To The Finland Station And Back Again

This post accompanies my recent piece on Sweden. I have been scratching my head and trying to see what could be learnt from making a comparison between Finland and Sweden. Some of the differences are obvious - one is in the euro, and the other isn't, once can adjust monetary policy and currency values, and the other can't. Others are less so. Finland's goods trade surplus has been declining steadily since joining EMU while Sweden's has remained relatively constant. And Swedish males live on average three years longer than their Finnish counterparts. So what is important here, and why? And if convergence theory has anything positive to be said for it, shouldn't we be able to observe so sort of convergence going on here.


First, and just to remind ourselves, here is the chart from Claus Vistesen which shows what the relation between population ageing and current account balance might look like. The key point is that as populations age beyond a certain point, a tendency to run a current account surplus emerges, as domestic demand steadily weakens, and becomes insufficient to drive growth. Evidence for this phenomenon can be found in Germany, Japan and Sweden.




The idea is that as median population age rises the current account dynamics of a country change. The last ageing phase shown to the right of the diagram is purely speculative at this point, although theory suggests that if the underlying momentum of ageing is left unaddressed it may well be what happens. But it is a development which is to be strongly avoided since although we do not yet know what happens when a society starts to dis-save at an advanced median age, the longer we can put off finding out, the better.

Which is why looking at Finland is important, since unlike the three aforementioned "ideal type" agers, Finland has in fact seen a deterioration in its external position over the last decade, and even though it has, up to now, remained a surplus country, the trend is certainly towards deficit, and this trend needs to be halted and reversed. Indeed this is the most pressing policy problem facing the Finnish authorities during the current recession.


Now, as in Finland, Sweden's external position underwent a structural shift in the mid 1990s, just as Claus's model predicts. First positive balance - the submarine breaks water - in 1994, meadian age 38.4 (quite young in international comparisons so interesting). So so far so good.

So Sweden is a sort of normal case, now let's look at Finland. Once more the mid 1990s "transition" is clear. Finland moves from deficit to surplus. But unlike the Swedish case the surplus peaks around the turn of the century, and since then has been steadily weakening.



There can be a number of explanations for this. The pattern of ageing could, for example, be different in Finland. Or the euro might be a factor, with the loss of control over monetary policy leading to a steady deterioration in the level of international competitiveness. As we will see below, some part of the explanation may be provided by each of these, but first, lets take a look as some of the empirical aspects of Finland's present recession, since it is evident that Finland, like many other countries, has entered a strong recession on the current back the global crisis.

Strong Decline In Finland's GDP

In the first three months of this year GDP was down by 2.7% when compared with the last three months of last year (an 11.2% annualised rate of contraction).

And it was down by 7.5% when compared with the first quarter of 2008 (Eurostat data).




One significant difference which can already be noted between Sweden and Finland is that while the last three months of 2008 were definitely much worse than the first three months of 2009 in Swedan, in Finland, as in many other Eurozone economies, Q1 2009 was definitely much worse than Q4 2008. And indeed, while Sweden's economy shows some definite signs of small green shoots in Q2 2009, as far as we can see, Finland's economy still remains deeply mired in recession. Finland does not have a local variant of the ubiquitous Purchasing Managers Surveys, but the statistics office does maintain a monthly gross domestic product (GDP) indicator. Now, while the methodology is very different (the PMI composites are survey based and qualitative, and much more reliable) for what it is worth Finland's GDP indicator fell 9.2 percent in April in comparison with April 2008, that is to say, the year on year contraction was greater than in the first quarter, but it is difficult to draw any definitive conclusion from this, since there are many statistical factors at work here.

According to Statistics Finland building and manufacturing industry were the hardest hit.




The April data showed production in construction and manufacturing - both key contributors to the Finnish economy - down around 17 percent year-on-year. Production in April was down 0.6 percent from March. Output in agriculture and forestry showed slight growth on an annual basis of just below two percent, while services fell six percent.

