a decline in both Estonian retail sales and industrial production, which fell in each case for the fifth consecutive month in September, leading us to expect the rate of GDP contraction to accelerate further in Q3.
And of course, consumer confidence is not only falling in Estonia, it is also falling among potential consumers of Estonian products in all Estonia's export destinations. Indeed general European economic confidence saw its biggest ever fall in October as the global bank crisis generated the bleakest outlook since the early 1990s, at least these are the findings of this months European Commission economic sentiment survey. The survey results give us just one more dramatic illustration of the devastating impact the financial turmoil is having on Europe's real economy. Pessimism has risen dramatically on all fronts - from manufacturers' expectations about exports to consumers' fears about unemployment.
The European Union executive's "economic sentiment" indicator for the 27-country bloc fell by 7.4 points in October to 77.5 points. The latest index reading was the lowest since 1993 and marked the largest month-on-month decline ever recorded.
And even as confidence deteriorated sharply in key EU economies like Germany, Italy and Spain, the increasingly-worrying outlook for all those previously fast-growing eastern European economies is now hitting business and export opportunities pretty hard, and this is plain from the survey. All three Baltic economies registered another sharp lurch downwards, with Lithuania, as has now become almost traditional, hanging back slightly from the Ocean depths currently being combed by her Estonian and Latvian neighbours.
The Outlook Darkens
And just to add to all these woe's Eastern Europe is currently experiencing what amounts to its biggest credit rating downgrade in at least a decade, adding to evidence that the region far from avoiding the impact of the global credit crisis, may well find itself at the very heart of the next stage.
and now a forecast which, it seems to me is based on the same faulty methodology that lead the current deline to be "more abrupt" than they expected earlier.
As I say above, I expect wage declines, and not slowing wage growth, but this is beside the point. Household consumption will undoubtedly decline in 2009, but I am not expecting any significant recovery in 2010. And the reasons for this expectation are based on some of the main tenets of economic theory as I understand them. Basically Estonia is in the midst of the transition from being a domestic consumption driven economy to being an export driven one. This, in part, has something to do with the demographic transition which Estonia is currently passing through.
Estonia is, if you like, about to become more like Germany and Japan, and less like the UK, or the US, or France, in terms of a basic typology of economies. And if you look carefully, you will see that the one thing that doesn't recover (ever) in Japan or Germany is household demand. The reason for this is obvious, and it has to do with the demand for credit. Proportionately less people in the age groups which drive the demand for credit increases means that credit (and with it domestic consumer demand) becomes less of a driver of economic growth and exports become proportionately more important. This is why German and Japanese banks have relatively less exposure to their own domestic property booms, but have been carrying losses from housing liabilities elsewhere.
Unfortunately, this is not some strange opinion I have acquired from some distant planet or other. It is based on, and supportable by, fact, and by what is going on right in front of our noses. We are not playing some sophistocated intellectual game here to see who is right and who is wrong. People's livelihoods and those of there children depending on getting a hold on this, and the sooner that the economists over at Eesti Pank (and elsewhere) get the underlying dynamics straight, the better.
Retail Sales Fall An Annual 8%
Retail sales, excluding cars and fuel, fell by an annual 8 percent in August, the largest such decline registered since at least 2001. This follows a 6 percent in August. The year on year chart (see below) couldn't be clearer.
Sales were also down month on month (ie with respect to August), this time by a non seasonally adjusted 7%. In fact, on a seasonally adjusted basis retail sales peaked in February 2008, and have been trending down since. We still don't have the seasonally corrected data from Eurostat for September, but looking at the uncorrected data we do have from the Estonian statistics office, it does seem that retail sales were down again in Q3 over Q2.
Thus retail sales turned negative in March and the trend simply continues. The decrease in the retail sales of goods was most influenced by the stores selling manufactured goods where sales decreased by 12% compared to September 2007. Sales in non-specialized stores selling manufactured products and shops selling household goods and appliances, hardware and building materials were the worst hit.
Sales in grocery stores have, as might be expected, been rather more stable, with sales only down 3% . As had been the case in previous months, the decrease in food sales was largely influenced by the rise in food prices and the resulting decline in consumption.
Industrial Output Down 3.8%
Output adjusted for working days decreased an annual 3.8 percent, compared with a revised fall of 3.7 percent in August.
