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Monday, December 24, 2007

Merry Xmas and A Happy New Year

Well, a Merry Xmas and a Happy New Year to all my readers. Thank you for taking the time and trouble to pass-by. This blog will now - failing major and surprising new developments in the global economy - be offline till the end of the first week in January, or till after the festival of Los Reyes Magos in Spain (for those of you who know what this is all about). Come to think of it, maybe this is just what our ever hopeful central bankers are in need of even as I write - some surprise presents from the three wise men - but I fear that this year if these worthy gentlemen do somehow show at the next G7 meet, the star in the east which draws them will not be the one described in the traditional texts, but in all likelihood the rising star of India.

Credit crunch, did someone use the expression credit crunch?

Russian Wages and Inflation, Onwards and Upwards We Go

The Russian government plans to submit amendments to the federal budget to keep its promise of increasing the wages of government employees, Prime Minister Viktor Zubkov told Russia's newly elected lawmakers today.

"I especially underline the importance of passing amendments to the budget to increase the wages of government employees and military personnel," Zubkov said in a speech before the State Duma lower house of parliament in Moscow today. "We should strictly fulfill all our promises to citizens,'' he told the Duma's opening session in remarks broadcast live on state television. Higher-than-anticipated inflation this year has made it necessary to budget extra funds for salaries, he said.

The Russian parliament has already approved an increase in government spending this year of about 2 percent of gross domestic product as part of the preparations for the parliamentary elections held on Dec. 2 and for the presidential vote which is due in March 2008. President Vladimir Putin, who has said he's ready to serve as prime minister beginning next May under his chosen successor, Dmitry Medvedev, said on Dec. 19 that the 2008 budget increase was essential to retain the "trust'' of the people.

Now far be it from me to criticise politicians for keeping their electoral promises, but there are promises and promises here, and some promises are simply populism and demagogery, especially if they involve effectively printing money to fuel ongoing inflation.

Russia's inflation rate rose to a two-year high in November, driven in part by unavoidable increases in the price of fresh fruit, vegetables and other food items, but also fueled by growing labour shortages as the 6% odd growth which the Russian economy is experiencing put pressure on a labour supply which is under great strain due to Russia's unusual demographics (a full analysis of this problem can be found in this post).

The inflation rate rose to 11.5 percent in November, the highest since October 2005, up from 10.8 percent in October, and there is certainly no sign in the immediate future of all this letting up.

The Russian government's "massive additional spending'' this year is pushing up inflation, according to the OECD. The OECD raised its forecast for Russian inflation up to 11% for this year and 9.5% for next year, from an earlier 7.5% for 2007 and 6.5% for 2008 as a result of the country's relaxed monetary conditions and tightening labor market, according to their twice-yearly economic outlook published earlier this month.

"The government's attempt to damp inflation by imposing artificial restrictions
on retail prices, both at the federal and regional level, appears to be
ill-advised," the OECD said. "Such steps create new distortions without
addressing the underlying roots of inflation."

The OECD identified private consumption and fast rising real wages together with credits to households as the main engine of growth., noting that massive net capital inflows, which aren't sterilized, and an unemployment rate that has fallen below the historic low of 6.0%, have played as big a part as food prices in boosting inflation.

So today's statement by Viktor Zubkov only pours additional oil onto already troubled waters. Russian wages have increased considerably in recent years, and the average monthly dollar wage (see chart below) has increased from around 175$ a month in 2003 to approxiamtely 500 dollars a month at the end of September 2007, including a 31 percent increase in the first nine months of 2007 as the rouble continued appreciating against the US dollar. The current trends suggest that the average monthly dollar wage at the end of December 2007 may exceed USD 520.

According to Rosstat, average real wage and disposable income increased by 16.2 and 12.9 percent, respectively during the first nine months of the 2007 (see chart below). Increases in real wages continues to be well above growth in GDP - and evidently well above productivity growth - in most sectors of the economy. Almost all sectors of the economy are now reporting increases in nominal wages well above 20 percent during 2007.

And there is no immediate end to this in sight. Conceptually we could think of Russia being about to have a very large version ofthe "Baltic problem" (the canaries down the coal mine). All you need to do is make a mental switch and replace capital inflows from oil lying under the ground for the people working out of the country in the Baltic (or Bulgarian, or Romanian, or Polish, or Ukranian) case. Both mechanisms produce a large inflows of funds, which go to work in domestic sales and construction. Since we are short of people in each case, then this surge in demand naturally squeezes up wages and then rapidly makes exports non-competitive. As a consequence the country involved becomes more and more dependent on imports.

Call this the Baltic syndrome if you will, and plagiarising an old adage, we might say that once the Baltics sneeze it is the global economy which catches the cold.

Amazingly, we are brought to the conclusion that if inflation continuies at this pace, and the rouble does not fall to compensate, then Russia could eventually have a trade deficit, even with all the natural resources she has in play, and at the rate we are going this point may not be too far away. What we need to bear in mind is that while global oil prices may drop back slightly (depending on whether and to what extent there is a slowdown in global growth in 2008), they are unlikely to continue to rise at the same pace as they have been (imagine a US consumer facing oil at $200 a barrel) and so since Russian oil capacity is, at best, more-or-less constant (due to depletion issues), Russia cannot continue to rely so heavily on oil exports for continuing growth (and as living standards rise oil revenues will gradually and inevitably come to consitute a declining share of GDP). And this will become doubly the case if the rouble is allowed to rise (as it must be at some point) since the roublevalue of the oil revenue will become accordingly less.

Really, if you want to understand more about this very important problem, my lengthy analysis of Russia in Too Much Money Chasing Too Few People is a must read.

German GFK Consumer Confidence January 2008

German consumer confidence unexpectedly rebounded ever so slightly from what had been the lowest level in almost two years at the end of December as shoppers appear to have become slighly more willing to spend as the holiday season approaches. GfK AG's index for January, based on a survey of about 2,000 people, rose to 4.5 from a revised 4.4 in December, the Nuremberg-based market-research company said in a statement at the end of last week.This "snippet" of news lead to all sorts of speculation in the financial and business press, but I think we need to be very careful indeed here. There is such a thing as clutching at straws, and we all have a tendency to see what we want to see, to emphasise the good news, and play down the bad, to hold to what conforms to how we see the world and to discard the world. I do it, you do it, and of course the financial and business media do it bigtime.

So if you come to look at the chart below, what stands out is not the difference between December and January, but how similar they are with each other when compared with, say, October or September. Consumer confidence in Germany is plumming the lows, and at the moment it is staying there. Of course some sort of rebound is only to be expected after the beating which German domestic consumption has taken across 2007. Again let's look at the chart:

2007 has been a baaad year, and there's no mystery about why. VAT was raised by 3 percentage points on the 1st January, giving the German consumer a hefty hit where it hurts, in the pocket. So clearly, after things being so bad, they have to get just a little better (or at least so the theory would go, and here's hoping). All I would say is that on the Gfk reading it is way to soon to start declaring that this slight rebound has taken happened (don't hold out hope for a massive recovery, look at the longer term trend). And this situation is only confirmed when we come to look at the index sub components.

