Is An Emerging Market Correction Coming in Eastern Europe?

According to wikipedia, the noun "correction" comes to us, via the French, from a Latin original corrigěre 'to make straight (again)', and is used to describe an action which can rectify, or make right a wrong. Wikipedia lists a number of possible meanings, three of which are of interest to us here:

• To set straight an error, clarify a misunderstanding, undo resulting damage; e.g. a correction in a newspaper is the posting of a rectification of a mistake that appeared in a previous issue of the newspaper.
• To rectify an abnormal state of affairs - e.g. a market anomaly - as occurs, for example, in a stock market correction.
• A euphemism for a punishment, which may be of various kinds, mainly physical; in institutional terminology specifically used for imprisonment, e.g. correctional facility (prison) or corrections.

Basically wikipedia give us a very reasonable account of the useage of the term "correction", and of its ambiguity in an economic context. "Correction" it seems means both punishment and putting right. What is so unique and so surprising about the coming correction in the East European economies is that it fits the definition of correction in neither of these senses.

In the first, and most obvious case, if there is to be a punishment, then there must have been a crime, right? But where is the crime in the current case of Eastern Europe - unless it is to be some modern variant of original sin - since it seems evident that the only things that policy makers in the EU10 economies have been doing is "following orders", irrespective of whether these came from the EU Commission, the ECB, the IMF or the World Bank. They took the best expert advice available at the time, and they acted on it. Surely they can hardly be blamed - let alone punished - for that. If there have been errors, they are surely human ones, a bit too much public spending here, the odd currency peg or other there, but when we look beyond all this surface detail, and move to the underlying structural level, we find that there is a most depressing uniformity about things. I say depressing, since I do think it is hard to say the Eastern Europe has done much to bring about or deserve the tragedy which is about to unfold and come crashing down upon its head.

If the twentieth century was - for no fault of their own - a bad one for many of these countries, it now seems that the twenty first one - oh horror of horrors - might turn out to be even worse.

Why do I say this? Because many of these countries are quite literally dying, in the demographic sense. And since at the present moment almost all of them - with the honourable exception of Hungary - are working pretty much flat out, it might not be going to far to suggest that they are "dying on their feet" or "dead men running (on empty)" even.

Which brings us back to the second meaning of correction, that of putting straight or "making whole".

Unfortuantely this is just what the coming correction is not going to do. The explanation for why it will not do this will come in the following post, but suffice it to say here that - due to major underlying demographic processes and the impact of migratory flows - the traditional homeostatic mechanisms which operate during economic corrections will not be at work in this one.

That is to say, what is about to happen next in Eastern Europe is about to establish, and I suspect beyond all possible doubt for the company of reasonable men, that the widely accepted neoclassical idea of general economic convergence towards a - even hypothetical - situation of "steady state growth" is quite simply a mistaken and non-valid one. Demography does matter, and fertility with a lag of twenty or so years does seem to be important.

Now lets take a look at why.


The Problem-Set Facing the EU10

Basically the principal outstanding issues confronting the EU10 countries are threefold:

1/. Labour capacity constraints (which are normally a by product of long-term low fertility and large scale recent migration flows) are producing significant wage inflation and strong overheating.

2/. A structural dependence on external financing - which is in part a by-product of the effect of low levels of internal saving, and which is another factor which separates the EU 10 from those like India or China who are benefiting from a typical demographic dividend driven catch up, is leading to large current account deficits, and potentially high levels of financial instability.

3/. A loss of control over domestic monetary policy due to eurozone convergence processes which - with or without the presence of formal pegs - make gradual downward adjustment in currency values as a alternative to strong wage deflation virtually impossible. This issue is compounded by the likely private "balance sheet consequences" of any sustained downward movement in the domestic currency given the widespread use of mortgages which are not denominated in the local currency.

Now the worrying part about all three of these is that they are not simply cyclical in character. As such they are not problems which will "self correct" as a result of a recessionary slowdown, whether this be of the "soft-" or "hard-landing" variety. This problem simply is not being taken into account in many of the current pronouncements on the EU10, and certainly is in no way reflected in the current "fiscal deficit obsession" which we can find in the discourse which exists at EU Commission level (for a consideration of this in the case of the Czech Republic see this post).


The IMF, the World Bank and the ECB


The macro imbalances which currently exist in many of the EU10 economies are substantial, and as I have tried to argue at some length here, they stem from a virtually unique set of circumstances (historically unique I mean, at the present time the underlying dynamic across all the East European EU member states is remarkably similar, with the possible exceptions of Hungary and Slovenia, and in each of these latter two cases for different reasons).

The sad reality is that many of the EU 10 countries (and in particular we are talking here of the Baltic States, Bulgaria, Romania and Poland) are facing, at one and the same time, a very considerable inflow of external funds to fuel domestic consumption (whether this be in the form of the bank flows which drive the supply of cheap credit, or the worker remittances which drive the demand for it), and a very significant reduction in the potential labour supply following a couple of decades of below replacement fertility, and a large and sustained outflow of migrant workers which has accompanied EU accession and which is driven by the very large East-West wage differentials. Put another way, demand side factors are increasing rapidly, while supply side capacity ones not only are unable to keep pace, but are actually shrinking (if we think about the number of people of working age in the total population, and of the proportion of these who are available for work inside the country).

In recent weeks a variety of players on the international economic stage have been active in pointing to the mounting problems which are now only to obvious to the trained macro economic eye.

In the first place the World Bank, in its most recent report on the economic outlook for the EU 10, had the following to say about the labour shortage situation:

Unemployment has fallen substantially in virtually all EU8+2 countries since 2004 due to strong growth in labor demand. This has given rise to skill shortages and associated wage pressures, often amplified by out-migration of EU8+2 workers.....