And the outlook for the rest of this year does not look much brighter. The OECD forecasts growth in the Finnish economy will fall by 4.7 percent in 2009 with a return to 0.8 percent growth next year. Significantly the OECD also stressed that uncertainty in the evolution of international trade poses the greatest risk in the outlook for the Finnish economy.

The IMF currently expects the economy to shrink by 5.2 percent this year and again by 1.2 percent next year, while the latest finance ministry forecast is for a 6.0 percent shrinkage this year followed by 0.3 percent growth next year. All the 2009 forecasts seem to be subject to downside risk, while the 2010 ones are no better than guesses, since the level of uncertainty is so high, and Finland is so dependent on external trade, but further contraction seems more probable than growth at this point.

Short Term Indicators

Industrial output fell again in May (year on year) for the seventh consecutive month, and was down by 23.2 percent over May 2008. This follows a revised fall of 21.3 in April.

Month-on-month, industrial production also fell - by 2.2 percent from April when it fell by 3.8 percent over March. So the industrial situation is deteriorating, not improving at this point. Output fell in all main sectors, with metal industry reporting the biggest decline around 28 percent, while the paper industry production also shrank by nearly 28 percent year-on-year.



Over the January to May period, industrial output decreased by close on 22 per cent from the corresponding period in the previous year. And there seems to be little improvement on the horizon. According to Statistics Finland, the value of new orders in manufacturing was 39.6 per cent lower in May 2009 than in May 2008, slightly above the January to May average decrease of 38.9 per cent year-on-year.



As in earlier months, the decline in new orders was strongest in the metal industry (47.5 per cent). In the chemical industry new orders fell by 30.7 per cent, in the textile industry by 28.5 per cent and in the manufacture of paper, and paper and board products by 19.4 per cent.

Construction activity is also well down, falling by 14.4% year on year in March (the latest detailed data we have), and by around 17% in April according to the GDP indicator.







Finland did not have a massive construction boom. The construction of new dwellings shows no obvious surge in the first decade of the century.



On the other hand rate of household indebtedness is up, with the ratio of debt to disposable income rising to 101.4 percent in 2007, from 70.3 percent in 2002. Significantly, the rate of indebtedness among households composed of persons in the key 25 to 34 age range reached 189 percent in 2007. House prices seem to be a story of one long steady march upwards since 1995, but prices did start to fall in 2008, and this trend now seems set to continue.



Retail sales, which give us a measure of domestic demand, are also falling, if still only moderately. According to Eurostat, retail trade sales fell by 2.99 percent year on year in April. According to the Finnish Statistics Office, sales between January-April were down by 1.6 percent over a year earlier. During the same time period, motor vehicle trade sales were down 31.8 percent and wholesale trade sales down 17.5 percent.






Finland's unemployment rate continues to rise, and at an accelerating pace. The increase in those unemployed from April to May alone was greater than that in the whole of last autumn, according to Statistics Finland. From January to May the seasonally adjusted jobless rate was up by two percent and there were more than 300,000 people recorded as without work in May, 60,000 more than in May 2008, taking the national unemployment rate as measured by Finland Statistics to 10.9 percent.

Using the EU (ILO compatible) methodology, Eurostat report the May unemployment rate as 8.1 percent. The OECD expect unemployment to continue to rise in Finland, and forecast an unemployment rate of 8.7 percent this year, rising to 10.8 percent next year (ILO methodology).





The OECD is also worried about employment in Finland in the longer term, and point out that while the country has taken important steps to remove the barriers to employment of older workers (see the OECD publication Ageing and Employment Policies in Finland) more needs to be done. Since the early 1990s, Finland has introduced programmes to support the employment of older workers, notably the National Programme on Ageing Workers. It has also recently undertaken a major reform of the old-age pension system and will phase out early retirement schemes.



However, Finland’s median age is rising steadily (see chart above) and the old-age dependency ratio (population aged 65 and over as a proportion of the population aged 20-64) is projected to increase from 25% in 2000 to 43% in 2025 compared with an OECD average of 22% in 2000 and 33% in 2025. This is a very steep rise, and raising employment rates among the older population is going to be the key to meeting the challenges presented by the need to find export lead growth.