The indicator measuring households' willingness to spend rose to minus 10.7 from minus 21.8 in the previous month, indicating a slight improvement in the climate as we entered the xmas season, but there is little remarkable in that, indeed it would have been remarkable if things had not recovered slightly. On the other hand consumers income expectations fell to minus 1.7 from zero and shoppers also became less optimistic about the general economic outlook, with this indicator declining to 23.6 from 24.1.

According to Klaus Wuebbenhorst, chief executive officer at GfK, today's report is "good news, giving reason for optimism for 2008"...."Consumers are more willing to buy more expensive products, which is good news for Christmas sales." Well, as I say, there are opinions here to suit all tastes, so from here on in its up to you to make up your own mind what the reading actually means.

Thursday, December 20, 2007

Japan Exports November 2007

Japan's export growth slowed in November as the U.S. housing cut demand for automobiles and construction equipment, and the knock-on effect of the sub-prime turmoil started to be noted in other developed economies. Also worthy of note this month is that exports to China fell back slightly, from a revised 1.17 trillion yen in October to 1.14 trillion yen in November. Likewise exports to Europe, which fell from 1.14 trillion in October to 1.03 trillion in October.

Shipments to the U.S. declined on a year on year basis for a third consecutive month, the worst string of declines in more than three years. Since Japan's economy is now more dependent than ever on exports for growth this would seem to be the final nail in the coffin of the coming recession.

Exports rose 9.7 percent from a year earlier, the Finance Ministry reported in Tokyo today, following a 13.7% annual growth rate last month.

Imports rose 13.2 percent in November, the ministry said, after climbing 8.6 percent in the previous month, causing the trade surplus to fall 12.2 percent to 797.4 billion yen. Analysts expected an 11.8 percent increase.

Exports, we might like to remember, led by shipments to Europe and China, carried almost the entire weight of Japan's 1.5 percent annualized growth in the third quarter.

Oh yes, and almost as an afterthough, the Bank of Japan decided yesterday to maintain the 0.5% base rate on hold for yet another month. Did anyone in their right mind ever imagine otherwise!

Wednesday, December 19, 2007

Germany IFO Index December 2007

Well, this is almost getting boring at this point, as a certain predictability and inevitability enters into all the data, and especially the sentiment indexes, which are down, down, and down again. Today it is the turn of IFO Institute's German business confidence index to fall to its lowest level in almost two years in December as rising credit costs, higher oil prices and the euro's appreciation threatened to curb growth in Europe's largest economy.

The Munich-based Ifo research institute's business climate index, which surveys 7,000 executives, declined to 103 from 104.2 in November.

"The risks to price stability over the medium term are clearly on the upside" Jeab Claude Trichet told the European Parliament's economic and monetary affairs committee in Brussels yesterday, and, he might have added, the risks on the economic performance and growth front are all pointing to the downside. But still, a mandate is a mandate I suppose. Now how did the poem go? Ah yes, half a point, half a point, half a point upward, into the valley of death rode the 600.

Tuesday, December 18, 2007

The Economist on India

Well, I am revving myself up again now to come back at all those people who said that India was overheating when it was growing away at a mere 8%. In fact India grew at an 8.9% year on year rate during the last quarter (and this following 9.1% in the first and 9.3% in the second quarters of 2007), and far from inflation shooting through the roof it is currently not too far from the Reserve Bank of India's 5% target. Perhaps it is towards China that people should be directing their attention, or towards Eastern Europe, or even - god forbid - the eurozone, but India it seems is one country where the "great overheating" argument is steadily running out of steam. Of course one country which everyone will readily admit is not overheating is Japan, but I thinkwe'll leave that topic on one side for today.

Here I just want to repost part of a reply I gave to the Economist when they had the kindness to try to answer some points I had raised about the general quality of their economic coverage, and about what I take to be their obsession with ignoring the demographic component in economic growth. For the Economist, it seems, growth and development is a single issue item, and is all about insitutions, and institutional quality. Which makes it kind of funny that Argentina, which must be among the worst of the emerging economy pack in institutional quality is still powering away, despite more or less openly manipulating the economic data.

Obviously institutions matter, but so does demography. This is not a one horse race, or if you prefer, this particular horse doesn't only run on one leg.

The topic in question here is India's potential growth rate. Recent GDP performance at just under 9% must have been astounding many of India's critics, especially given the way inflation, despite all that growth, has been kept pretty much under control.

Wholesale price inflation has been preforming even better:

So to go to the start of our story, back in September 2006, I post a piece on the India Economy Blog entitled "Uncharted Water" where I argued precisely the following:

What is clear is that the Indian economy is currently gathering steam,
and this at a time when there is a general consensus that the political will for
reform isn’t what it used to be. Strange isn’t it?

My meaning here isn’t that reforms aren’t necessary, but that there are other
factors at work, and in particular demographic ones. The importance of these
demographic factors generally can be seen from the fact that it is now the newly
developing countries (China, India, Brazil, Chile, Thailand, Turkey) who are
pulling the global economy (and in the process pushing up energy and commodity
prices). The developed world - which makes up say 50% of global GDP is growing
much more slowly than the developing world - and some of this for ageing related
demographic reasons. Global GDP is forecast to grow at a 5% annual rate this
year, yet the US is growing at around 3.5%, Japan 2.5% and the eurozone around
2%. So you tell me, who is pulling who here?

And this is why I say we are moving into uncharted territory. Economists
used to have a little model which worked on the assumption of each economy
having a certain growth capacity in any given moment. But could any one tell me,
what *is* the growth capacity of China or India? I certainly have no idea, and I
haven’t seen anyone else make a convincing case on this topic. The magnitude of
the growth we are now seeing in the developing world is beyond all historical

Doesn't look to bad at all does it, in the light of what has been happening during the second half of this year. And remember this was written in the Autumn of 2006, not Autumn 2007 when just about everyone and their auntie is saying something like this. Of course this whole debate is ongoing. Nandan Desai had an excellent piece on IEB which put things pretty much in perspective and in October 2006 I had another piece in the IEB, basically in response to the Sizzling India article in the Economist. I said this:
I am even brazen enough to believe that trend growth may well
have moved up beyond 8.5% going forward, and that indeed within 5 years we may
well see India overtaking China in terms of average quarterly growth rates (of
course this may well vary from one quarter to another, a phenomenon known as
volatility, and of course 5 years from now the Chinese economy may not still be
sustaining the very high growth rates we see today).

Again, I am really comfortable standing by this, and even the point about China, since the inflation problem really does seem now to be getting a grip (remember they have had nearly 30 years now of the one child per family policy, and at some point soon their labour market is going to tighten and tighten, for what may well happen next see my recent article on the growing problem we now have in Russia: "Russian Inflation, Too Much Money Chasing Too Few People" (not too much danger of this getting to be a problem in India in the near future, now is there?).

Since this time of course, the whole recoupling/decoupling issue has really taken off as a live debate. My latest thoughts on this can be found here, and Claus Vistesen's post - The Global Economy, Compass and Charts Needed - follows up on and continues the "uncharted waters" theme.