In contrast to the earlier period of weak labor demand it is now the supply side of the labor market that constrains new job creation. Many persons of working age are economically inactive in EU8+2 either because they lack skills demanded by employers, or because of labor supply disincentives, such as early retirement benefits, generous disability schemes, high payroll taxes, and limited opportunities for flexible work arrangements. These effects are concentrated among the younger and older workers, while the participation rates for middle aged workers are similar to those of the EU15. Hence the main challenge facing now EU8+2 is to mobilize labor supply to meet the demand.

Really anyone seriously interested in this problem needs to read the whole report, but the above, in essence, is one part of the picture.

Then, earlier last week, the IMF published the autumn edition of its World Economic Outlook, and Chapter 3 - Managing Large Capital Flows - to some extent focuses on the current problems of Eastern Europe. According to the IMF the economies of eastern Europe are vulnerable to a reversal in the surge of private capital that has poured into emerging markets in recent years. The IMF says that "large capital inflows are of particular concern to countries with substantial current account deficits, such as many in emerging Europe", as well as countries with inflexible exchange rate regimes (and among these are, of course, to be found four EU 10 members: Estonia, Latvia, Lithuania and Bulgaria).

Eastern Europe is in fact the only region singled out by the IMF in this way as being particularly vulnerable to a change in the direction of private capital flows at this point in time. While the IMF draws the fairly comforting conclusion that most emerging markets now have much stronger and more defensible current account positions than they did in the late 1990s - since they have been steadily building up their foreign exchange reserves during the good times - this is not the case with most of Eastern Europe. Gross capital inflows into the region have reached levels relative to gross domestic product that are "unprecedented for emerging market countries in recent history" while "unlike in other regions…net capital inflows have been accompanied by a deteriorating external position".

So, I would say, we have been warned. It couldn't get much clearer than this.

Lastly there have been a number of recent indications that over at the ECB people are not all that calm about what is happening at the moment. The most recent example of this unease is to be found in a speech given by European Central Bank board member Lorenzo Bini Smaghi where he specifically identified the fixed exchange rates in Bulgaria and the three Baltic states as part of the cause of the accelerating inflation and current-account deficit problem which exists in those countries since the currency board arrangement limits the central banks' ability to control the rate of price and credit growth. According to Bini Smaghi:

Keeping nominal convergence on track is the main policy challenge in the region. The problem becomes particularly acute in countries which have given up monetary policy independence by choosing an exchange rate target or adopting a currency board arrangement.

The key question for these countries is: how is it possible to keep inflation under control by pegging the exchange rate, which means adopting de facto the monetary policy of the euro area, especially since the euro area economy is growing at a rate that is less than a third of what a catching-up economy should aim to achieve? In other words, how is it possible to keep inflation under control with very low or even at times negative real interest rates? What are the risks for financial stability of having persistently low real interest rates, much lower than the rate of growth of the economy?......

Bini Smaghi has it right, the key question for the EU 10 countries is how to maintain the levels of "catch up" growth which would enable them to close the gap in living standards which exists between East and West, and how to do it, so to say, when they don't have the raw material (in terms of labour supply) to hand to aid them in this.

So, at the risk of repetition, there are three large and oustanding problems to be faced in Eastern Europe now.

1/ The labour shortages issue

2/ The capital flows, current account deficit, dependence on foreign investment, non local currency denominated debt issue

3/ The currency peg issue, in the case of the four countries which are on a peg, or the rising real exchange rate one in some of the countries which aren't like Romania, Poland and Hungary. Given the dependence on foreign lending for survival, the difference at the end of the day is not significant between these countries, with the possible exception of the fact that any attempt to break the peg by one of the four countries who have one could prove to be a very dramatic event, and indeed could serve as the immediate signal for setting off the whole large scale "correction" which is so evidently in the process of coming. It's in the post, as it were.

In this situation the only real tool left to the domestic authorities is the generation of fiscal surpluses to try and reduce domestic demand, to try, as it were to dredge domestic demand from the system. But if this is not to remain something akin to draining the ocean with a soupspoon these surpluses need to be very large indeed. The IMF has been arguing for a surplus of 4% of GDP in the Latvian case, and it is far from clear that this in itself would have been sufficient (I say would have been, since, of course, the closing down of the credit mechanism which is being already operated by the banking system may well now make this unnecessary, and this closing down is happening very rapidly indeed, as Latvian abroad makes plain here). Naturally the local authorities - not really grasping the gravity of the situation, and who can blame them since who really anticipated the severity of this problem - have flinched in the face of introducing such severely deflationary fiscal surpluses. As Bini Smaghi says:

"I guess the real question to ask is: how large should the budget surplus be to counteract the inflationary effects produced by a pro-cyclical monetary policy and would this be acceptable for a catching-up country? How far reaching, and acceptable to the population, should structural reforms be? All in all, the requirements for the budgetary and structural policies associated with an exchange rate linked to the euro might just be too demanding to counteract the procyclical effects of very low real interest rates. This might lead to boom and bust cycles, with potentially very severe adjustments costs that may delay real convergence."

I entirely agree, and what we are faced with here are a whole new set of problems for monetary policy, ones which were not at all anticipated when the euro was set up, or the new members accepted into the EU fold.

Why Doesn't Homeostasis Operate?

And so to finish where we started. This correction will not correct, at least it will only correct in the punitive sense, since little that is good can come out of the affair. To understand why this is you need to look at the population pyramids of the various countries involved.

To help make this a bit plainer I have comparative pyramids for Ireland and Latvia online here. This comparison basically is to illustrate why a country like Ireland was able to get a demographic dividend which facilitated so much rapid catch-up growth, and why Latvia isn't.