According to the OECD, only around 30% of people aged 61 are currently working – a drop of more than 50 percentage points compared with 51 year olds. This steep drop in employment rates can primarily be explained by the fact that Finland has too many pathways to early retirement, notably unemployment benefits, unemployment pension, disability pension and individual early retirement pension. Already at the age of 50, 18% of individuals are receiving either unemployment or disability benefits, increasing to more than 46% by the age of 60. Moreover, in the age group 60-64 most unemployed persons transfer to the unemployment pension with a further 20% relying on disability benefits and about 10% rely on the individual early retirement pension.


Deflation dynamics


Like Sweden, the inflation data also throws into the limelight the disparity between the EU HICP measure (which does not include housing interest) and the national CPI (which does). Year-on-year inflation, calculated by Statistics Finland dropped to 0.0 per cent in May, while in April it was still 0.8 per cent. According to Statistics Finland the drop was primarily due a fall in food prices and interest rates. Between April and May, consumer prices fell by 0.2 per cent. On the EU HICP index, however, year on year inflation is currently running at 1.5 percent. Thus, in a time of falling house prices and lowered interest rates, the HICP totally underestimates the deflation danger.



It is important to remember here that two-thirds of Finland’s housing stock consists of owner-occupied homes, and home ownership is widespread in all forms of housing, including apartments as well as detached houses and row houses. Normally falling interest rates would produce rising house values, due to the affordability effect, but under current conditions we are observing the opposite. I can't help feeling that European monetary policymakers need to think more about this type of thing.


More evidence for deflationary headwinds is offered by producer prices for manufactured products, which fell by 8.1 per cent year on year in May. Export prices were down 9.8 per cent and import prices fell by 11.7 per cent. The year-on-year change in the wholesale price index was -8.9 per cent.





So Where Are We?


Finland's economy faces important challanges in both the short and long terms. Finland's state debt is low at the present time, which gives the capacity for short term stimulus and bank bailouts. But it is rising, and reached a record high of 70.6 billion euros by the end of the first quarter of 2009. General government debt, calculated according to Eurostat methodology, grew by 7.5 billion euros in January-March, and reached 38 percent of 2008 gross domestic product (GDP). Still, there is plenty of stimulus ammunition left, the important thing is to use it wisely, and try to engineer an economic transition.



The severe contraction in the Finnish economy is also likely to take its toll on bank credit fundamentals, according to the credit rating agency Moody's. The agency recently reaffirmed its negative outlook for the Finnish banking system. Up until now the Finnish banking sector - lead by Pohjola Bank and local branches of Nordea and Danske Bank - appear to have been weathering the storm without undue difficulty due to minimal exposure to toxic assets and a focus on traditional banking activities, according to Moody's. However:


"Given that the crisis on financial markets has now spread extensively into the real economy, Moody's expects Finnish banks to be adversely affected," according to the latest report. Moody's said an increase in bankruptcies was indicative of the weakened credit environment.

Corporate bankruptcies increased 33 percent in January-May from a year ago, according to Statistics Finland.


The Finnish government has already approved one supplementary budget for 2009 including a special stimulus package. The overall impact is estimated at around €2 billion (although new spending is estimated at only €1.2 billion), and includes about €140 million in transport infrastructure projects. The government has committed itself to implementing a guaranteed pension from the beginning of March 2011. This will cost around €111 million a year, and will raise the lowest pensions by about €100 a month - affecting about 120,000 people.

There have also been a number of measures aimed directly at helping corporate finance. The government now offers banks operating in Finland both deposit guarantees and capital, and will also invest its pension funds in corporate bonds, offer companies financial support through the specialised state-owned finance company, Finnvera, and provide partial financing for the construction of thousands of new homes through the state-owned credit institution Kuntarahoitus (Municipal Finance).

Overall, the government has pledged about €60 billion in guarantees, loans and investments, and is expecting a boost of €45 billion in corporate financing. Prime Minister Vanhanen described the decisions as ‘massive, even gigantic’. The largest sums of money are in the bank support package, which aims to secure the continuity of corporate credit. In fact, the Finnish parliament has already approved guarantees of €40 billion to help banks to raise capital.