If we look at the seasonally and working day adjusted output index, then we can see that the level of output is now meandering downwards, and we now are way off the highs reached during last October and November. With this in mind we should expect the year-on-year percentage drops to start to decline after December, but it will then become much more interesting to follow the evolution of the absolute levels indicated by the general output index.
The main reason for the decline in output is evidently the lack of demand. The fall in manufacturing output was greatest in food, wood and building materials production. Food output was especially hit by the decrease in consumption resulting from this years large price increases. Although the rate of price increase has decelerated in recent months, food product prices are still up by 12% compared to September 2007.
The other area with big output drops is the manufacturing of wood and wood products, where the drop in sales in both domestic and external markets continues. The Estonian market is influenced by the construction slump, while in the external market Estonian manufactures are having a hard time due to the competitive environment and their own weaknesses in price competitiveness. Compared to September 2007, 22% less sawn timber and 9% less glue-laminated timber were produced. The largest drop (32%) was in the production of building materials which is directly connected with the decline in the construction market.
Some export-oriented industries have been continuing to expand - even in this difficult environment - especially enterprises involved in the manufacture of metal products, chemical products, and electrical machinery. Output was also up in the manufacture of machinery, radio and communication equipment, precision instruments and motor vehicles, since again a lot of the output is for export. The export share is 97% in the manufacture of radio and communication equipment and 91% in the manufacture of precision instruments.
Both Wages and Unemployment Still On The Rise
Wages continued to rise rapidly in the second quarter, up by 15.2%, even if this was the slowest pace of increse in more than two years, while the unemployment rate rose - to 3.1 percent in September - the highest level in more than three years.
Estonia's jobless rate, based on the number of unemployed registered with labor offices, rose to 3.1 percent, the highest since July 2005, from 2.9 percent in August, according to data from the Estonian Labor Market Board. The number of people signed on as seeking a job rose 6.6 percent from the previous month to 20,015. This number is of course, incredibly low by any comparable international standard, and is hard to square with a country in the midst of a very deep rcession (even after all the ritual genuflections towards the labour marekt being a lagged indicator). In order to understand how this situation is possible it is important to take into consideration Estonia's special demography and migration history.
However, it is also true to say that unemployment does normally follow changes in economic output with a time lag, se we should expected it to rise considerably in the coming months and quarters. Indeed the unemployment rate as measured by the Estonian statistics office in quarterly labor surveys is nearer to 4 percent in the second quarter (and the EU harmonised rate which is based on the survey shows 4.2% for September in the Eurostat database), and may rise as high as 10% according to recent estimates from Erkki Raasuke, head of Baltic research for Swedbank AB (not that they have been getting too much right of late, but still).
Despite the fact that unemployment will undoubtedly rise further as the recession deepens, it is the very tighness of the labour market (which is, as I say, in part a product of Estonia's demography) which prevents wage increases slowing down more rapidly, and thus the entire Estonian price system adapting to the slowdown (this phenomenon is often called "sticky wages and prices", and as we can see, the degree of viscosity here is almost treacle like). So Estonia's low earlier fertility fuelled the initial wage craze which along with the credit boom got us to the present point, and now the same lack of strength in depth in the labour market blocks the downward adjustment. In both cases the net by-product is massive pressure on the Kroon-Euro peg as Estonia struggles to find export competitiveness.
Consumer Confidence Falls Again
Unsurprisingly Estonian consumer confidence fell again in October, hitting its lowest level in more than 9 years, a sure sign the that the economy is about to shrink again, as domestic demand continues to search for a bottom. The Tallinn-based Konjunktuuriinstituut consumer confidence index declined to minus 27, its lowest reading since June 1999, and down from minus 22 in September. The institute cited worsening expectations for personal and state finances as the key drivers behind the drop.
And of course, consumer confidence is not only falling in Estonia, it is also falling among potential consumers of Estonian products in all Estonia's export destinations. Indeed general European economic confidence saw its biggest ever fall in October as the global bank crisis generated the bleakest outlook since the early 1990s, at least these are the findings of this months European Commission economic sentiment survey. The survey results give us just one more dramatic illustration of the devastating impact the financial turmoil is having on Europe's real economy. Pessimism has risen dramatically on all fronts - from manufacturers' expectations about exports to consumers' fears about unemployment.
The European Union executive's "economic sentiment" indicator for the 27-country bloc fell by 7.4 points in October to 77.5 points. The latest index reading was the lowest since 1993 and marked the largest month-on-month decline ever recorded.