Now if we look at the pyramid for Turkey in 2000:



and if we now compare this with pyramid of Latvia's population in 2000, we should be able to see straight away why Turkey could correct rapidly, and why Latvia will not be able to.




Essentially if we look at the size of the "10 to 14" and "15 to 19" generations in comparison with the "20 to 24" one in both cases. Think of water running down a river, and the recession/correction as a kind of dam you place across the flow. In the Turkish case closing the dam gates causes the water to back up in the system and accumulate, ready to be subsequently released as part of a flood which due to its volume maintains wages at a very low level, which is exactly what we have just seen take place in Turkey post 2000.

If we look at a chart of Turkish GDP growth from the late 1990s we can see this process at work very clearly:



During the years 2000 to 2002 the Turkish economy underwent a correction in the true sense of the word. There was a problem, and it was corrected. The evidence for the effectiveness of this correction can be seen in the subsequent growth rates, and even, as I explain in depth in this post, from the way in which the Turkish economy has rebounded from the currency crisis of the summer of 2006. The Turkish economy is now reasonably robust, and one of the reasons that it is so robust - given that it has made more or less similar structural reforms to all the economies of Eastern Europe - is that it has the demographic winds behind it, and not, as in the EU 10 case, blowing into its face.

In the Latvian case, on the other hand, (and for Latvia here, of course, read any one of the other EU 10 countries which you please) stopping the flow temporarily doesn't correct the problem since in each time period there are progressively less people arriving to the gates of the labour market dam. It could even be that the correction here may only make matters worse, since it could in fact send many more potential workers out of the country in search of work. So far from bringing wages back into line with a competitive level, wages could in fact get "stuck" and only adjust downwards slowly, far too slowly to generate the new employment which will be needed to seriously restart the economy.

This is also why all those comparisons between what is happening in the Baltics now and what happened in Scandinavia in the 1990s miss the central point, since the demographic situations of the countires involved was very different.

Of course the EU10 still have the potential labour force left to get economic growth, what is in question is where they are going to get the labour supply from for the very rapid rates of catch up growth they obviosuly want and need.

And all of this has been a very long and tortuous way of saying that (and to answer my own question) yes, I think a correction is coming, indeed it is already arriving, and it will be a serious one whose impact will be felt right across the eurozone. But at the end of the day it may well not do what corrections by their very nature are supposed to do, namely correct.


References

By the very nature of the limitations of a blog post, a lot of assertions have been made above which are, to some extent, in need of substantiation. Below I list a number of previous posts where some of the issues raised are treated in more detail.

Firstly, the issue of neo-classical growth, and why this is important. A good starting point on this topic would be this post here.

It has been asserted that the EU 10 economies are overheating due to labour shortage problems. This is explained in the Latvian case in great depth here.

Claus Vistesen does a similar job for Poland here, and for Lithuania here.

I have examined Romania in depth here, and Bulgaria here.

As has been argued, in fact not all the EU 10 economies are by any means identical, and the problems do vary. Despite sharing a similar demography with the rest the cases of the Czech Republic and Slovenia seem to be very different. One of the factors at work here is undoubtedly the existence of migratory flows within the EU 10 themselves, and in this sense not all will or need to follow the same trajectory (although of course at the end of the day the numbers simply don't add up, so there will be losers as well as winners). I have made some initial attempt to look at the situation of the Czech Republic here.

Hungary is again a very special case, and is certainly not overheating at the present time. I have a whole blog dedicated to trying to understand what is happening in Hungary and why it is so different, this post and this one might be a good place to start.

One common assumption is that labour shortages in the EU 10 can be met over the longer term by inward migration from other parts of the old Eastern Bloc like the current CIS countries. Immigration may well be part of the answer for the EU 10, but the CIS itself is unlikely to be a durable source of supply here, basically because a large part of the CIS has a similar demographic profile. This post goes into the Ukraine situation in some depth, and here is a link to some work by Russian economists who advise the World Bank, and who argue that Russia may well be already in need of around a million migrants a year if she herself is to be able to maintain current growth rates.

I even went so far as to check out Uzbekistan, since many seem to think that these Asian members of the CIS might be better placed, but unfortunately my conclusion was that with all the demands which are being placed on them, and all the money which is heading back home in remittances to fuel growth it won't be long before they run out too.

Finally, if you have gotten this far, all I can say is thanks for your time, and good luck and good reading.

The Implications of Bulgaria's Inflation Surge

Bulgarian inflation, which is now rising faster than in any other country in the European Union, accelerated once more in September on the back of rising food, wages, utility and education costs. The Bulgarian "major groups" index rose to a nine-year high in registering an annual rate of 13.1 percent, a figure which was up from the 12 percent one registered in August. Consumer prices rose 1.3 percent on the month following a 3.1 percent increase in August.

At the same time Bulgaria's annual inflation rate, as measured by the EU- Harmonized Index of Consumer Prices, rose to 11 percent in September, from 9.3 percent in August. On this index monthly prices climbed 1.2 percent in September, after rising 2.2 percent in August.

Now one common explanation for this inflation acceleration phenomenon has been the impact that the hot and dry weather at the end of June and in July - which was then followed by floods which also destroyed crops - has had on food prices prices. But there is obviously more to this situation than food costs. In the chart above I have included both the Bulgarian "home grown" index and the EU designated harmonised one, and, if we look at the latter, we can observe the way the two lines diverge back in May just as the food price issue started to gain traction, so we can see the food effect there in the divergence. The EU harmonised index evidently gives a lower overall weighting to food.

