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Thursday, November 29, 2007

Alarm Bells Ringing in Romania?

According to the Financial Times, in this article, it was just 5 years ago that Raiffeisen International, the Austrian-based bank with the greatest involvement in Eastern Europe, bought Casa Agricola, a struggling state-owned Romanian bank, for $45m and invested about $250m in its modernisation. Today, analysts estimate the bank could be sold for $2.5bn (€1.68bn, £1.22bn). The rise in value is attributed to Raiffeisen’s success in overhauling Casa Agricola as well as to Romania’s soaring economic growth, rapid credit expansion and spiralling asset appreciation. Many business people in Bucharest see the case of Casa Agricola as exemplary, and argue that similar success stories are developing across the board.

Not everyone, however, sees things like this. The International Monetary Fund, for example, (and of course yours truly the blogger here) takes a rather different point of view. Concerned about the continuing impact of the global credit market turmoil, the IMF has been consistently warning (and here) about the dangers of economic overheating in Romania, citing in particular the yawning current-account deficit and the financing problem that this could pose should there be a sudden and sharp reversal in investor risk appetite.

In addition inflation, which had been falling steadily in recent years, jumped to 6.8 per cent October after climbing steadily from a low around 4 per cent in the January-July period.

Rising world energy and food prices, compounded by a drought inside Romania itself, are playing their part. But so is rapidly rising local pay (fuelled in part by labour shortages which are caused by massive outmigration - the consequences of which the Romanian authorities are effectively in denial about - and years and years of below replacement fertility). Wages seem set to rise this year by about 25 per cent in money terms (or about 20 per cent in real terms) year on year.

Far from running a fiscal surplus to try and cool the economy - as advised by the IMF to drain excess liquidity from the system - government spending is being increased, with a 43 per cent increase in pensions currently being implemented, and a further 30 per cent rise having already been approved for early 2009.

A steady and increasing flow of remittances from Romanians working abroad is also helping to fuel a credit surge, particularly in home loans. In fact the IMF is not the only entity drawing attention to this situation. The National Bank of Romania published data earlier this week - in its Monetary indicators October 2007 press release - which shows that private debt in Romania increased an annual 51.4 percent in October as individuals and companies took out more loans in foreign currencies. Debt rose to 133.3 billion lei ($55 billion) as of Oct. 31.

And the combination of all these factors means that GDP goes charging forward at what may well be an unsustainable pace. According to data just released from INSSE (the National Statistics Office) GDP in Q3 2007 again accelerated again (slightly) to an annual 5.7 %, up from 5.6% in Q2.

Now according to the Romanian National Bank:

In October, non-government credit went up 3.3 percent (2.3 percent in real terms) from September 2007 to RON 133,319.6 million. RON-denominated loans picked up 3.3 percent (2.3 percent in real terms), while foreign currency-denominated loans increased by 4.0 percent when expressed in EUR and by 3.3 percent when expressed in RON. At end-October 2007, non-government credit advanced year on year by 51.4 percent (41.7 percent in real terms) on the back of the 40.5 percent growth in RON-denominated loans (31.5 percent in real terms) and the 63.3 percent rise in foreign currency-denominated loans expressed in RON (when expressed in EUR, forex loans expanded by 72.4 percent).

The IMF has warned that borrowers might be assuming too much risk, especially as an increasing share of the loans are either in foreign currency, mainly euros, or indexed to foreign currency.

And of course all this increase in credit is financing soaring increases in imports, boosting this year’s likely current account deficit to 14-15 per cent of GDP – a level the IMF considers dangerous. Last year the €10bn deficit was largely financed by privatisation-boosted FDI of €9bn. But this year’s forecast FDI of €7bn will fall far short of the likely €17bn deficit – leaving banks to finance the gap with credit, much of it short-term.

The IMF take the view that this is unsustainable, particularly with global conditions worsening. But Bucharest-based bankers argue much of the credit is quasi-investment as it is provided in-house by multinational banks to their Romanian subsidiaries.

Of course one of the areas where all this extra economic heating is most directly noticed is in construction, and Romania recorded in August (the latest month for which comparative data are available from Eurostat) the highest annual pace of construction growth (37.5%) of any country in the European Union. According to data supplied to Eurostat, Romania is way out in front here, followed by Great Britain with a 7.7% year on year rate and Slovenia with a 4.6% one. Even the Baltic countries have no dropped out of this particular race.