Now for the Economist. What I said in my response to them was as follows:

To The Economist

Well, at the risk of having to assume some kind of modern "j'accuse" mantle (for which of course there are ample precedents in the early origins of your own magazine) I am going to put up yet another comment. Maybe this is because I would like to participate in that "severe contest between intelligence, which presses forward, and an unworthy, timid ignorance obstructing our progress" which your contents page so boldly announces.

Maybe it is also because I want to pin down quite clearly for future reference just what the issues are, and just why it isn't "absurd" to suggest that the Economist currently systematically fails to factor-in the demographic components in economic growth (or the lack of it). Well, saving the best (or should that be the worst) to the last, I would like now to come to the case of your India correspondent. This gentleman (and I sincerely hope that despite his evident predilection for strong Vindaloo curry he is one of these) has been systematically re-adjusting upwards India's potential trend growth rate in recent months. In fact his estimate seems to have shot up from 6.5% in November 2006 to 7% in February 2007, to 8% in June 2007. Now that's an upward adjustment of around 25% in trend growth in roughly 8 months. Quite an achievement, especially since he offers absolutely no explanation whatever for these adjustments, but what he does not fail to tell us - oh, he never lets a moment rest without beating this drum - is that: "India's economy, like Delhi this week (or Vindaloo curry perhaps, EH), remains far too hot."

Now just in case what I am suggesting here is questioned I would like to quote chapter and verse, since the issue is an important one.

In November 2006 the Economist's India correspondent estimated capacited growth for India at around 6.5%.

23 November 2006 Too Hot To Handle

INDIA'S curries can be even hotter than the fieriest of Chinese hotpots; likewise the temperature of the two economies. Despite widespread claims that China's economy is overheating, actually India's shows more signs of boiling over.

In the year to the second quarter, India's GDP grew by an impressive 8.9%, while China's more up-to-date figures show even more breathtaking growth of 10.4% in the year to the third quarter. But to judge whether an economy is too hot, one needs to compare this expansion in actual demand with potential supply, ie, the sustainable rate of growth. Despite India's growth spurt in recent years, its sustainable pace is still much lower than China's, which puts its economy more at risk of overheating and rising inflation.

India's trend growth rate has almost certainly increased but it is still
nowhere near as high as China's. Mr Prior-Wandesforde estimates that it is now
around 6.5%, up from 5% in the late 1980s. But India's recent acceleration
largely reflects a cyclical boom, thanks to loose monetary and fiscal policy.
The Reserve Bank of India has raised one of its key interest rates by one and a
half percentage points to 6% over the past two years, but inflation has risen by
more, so real interest rates have fallen and are historically low. This makes
the economy more vulnerable to a hard landing.
By February 2007 the estimate had risen to "not much above" 7%.

1st February 2007 India overheats
"But the problem is that this new speed limit is almost certainly lower than the government's one. Historic data would suggest a figure not much above 7% - well below China's 9-10%......If something is not done, then a hard landing will
become inevitable."

and by June 2007 it had been revised up nearer to 8%.

June 7th 2007 Waiting For The Monsoon
"This is not to deny that India's economic speed limit has increased, to perhaps 7-8%, thanks to stronger investment and economic reforms. But growth has
exceeded that limit. The economy still shows alarming symptoms of overheating"

And depispite all this, we are now in December 2007, the Indian economy has been growing at around 9% for the last three quarters, and inflation has been kept remarkably under control.

So actually what we are all really waiting for here is not the arrival of the monsoon, but some explanation from the Economist's India correspondent about how he is calibrating all these estimates. There is nothing particularly to be embarassed about in getting this one wrong, since it is pretty difficult to put a number on where Indian growth is going, but it does seem hard to maintain the credibility of your calls if you conveniently keep ignoring what you were saying only yesterday, and more importantly fail to diagnose exactly why it is that India has been able to grow so much faster than you expected. And of course one day India may overheat, and stopped clocks do give the right time twice a day, but this doesn't make them especially useful measuring instruments.

Back in the autumn of 2006, on the India Economy Blog, I argued that we were now entering "uncharted waters" and that no-one really had any accurate idea of what India's true mid-term trend growth rate actually was. I also asserted that it was in all probability way above the more conservative and conventional estimates. I was guessing really, but behind my guesswork was a long hard look at India's underlying demography, and it is just this kind of approach that your India correspondent discounts. Again, chapter and verse:

1st February 2007 India On Fire
Many Indian economic commentators say that further structural reforms, though desirable, are not essential to keep the economy growing at 8% or more because
of the "demographic dividend". A fast-growing working population and a falling
dependency rate (thanks to a lower birth rate) will ensure more workers, more
saving and hence more investment." "India's demographic structure is indeed
starting to look more like that in East Asia when its growth took off. But this
mechanistic view of growth assumes that demography is destiny and that economic
policies do not matter. In fact, open markets, education and investment,
especially in infrastructure, were the three chief ingredients of East Asia's
success. Population growth by itself does not add to prosperity, unless young
people are educated and new jobs are created. India needs to reform its absurdly
restrictive labour laws which hold back the expansion of manufacturing

Basically I find myself in agreement with the Indian economists he doesn't like. It isn't that these reforms aren't desireable, as he admits, we all agree on this. But the point is, even ex-reforms (and of course there have been reforms and global opening) demographic momentum would indicate that substantial growth is now going to occur. How substantial? Hard to say, but I think it is quite probable that 5 years from now India will be growing faster than China, and may even peak out at the highest annual growth rates yet seen for a significant economy over the 5 to 10 year window. I can justify why I think this with some sort of coherent argument if anyone wants. I think the big danger for the sort of view you are advancing here at the Economist is that you imagine virtually nothing is possible with institutional reform, and this is just as big a mistake as saying demography is everything. You need to systematically take the two components into account. If you don't do this you risk getting into the ridiculous position the World Bank found itself in this week, when countries like Argentina and Thailand complained that since their countries were registered as going backwards on the global governance index, while both countries were growing quite nicely, then logically the methodology used to construct the index must be wrong. IMHO the World Bank has been totally mechanistic about institutions and thoroughly deserves all the problems it creates for itself on this count. OK, so that's it. I finally rest my case. The dialogue will continue.

And it is, undaunted by the failure of all that vindaloo curry to overheat more than his own digestive tracts our dear correspondent is now worrying about, guess what, the rise of the rupee.

As he says:
The rupee's rise may be less dramatic than that of the Philippine peso, Brazilian real or Turkish lira. But it is uncomfortable nonetheless.

Nothing it seems is able to be good news for our valiant correspondant, everything needs to be tinged with it's due dose of schadenfreund. So what's all the fuss about. Well the rupee certainly is rising. Here is a chart showing how it has risen vis-a-vis the US dollar over the last 2 years.