Food prices in fact account for 35 percent of the Bulgarian consumer-price basket, and food rose 2.1 percent in September, following a 7.3 percent increase in August. This gives us a whopping 25.1% year on year food inflation rate in September. Other factors which played their part like restaurant prices, which went up 17% year on year.

But going back to the indexes, we can see that even on the harmonised basis, Bulgarian prices are "only" rising at an annual rate of 11%. But this precisely gives us a measure of the extent of the problem. It is clear that inflation has suddenly accelerated in Bulgaria, and given the way the Lev is pegged to the euro, it is hard to see what the central bank can do, since raising interest rates would, in the short term, only attract a greater inflow of funds, accelerate the overheating even further, and put strong upward pressure on the currency.


Whichever way you look at it all of this is far from over, and inflation looks set to continue at a high level, if indeed it doesn't continue to accelerate. The International Monetary Fund recently doubled its Bulgarian inflation forecast for this year to 8 percent. This now seems like it might be a conservative estimate.

Beside food one factor is certainly of growing importance: wages. And wages are, as we all know, one way or another associated with the supply of labour. And it is just in this department that countries like Bulgaria find themselves in difficulty, as the world bank recently highlighted in a report on the growing labour shortages the EU 10 countries now face. Getting a clear fix on the labour supply situation in Bulgaria is something of a headache, however, given the absence of dependable data from the Bulgarian government on Bulgarians working abroad.

This issue is an important one, since if the Bulgarians are not in Bulgaria then they are evidently not able and willing to work at the time and in the place that the employment market needs them. On the other hand if we look at the evolution of the official numbers of unemployed in Bulgaria, we will see that they have been reducing quite substantially over the last two or three years.



If we then look at the data for the number of people employed, we will see that this has been steadily rising:



Now obviously these two graphs simply don't match, since they are self evidently set on collision course, and especially in a society which has now been having very low fertility for nearly twenty years and which has a significant proportion of its working age population outside the country working elsewhere. So if we look at the next chart we can see the quarterly year on year increases in those employed. That is to say we can see how many extra people were employed in the previous year.



As we can see the "assimilation rate" of new workers into employment has been accelerating since the end of last year, and indeed in the second quarter there were 312,000 extra workers employed, a feat which would be quite impossible over the next year (if the same participation rates are maintained) since there are currently only 237,000 registered unemployed in Bulgaria, and of course the problem will not be resolved by younger labour market entrants joining the labour force, since from now on pregessively more people will be leaving than will be joining, so this factor only makes things worse.

Naturally with the labour supply being exhausted at this rate, a response from the wage rate was only to be expected, and we got it.



As we can see, wage rates have been increasing fast since the start of 2004 (and have risen by nearly 50% over that time) and have been accelerating rapidly as this year has progressed. So this story is no longer only about food. It is in large measure a labour supply capacity problem.

As such, the issue is not a "homeostatic" one, in the sense that a recession will not bring things back to where they were before, since all that will happen as the years pass is that even less people will be available for work, due to natural population drift, even assuming the best case that another wave of people do not leave during the recssion. That is a "correction" in this case will not do what it is supposed to do - namely correct - since the Bulgarian population structure is now so badly distorted, it is hard to see what can actually be done at this stage. And the situation has all the hallmarks of being about to turn critical at just this very moment in time.

Of course, the position is complicated even further by the presence of the euro peg, and the currency board, since this to all intent and purpose leaves the central bank standing on the touchline as a virtually helpless spectator.

Naturally, the press has been full of gentle comments in recent weeks about how it might be adviseable for the Baltics and Bulgaria to begin to consider whether it might not be in their interest to steadily abandon the pegs.

Only last week European Central Bank board member Lorenzo Bini Smaghi gave a speech where he blamed fixed exchange rates in Bulgaria and the three Baltic states for accelerating inflation and current-account deficits because the currency board system limits the central banks' ability to control surging price growth. According to Bini Smaghi:

Keeping nominal convergence on track is the main policy challenge in the region. The problem becomes particularly acute in countries which have given up monetary policy independence by choosing an exchange rate target or adopting a currency board arrangement.

The key question for these countries is: how is it possible to keep inflation under control by pegging the exchange rate, which means adopting de facto the monetary policy of the euro area, especially since the euro area economy is growing at a rate that is less than a third of what a catching-up economy should aim to achieve? In other words, how is it possible to keep inflation under control with very low or even at times negative real interest rates? What are the risks for financial stability of having persistently low real interest rates, much lower than the rate of growth of the economy?......

I guess the real question to ask is: how large should the budget surplus be to counteract the inflationary effects produced by a pro-cyclical monetary policy and would this be acceptable for a catching-up country? How far reaching, and acceptable to the population, should structural reforms be? All in all, the requirements for the budgetary and structural policies associated with an exchange rate linked to the euro might just be too demanding to counteract the procyclical effects of very low real interest rates. This might lead to boom and bust cycles, with potentially very severe adjustments costs that may delay real convergence.

Bini Smaghi has it right, the key question for the EU 10 countries is how to maintain the levels of "catch up" growth which would enable them to close the gap in living standards which exists between East and West, and how to do it, so to say, when they don't have the raw material (in terms of labour supply) to hand to aid them in this.

Thus in many ways the European Central Bank might be thought to be increasingly giving the impression they would not be displeased if the Baltic nations and Bulgaria drop their exchange-rate pegs because they contribute to increasing economic imbalances, according to a research note from Danske Bank:

``It seems that the ECB is suggesting what would have been unthinkable a year ago: that it is time to change the exchange- rate policies in the CEE countries with exchange-rate pegs,''

This, at any rate is the view of Lars Christensen, a senior analyst at Danske Bank. No smoke without fire is normally a good watchword in these matters.

