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Friday, December 14, 2007

Eurozone Inflation November 2007

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

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

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

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

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

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

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

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

Does One Size Really Fit All?

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

Thursday, December 13, 2007

Germany Economy, What Price the VAT Effect Now!

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

Inflation on the Rise

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

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

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

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

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

An Unlimited Need For People

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

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

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

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

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

And Inflation Continues To Rise

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

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

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

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

Lithuania Unemployment Q3 2007, Running on Empty?

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

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

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

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

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

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

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

Same Situation in Bulgaria

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

And in Romania

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

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

Migration and Labour Shortages?

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

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

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

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

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

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

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

Second question: when and how will the adjustment come?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Obviously the presence of fiscal deficits has been one issue.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

It's the Demography?

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

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

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

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

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

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

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

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

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

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

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

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

Tuesday, December 11, 2007

ZEW Investor Confidence Index December 2007

Investor confidence in Germany dropped more than economists forecast in December, reaching the lowest level in almost 15 years, as rising credit costs dimmed the outlook for economic growth. The Mannheim-based ZEW Center for European Economic Research said its index of investor and analyst expectations fell to minus 37.2, the lowest since January 1993, from minus 32.5 last month.

InterBank Rates

The cost of borrowing euros for three months rose to the highest since December 2000 today as banks seem to be hoarding cash to cover their commitments over year-end. The euro interbank offered rate, the amount banks charge each other for such loans, rose 3 base points to 4.93 percent, the European Banking Federation said today. That's 93 basis points more than the European Central Bank's benchmark rate. If we look at the latest available data from the British Banking Association we will see that the three month euro Libor rate turned up once again in mid November, and has not stopped rising since.

It is important to realise here that this movement in the 3 month libor that we see since the start of August has taken place without any change in interest rates at the ECB. But these rates will affect all those borrowers who are on variable interest rates tied to Euribor (or Mibor) and, for example these are nearly 80% of mortgage holders in Spain, so a sharp tightening is now taking place, even as general economic conditions deteriorate.

Growth in Germany is expected by virtually everybody to slow next year, although no-one really knows by how much, and downside risks abound. A drop to 1.7 percent next year was forecast by the RWI economics group last week, but even this may be on the optimistic side.

German Exports

Meanwhile German exports unexpectedly rose in October, pushing the trade surplus to a record.

Still, the euro's 11 percent advance against the dollar this year is making German exports less competitive abroad, adding to concerns. Exports were the driving force behind last year's 2.9 percent economic expansion, which was the fastest in six years. And if we come to look at the evolution of the year on year growth rates in exports (which is the key data point I would argue), we can see that the trend is now definitely down, and indeed that the export component in this present expansion probably peaked sometime in the last quarter of last year.

So what can we expect from this. Well it may be worth reminding ourselves about what happened last time round, ie last time the acceleration in the Y-o-Y growth rates in German exports effectively stalled. That was back in early 2000, as we can see from the chart below. And what happened at that time? Well the fed was easing as the US entered recession, and the euro was to some extent rising, both of which put a strong break on German exports. So it isn't the rise in the currency alone that matters, you have to think about the whole environment which produces it. Why your currency is rising, while someone else's is falling. And of course, in German export terms, after the rise comes the fall. This is the cost of not being able to depend on your own internal demand, you have to depend on someone else's demand.

As we can see once the rate of increase in annual exports entered real decline, GDP was not far behind, and off Germany went into recession. So this time round the same thing may well happen, and domestic demand may well not offset any fall-off in foreign sales as oil-driven inflation and rising borrowing costs steadily sap German consumer and corporate spending power. Last month, consumer prices rose 3.3 percent from a year ago, the most since records began in 1996. The price of oil has gained 44 percent this year. At the same time German wages, as is well known have had only very weak increases in recent years.


Following some discussion in the comments section, I am adding the following charts to try and clarify what I am saying about internal consumption and construction. The first chart shows clearly how the construction and housing sectors are in long term decline in terms of their importance in the German economy. If we leave of the very exception Q4 2006 and Q1 2007, housing simply hasn't turned back up since the end of the boom in 1995. As I keep saying I think the strongest explanation for this is the demographic one, and it is this element that those who keep hoping against hope to get a turnround simply are not seeing.

If we look at the most recent data, it is clear that there is an annual cycle, but otherwise there is very little movement, except for the uptick at the end of 2006, begining of 2007.

If we now look at the co-movement of a number of different components - exports, GDP and housing - we can see that every time the rate of increase in exports slows (the green line), GDP (the red one) follows it down. And at the moment, of course, the rate of export increase is slowing. If we then add to this what is happening in housing and construction, where we have a very rapid decline from the VAT rise provoked boom (houses also went up 3% on 1 January 2007), and the deteriorating external environment, it isn't at all clear to me at this point that we won't see a German recession in 2008, in fact I would put the odds on a German recession slighly higher than the 40% probability most people are attaching to a recession in the US (let's say 50-50).

Finally, as I keep indicating, the backdrop to the whole situation is the vulnerability of domestic consumption, and quite how fragile all this is has been brought home by the boom-bust type dynamic produced by the VAT hike, which can be seen at the end of 2006.

Of course, it is not only Germany's median age which is rising, the population structure is in continuous change, and in particular the proportion of the population in the key 25-49 age group is now falling. Let's look at the chart:

As can be seen from the chart this crucial age group touched its highpoint in 1997/98, precisely around the time that the mid 1990s boom in construction came to an end.This could be imagined as the moment of maximum capacity for the German economy as a whole. In closing I would wish to point out that I am not trying to draw all this to your attention in order to criticise, or in some way have a go at Germany. Au contraire. It is because I am concerned that I am going to all this trouble. The first step to getting to grips with and fixing a problem has to be recognising that it exists. That drop in fertility that happened deep in the past, may now seem like a long forgotten event, but its presence is forever with us. Something obviously needs to be done, and better late than never. Putting all your eggs in one basket is never the best of ideas.