As the Economist India corresponent points out, India's currency has strengthened by about 15% against the dollar in the last year alone, and by over 10%, on an inflation-adjusted, trade-weighted basis, since August 2006. And why is this. Again our correspondent is pretty much to the point:

This vigour is due to a strong inflow of foreign capital, some of it enticed by India's promise, the rest disillusioned by the rich world's financial troubles. The net inflow amounted to almost $45 billion in the year to March, compared with $23.4 billion a year earlier.

Although I can't for the life of me understand why the latest data he has is from back in March. Can't this guy ever do a professional job? Data up to the start of December is readily available here, and fascinating reading it is, as you can see it in the chart below.

So as we can see, while the net inflow in the year to March was $23.4, the net inflow between March and the start of December has been $74.4 billion, or three times as much (and $41 billion of this since 15 August). This is, of course staggering, but unfortunately, it seems, you aren't going to read about it in the pages of the Economist (before they said I was cross, this time I am angry aren't I, does it show?). As can be seen dircetly from the chart, the money really started to flow in from mid-September and the very fast rate of inflow continued till mid November.

Now the locus classicus on all this is certainly Morgan Stanley's Chetan Ahya, really it was this post of his which alerted me to the extent and significance of what was happening.

Over the seven weeks ending November 2, 2007, India’s foreign exchange reserves have increased by US$34 billion (annualized inflow of US$250 billion). Indeed, the trailing 12-month sum of FX reserves has increased to US$100 billion. This compares with the average annual increase of US$38 billion over three years prior to these seven weeks. With the current account still in deficit, the increase in reserves is being driven largely by a spike in capital inflows and to a very small extent because of conversion of non-dollar reserves into dollars. During the last seven weeks in which FX reserves have shot up, we believe that capital inflows would have been US$35 billion. Out of this, not more than 10% has been on account of FDI inflows. Non-FDI inflows including portfolio equity and external debt inflows form a major part of these inflows.

While the inflows are pouring in at the annualized run rate of US$250 billion, in our view, currently the country can absorb only about US$40-50 billion of capital inflows annually without causing any concern on attended risks of overheating. The key question policy makers are grappling with is how to manage these large capital inflows. As the strong growth in domestic demand has resulted in overheating of the economy recently, the central bank does not want to leave such large capital inflows fueling the domestic liquidity. Not surprisingly, the central bank has accelerated the pace of the sterilization by way of issuance of market stabilization scheme (MSS) bonds and an increase in the cash reserve ratio (CRR). Over the last 12 months, the RBI has sterilized about 58% of the foreign inflows. The sterilized liquidity (excess liquidity) stock including reverse repo less repo balances, MSS bonds, government balances with the RBI and the increase in the cash reserve ratio has shot up to US$77 billion as of end-October 2007 from US$19 as of end-October 2006.

Now while the issue of whether or not India is overheating raises its head again here, the context is quite different, and it is clear that the Reserve Bank of India is now struggling with the problems that may arise in the wake of such a massive influx, especially if it continues, as it may well do if the problems in the developed economies experience in 2008 turn out to be greater than may appear to be the case at present, and again if not all the emerging economies are as sound as they appear to be. Also, India is hardly to blame for this state of affairs, since the money is leaving one place (the developed economies following the sub-prime bust, rather than intentionally going somewhere. It is just that, amongst all that growing risk you can see out there, India looks to be as good a safe haven as you can find these days.

But this is not the moment to take all this into those still uncharted waters. If you want to read more on this aspect of things, then I cannot recommend a better source than Claus Vistesen's Compass and Charts Needed. For my part, I think all I want to register here is that something profound and important is taking place, and not simply a tepid repeat of events we have seen all to often in the past. Starting from this recognition, let the debate as to where we go next, and what to do about it, commence!

Friday, December 14, 2007

Eurozone Inflation November 2007

European inflation accelerated more than initially estimated in November, to the fastest pace since May 2001, making it very hard for the ECB to justify moving towards a cut in interest rates even as economic growth slows across the zone. Now normally neither Claus or I pay special attention to the 13 nation eurozone average inflation rate (the so called MUICP), since this aggregate figure masks as much as it reveals, given that in the case of the eurozone the differences which exist between countries are always very important. However since this data point is now destined to play such an important role in ECB history, it is worth making an exception this time round.

The MUICP inflation rate in the 13-nation euro area in fact rose to 3.1 percent in November from 2.6 percent in October, according to Eurostat data released today. That exceeded by one tenth of a percentage point an initial 3 percent flash estimate published on Nov. 30.

The European Central Bank has been unable to follow its counterparts in the U.S., the U.K. and Canada in reducing borrowing costs, since it has rather boxed itself in with its discourse that surging commodity prices and declining unemployment will trigger an inflationary spiral. ECB President Jean-Claude Trichet even went so far as to say on Dec. 6 that some governing council members actually favored raising interest rates. Commodity (and especially food) prices certainly are a problem, but the unemployment situation is more tricky than it seems, since noone has yet gone to the trouble of re-calibrating the standard NAIRU charts to take into account the sort of ageing labour force employment dynamics we have been seeing in Italy, Germany and Japan, where in each case the drop in unemployment has NOT been accompanied by a surge in wage inflation. The implications of all this still, as I say, await calibration and assessment, and I think that the central banks are treading on dangerous ground if the take strong policy decisions without carrying out the necessary studies.

In Germany, as noted in my last post, inflation picked up in November to 3.3 percent, the fastest pace in 12 years. What isn't clear at this point is what proportion of this acceleration in German inflation is a result of the base effect of January, when, it will be remembered, prices of most retailed goods rose by 3% due to a government VAT hike. So whose expectations exactly are we trying to steer here? Government ones that they should not pass the funding cost of rising elderly dependency ratios onto domestic consumers who are already weakened by the impact on wages and consumption of the rising median age? I both hope so, and hope not. I hope so, in the sense that I hope noone will now repeat this very ill advised move on the part of the German government, and I hope not in the sense that it would be stupid to try and make German citizens pay in the form of a longer and deeper than necessary recession for the errors of their government. Let's learn the lesson and turn the page here.

More worryingly, the Spanish rate surged to 4.1 percent from 3.6 percent. This is quite notable, since, as can be seen in the chart below, Spain inflation had been slowing under the impact of the steady unwind in the property market that the ECB's rate tightening policy had been producing, and, as I show in this post here, all the signs now are that the slowdown in the Spanish economy has been accelerated by the sub prime turmoil, and is now developing pretty quickly. The problem is that Spain, even despite this short term surge, definitely needs monetary loosening, and as soon as possible. Nearly 80% of Spain's very heavily mortgaged house-owning population have variable rate mortgages based on Mibor or Euribor, and these are all set to rise significantly in the coming months, even as the Spanish economy slows. And again, if, as now seems quite probable, the two "usual suspect" economies in the eurozone (Germany and Italy) fall into recession next year, they will be joined this time round by Spain, which will only leave us with France, to be holding the fort as it were, in the absence of the other three.

Greece, while a much more minor player in this particular game, is really a very similar situation to Spain, given the extent of the housing boom there in the past, and given the endemic tendency to higher than eurozone average inflation. The Greek economy is now surely slowing, and probably significantly so.