But the problem is that these countries will find it very difficult, if not nigh impossible, to break the pegs, quite simply because of the balance sheet consequences of all the foreign currency denominated (largely euro denominated) debt the citizens of these countries have been busily acquiring in recent years, and with the reasuurance that with a peg in place, and euro membership nothing could possibly go wrong. Except it can.

I think I have said enough here for one post, so I will not go into this issue further now, other than to point out that Claus Vistesen has conveniently done a timely post on the theoretical literature on balance sheet effects so we can all to some extent prepare ourselves for what might well now be about to happen. Claus will also be covering in more depth the capital flows and foreign debt side of things. So that will have to be it for this note. I doubt however that you have now heard the last of all this, or that much time will now pass without fresh news on this whole front, especially after the recent World Bank EU10 labour shortages report and the latest issue of the IMF World Outlook which focuses on the CA and debt imbalances in Eastern Europe. Basically the acceleration we have seen in inflation across a number of the EU 10 economies will have set alarm bells off ringing all over the place. The fire may well not yet have started, but I doubt it will be long now in kindling itself.

Inflation Surge In Estonia Raises Questions About 'Soft Landing'

Estonian inflation surprisingly accelerated in September to reach a new nine-year high, largely on the back of rises in food, housing and services costs. The Estonian Finance Ministry has said it expects Estonia's inflation rate to remain near the current level for the immediate future. The annual rate rose in September to 7.2 percent, which was its highest level since October 1998, and was up from 5.7 percent in August, according to data released by the Estonian statistics office at the end of last week. Month on month, prices rose by 1.1 percent.

The largest increases were registered in food prices (7.8% annual rate), housing (16.1%) and services (hotels, cafes and restaurants, 12%). Here is the monthly inflation chart.

Now the Estonian central bank and Finance Ministry have been insistent in recent months that the Estonian economy remains on course for a ``soft landing'' as the property sector cools and credit growth slows. This outcome is far being a self evident one, however, as this and other recent data which will be reviewed in this note make clear.

Overheating in the Baltics?

What is happening in Estonia may seem to be lacking in any great global significance, given the size of the country and its economy, and its lack of general importance at the global level. But such a conclusion might be over hasty, and premature, as I will try and argue here, given how representative what is happening in Estonia now is of processes at work in many EU10 economies (although not of course all, as the notable exception of Hungary shows).

In fact all three Baltic economies show clear signs of overheating, despite the fact that assessing the extent of the overheating in the Estonian case was initially complicated by an overly negative preliminary Q2 2007 GDP relase, which cited figures that were subsequently revised substantially upwards. I have addressed some of these questions in this post, and Claus had dealt with the external balance sheet position in this note here.


Slowing Down Nicely?

When we come to look at the details we can quickly appreciate that the Estonian economy certainly does show some clear signs of slowing, as can be seen from the GDP quarterly growth rates:



Also, and according to data from Statistics Estonia, industrial production increased in August 2007 when compared to August 2006 by only 4.4%, a pace which which was slightly down from the annual 5.2% increase recorded in July, and indeed the year on year rate of output growth has been slowing now since April, as can be seen from the chart.



But other data show if not a completely different picture, at least a more qualified one. If we look at retail sales for example, and again according to Statistics Estonia, we find that in August 2007 retail sales were up 13% year on year over August 2006. This rate is actually down on those registered earlier in the year, but it is still very high.


Actually, compared to July 2007, the level of retail sales in August was more or less stationary:



And again if we look at the monthly annual change figures, the rate of increase is clearly slowing.

Wage Push Inflation?

One big part of the underlying isssue here is undoubtedly strong wage-cost push inflation, of the old school kind. If we look at the quarterly chart we can see that though the rate of annual increase in wages and salaries has fallen back somewhat in the second quarter from the first, it is still very substantial:

Now if we move on to look at producer prices, which is where all the "cost-push" inflation shows up, we can see that these have been rising steadily over the last 18 months, and while they may well now have peaked in terms of the rate of increase, the pace is showing no real sign, up to now, of having eased off to any substantial extent.



The situation is even more problematic if we come to look at the rate of producer price increases in the export sector:



The reason this situation is so problematic is the impact that this sustained inflation on producer prices is bound to have on Estonia's ability to export, especially given that the kroon is effectively pegged to the euro, so prices cannot adjust via a downward movement in the currency.

We can perhaps get a point of comparison if we take a look at what has been happening in Hungary. The Hungarian economy has certainly been undergoing a "correction" since the autumn of last year, internal demand is down very sharply, and while domestic inflation remains stubbornly high - though not as high as Estonia's - export prices show a completely, and much more desirable pattern, since wage deflation has been very significant in Humgary.

Here is the chart for month-on-month changes in domestic sales prices and export prices in Hungary:

and below are the equivalent year on year changes. What we can observe is that there is now a very strong disinflationary process at work in Hungary, a disinflationary process which has yet to be seen in Estonia, or for that matter in the Baltics generally.



Now I think I need to be clear here, since I am certainly not recommending the kind of strong wage deflation they are having in Hungary as a preferred recipe for the Baltics. I am simply trying to suggest that this problem exists, and must eventually be addressed, either by coming off the peg, or by other means. There are even doubts in the Baltic acses that wage deflation as such could be operated, given that omnipresent danger of increased outward migration is bound to make wages and prices more "sticky" than in the Hungarian case (where among other things out-migration has not been present to any significant extent, at least to date it hasn't).