But in the longer term the issues raised at the start of this post need to be addressed. Competitiveness needs to be restored to the Finnish economy, and exports boosted, as illustrated by the REER chart below. In particular the situation pre 2007 needs to be restored. The change is not massive (maybe only 5% or so), so it is doable, and it needs to be done, especially since the Swedish Krona has been significantly devalued.




As mentioned previously, the goods trade balance has been deteriorating, and the earlier positive balance now needs to be restored.



One of the things that stands out is Finland's differential preformance vis a vis Sweden. Using data prepared by Eurostat which shows the volume indexes of GDP per capita as expressed in Purchasing Power Standards (PPS) (with the European Union - EU-27 - average set at 100) it is apparent that a gap exists (see below) and that it is not being closed. In fact, after 1998 the two lines move tantalisingly in tandem, but with Finnish per capital GDP stuck just short of the Swedish level. Any reading on these indexes of over 100 implies that the country's level of GDP per head is higher than the EU average and vice versa, and relative movements in the indexes imply that the rates of change in GDP per capita are either improving more or less rapidly than the EU average. The basic data behind the charts is expressed in PPS which effectively become a common currency eliminating differences in price levels between countries making possible meaningful volume comparisons of relative GDP per capita. Since the index is calculated using PPS figures and expressed with respect to EU27 = 100, it is only valid for cross-country comparison purposes and not for individual country inter-temporal comparisons, nonetheless charts based on such data are extraordinarily revealing.



So the real reason is why (given some sort of loose convergence expectation) this gap is not being closed. There can be several explanations. One may be differences in institutional quality (education systems, for example), another might be the impact of euro membership: it could be, for example, that, as OECD economists Jorgen Elmeskov and Romain Duval argued in a suggestive paper (Structural reforms in product and labour markets) presented at the 2005 ECB conference "What effects is EMU having on the euro area and its member countries?", that membership has up to now slowed down rather than accelerating the reform process. Thirdly, the issue could be differential demographics. Few economists seem willing to investigate this possibility in any depth, despite mounting evidence that it may be important.

One demographic indicator that springs to mind immediately when I think about these two countries is the differential in life expectancy. Swedish males live on average around 3 years longer than Finnish males (see below). Now this may be important, although no one has started to calibrate this effect yet. The economic intuition for the importance would be, think of investment in a machine (physical capital), then obviously the value of the investment is greater (other things being equal) if the machine keeps running five years longer.



Things cannot be that much different with human capital. The education and on the job training costs are similar, but the person is able to work three years less. Is it mere coincidence that labour market exit at 61 is so typical if the health outlook is worse? Here are the relative labour force participation rates for me between 55 and 65. It is my contention that this alone accounts for a substantial part of the GDP per capita difference between the two countries.



But the solution to this problem is not an easy one, and the OECD and others really need to think much more seriously about this phenomenon when they indisciminately propose raising higher-age participation rates across the board as a solution to the declining workforces problem.

What is involved here is a complex mix of health provision, lifestyle and genetic differences, and any response needs to take account of all of these.

Raising the health and life expectancy of the Finnish population would be one sure way to raising GDP per capita, another way (in the longer term) would be raising fertility back up to replacement levels, and a third path would be extending the younger labour force by encouraging immigration (which interestingly has been on the rise in the Helsinki area in recent months, although if many of the newcomers simply arrive from equally affected Estonia this is nothing more than moving the deckchairs around). Whichever way you look at it though, in both the short and longer term the deterioration in Finland's trade surplus needs to be addressed. If it isn't the outcome will not be a pleasant sight.

Sweden's Economy At A Glance

Basically this post accompanies the Swedish monetary policy and devaluation post I have recently put up on the Global Economy Matters Blog. But first some theoretical structure from Claus Vistesen.