Meanwhile the Romanian leu continues its downward course, falling again early in the week for the third straight week against the euro as investors became increasingly concerned about the widening current-account deficit and accelerating inflation. The leu has been the world's worst-performer against the euro in recent weeks, falling the most since August 2005, as investors trended away from higher-yielding emerging-market assets amid a sell-off in Romanian stocks.

As can be seen above, in the few days the fall seems to have been brought to at least a temporary halt after central bank Governor Mugur Isarescu said sharp swings in the exchange rate can harm the country's economy and indicated the possibity of a further tightening of monetary policy to address the inflation problem.

The National Bank of Romania raised its key interest rate to 7.5 percent from 7 percent at the end of October following the rise in the inflation rate to a one-year high of 6% in September and 6.8% in October. But Isarescu has also warned about the sharp rise in indebtedness and the limits to conventional monetary policy in the current environment.

"In the last four or five months, credit in foreign currencies exploded...When we raise rates, foreign currency loans rise because they look cheaper. We have reached a limit of monetary policy.''
Romanian Central bank Governor Mugur Isarescu

Now although Romania nominally has a relatively high unemployment rate - some 7% using ILO methodology - it is impossible to know just how realistic this figure is, since we do not really know how many Romanians are actually in the country and ready and available for work, or indeed the quality of the unemployed labour force that actually are. One measure of the situation though can be found in the recent statement by economy and finance minister Varujan Vosganian that Romania has a current labor shortage of about 500,000 workers, especially in construction, heavy industry and car manufacturing.

"We need more engineers, mechanics and bricklayers........We have a labor deficit of about 500,000 employees," he admitted at the opening of a conference on professional and technical education recently.

One of the really difficult problems which comes into operation in a situation like that which Romania is currently experiencing, and where a strong level of euro indexing of prices and a significant number of households and companies are paying loans which are in or indexed-to euros (or other foreign currencies), is that exchange rate and monetary policy become effectively impotent (this is what Mugur Isarescu means when he talks about the limits of monetary policy) to correct growing competitiveness problems - since given the indebtedness it is just not practical to encourage any substantial downward correction the exchange rate, while increasing the interest rate only puts upward pressure on the currency and attracts additional funds in search of yield, and these only serve to make the excess demand problem even worse. Thus the only real arm left in the government policy arsenal is the fiscal policy one, whereby the government attempts, by running a fiscal surplus, to "drain domestic demand" from the system, and thus work to effect some form of price deflation (for a fuller discussion of this complex topic in the Latvian context see this post). And this, of course, is exactly the policy that the IMF economists tirelessly advocate that the Romanian government practices, but unfortunately the message seems to be falling on deaf ears.

Now, evidently, running a deficit stimulates demand, which increases economic growth, and this extra growth does, of course, bring in increased revenue which can help pay for extra spending, but if the economy is already running up against its capacity limits then this extra growth is rather artificial, and such attempts at growth really only has one result, that of pushing up wages and prices, and thus increasing inflation, and given the difficulties associated with implementing a strong downward correction in the currency this inflation means only one thing, a loss of export competitiveness, and this, of course, is what we are seeing happening in the Romanian case.

And on top of this we have the issue of remittances coming back home, stimulating even more demand, demand which would lead to the employment of those workers who have migrated, only they are now no longer there. Undoubtedly this flow of remittances (around 4.3% of GDP in 2006 according to the World Bank) carries some of the responsibility for the escalating home demand, and rush to borrow, since you don't have to be an economic wizard to see that the money can be initially used to accumulate the deposit to purchase a new family home, and then subsequently as a stream of income to help make the mortgage repayments.

So more than having the alarm bells ringing, the writing is now on the wall I would say. Even Central bank Governor Mugur Isarescu warned on Nov. 1 he was concerned that foreign-currency lending ``exploded'' in recent months, increasing the risk associated with any depreciation of the local currency, and the national currency the leu was the world's worst-performer against the euro last week, falling the most since August 2005, as investors shunned higher yielding emerging-market assets amid a sell-off in Romanian stocks. So take note of the old adage, caveat emptor.