Italy is a rather case, since the Italian economy is slowing by the day, and may well be headed into recession in 2008, and inflation - despite that ever tightening labour market - has failed to surge to the extent that it has in other parts of the eurozone, remaining down at 2.6%.

Finally we could just take a quick look at Slovenia, the zone's most recent member, and the only country in the EU10 to have joined the common currency so far. Inflation in Slovenia accelerated to 5.9% in November. I have done a longer country study of Slovenia (here) but all of this does make you wonder just whether Slovenia is headed to some extent off where the rest of the EU10 seem to be going, and if it is at least we ought to ask ourselves the question: is being a member of the eurozone a help or a hindrance in this situation?

Does One Size Really Fit All?

ECB staff has forecast that inflation will accelerate to an average of 2.5 percent in 2008 from 2.1 percent this year, according to projections published on Dec. 6. Trichet noted at the time that these forecasts assume no ``second-round effects,'' such as wage increases. Council members Juergen Stark and Erkki Liikanen have both said they disagreed with the forecasts, calling them too optimistic. So far, however there has been little sign of second-round effects. If you look at the Eurostat data you find that eurozone labor-cost growth has been pretty "steady" at 0.6 percent for almost two years. The bigger danger in the eurozone at the present time is that a number of countries fall into a deeper and longer recession that really need be the case. But to adequately handle the needs of each country in critical and complex situations like the one we have on our hands right now we need a much more sensitive type of montetary policy. Unfortunately this is simply a luxury we no longer dispose of.

Thursday, December 13, 2007

Germany Economy, What Price the VAT Effect Now!

I don't think there is much to say about the chart below. I created it as I was going through the detailed data for Q3 2007 German GDP. Some of the things you were taught in Econ 101 do turn out to be more or less valid, despite what a whole battery of people who should have known better (from the FT to the Economist) were telling you not so long ago. You can't raise prices without some effect on demand. And when you tell people you are going to raise them in advance, then you should expect them to stock up as best they can. So we get a big spike at the end of 2006, and then 3 quarters of year on year negative consumption growth. I'm not sure after this experience people will be piling ageing society costs onto already fragile domestic consumption again. I do hope they are looking at this data in Japan.

Inflation on the Rise

And just to make things really complicated for the ECB German inflation accelerated in November to the fastest pace in 12 years, led by surging oil and food costs.

onsumer prices, measured using a harmonized European Union method, rose 3.3 percent from a year ago after increasing 2.7 percent in October, the Federal Statistics Office in Wiesbaden said today, confirming a preliminary estimate published Nov. 27. That's the fastest inflation measured since harmonized data for Germany started being collated in January 1996. In the month, prices rose 0.5 percent.

An 84 percent surge in oil prices since mid-January is driving up inflation even as the euro's ascent to a record against the dollar makes imports cheaper. While the European Central Bank on Dec. 6 left its key rate at 4 percent, President Jean-Claude Trichet threatened to raise borrowing costs if workers win bigger pay increases to compensate for higher costs. While the wage response to the price pressure is likely to be moderate, the inflation squeeze following on the back of the VAT hike is likely to weaken an already weak domestic consumption even further.

As we can see in the chart below - which gives a breakdown in Q3 GDP component contributions to growth, the heavy lifting was carried out by exports, and these were followed by machinery and equipment investment (which to some extent is related to export needs). So if external conditions deteriorate, even slightly - which all the forecasts suggest they will for 2008 - then Germany will have increasing difficulty maintaining the pace of the export expansion. Remember, for Germany to fall into recession we don't need to see negative export growth, just a substantial reduction in the rate of increase.

and just to end up where we started, here is a chart of the contributions of private domestic consumption to GDP growth in recent quarters. As can be seen, during the three last quarters (following the VAT anticipation spurt) consumption has acted as a drag on growth. With inflation now biting into consumers pockets, and monetary conditions effectively tightening, this position is more than likely going to deteriorate.

An Unlimited Need For People

The gentleman in the photo is Konrad Jaskola, Chief Executive Officer of Polimex-Mostostal SA, Poland's biggest construction company, and according to this article in Bloomberg today, he has just one message for us all: "I have an unlimited need for people".

The issue is that Joskola has plans to hire "several thousand" new workers next year to meet demand for new bridges and factories, but the problem is that due to Poland's growing labour shortages he may have difficulty finding them.

Construction in Poland rose 20 percent in the first nine months of 2007 as the economy grew at an annual pace of 6.7 percent. According to Joskola, Polimex needs to offer higher salaries to engineers and managers as skilled workers move abroad and local competition increases.

Polimex has raised wages by 11 percent over the last 12 months and will need to raise them them by a further 10 percent next year.

The former state machinery supplier, established to drive Poland's post-World War II reconstruction effort, plans to spend as much as 200 million zloty on acquisitions next year, to add workers and production capacity, Jaskola said. I imagine some, at least of those acquisitions will have to be of workers from outside of Poland.

And Inflation Continues To Rise

Meantime Polish inflation accelerated to the upper end of central bank's target range in November on the back of higher food and oil prices, meaning policy makers at the central bank may be forced to raise interest rates again in the coming months, in so doing possibly pushing up the value of the zloty, and attracting even more funds in search of even more workers to put to work.

Polish inflation rate rose to 3.6 an annual percent in November from 3 percent in October, the Central Statistical Office reported today in Warsaw. Consumer prices gained a monthly 0.7 percent after rising 0.6 percent in the previous month. Food prices grew an annual 7.2 percent 1.3 percent from the previous month, while fuel prices soared 13.2 percent from November 2006 and 2.5 percent from last month

As I say, inflation in Poland is also being fed by a 10 percent average wage growth and record low unemployment this year. The central bank lifted the seven-day reference rate a quarter-point to 5 percent only last month, and this was the fourth increase since April, when the key rate was 4 percent. So as we can see, at this point of time , and against all traditional expectation, monetary tightening may actually be having the perverse effect of accelerating the economy.

At the same time the zloty continues its rise, trading at 3.58 to the euro after the release, holding near its highest in five and a half years.

Lithuania Unemployment Q3 2007, Running on Empty?

Lithuania's unemployment rate fell to record low in the third quarter, the statistics office reported today, following their quarterly labor-force survey.

Statistics Lithuania reports that, according to the labour force survey data, the number of the unemployed in the country in iii quarter 2007 was 63.5 thousand, i.e. The lowest over the recent 5 years. As compared to iii quarter 2006, the number of the unemployed decreased by 27.3 thousand persons, or by one-third. Over the year, the number of young unemployed persons (aged 15-24) decreased from 15.2 to 13.4 thousand.

The jobless rate dropped to 3.9 percent from 4.1 percent in the previous three-month period. The chart below shows the evolution in the Eurostat harmonised unemployment rate, which is calculated slightly differently, but the picture is broadly the same.