And even as confidence deteriorated sharply in key EU economies like Germany, Italy and Spain, the increasingly-worrying outlook for all those previously fast-growing eastern European economies is now hitting business and export opportunities pretty hard, and this is plain from the survey. All three Baltic economies registered another sharp lurch downwards, with Lithuania, as has now become almost traditional, hanging back slightly from the Ocean depths currently being combed by her Estonian and Latvian neighbours.
The Outlook Darkens
And just to add to all these woe's Eastern Europe is currently experiencing what amounts to its biggest credit rating downgrade in at least a decade, adding to evidence that the region far from avoiding the impact of the global credit crisis, may well find itself at the very heart of the next stage.
“We expect the EU and the IMF to announce additional rescue packages for other Central and Eastern European economies in the coming days and weeks. Top of the list are the most imbalanced countries in the region - the Baltic States, Romania and Bulgaria."
Lars Christensen, Danske Bank, Copenhagen
Both Standard & Poor's and Fitch Ratings have responded over the last month to mounting risks from the global credit crunch by downgrading or revising credit rating outlooks to negative for a number of CEE economies including the Baltic states, the Balkans, Hungary and Ukraine. Moody's Investors Service has also revised its outlook to negative for Latvia and downgraded Ukraine.
S&P and Fitch both downgraded long-term sovereign ratings to Latvia and Lithuania on Oct. 27, citing recession risks and the growing need for external financing, while Estonia, had its rating cut by Fitch and outlook revised to negative by S&P. Basically, the crunch is biting in terms of both the cost and the availability of credit. This tightening in credit conditions is not, of course, new in Estonia, and in many ways we could say that the credit conditions should never have been allowed to get so "loose" in the first place. As can be seen from the chart below, the year on year rate of increase in peaked at the end of 2006, and since then the slowdown in Estonian domestic demand has been driven by the slowdown in the availability of credit (strictness off the terms, documentational requirements etc). Evidently, if such criteria had been applied much earlier, and the rate of annual increase never approached 80% all this may well have been a much less dramatic process.
The Estonian central bank said last week revised it's forecast for the economy, which has already made the turn around from being the second-fastest growing one in the EU in 2006, to being one of the most rapidly contracting ones in 2008. According to the bank the Estonian economy may shrink 1.8 percent in whole-year 2008 and 2.2 percent in 2009. As we have noted above the economy sank by 0.8% q-o-q in Q2 and by 1% year on year.
The decrease in GDP in Q2 was mainly a result of weak domestic demand, but the drop in both imports and the rate of increase in the export of goods and services meant that the contribution from external trade was negative. About the only item which maintained some momentum was government spending - buoyed by the tax income from an earier and better epoch. Compared to Q2 2007, total domestic demand was down by 2.8% , largely as a result of adecrease in private consumption and capital investments ( down by 2.0% and 2.5%, respectively).
Private consumption decreased mainly due to the decrease in expenditures on transport and clothing and footwear. The growth of expenditures on food and non-alcoholic beverages decelerated. Capital investments decreased in both the financial and the household sector. Investments in manufacturing industry were almost stationary year on year. At the same time public sector construction investments accelerated.
The decrease in exports and imports since the second half of 2007 which had been noted in Q1 went even further in the 2nd quarter. Compared to the 2nd quarter of the previous year, exports of goods and services decreased by 4.9% and imports by 8.2% (at constant chain-linked prices).
Goods exports were down by 3.2% primarily due to the decrease in exports of refined petroleum products. At the same time, exports of basic metals and electrical machinery (electrical motors and appliances), which significantly influence export movements, increased. Exports of services decreased by 8.9% primarily due to the decrease in exports of services for railway cargo, airway passengers and cargo transport and trade related exports services. The decrease in imports of goods was influenced mainly by the decrease in imports of refined petroleum products and motor vehicles. While imports decreased faster than exports, the deficit of net exports in GDP has increased since the second half of 2007 and amounted to -4.6% of GDP in the 2nd quarter. In the 1st quarter the impact of net exports was -7.1% (so the negative impact slowed vis a vis Q1).