As we can see above, the idea is that as median population age rises the current account dynamics of a country change. The last ageing phase of the diagram is purely speculative at this point. Basically we simply do not know what happens after a society starts to dis-save at an advanced median age. We have, as yet, no experience with this phenomenon.

Now, as is well known, Sweden's median population age has been rising steadily, and reached 41.3 in 2009 according to the latest estimates from the US Census Bureau. This makes it a little younger than Germany and Japan (ma circa 43) but still over the critical 41 threshold (which is itself a tentative first estimate, and still needs calibrating from case to case).

Cliff Hanging In Bulgaria

The International Monetary Fund this week forecast the recession in Bulgaria would be deeper than it previously predicted. Such a decision should come as no surprise to anyone, since the country's economic dynamics in both the short and long term look extremely unstable, and Bulgaria is now almost certainly headed towards a series of more or less hair-raising roller-coaster rides. Even the briefest of glances at the population chart above should lead all but the most sceptical among us to stop and think a little about the possible economic implications of such an appauling demographic outlook. As can be seen, the opening to the west brought a sharp outflow of people in the late 1980s (mainly ethnic Turks), but the important thing to note is that the decline has continued almost continuously ever since. That is, the decline was not a one-off demographic "shock", but rather it has become a way of life (or, if you prefer, of death, since deaths constantly outnumber births, even before you consider emigration). And it is this "terminal style" dynamic which virtually guarantess that the coming ride will be a bumpy one, not only in the short term (guaranteed by the size of the current account deficit - 25% - which Bulgaria needs to correct) but in the longer term, since according to any known growth theory there is simply no way any country can sustain headline GDP expansion with potential labour force and population contractions of this magnitude.

Sharp Recession in 2009

Well, to come down to earth with a bump, let's now get into the immediate situation, and return to the fact that the IMF now expects Bulgaria’s economy to shrink by 7 percent in 2009 (previously they were forecasting a 3.5 percent contraction). They also upped (or downed) their 2010 outlook to an anticipated 2.5 percent contraction, from an earlier 1 percent one, although such an adjustment at this point this is now better than mere guesswork. The point is we are in for a severe contraction, and it isn't going to be any laughing matter.

The IMF revision also follows last weeks announcement that it now expects a “sluggish” global economic recovery and its 2009 forecast reduction for central and eastern European, which went to a 5 percent contraction from an earlier 3.7 percent one.

The heart of the Bulgarian problem at the moment stems from the need to correct a current account deficit which reached 25pc of GDP in 2008, the highest of the 80 emerging markets around the world tracked by Fitch Ratings. Gross external debt reached 102 percent of GDP.




Bulgaria faces a drastic process of external adjustment process which with the shadow of the current international economic crisis hanging over it will surely be far from painless. Vulnerabilities accumulated during the boom period - a marked rise in private sector external, debt along with a rapid increase in credit growth and widespread FX-denominated borrowing - will make demonstrating unwavering commitment to the currency board arrangement very hard work indeed. Neil Shearing at Capital Economics estimates Bulgaria’s external financing needs at $25 billion this year, including the current-account deficit, short-term private foreign debt payments and interest payments. Foreign investment has fallen by almost half over the last year. Meanwhile private debt is up to just shy of 100 percent of gross domestic product, while the government budget revenue fell 6 percent in May.

Plummeting GDP


The Bulgarian economy contracted 3.5 percent in the first quarter when compared with the first quarter of 2008, according to the most recent figures from the National Statistics Office. The turnround is massive when you consider that the economy actually grew by 3.5 percent year on year in the last three months of 2008. In fact, GDP actually shrank by 5 percent from the fourth quarter (or at an annual 20% rate), when it contracted 1.6 percent, according to quarterly data which the statistics institute published for the first time (although these are not seasonally adjusted, so we need to be careful in drawing conclusions). At this speed, I would say even the IMF estimate may well fall significantly short of the final outcome, and we could well be looking at a double digit contraction in 2009. Basically make this kind of current account correction without any sort of currency adjustment is extremely costly in short term GDP, as we are seeing in the Baltics.