Lithuania's jobless rate has been falling since 2004. When the country joined the European Union the rate stood at 13 percent. Lack of available labor has forced employers to raise salaries, which accelerated an annual 18 percent in the third quarter. The unemployment rate has fallen steadily as people have emigrated to those European states that have opened their labor markets. Top destinations for Lithuania's migrants include the U.K., Ireland and the U.S., the statistics department said. Claus Vistesen has examined the Lituanian situation in some depth in "Lithuania Under the Loop" and "End of the Road in Lithuania". This twin pincer, of rapid economic growth plus large scale out migration is increasingly producing severe overheating, labour shortages and inflation all across the EU10 (with the honorable exception of Hungary which is spiraling downwards into recession). To the issue of migration must be added the long term presence of below replacement fertility, which means that new entrant cohorts are very small, and cannot compensate for the loss, and low male life expectancy, which means that poor health makes it very difficult to raise participation rates among older workers.

And all of this, of course, means that inflation goes up and up. In fact Lithuania's inflation rate accelerated in November to the fastest pace in a decade, deepening concern the Baltic nation's economy may be overheating. The inflation rate rose to 7.8 percent, the highest since December 1997, from 7.6 percent in October, according to the Vilnius-based statistics office earlier this week. Prices rose a monthly 1.1 percent, compared with 1.5 percent in October.

Lithuania is struggling to contain consumer-price growth as the economy expands at the second-fastest pace in the European Union after Latvia. Gross domestic product rose 10.8 percent in the third quarter. On Dec. 7 Fitch Ratings followed Standard & Poor's in cutting Lithuania's credit rating outlook, citing the growing risk of an abrupt slowdown triggered by inflation.

To cap it all gas prices are scheduled to rise 69 percent for Lithuanian citizens next year. Food costs, which constitute the biggest item in the consumer basket with a 25.9 percent weighting, rose an annual 15.4 percent in November. Household expenses such as gas, water and electricity, the second biggest category in the index, rose 11.3 percent.

Same Situation in Bulgaria

Bulgarian inflation rose again last month, reaching 12.6 pct on an annual basis (as measured by the Bulgarian statistics office index of major groups), largely as a result of rising food prices. The index had fallen back (to 12.4%) in October on a year on year basis from September's high of 13.1%. The Bulgarian index rose by 1.6 pct in November from the figure for October the National Statistical Institute said in a statement. Here's a chart for the Bulgarian index and the EU harmonised index. The reason the HICP is consistently lower is largely a question of the differing weights attributed to food in the EU wide measure, but the local Bulgarian index may well be a much better reflection of the inflation situation on the ground in Bulgaria, since being a comparatively poor country food is a significant part of the household budget.

And in Romania

Well here is the Romania inflation chart, I wouldn't say the November figure was exactly good news, but a drop in inflation to an annual 6.67% from an annual 6.84% isn't bad news at any rate, unless you thought inflation was going to suddenly go away it isn't.

On one level you might have thought that the rot had been stopped, but it's not that simple. The month on month rate is 0,93, which is down from last months 0,97. But if we look at the components, then food rose 1,17% month on month, while services rose 1,21 month on month. In October food was up 1.3% over September, while services where only up 0,98. So food seems to be slowing, but price increases in services are accelerating (pass through) and this is not good news.

Migration and Labour Shortages?

Of course the big problem with all this inflation is the danger of a wage price spiral, given the constraints which have been placed on the local labour markets by low male life expectancy, declining populations, heavy out migration and years and years of very low fertility.

According to Romanian Labor Minister Paul Pacuraru, quoted in the newspaper Ziarul Financiar, Romania needs at least another 300,000 workers to meet current needs and will need more than 1 million within a decade.

The labor shortage, Pacuraru said, is caused partly by a migrating workforce and partly by a declining population, and is most acute in construction, and the textile, automobile and food processing industries.

Maybe he has been reading this blog (and here, and here).

Actually, according to the UK Daily Telegraph Romania's finance minister, Varujan Vosganian, aims even higher, saying Romania lacks half a million workers."We need more engineers, mechanics and bricklayers," he is quoted as saying "We have a labour deficit of 500,000 employees."

And he wasn't talking about the elites - doctors and IT programmers gone to make their fortune elsewhere, though that would be damaging enough. Romania needs its skilled labourers to return - the people who are going to build up the infrastructure that the country so severely lacks. But when we look at the wage differentials, this idea of a mass return would seem to be a forelorn hope to me, in Latvia, in Poland, in Ukraine or in Romania.

So the simple issue is, what is now the normal capacity neutral growth rate for Romania at this point (remember this will get less as the population continues to decline)? That is, what is the annual growth rate which Romania is capable of without seeting off the sort of inflation we are seeing at the moment? Noone really knows, but it is obviously well below the rate Romania is currently growing at.

Second question: when and how will the adjustment come?

Just Why Is Hungary So Different From The Rest of the EU10?

According to the Hungarian Statistics Office (KSH) gross domestic product grew in Hungary by just 0.3% on a quarter by quarter basis from to July-September 2007. The KSH also took the opportunity to reduce their growth figure for the second quarter to zero, which was down from the previous 0.1% estimate.

On a year on year basis, economic growth in Q3 was just 0.9% according to unadjusted data or 1.0% if you prefer your figures to be adjusted for seasonal and calendar effects. In either case this is a very low reading end especially when you bear in mind the very rapid growth we are seeing in many other EU10 countries, and all the indications are that this figure is likely to drop further. Which raises three questions directly in our minds: a) why is Hungary so different from the rest of Eastern and Central Europe, b) where is Hungary headed, and c) what can we learn from Hungary about the future path of those EU10 economies who are now visibly overheating, after they have passed through their inevitable "correction" that is.

Looking at the evolution of Hungary's GDP on a year on year basis, the slowdown is evident. The first thing that strikes you when you look at the chart below is that annual growth rates seem to have peaked in 2004 (that is before the correction and fiscal adjustment of 2006), growth slowed entering 2005, and it was at this point that the expansion in the fiscal deficit became important, but it was a fiscal expansion to try to arrest a general downward tendency in the rate of output expansion(very reminiscent in its way of things we have seen in Japan and Italy if we work our way back through the data). And on a year on year basis Q3 2007 represents yet another step backwards, since the comparative figure for Q2 was 1.2%. And this process seems set to continue, and I would go so far as to say that no-one at this point has any idea where the bottom is on this one.

The engine behind what little growth Hungary is now getting continues to be industrial output which registered a 7.4% yr/yr growth in Q3, and this output was pulled along to a considerable extent by the 14.6% export growth which was registered.

The main drag on growth was, unsurprisingly, final household consumption, which declined by 2.0% yr/yr. Previously, the slowest pace of growth in recent memory was back in 1996 when the fiscal adjustment package of Economy Minister Lajos Bokros pushed growth to below 1% y-o-y.

If we now come to look at the evolution of GDP shares for some of the components, we will see, for example, that both agriculture and construction have been more or less stable in recent years (ie we have not had any sort of dramatic construction lead boom in recent years. On the other hand, if we look at manufacturing and real estate and financial services, we will see that the latter have clearly grown in importance in relation to the former, which is in many ways a pretty normal development.