What I am suggesting is that there may well be other ways available to address the problem, even if they do involve "unconventional tools" and "out of the box" thinking. One of these unconventional measures would certainly be a flexibilising of the labour market through a significant and substantial opening to international migrant labour. In order to work this opening would have to be large scale, and should not simply be confined to skilled worker categories. At the end of the day, it is a question of which you prefer, to be flayed alive by systematic wage deflation (and all the problems of out migration that this might produce) or a rapid transition to a modern multi-cultural society. There are not many other options to play around with here I think. And time is pressing.

Now, returning to what I said above, the reason why all of this producer price inflation is so problematic for Estonia is the corrosive impact that it has on Estonia's ability to export its way out of difficulty. This impact is evident enough if we take a look at the recent evolution of the external balance in goods and services for Estonia:

Not a pretty picture, is it? And again, the dimension of this problem becomes even clearer when we come to look at this deficit as a share of GDP:

Well, according to Eesti Pank (Estonia's National Bank, see link above):

The average goods and services export growth rate has been fast, although the situation varies by groups of goods and by markets. Although the growth rate of merchandise exports slowed considerably at the end of 2006 and at the beginning of 2007, we are mainly speaking about the so-called transit goods. When we leave aside transit and the subcontracting sector, there are no reasons to assume the competitive ability of other sectors has substantially declined.

This assessment of the situation seems fairly reasonable when we take into account the impact of accelerating producer price inflation and its impact on competitivity. As we can see from the chart below, both exports and imports "peaked" back in May, and this peak in exports occured despite an extraordinarily favourable environment from an external point of view. This is not what should be happening in the case of a "correction". Domestic demand should, of course, be weakening, but exports should be beginning to play an increasing part in maintaining aggregate demand, otherwise this situation simply shows us that Estonia is moving steadily off into a recession, but since the currency cannot adjust, it is not clear where the actual correction to bring her out of the recession again is to come from here. Unless, of course, the recession produces a very sharp deflation in wages, but isn't that exactly what everyone would mean by a hard landing? (ie a strong recession accompanied by a long and sustained period of wage deflation). As I say in my original post I am simply not clear what kind of vocabulary register is being used by many of the participants here. Indeed, I would venture to say that the people who are using this vocabulary are themselves no more clear than I am.



Labour Shortages The Core of the Problem

Again according to Eesti Pank

In spite of slower economic growth, the number of jobs increased, although more sluggishly than before. In the second quarter of 2007, 1.3% more people worked in Estonia year-on-year. Employment increased to 62.9% of Estonia's workforce and the unemployment level fell to 5%.

This is precisely the problem. Even though the growth rate is slowing, the process of labour market tightening continues. This is due to the fact that there is no inbuilt correction mechanism in the labour market due to the shape of Estonia's population pyramid.

What do I mean by this? Well let's look at some more of those charts. Firstly annual unemployment rates in Estonia:

As we can see, these have been steadily coming down since 2000. Now lets look at the numbers of available unemployed:




As we can see the numbers of people registering as unemplyed and seeking work has dropped steadily since the end of 2000. At the same time the number of people working has steadily risen, as is only to be expected given the strong rate of economic growth.





So it is this path which is not sustainable, especially when we take into account that participation rates have also surged strongly.



As we can see the participation rates for older workers is now quite high by international standards, especially when we consider the compartaively low male life expectancy of around 67. Now if we come to look at youth unemployment:



We can again see that the rate of youth unemployment has been declining steadily since the start of 2005. And it is important to remember that these percentages are on a reducing total youth population as can be seen from this, the last chart in this series, which shows how the 0 to 14 age group - or if you like tomorrows young workers and labour market entrants - has been steadily declining as a proportion of the total population since the early 1990s and it is the impact of this steady reduction that is now about to make itself felt.

So there we have it. I basically don't see how - whether you talk in terms of hard landing or soft landing - the Estonian economy is ever going to "correct" unless this structural issue is addressed.

The macro imbalances we are refering to here are substantial, and as I have tried to argue at some length here, they stem from a virtually unique set of circumstances (historically unique I mean, at the present time the underlying dynamic across all the East European EU member states is remarkably similar, with the possible exception of Hungary). Estonia is facing, at one and the same time, a massive inflow of external funds, and a significant reduction in its potential labour supply after years and years of below replacement fertility. Put another way, demand side factors are increasing rapidly, while supply side capacity not only is unable to keep pace, it is actually shrinking (if we think about the number of people of working age).

So there are two problems to correct here, and they are both large and important. Essentially Estonia needs:

a) more labour supply, both skilled and unskilled
b) a lower rate of inflow of structurally distorting funds, whether these be bank credit, remittances, or even (possibly, this needs investigating further) EU funding for projects which Estonia cannot reasonably expect to carry through in the time horizon outlined, given the capacity constraints.
c) more Foreign Direct Investment to create value creating jobs, especially in manufacturing and services areas with export potential
d) increased spending on education and training projects to upgrade the human capital of the existing population

In this post I have been talking about Estonia, but we could just a well have been speaking about Latvia or Lithuania, about Romania and Bulgaria, and - if nothing is done of an international level to address the problem - in the not too distant future about Poland and Ukraine. If we simply sit back and wait for the crunch to come here, then quite frankly it will, and the end product of all that negligence will be much more significant than many seem to currently appreciate.

Are Prodi's Proposed Italian Budget Cuts For 2007 Too `Modest'?

Such at any rate is the opinion Bank of Italy Governor Mario Draghi holds of Prime Minister Romano Prodi's 2008 budget. He stated yesterday that the budget proposals fail to cut spending and sufficiently reduce what is effectively the biggest government debt in the EU.

"Progress on deficit cuts is modest" Draghi said during testimony in Rome's Senate. Next year's proposed budget "doesn't take advantage of an increase in tax revenue to accelerate debt reduction" and puts at risk the objective to balance the budget by 2011.

