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Monday, September 3, 2007

Lithuania Under the Loop

by Claus Vistesen

Cross posted from Alpha Sources

As promised below in my brief note on my continuous coverage of the CEE economies I am going to take a close look at Lithunia's economy and as such try to give a solid picture of what the risks are of a hard landing. More specifically, I will be looking at the labour market and the formation of price and employment expectations. My immediate impetus to do this is the amount of attention I got regarding my last in-depth look at Lithuania where I asked the timely of whether in fact Lithuania was running fast out of capacity relative to the sizzling growth rates. In short, I want all my bases covered on this one.

In this way, this entry will be pretty data intensive so be sure to load up on the caffeine for this one.

If we turn first to the general economic indicators I already noted in my last post how growth measured by GDP was powering ahead. An important part of this picture is of course to look at the external balance as where Lithuania as well as Latvia has seen its external balance deteriorate somewhat lately. This is visualised in the two figures below ...



If we turn to various measures of prices we also see a secular increase in price levels which is a clear sign that capacity issues are mounting. Note especially the soaring labour costs as well as the ever creeping CPI. Regarding the PPI I have to say that I cannot account for its rather dodgy course as of late (feel free to illuminate this in the comments section). In general, we should also note (as a reference) that while the figures indeed look sizzling in Lithuania they are not at the level of Latvia's where both the CPI measure as well as labour costs are demonstrating higher growth rates than in Lithuania.



As should be readily clear through the numbers Lithuania is very much thundering ahead at the moment and given the underlying capacity issues I have already drawn somewhat attention to, the question still remains as to how far this can go without a correction. Yet what is it with that Lithuanian labour market then and what are indeed the underlying capacity issues? In order to shed light on these questions we need first to get a grip on the latest developments in the Lithuanian labour market as well as to gauge the future expectations of prices and employment from the point of view of producers (and YES, I do have data on this :)). As we go through the following figures it is important to keep the long term development in mind as it was sketched out in my previous post on Lithuania linked above. The two main points to watch out when we gauge future trends is the secular decline in the labour force as well as the annual net outward migration (see the two graphs in the previous post linked above). Now, if we look at the unemployment rate first as I cited it at 2.7% we need to be aware of a fundamental downward bias in this figure relative to the figures cited at Eurostat and the Department of Statistics in Lithuania. As such the figure cited by Bloomberg both in terms of unemployed people in total as well as the official unemployment rate comes from the Vilnius-based Labor Exchange office. Now, this small detail is important since it appears as if there is some discrepancy between the figures released under the seal of the official statistics department and the labor exchange office (Eurostat seem to cite from the former). This might of course be due to methodological issues but in the case of Lithuania the difference is not so trivial. At this point, the confusion might of course seem total but the figures below should aid you with the big picture (note the difference in time perspective of the graph sets).





Before moving further I would like to point towards the last graph which also shows the rise of vacancies. As can be seen the trends in vacancies and unemployed people are now moving in opposite direction which is of course a de-facto proxy for declining capacity. Now for somebody not trained in economics it might seem a bit overdone all this since there is clearly still enough unemployed persons relative to vacancies. However, here we need to think about two things. First off is the general trend. As the economy keeps growing new jobs will be created which will put a pinch on the labour supply as vacancies rise relative to dwindling capacity. However, more worrying is the fact that that there are also structural factors at play here such as the general demographic profile and net outward migration. In short, these two curves are moving rapidly closer. Secondly, and this is where your economic wit is tested, only in a very perfect world can we expect a perfect match between demand and supply on the labour market. In fact, there are bound to be notable mismatches on the labour market already given the very low unemployment rate and as vacancies rise this will exacerbate the situation through rising labour costs and inflation which is clearly not warranted given the economy's ability to absorb the activity. Moreover, the prospect of raising participation as well as to ameliorate the structural mismatches (often sectoral) is very dim in this environment since the gap is closing really fast.

Lastly and before I leave you to digest all this I present two very graphs which sort of nails this whole idea of how capacity is not able to match current and in this case expected growth rates. The graphs themselves are informative but not, as it were, very logical and a bit messy too (which BTW is my doing entirely). Any value over 0 indicates that optimists outweigh pessimists. The value itself indicate the amount of percentage points which one group outweigh the other. A small value close to 0 thus indicate a close even balance between the two groups but it does not tell us whether this is because the two groups are very large (i.e. a polarized distribution) or whether the amount of respondents who take the middle position (i.e. status quo) is large which would indicate a centered distribution. Pff, let us look at the graphs shall we?



So, what the heck are we looking at here then? Well, in fact it is not that complicated and quite frankly graph number one does not make me any more calm about the general economic prospects. As such, the employment expectations in all key industries not only show a clear, but also in some of the cases, substantial level of expectation to hire more workers in the next 2-3 months. In fact the propensity to hire more workers has shot up lately in the first part of 2007 with the exception of the industrial sector. Once again this is sign that expectations are still running high relative to what seems to be the economic fundamentals. Especially, if the relative propensity to hire more workers across a wide selection of sectors stay at this level it is hard to see how this cannot end with some kind of correction since it will only make worse the run on capacity. Moving to second graph it seems as if inflation expectations on the push side seems to somewhat better anchored than for example is the case in Latvia. The notable exception here of course is the construction sector where both employment and price expectations seem to be rather elevated although we can't of course say anything about the actual expected price level from these indicators.

In Summary

With the graphs and notes above I hope that I have now delivered a sufficiently comprehensive account as regards to my general thesis that many CEE economies are in for some kind of correction. In Lithuania, we should be able to take some comfort in the fact that inflation expectations and pressures seem to be somewhat milder than in e.g. Latvia but still the labour costs indicator is, for all intent and purposes, in red hot territory. The most alarming signs of a potential correction comes from the labour market where (whatever indices you abide by) expectations of future and able capacity clearly seems out sync with current and future levels given the well known structural driving forces. In this way, it won't take long after expectations of future employment has corrected before the effect trickles down to confidence and demand measures and thus economic activity. As I previously argued, Lithuania needs to stop and preferably reverse the migration flow and this needs to happen in 2007. Moreover, efforts need to be taken to improve labour market participation rates. As regards to the external balance which is also getting much attention the relative decline in competitiveness is of course also an important aspect to watch out. In this respect the recent sharp drop in the PPI measure surprises me a bit.

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