On a quarterly basis, the largest growth was observed in industry (3.1%), followed by services (1.3%) and transport, storage and communications (0.9%). Consumption expenditure of households fell by 0.8% yr/yr and 0.2% q/q, while public consumption fell by 3.8% yr/yr and 3.2% on a quarterly basis.

Exports rose by 4% q/q (vs. 2.0% in Q2) and imports increased by 5.9% from the previous quarter, against a q/q decline of 0.3% in Q2. What this means is that while Hungary has now managed to achieve a small goods trade surplus:

The rise in imports pegs pretty closely on to the the coat-tails of the rise in exports, something for which the very strong value of the forint must undoubtedly bear some responsibility, since as the euro rises, and the forint clings on to par with the euro, the general tendency of opening the doors to products from China and other low-cost manufacturers (as well of course Japan, and a now much cheaper and more competitive United States) must have a reflection of the Hungarian import situation.

So it is really rather cold comfort that the 0.3% q/q growth obtained in Q3 is the largest so far this year, firstly because, as Portfolio Hungary indicate, it is disappointingly small and secondly, because it would really be very premature to start speaking of any kind of upswing even in the short term.

Hungarian central bank (NBH) Deputy Governor Ferenc Karvalits is quoted this morning as saying he believes the central question is not whether the growth rate of the Hungarian economy will start to increase but to what extent and up to which point. I think he is basically right, but he forgets one additional issue, when it will stop falling, and how much farther it still has to fall? Certainly if we look at the path of domestic retail sales, there is no sign at all that we are done yet.

And to this slowdown in private consumption we need to add future purchasing power, since real wages are also falling in Hungary. If we look at the chart below, the sharp improvement in the negative real wage tendency which we can observe in September 2007 is due to the base effect of the austerity package tax and social security measures introduced in September 2006 having moved out of the calculations (since these meant that between September 2006 and August 2007 net wages rose much more slowly than gross wages) and hence the change does not reflect any sudden spike in actual wages paid, and of course, inflation continues to be strong.

And when we come to think about public consumption it is important to bear in mind that the Hungarian government - according to its own latest Dec 1st estimates - is still running a fiscal deficit this year of 6.2% of GDP. The government are committed to reducing the deficit further next year, so this has naturally to be subtracted from GDP: that is we are going to face more fiscal tightening. In fact, what is incredible is that Hungary is currently only able to get 1% y-o-y GDP growth despite this whopping fiscal stimulus. Which is why a close examination is needed of just how Hungary got into this mess in the first place, and in that context why it is that Hungary is so apparently different from the rest of the EU10.

Obviously the presence of fiscal deficits has been one issue.

But again, and in the end, what is so striking is just how little "bang for the buck" (or forint) Hungary has been getting for all this fiscal stimulus. As I pointed out above, a lot of the sparkle had already been going out of Hungary's GDP growth some time before the fiscal correction came into force.

In addition monetary policy is likely to remain restrictive. The current Central Bank base rate of 7.5% is the highest in the European Union, and there is little room for any substantial reduction given the rate of domestic inflation - the government has just agreed to raise public sector wages by an average 5% in 2008, so it is hard to see inflation being anywhere near the "comfort zone" yet awhile.

Ideally, even considering the current inflation, given the state of domestic demand, you might have though that some element of monetary loosening would be desirable, especially since this would probably serve to weaken the currency, and this would help exports and in so doing increase that at present very minimal trade surplus. But it is just here that we hit one of Hungary's biggest headaches moving forward, the Swiss Franc Mortgages.

The use of non-local-currency denominated loans has become a widespread phenomenon in Eastern Europe in recent years. In Hungary the most common currency for such purposes is the Swiss Franc and around 80% of all new home loans and half of small business credits and personal loans taken out since early 2006 have been denominated in Swiss francs. A similar pattern of heavy dependence on foreign currency denominated loans is to be found in Croatia, Romania, Poland, Ukraine (US dollar) and the Baltic States, although the mix between francs, euros, the dollar and the yen varies from country to country.

First off, here's a chart showing the evolution of outstanding mortgages with terms over 5 years since the start of 2003. As we can see the outstanding debt is now over 5 time as big as it was then.

Now if we look at the growth of forint denominated mortgages over the same period, we can see that while they initially expanded very rapidly, they peaked around the start of 2005, and since that time they have tended to drift slightly downwards.

Then if we come to look at the growth of non-forint mortgages, we will see that since early 2005 the rate of contraction of such mortgages has increased steadily.

The Magyar Memzeti Bank (the Hungarian central bank) recently published the October edition of its bulletin on Household and non-financial corporate sector interest rates, interbank lending rates (careful PDF). This bulletin contains a lengthy summary of the state of play with non-forint denominated loans to individuals, and in particular a section on Swiss Franc loans in Hungary.

According to the Bank, following a moderation in the demand from Hungarian households for Swiss franc-denominated consumer loans, a sharp turnaround in demand occurred in October. The monthly volume of new mortgage loans for consumption purposes (ie not for buying homes, refis) leaped by 30% to reach an all-time high. It is also a noteworthy that even before the start of the real Christmas season the volume of new CHF-denominated consumer credit jumped by 25% from September, setting yet another historic high.

The amount of new mortgage loans rose to the previously unseen level of HUF 130 bn in October, and this increase is almost exclusively attributable to the increase in CHF-denominated loans (HUF 120 bn). Detailed data from the bank show that while the monthly amount of new CHF-denominated housing loans rose to the exceptional level of HUF 55-60 bn, mortgage loans for consumption purposes (ie "refis" or liquidity extraction, not to buy houses) became pretty fashionable, rising by 30% month on month to reach the level of HUF 62.5 bn.

Within these new mortgage loans, the ratio of foreign currency to total loans increased to 92.5%, setting yet another record. What all this suggests to me is that a lot of Hungarians are trying to maintain current consumption by borrowing forward in the hope and expectation of rising property values in the future. If this rise does not materialize, then the very least that can be said is that all of this will need, at some point, to be clawed back from current consumption. This whole process also represents a new form of moral hazard for the central bankers, since such borrowing in Swiss Francs is based on the assumption that with so many people doing this the Hungarian authorities will never dare to let the forint slide (you know, there's safety in numbers) or, pushing the buck back one stage further, the EU Commission and the ECB won't let it happen.

But this is very dangerous thinking, since in the first place there are a lot of people now out there riding around on the back of the same idea (think Italian government debt, for eg), and people may be seriously overestimating the ability of the political and monetary authorities to contain such a large and complex set of problems. It should not go un-noted that the whole weight of the ECB is currently not able to stop the spread of the growing credit crunch across the entire eurozone and beyond. Secondly, and just as importantly, all of this puts the Hungarian central bank in a real double-bind, since they cannot ease monetary policy at this point without precipitating a tremendous weakening in the forint, so interest rates stay high, and Hungarian domestic demand gradually gets strangled, while all the inflation puts a strong brake on export growth.