Domestic consumption fell 5.4 percent in the first quarter from a year earlier after a 1.4 percent increase in the previous three months. Industrial output, which makes up 31 percent of total GDP, plummeted an annual 12.4 percent in the first quarter, after a 3.7 percent decline in the fourth quarter of 2009. Agricultural output, which accounts for 4 percent of the economy, dropped 4 percent after rising 26.7 percent in the fourth quarter. Services, which make up 65 percent of GDP, rose an annual 2.5 percent after a 3.8 percent gain in the previous quarter, although it is obvious that on a quarter over quarter basis even services are now contracting.

First-quarter exports dropped 17.4 percent, while imports dropped 21 percent, meaning that the net trade impact on GDP was positive.


Short Term Indicators


Bulgarian industrial production continues to fall and was 22.1 percent from a year earlier in May - the eighth consecutive monthly decline. Output was also down month on month - by 1 percent over April. Retail sales dropped an annual 10.4 percent in May.




Construction activity is also well down, falling by 9 percent in April, over April 2008 according to Eurostat data.

Domestic demand is in full retreat, as evidenced by retail sales which were down by 3% year on year in May, with the pace of decline steadily increasing.

Unemployment is also rising, and hit 6.5% in May, according to the EU harmonised methodology. This is still comparatively low, but the rate will continue to rise sharply throughout the rest of this year.

With all this contraction going on, deflation must surely be looming for Bulgaria, but given the very high levels which inflation hit in the second half of last year, the annual rate of inflation continues in positive territory, and what we are seeing for the time being is (not so rapid) disinflation. Bulgaria's annual inflation rate only fell to 3.9 percent in June from 3.9 percent in May. This is the lowest level since July 2005, and there is surely much more to come, even if the pace of disinflation raises issues about the ability to maintain the currency peg.



More evidence of the deflationary pressures which are now about to arrive can be found in Bulgarian producer prices, which slumped the most in more than a decade in May, led by falling manufacturing, mining and quarrying costs. Factory-gate prices dropped 3.2 percent on an annual basis after a 2.3 percent decline in April. Producer prices rose 0.3 percent in the month, after April’s 0.8 percent decline.


Mining and quarrying producer prices slumped 13.4 percent in the year, reflecting a global decline in commodity prices, after a 15.7 percent drop in April. Metal producer prices plummeted 30.9 percent in year, after a 29 percent decline in the previous month.

Another Candidate For Internal Devaluation?

Many supporters of the continuty of the current Currency Board Arrangement aregue that while the adjustment process is likely to be a bumpy one the CBA should be able to ride out the storm. I severely doubt this, for many of the reasons I have already offered in the case of the Baltic Countries (here, here, here, and here). Advocates for maintaining the peg argue the CBA is solidly based and able to weather adverse shocks, given the substantial buffers accumulated in the fiscal reserve account (around 15.0% of GDP) and the existence of large foreign reserves. Bulgaria’s "safety margin" - the sum of international reserves and the domestic currency component of the government’s fiscal reserve account — is estimated to be around 48% of GDP. This compares favourably with the rating agencies’ estimate of contingent liabilities from the financial sector under a reasonable worst case of around 30% of GDP (Standard and Poor’s, 2009). Also, as in the Baltics there is strong feeling of national identification with the CBA, which, coupled with the solid backing of all potential stakeholders (the EU and the IMF in particular), could be consided to offer a robust anchor to the CBA. But as with the Baltics, this kind of support may not be sufficient. Lets have a look at why not.

The first and most obvious issue is the competitiveness one. Since Bulgaria's domestic construction, borrowing and spending bubble has now most definitely burst, and since government spending will be brought under a tight lease by the IMF (when they inevitably arrive) Bulgaria is now (like the Baltics) destined to live by exports (not only live, but also pay down some of the accumulated debt) and this is just where we hit a snag. If we look at the chart for Bulgaria's Real Effective Exchange Rate, then we will see that the country has experienced a significant drop in international competitiveness since the end of 2005, due largely to the high level of inflation the country has suffered.