Romano Prodi has proposed a spending package that cuts housing taxes, lowers levies for poor families, and boosts spending on public works, while polls indicate his popularity is sagging to an all-time low. All the members of Prodi's nine-way coalition resisted spending cuts, and some are threatening to vote against the budget - and the government - if the Prodi refuses to scale back plans to contain pension costs.

Draghi's criticism comes just two days after European Union Monetary Affairs Commissioner Joaquin Almunia said Italy's budget wasn't "ambitious" enough in it's attempts to tame the deficit and debt, which is forecast to fall to 105 percent of gross domestic product this year from 106.8 percent in 2006.

Also it comes hot on the tail of a decision by the EU finance ministers to urge the Debt Rating Agencies to be more vigilant. I'm sure the Italian case was not in the forefront of their minds when they took this approach, but as Claus Vistesen observes rather wryly, the Italian representatives may well have been sitting at the table with some uneasiness during this entire discussion.

Rather significantly Standard & Poor's said last week that the current budget plan won't alter its rating outlook, and it predicts Italy may fail to meet its goal of bringing the debt below 100 percent of GDP by 2010.

"In the absence of any significant structural reforms, Standard & Poor's believes that the government will fail to meet its target debt level of less than 100 percent of GDP by 2010" the rating agency said in a press note, and I'm sure the EU finance ministers said "quite right too".

All of this follows hot on the heels of declarations by Italian Finance Minister Tommaso Padoa-Schioppa that substantial tax cuts will only be possible once the government slashes interest payments on thedebt by half.

Italy's debt is "gigantic" and costs Italians 1,200 euros ($1,700) each annually, Padoa-Schioppa told the Italian Senate last week. "Halving debt servicing costs to 35 billion euros could free up money for cutting taxes..... but for now, interest expenses and widespread tax evasion limit the government's ability to trim taxes".

"We know that taxes are high in Italy.....No one brings up the fact that these two issues make our case truly singular."

Italy last year spent 69 billion euros servicing the debt, an amount that is twice the size of Slovenia's entire GDP.

EU Ministers and the Czech Deficit

Well, I can't help thinking some people have an obsession with fiscal deficits at the moment, I really can't. EU finance and economy ministers, meeting yesterday in Luxembourg, took it upon themselves to criticise the Czech government for their fiscal policy telling them in the process that they must "take effective steps" to cut their budget deficit to bring it into line with European Union rules, and that they must do this no later than next year. In fact they have given the Czech Cabinet until April 9, 2008 to take measures to ensure that next year's fiscal deficit, adjusted for one-time factors, falls below the EU limit of 3 percent of gross domestic product. At the present time the Czech government government projects a fiscal deficit of 3.6 percent of GDP this year, compared with an initial 4 percent target.

Now in the face of ageing societies I am all for structural reforms and fiscal rigour I really am, but I think there is a time and a place for everything, and a sense of proportion is needed here. The Czech economy is, as I tried to have illustrate yesterday, one of the few real relative success stories to be found among the EU 10, and as such there is a real need for balance and for classifying issues in terms of their importance here. (This stance on the Czech Republic seems to parallel recent exchanges over the level pf the current French deficit between Trichet and Sarkozy, exchanges which seem truly out of proportion when you consider the extent of the accumulated debt problem which exists in say Italy or Greece, and well, I would make a similar point about how the Czech Republic. "Overheating", while still an issue, is far less problematic in Czechia than it is in many members of the EU10, and this "detail" would be my personal initial point of departure for assessing the robustness of the Czech economy, and the margin for manoevre the government may or may not have in terms of fiscal deficits).

The Problem Facing the EU10

Basically the principal outstanding issues confronting the EU10 countries are threefold:

1/. Labour capacity constraints (which are normally a by product of long term low fertility and large scale recent migration flows) producing significant wage inflation and strong overheating.

2/. Structural dependence on external financing leading to current large current account deficits.

3/. Loss of control over domestic monetary policy due to eurozone convergence processes which - with or without the presence of formal pegs - make gradual downward adjustment in currency values as a alternative to strong wage deflation virtually impossible. This issue is compounded by the likely private "balance sheet consequences" of any sustained downward movement in the domestic currency given the widespread use of mortgages which are not denominated in the local currency.

Now the worrying part about all three of these is that they are not simply cyclical in character. As such they are not problems which will "self correct" as a result of a recessionary slowdown, whether this be of the "soft-" or "hard-landing" variety. This problem simply is not being taken into account in many of the current pronouncements on the EU10, and certainly is in no way reflected in the current "deficit obsession" which we can see at EU Commission level.

The Immediate Problem


The current controversy has its roots in a decision by the Czech government last September to push through Parliament a set of tax changes and spending cuts that are intended to narrow the fiscal shortfall to 3.2 percent of GDP next year and 2.8 percent of GDP in 2009, an outcome that the Czech finance ministers consider to be "plausible'' in spite of the "considerable uncertainties'' which are linked to the tax overhaul.

The controversy has of course been well served by a 17 percent jump in welfare spending approved before elections last year, and these have, of course, boosted spending even as a record 6.4 percent pace of economic growth in 2006 brought in more tax revenue than expected. The economy is expected to expand 5.9 percent this year, according to the Finance Ministry forecast in the 2008 draft budget.

``In the absence of measures to address the budgetary impact of aging, the debt ratio is likely to increase significantly over the next decades'' from about 30 percent of GDP now, EU finance ministers said, in their statement. I agree completely, but are we not in danger of confusing two issues here, longer term structural issues, and short term budgetary ones?