Fiscal Crunch Coming
Basically, as the economy slows, and government income increases even while counter cyclical spending policies add to expenses, the government is moving into tricky fiscal deficit territory. Mindful of this the Estonian government approved on September 25 a draft 2009 budget which attempted to balances overall finances, including local government and the social insurance funds. The budget, which is still to be finally approved by the Estonian parliament, will fall into a deficit and need to be covered from government reserves, according to former Prime Minister Vaehi in a recent interview with the Maaleht newspaper Maaleht.
A deficit of 10 billion krooni would equal 3.5 percent of the expected gross domestic product of 283 billion krooni forecast by finance ministry in August. SEB have forecast a deficit of 1 percent of GDP in Estonia's overall finances next year.
Falling tax revenue has forced the Estonian governemnt of Prime Minister Andrus Ansip to cut spending and seek out new financing in an attempt to maintain a balanced budget, formerly a linchpin of the country's fiscal policies. The Finance Ministry have already forecast the budget will fall into a deficit of 3.1 billion krooni, or 1.2 percent of gross domestic product this year, after running surpluses in each of the last 6 years.
Two Questions In Conclusion
Basically then, it is hard to call the exact impact of trade on Q3 data without having the September trade data in front of us, since although the July and August export numbers are well below the April and May ones, we also need to take into account the accompanying drop in imports (which helps net trade, and thus is GDP positive). On the other hand the general impression you should get from all the data is that we are in for another shocker in Q3. Which leaves us with two questions:
1/ Where do we go from here?
2/ Just how long will it be before we hit generalised price deflation?
Let's take the second one first. Possibly for many people the question will appear to be a ridiculous one, but it isn't. If you look at the CPI index itself (this now becomes much more important than the year on year inflation rates, since what we need to watch for are the price movements from month to month. Now in the rate of increase from one month to another has been slowing, and in September the index was barely up over August (less than 0.5%, following a virtually stationary reading in August over July) so we should not be surprised to see the index hit a ceiling at some point, and then start to come down. Basic economic theory leads us to expect this (on the back of falling commodity and food prices and in a situation where internal capacity is way above the sum of internal and external demand available to the Estonian economy at current prices). Thus there is only one way for prices and wages to go: down. Although people may struggle with all this yet awhile before they accept the inevitable.
So what about the future of the economy in general? Well, let's take two quotes from the most recent Eesti Pank growth forecast. First, a recognition that they got it wrong in the past:
According to the base scenario of Eesti Pank's 2008 autumn forecast, Estonia's gross domestic product will decline by 1.8% in 2008 and by 2.1% in 2009. So far the economic correction has been more abrupt than expected primarily due to decreasing domestic demand. In addition to the cessation of the rapid real estate market expansion, also private consumption dropped in spring more than forecasted.
and now a forecast which, it seems to me is based on the same faulty methodology that lead the current deline to be "more abrupt" than they expected earlier.
According to Eesti Pank's estimate, the economy should pick up again either at the end of 2009 or at the beginning of 2010. The average economic growth rate of 2010 will be 3%. Private consumption growth should recover in 2010 along with the revival of household confidence, whereas 2009 will be characterised by slowing wage growth and increasing unemployment.
As I say above, I expect wage declines, and not slowing wage growth, but this is beside the point. Household consumption will undoubtedly decline in 2009, but I am not expecting any significant recovery in 2010. And the reasons for this expectation are based on some of the main tenets of economic theory as I understand them. Basically Estonia is in the midst of the transition from being a domestic consumption driven economy to being an export driven one. This, in part, has something to do with the demographic transition which Estonia is currently passing through.
Estonia is, if you like, about to become more like Germany and Japan, and less like the UK, or the US, or France, in terms of a basic typology of economies. And if you look carefully, you will see that the one thing that doesn't recover (ever) in Japan or Germany is household demand. The reason for this is obvious, and it has to do with the demand for credit. Proportionately less people in the age groups which drive the demand for credit increases means that credit (and with it domestic consumer demand) becomes less of a driver of economic growth and exports become proportionately more important. This is why German and Japanese banks have relatively less exposure to their own domestic property booms, but have been carrying losses from housing liabilities elsewhere.
Unfortunately, this is not some strange opinion I have acquired from some distant planet or other. It is based on, and supportable by, fact, and by what is going on right in front of our noses. We are not playing some sophistocated intellectual game here to see who is right and who is wrong. People's livelihoods and those of there children depending on getting a hold on this, and the sooner that the economists over at Eesti Pank (and elsewhere) get the underlying dynamics straight, the better.
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