Wage costs have risen significantly, and even as recently as the first quarter of this year total hourly labour cost rose by an annual 19.2%. The total hourly labour cost was up by 18.5% in industry, by 16.3% in services and by 32.2% in construction according to the statistics office.

Basically then, in order to maintain the CBA Bulgaria will need what is called an "internal devaluation" (generalised reduction in prices and wages) of something like 20%, and seeing the pace at which this process has progressed in the Baltics, there are serious questions about whether Bulgaria would be able to implement such an internal devaluation (ecen with IMF support) before it gets caught in a vicious and painful spiral of falling GDP, falling tax income, falling government spending and even more rapidly falling GDP. Also, unlike the case of the Baltics, where the other Scandinavian countries have been able to render assistance to some extent, there is no obvious external supporter for the Bulgarian peg, and indeed the banking system in some of the countries involved in Bulgaria (Greece in particular) may be nothing like as strong or willing to maintain funding as their Swedish counterparts.

Nonetheless the Bulgarian central bank rejects devaluation, saying the country’s reserves of $16 billion is sufficient to protect the peg, and favours an “internal devaluation” byforcing down domestic wages and prices, a process which will weaken domestic demand, trigger deflation and prolong recession in my view.

Further, since there is no realistic prospect of Bulgarian euro membership in the short term, sticking to the peg for the sole purpose of quickly adopting the euro is a non sequitur, and there is no obvious exit strategy in sight.

On the other hand, while a devaluation would obviously close the current account gap far less painfully, it would not help improve Bulgaria's external financing picture owing to adverse balance sheet effects and the likely rise in bankruptcies. But as has been amply discussed in the Baltic case, the difference with an internal devaluation does not exist from this point of view, and indeed the internal devaluation path may be even more damaging given that even those with loans in Lev would be affected.

The current account will adjust in either case, since it has to, as financing is no longer viable, but this can either be done more painfully, or less painfully, and this is the real question. On the face of it Bulgaria’s incoming government, led by Sofia Mayor Boiko Borissov, advocates taking a loan from the IMF and the World Bank, and following in the footsteps of Latvia, Romania, Hungary, Serbia and Ukraine. The outgoing Socialist government ruled out any international loans. Negotiations are expected to start shortly after the new Cabinet takes office, with the loan itself would probably coming at the end of this year or during the first quarter of 2010, according to Bisser Boev, an economist in the election winning GERB party, in an interview last week.

Neil Shearing, an emerging Europe economist at Capital Economics, goes further, and says Bulgaria’s next government faces a deepening recession and an “imminent” loan agreement with the International Monetary Fund. Basically I agree with Neil: the loan will come sooner rather than later, since having the "bad cop" of the IMF to wave is the only way the new government will be able to govern and implement the internal devaluation, which it is likely will be attempted for a time, even if a breaking of the peg is the most probable medium term outcome.

Neil Shearing also forecasts Bulgaria’s economy will contract by 5 percent this year and 4 percent in 2010. My own feeling is that Neil is a bit to cautious here, and looking at the Q1 contraction and the pace of the decline since, we may well be in for a double figure (10 percent plus) 2009 contraction. Evidence from the Baltics would also tend to confirm this view: struggling to maintain a currency peg in this environment can be very costly in terms of lost GDP, since almost all the burden of current account correction falls on reducing imports, with exports falling rather than rising due to short term competitivity issues, especially when a number of other countries - Poland, Romania, the Czech Republic and Hungary may either devalue or see their currencies fall through sell-offs if they try to lower the currently punitive interest rate firewall (Hungary and Romania).

The markets also appear to be far from convinced, and credit-default swaps linked to Bulgarian five-year bonds are up in the region of 400 basis points from the one year low of 290.4 hit on May 20, as perceptions of credit quality deteriorate.