Certainly, when compared even with many existing eurozone members, the Czech deficit problems can hardly be said to be of the "basket case" variety:



And as the EU finance ministers accept, the debt to GDP ratio - which is currently around 30% - is hardly huge in comparison with some others I could mention.



So the issue here is the need for longer term structural changes - just like in France - and the best way to achieve this may be by presenting the necessary laws and longer term reforms, and not by focusing on short term deficit issues. As I have indicated, there are far more pressing issues on the table all over the place at the present time.

And even when we come to the external balance position, the Czech position is far from being a chronic one. Trade in goods and services is now in balance:


And even the CA deficit, which does need addressing, is not large in comparison with many of the rest in the EU10.





Finally, and as an example of a more balanced view I would draw attention to the fact that the most recent IMF staff report on the Czech Republic had this to say:

Lingering slack in the labor market has helped contain wage inflation. Despite strengthening demand for labor, suggested by rising vacancies, wage pressures have remained subdued, as rising inflows of immigrant workers have helped offset the impact of population aging on labor supply. Recent employment gains have been concentrated in industry and private services, including real estate, and do not yet appear broad-based. Unemployment has fallen, but remains around 7 percent, as continued geographical and skill mismatches have kept structural unemployment high.

and this:

The main concerns center on the erosion of fiscal discipline in 2006-7 and the medium-term fiscal outlook. The expansionary fiscal stance for 2007 is out of place in view of the expected robust growth. The authorities’ medium-term consolidation plans are appropriate, but supporting measures should be identified without delay. A cutback in high mandatory social spending would improve fiscal flexibility and efficiency. The institutional fiscal framework also needs to be strengthened.

Well exactly. So let's just try and keep things in proportion, shall we?

German Exports August 2007

It is important to bear in mind that the data mentioned in the last post referred to future orders, not work already completed. In fact German exports rose at the fastest rate since April in August, according to data released today by the Federal Statistics Office:

According to provisional data of the Federal Statistical Office, Germany exported commodities to the value of EUR 77.7 billion and imported commodities to the value of EUR 63.6 billion in August 2007. German exports of August 2007 were thus 12.4% and imports 9.5% above the respective August 2006 levels. Upon calendar and seasonal adjustment, exports increased by 3.0% and imports by 5.6% on July 2007.

The foreign trade balance showed a surplus of EUR 14.1 billion in August 2007. In August 2006, the surplus amounted to EUR 11.0 billion. Upon calendar and seasonal adjustment, the foreign trade balance recorded a surplus of EUR 15.3 billion in August 2007.

Here's the chart in value terms.





And here are the year on year growth rates. Obviously we have slowed somewhat from the end of 2006, but tha rate of growth is still pretty health. This big question is, of course, what happens next?

Germany Factory Orders August 2007, Construction PMI

Well despite the fact that someone claims they have not enough data to make a judgement, evidence continues to mount of a slowdown in the eurozone and particularly in the key German economy. So, for those of you with a strong stomach, here is a bit more. First off, new factory orders in Germany, where manufacturing orders rose less than many economists had forecast in August after the euro's gains seem to be making exports less competitive while domestic spending follows its now traditional flat pattern..

Orders, adjusted for seasonal swings and inflation, rose 1.2 percent from July, when they dropped 6.1 percent, the Economy and Technology Ministry announced at the end of last week, based on data from the Bundesbank. The July decline, which was revised up from a 7.1 percent drop, was still the largest since at least September 1991. Particularly striking was the 10% drop in foreign orders noted in July over June.



As can be seen the level of orders has fallen back considerably from the, admittedly, very high level achieved in June.

If we now look at the construction PMI we can see a similar picture:



As can be seen, given that 50 is the dividing line between contraction and expansion, construction has been in contraction since February.

If we now take a quick glance at the manufacturing PMI:



We will see that while the German manufacturing sector is still expanding, the rate of expansion has been slowing steadily since the spring. I would say all the pointers are now there to show that a rapid slowdown is taking place in the German economy.

Japan Economy Watchers Index September 2007

The Economy Watchers index, which is a gauge of Japanese domestic demand based on a survey of workers who deal with consumers, fell for a sixth consecutive month in September, to 42.9, down from 44.1 in August, according to the Japanese Cabinet Office in Tokyo today (Japanese only). A number less than 50 means pessimists outnumber optimists.



Today's report, which is the first piece of consumer-related data we have for September, suggests Japanese consumer spending may may fail to support growth should exports cool as a result of the global slowdown. Sentiment among consumers, whose spending accounts for more than half of gross domestic product, has been battered by sliding pay, a tax increase and the government's loss of pension records.

As we can see, in the sub indexes sentiment among retailers fell 2.2 points to 40.4 - its lowest level in four years, while confidence at food-related businesses tumbled 7 points to 36.3, the worst since February 2003.

Wages have dropped in seven of eight months this year and have fallen around 10 percent in the past decade. Pay rose 0.1 percent in August, but this is in part explained by workers putting in overtime hours to make up for a production slump caused by an earthquake in the previous month.

Consumer confidence dropped in August to its lowest level in almost three years and stocks also had a downward correction. A withdrawal of tax rebates in June and the government's admission in May that it lost pension records may also be taking a toll on sentiment.

Today's survey showed shopkeepers expect spending to slow in the next two to three months, while the outlook index fell to 46 in September from 46.5 in August.

Sentiment indexes are often hard to read, and need to be thought about in junction with other "real" economic data. But when we put these results, which really do seem to be fairly clear, together with what we already know about weak Japanese earnings (despite the apparently tight Japanese labour market), weak consumption, and the export dependence of the Japanese economy, all the data does seem to be pointing in the same direction: as I suggest here (and see also Claus here), the danger of a recession in Japan is now real and strong.