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Tuesday, October 2, 2007

World Bank Report on EU10

by Claus Vistesen

cross posted from Alpha Sources

As my regular readers no doubt will have noticed I have been very preoccupied with Eastern Europe and the Baltics recently in the light of the rather peculiar and unique situation some of these countries might end up finding themselves in given the ongoing uncertainty in financial markets and in fact also the global economy. Now, I intend to stay preoccupied as it were and e.g. at some point soon I will be expanding my ongoing analysis of Lithuania. However, this time around I am not presenting my own analysis but rather pointing towards a recent report by the World Bank on EU10 (get main points in PDF here) which also takes on the recent economic development in the Baltics and Eastern Europe both from the point of view their own individual developments but also in the light of recent events in financial markets which, as I have argued, have tended to bring the region's issues rather more quickly to the front end of the debate than perhaps could have been expected.

The report progresses with great vigour and data sampling although of course I feel tempted to launch my traditional reservation regarding the fallacy of not, even with the faintest sentence, mentioning the underlying demographic dynamic of the region. This is especially odd given that, at least, part of the report's emphasis is on the region's labour market dynamics. On this, the report does not add much to the general story we get from the media and other economic analysis sources save perhaps one important point which relates to the underlying (un)sustainability of the growth in wages on the back of dwindling capacity as labour markets tighten not only overall but also crucially in key sectors. In this way the report puts numbers and words on something which I guess we all knew but have rarely emphasised ...

In all countries apart from Slovakia and Slovenia, wages are growing faster than labor productivity. Rising unit labor costs (see Chart 28) provoke central bankers in the region to tighten monetary policies (Poland and the Czech Republic). Apart from inflationary pressures, excessive ULC growth may undermine competitiveness and prospects for sustained long-term output growth and further labor market improvement.

Apart from this and as a general qualifier to the general discourse on the labour market I would clearly also add that we need to factor in demographic trends in the form of a sustained drop in fertility since the beginning of the 1990s which is now taking its toll as well as a sustained process of outward migration from many countries to Western Europe.

There are of course a lot of other interesting points and charts and I can widely recommend you to visit the report for a closer look. However, before I leave you I want to point one more interesting point from the report which relates to the financing of the current account deficits of some of the countries in question in Eastern Europe. Now, I know that this might seem to be a technical detail but in fact it is not in this case but rather pretty important. Here is the key quote ...

External positions in 2Q 07 in most EU8+2 were financed by FDI. In the Baltic countries they were financed by foreign borrowing through the banking sector. In most countries current account deficits remain largely covered by FDI – fully in the Czech Republic and Poland, in 90% in Bulgaria and 2/3 in Slovakia and Romania. Meanwhile in the Baltic countries, which have the largest imbalances, FDI cover 1/3 of CAD in Latvia and Estonia and slightly more (58%) in Lithuania with banking sector foreign borrowing remaining the primary source of financing.

This point links up quite well with my recent analysis of the risk of so-called balance sheet exposure in Lithuania in connection with the risk that the currency peg could come under pressure. The main venue of my analysis is of course the stock of credit expansion to households and cooperations and not so much a flow analysis as is the case with the World Bank's report. However, as we can see these two things (stocks and flows) are of course related and as such we see that especially in the Baltics the hefty increase of the stock of credit/loans outstanding (using Lithuania as a proxy) is closely tied to the flow composition which finances the three countries' current account deficit. Coupled with the exchange rate exposure which could potentially emerge if the pegs were tested the Baltic countries seem to be harboring a rather nasty mix of fundamentals in the context of the external financing. Finally, it should never escape your attention that all this of course is closely tied to the ongoing turmoil in financial markets since, as per definition given the situation described above, a substantial part of the increase in credit stocks has been supplied by foreign banks and as we have all witnessed in recent weeks risk aversion is set to rise significantly among those banks who have been most aggressive in the cycle which now seems to be ending. In the case of Lithuania the first shot already seems to have been fired across the bow as Swedish owned Hansabank for example already seems to be seriously contemplating its positions in the Baltics ...

(Quote Bloomberg)

AS Hansapank, the biggest Baltic lender, will diversify its credit portfolio in Lithuania after an economic boom in neighboring Estonia and Latvia caused credit to soar dangerously high, Chief Executive Officer Erkki Raasuke said.

Hansapank, owned by Stockholm-based Swedbank AB, will ``at some point'' have to set credit growth restrictions in Lithuania, the biggest of the three Baltic countries, Raasuke said in an interview in Tallinn yesterday. It has not done so yet because Lithuania's expansion trails growth in Latvia and Estonia.

The economies of Lithuania, Latvia and Estonia are among fastest growing in the 27-member European Union, creating a boom in credit and raising warnings that growth may be overheating. The global credit crisis adds to concerns about a Baltic regional ``meltdown,'' prompting banks to take steps to limit lending.

``We don't have any signs or confidence at this point that in Lithuania we would avoid the need for credit restrictions, but we would do it differently there,'' Raasuke, 36, said. ``Instead of setting internal limits for absolute credit growth, we should rather set targets on diversifying the credit portfolio. These are the steps we didn't take in Estonia and Latvia.''


In April, Hansapank's Estonian unit raised the minimum monthly income requirement for granting a mortgage to 7,000 krooni ($607) from 5,000 krooni, compared with the average gross monthly salary of 11,549 krooni in the second quarter.

Two joint applicants would need a combined income of 10,000 krooni, compared with 7,500 krooni required previously. The bank last changed the requirements four years ago.

Raasuke said it was ``obvious'' from Hansapank's business that lending behavior had changed within the last four to five months in Latvia and Estonia, citing a ``clear decline'' in new loans, compared with peak monthly levels and the average levels of the last three to four years.

So, the lemon is getting squeezed as I type; let us hope indeed that the wring won't suck out all the juice.

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