The translation problem that all these foreign currency loans may represent for Hungary, and some of the other EU10 economies where this kind of borrowing has become popular, are a matter which has been addressed by Claus Vistesen in this post. But what exactly is translation risk? Well let's take a standard type definition, such as this one from investopedia.com. Translation risk is "The exchange rate risk associated with companies that deal in foreign currencies or list foreign assets on their balance sheets. The greater the proportion of asset, liability and equity classes denominated in a foreign currency, the greater the translation risk".

Now as Claus points out much of the literature here refers to companies, and most of the words spent on the subject have been devoted to the description of companies' exchange rate risk when operating in foreign countries under insecure exchange rate systems and obviously subsequently how this risk can be hedged through the use of derivatives, or simply by adequately calibrating the denomination of the stock of liquid assets held on the balance sheets. But the issue in Eastern Europe is that the majority of this credit has been extended to households through loans intermediated by foreign financial institutions and thus it is unhedged, and even more to the point this borrowing is being facilitated either by bank flows or inward FDI which is what enables the current account at the end of the day to balance. The big problem will come if ever the direction of these capital flows reverses, and this is precisely why the Hungarian central bank is constrained in the way it can loosen monetary policy, since it simply cannot afford to either risk a reversal in the flow of funds, or a sharp rise in the cost of private debt servicing should the forint weaken significantly in value.

Those analysts who focus only on the secondary issue of steering inflation expectations are missing the bigger part of the problem here. As we are now seeing in the United States, and as we may well be about to see in an ECB context (indeed arguably we have already seen, since the inflation data treated alone may well have warrented an ECB raise this month) if expectations are your only problem, then the central bank can afford to be more flexible than many imagine.

It's the Demography?

So to return to where we started, just what is it that makes Hungary so different. The simple answer is that I don't know, but I know that it is, and that we need to keep digging. The philosopher Francis Bacon held that the important thing about doing science was to know how to put the right questions to nature, and the answers we get to some extent depend on the questions we ask. My intuitions tell me that Hungary's very special demography has something to do with it all, but others do not agree, and do not ask this type of question. But if we come to look at the demography, there are some things which we can hardly fail to notice. In the first place Hungary's population has been falling, and for many years now, in fact it peaked around the start of the 1980s.

Now something has to be said here. Noone knows what the long term consequences of having a declining (and ageing) population like this is going to be. We don't know, because quite simply we have never been here before. In previous periods, after a war or a plague, when population had fallen the Malthusian homeostatic mechanism of increasing wages lead to increased fertility, and this in and of itself corrected the problem. Indeed in some parts of Eastern Europe (though not Hungary) we are seeing a demographically driven form of wage inflation, but this is not leading to a homeostatically corrective rise in fertility because, quite simply, the old correlation between increasing wealth and increasing fertility has now been broken. More money today does not mean more children, indeed under certain circumstances it may mean less. So basically we don't know where we are going here, and my advice is don't let anyone convince you otherwise.

Having said all this, intuitively less people ought to constitute less domestic demand pressure, but this issue is undoubtedly more complex than this.

Turning now to fertility, it is worth noting that, apart from a brief episode in the late 1970s, Hungary has in fact been struggling with below replacement fertility since the early 1960s. The only real "novelty" about the 1990s is that Hungary transited from below replacement fertility, to lowest-low fertility (1.2/1.3 Tfr region).

Returning then, and in a demographic context to Deputy Central Bank Governor Ferenc Karvalits' question about how far and to what extent Hungarian growth will recover, as we have noted, domestic demand has been in virtual free-fall in recent quarters. What is not clear is when (ot whether) this component will ever recover to the extent of being able to drive growth, since now start to get into age-related elements (which I know not many people agree with me about at this stage, but still).

As a result of ongoing low fertility, and rising life expectancy, Hungary's median age is, of course, climbing steadily, and calibrating the macroeconomics of this ageing process in the context of Eastern Europe's comparatively low male life expectancy (ie calibrating how domestic consumption loses its relative strength as median age rises, in the way we have seen in Germany, Japan and Italy) is something noone has done at this point to my knowledge. In fact most people you talk to don't imagine that this is important, but then most of them didn't imagine that Hungary would fall into the hole it is currently falling into. As we can see below, Latvia and Hungary, despite having started the 1990s at not such a great distance from Germany, now have considerably lower median ages (please click on image for better viewing).

But this lower population median age is hardly a positive outcome, since it is not due to higher fertility or strong inward migration. Rather it is due to their much lower male life expectancy.

As we can see, male life expectancy is considerably lower in both Hungary and Latvia, than it is in Germany, and this must have consequences for economic behaviour and performance. Increasing the working life to 67 and beyond as they have in Germany is just not the same proposition at all in a lower life expectancy society like the other two, nor is the issue of getting employment participation rates among the over 60s comparable given the evident health problems of one part of the population.

So while we would not normally expect domestic consumption to run out of steam until the median age reaches 41/42 (this is the sort of lesson we can garner from Germany, Italy and Japan) there may be good reasons for imagining that this median age needs rounding down somewhat in the Latvian and Hungarian contexts. I will certainly stick my head out and say that the property boom which is now in the process of petering itself out in Latvia, like the 1992 one in Japan, and the 1995 one in Germany, is very likely to be the last of its kind we will see there, high median age societies just don't work like this. They do not ride on the backs of credit driven booms, and I would have thought that the reasons why would be obvious. Indeed, if we look at the proportion of construction in Hungarian GDP, this sort of confirms my suspicions, since in general terms this has not constituted a large share.

Indeed what we can note, as might be expected, is a very strong weather-driven annual cycle, and if there is any sort of trend discernible, it is ever so slightly downwards rather than upwards. This, again would fit in with a gradually ageing and declining population. The position is only confirmed if we come to look at the housing cost index.

So the first thing that strikes us is a local boom which we can see in the early months of this year, and which has since faded (and this is more than likely associated with a removal of public housing subsidies, a sharp rise in rents, and therefore a shift in the relative appeal of purchased property - always, of course, on low interest Swiss loans - and all of this at a time when internal demand is to all intent and purpose collapsing). Before this we can note the surge in prices in 2003/04. My guess is that this is/was Hungary's property boom, and that this phase has now come and gone. This also helps explain how the Hungarian fiscal side got into such a mess in 2005, as the government was increasingly having to shoulder the load against a faltering domestic demand. All of this is, as I say, very different from other parts of the EU10.

In conclusion then, we can assume that given sufficient determination by the central bank to hang on at all costs to the value of the forint, and absent a major external exodus from Hungary on the backs of a more general crisis, the systematic and sustained tightening on all fronts will eventually produce nominal as well as real wage deflation, especially if we sink into a deepish recession, which seems to look all but unavoidable when we come to think about the third factor - external conditions - which are almost certainly going to deteriorate over the next 6 to 9 months, as the powerhouse economies of the eurozone - Italy, Spain and Germany (France is the only semi-brightish star on the horizon) are all slowing mightily even as I write. So the message here is now twofold. Strap yourself in tight, since it is going to be a very bumpy ride, and secondly, Hungary is now about to join that honoured group, the export dependent economies. Of course, how rich she will ever get to be due to all the structural difficulties must remain a very open question.