Monday, November 26, 2007

Croatia and Economic Sustainability in Eastern Europe

The IMF is not amused, or at least better put, the IMF is not amused with Croatia. The reasons for their lack of amusement are many and various, but in particular they are displeased by the rising level of consumer and corporate indebtedness, and doubly so due to the fact that the debts are either contracted-in or indexed-to a foreign currency (mainly the euro, but the Swiss Franc is also used). They are also not unduly thrilled by the sustained and rising current account deficit, the existence of a fiscal deficit, the slow pace of structural reform and the relative lack of "greenfield site" FDI . According to the latest IMF staff report:

Notwithstanding that the financial sector is healthy and much progress has been made in improving supervision, rapid credit growth and the possibly widespread exposure of households to currency risk remain vulnerabilities. Compounding these vulnerabilities, the current account deficit widened to about an estimated 8 percent of GDP in 2006, and the external debt ratio to 84 percent.
Sound familiar? It should do, this profile is very typical of one we have seen extending across Central and Eastern Europe in country after country. Claus (in this post) has extensively covered the issue of what is called "translation risk" (or what might get "lost in translation" if the effectively "euroised" currencies like the Croatian Kuna need at some point or other to come off their effective pegs with the euro - to tackle the problem of the lack of export competitiveness produced by the high comparative value of the euro and ongoing above-par inflation sustained in many Eastern European countries, for example). So here I will concentrate more on some of the more general macro economic issues that the structural problems identified by the IMF pose for Croatia, and in doing so I will also attempt to situate them - as is now our custom here at GEM - in the looming demographic issues which Croatia, along with the the rest of Central and Eastern Europe and the CIS, is now about to face.

Well, let's take the points one by one. In the first place Croatia has indeed experienced solid growth and comparatively low inflation in recent years.

GDP growth has been "solid" but not "exagggerated" (think the Baltics or Bulgaria), so even though the rate has at this point accelerated to an annual 6.8% in the first half of 2007 (with a high point of 7% being attained in the first quarter) the average of around 4.75% for the 2001–2006 period does not seem out of proportion, and is indeed very close to the IMF staff economists estimate of capacity growth for Croatia as being in the 4 - 4.5% region. Thus it is hard at this point to speak of "overheating" in the Croatian context, although the 2007 surge in both GDP growth and construction-driven consumer indebtedness does need watching carefully.

Indeed contributions to growth from both private consumption and fixed capital formation have increased in the last few years, and both of these have been associated with rapidly expanding domestic credit and a continuing goods trade deficit which is the by-product of a growing dependence on imports.

The contribution of net exports to growth has been substantially negative, with domestic demand pressures and higher international energy prices leading both the trade deficit and the current acount one to widen as the century has advanced.

Now this sustained drop in export competitiveness should be sending out alarm signals all over the place for those with the eyes to see what is happening. Basically to understand what may happen to countries like Croatia it is important to bear in mind that we do not live in the timeless world of neo-classical growth theory, but in the world of real economies in real time where populations come and go, and, in particular, age. I will return to this point later in the post, but the big danger I see in Croatia is that as the demographics shift inexorably upwards to ever higher median ages, and as the share of fixed capital investment (which has been basically accelerated by large government funded civil engineering projects and domestic housebuilding) drops back (due to the fiscal constraints impost by a higher elderly dependent population on the one hand and the liquidity constraints on a steadily older population in terms of housebuilding activity). This is the process we have seen in Germany since the end of the property boom in the mid 1990s, and while, as I explain in this post, Germany has been able to shift the weight of maintaining employment growth on to the export driven back foot, it is hard to see how Croatia is going to be able to do this. And time here, along with population, is becoming an increasingly scarce commodity.

During 2007 the share of goods exports to imports (remember, due to the tourism element Croatia has a positive balance on services, but not sufficient to "sweat off" the goods trade deficit) has been hovering round the 45% to 50% mark.

Meanwhile, while headline inflation has been normally contained within the 2–4% range in recent years (see chart above) - and with core inflation even lower - in recent months the inflation rate has started to tick upwards following a pattern which has recently become all too familiar across Eastern Europe. Obviously it is too early at this point to say where this is leading, but the situation does need careful monitoring, and the Croatian central bank remember cannot use monetary policy here (see more on policy instruments below) due to eurisation, and is left depending on the national government implementing a strong fiscal surplus to drain excess demand from the system.