The coalition must work immediately to shore up revenue, which may fall as much as 3 billion lev ($2.1 billion) this year, said Boev, who was part of the team that mapped GERB’s economic policies and has been suggested by daily Dnevnik as the top candidate to run the Economy Ministry. “We’ll urgently revise the budget and cut what we can, postpone or freeze spending where we can,” said Boev. “This is our first task.” Bulgaria can only afford to co-finance infrastructure projects to bring roads and railways to EU requirements, Boev said. Restoring access to EU funds, which were frozen in 2008 over suspicions of graft, is crucial, he said. Bulgaria stands to receive 11 billion euros ($15.3 billion) in EU subsidies by 2013 to bring living standards closer to EU levels. Boev said the government would be “prepared” to cut investment spending and administrative costs, though it will leave social spending alone because reductions would generate additional unemployment.

The IMF forecast a budget deficit of 1 percent of gross domestic product this year and urged the previous government to cut spending by 20 percent. Ousted Prime Minister Sergei Stanishev froze public sector wages less than a month before the elections.

The Risk Of Spillovers

"The macro-situation in Bulgaria is dire," said Lars Christensen, emerging markets chief at Danske Bank.Foreign investment has plummeted. The downturn in the economy accelerated in May and June. While the new government is an improvement, I would not rule out a drop in GDP of 15 to 20pc from peak to trough," he said. My concern is that this is going to spill over into other countries. If you look at the main lenders, they are Greece, Hungary (OTP bank), and Italy."

The danger of a messy ending in Bulgaria adds another twist to the contagion worries which is facing Eastern and Southern Europe in the wake of the global crisis. A break in the Latvian peg (now, not in six months time) would be a blow, but it would, in my opinion, be containable. Estonia and Lithuania would have to correct in line, and pressure would come on Hungary and Romania, but if the Bulgarian peg goes, not in a managed devaluation but as part of a financial crisis inspired rout, which associated political chaos then the problems could rapidly escalate, immediately to four other countries in the west Balkans (Serbia, Croatia, Macedonia and Albania) and more indirectly down into an already weakend Southern Europe via the Greek and Italian banking systems.

But, you might ask, aren’t the Balkan economies too small to be a potential problem for Europe? This is true, but we need to bear in mind that all four of these nations, despite being outside the European Union, are in fact effectively euroised economies - in all cases their currencies are pegged to the euro. In addition all the Balkan countries have very close economic ties with southern Europe via the channel of expatriate remittances. And the economic problems which currently exist in Greece and Italy only serve to further weaken the nations of the Western Balkans, due to the strong trade linkages that exist within the region. These impacts will in their turn work their way back negatively into Greece and Italy due to their role in funding the region. South Eastern Europe could therefore, be quite literally at risk of economic seize-up.

And we should never forget that the political consequences of economic and currency reversals in the Western Balkans are potentially far greater than the Baltics simply because the former region has a population three times greater than that of the latter.

To be precise, maintaining Balkan GDP involves significant currency corrections. These corrections can take place by formal devaluations, or via the so-called "internal devaluation" process. The slower the Balkan currencies correct, the greater the depth and length of the recession. Basically, under these circumstances, I think that the incentive to devalue will, in the end, be too great. The immediate impact of such devlaluations will be most painful for countries like Croatia, which has a large proportion of euro-denominated loans.

When it comes to the short term dynamics of the looming currency crisis in Emerging Europe, one of the Baltic Three, probably Latvia, will be first to concede its peg. When it does others are almost bound to follow. Everything depends on whether the EU Commission and the IMF are proactive or limit themselves to a mere reactive, problem containment role. If the Latvian currency realignment is done in an organised and systematic fashion, then it may, even at this late date, be a containable process. If the situation is left to fester, and the country falls into the grip of a growing political anarchy, then containment will be much more difficult, since panic will more than likely set in.

A similar situation pertains in Bulgaria. Absent a Latvian devaluation, it is not unthinkable that the Lev peg may be maintained for another year or so. But if the authorities do go down this road, then we face the severe risk of a raggedy ending, since the problem is not one of sustaining the peg, but of restoring competitiveness and economic growth, and this is much more difficult without a formal devaluation. And if Bulgaria does go hurtling off that cliff on which it is currently perched, then just be damn careful it doesn't drag half of South Eastern Europe careering after it.