Wages and salaries have been rising significantly above the rate of productivity increase over the last 18 months, but while the trend is not unimportant we are still a far cry from the 20% plus rates being seen in Ukraine, the Baltics, Romania and Bulgaria. So everything now depends on what the real available labour supply in Croatia actually is (for which see below), since this will determine the ability of Croatia to keep growing and keep a lid on the inflation issue. Retail sales, which give us another indicator of domestic demand, have been growing at a nifty but not exaggerated pace, rising 7% year on year in the January to September 2007 period.

Now one of the problems which comes into operation in a situation like Croatia's where there is an effective euro peg, is that exchange rate and monetary policy become either effectively non-existent (in the former case) or impotent (in the latter) to correct any growing competitiveness problems - since given the euroisation it is not practical to adjust downwards the exchange rate and increasing the interest rate only puts upward pressure on the currency and attrcats additional funds in search of yield which only serve to make the excess demand problem even worse. Thus the only real arm left in the government policy arsenal is the fiscal policy one, whereby the government attempts, by running a fiscal surplus, to "drain domestic demand" from the system, and thus work to effect some form of price deflation (for a fuller discussion of this complex topic in the Latvian context see this post). And this, of course, is exactly the policy that the IMF economists tirelessly advocate that the Croatian government practices.

But it is exactly here that we hit a problem, since far from running a fiscal surplus as required, the Croatian governemnt has been running fiscal deficits, even if, up to the election year of 2007, they had been reducing.

Obviously the fact that this has been an election year hasn't exactly helped put politicians in the frame of mind to pay the necessary heed to the IMF recommendations and spending pressures have been steadily mounting. Government approved increases in child and maternity benefits and free school textbooks (all of which are in principle a good thing in a society which is short of children) were introduced at the end of last year, adding in the process 0.3% of GDP to expenditure, without compensatory reductions in spending elsewhere (unfortunately here there are no free lunches). Demands to boost wages in the state sector have been frequent in the run up to the election, as have those to increase the pensions of post-1999 retirees — whether this be through a reversal of the existing pension reform parameters, or through "off-budget" accounting schemes. Now evidently increased economic growth can bring in increased revenue which can help pay for extra spending, but if the economy is already running up against its capacity limits then that growth can only have one result, increased inflation, and given the effective euro-peg this inflation means only one thing, a loss of export competitiveness. What has been happening elsewhere in Eastern Europe should give clear indication that this is no joking matter.

The IMF estimate that if such spending pressures are acceded to by the incoming government then the consequent fiscal deficit could rise above 2.8 percent of GDP unless the envisaged increases are offset by cuts elsewhere. The Croatian authorities have, for example, already agreed with the public sector trade unions to a 6 percent wage increase (in place of the 5% increase initially assumed in the budget) and to paying bonuses to teachers in addition to the basic wage increase, again straining the budget wage bill. Moreover, it is anticipated that the national airline will receive additional unbudgeted subsidies.

On the surface it would appear that spare capacity does exist, since the unemployment rate remains high, despite recent declines that reflect both some small employment growth and a declining rate of labor-market participation. But this nominally high unemployment level may be deceptive since we do not know the quality of much of this (often elderly) reserve labour army, and indeed we do not even know how many of the people involved are even in the country (see below).

It also would seem that fixed capital investment growth — after the rapid acceleration we have seen in recent years — is likely to moderate, though investment remains high as a share of GDP.

If we look at construction activity, we can see that after taking off in early 2005, and remaining strong throughout 2006, the rate has remained more or less stable in 2007, and we have not seen further dramatic increases in avctivity. Thus while pressure on manpower and salaries in the construction sector remains, it does not seem to be accelerating dramatically at this point. However we should note that within a constant level of activity, the relative shares have changed, and domestic homebuilding - fuelled by comparatively cheap euro or swiss franc loans, and financed by streams of income from remittances - has now become a much bigger partner, while government financed large-scale civil engineering projects have become steadily less important (see the charts on domestic mortgages below).

One of the things we should now be learning from looking at what is happening across Eastern Europe is that in an environment where a number of underlying problems exist - ranging from lingering and heavy state presence in the economy, a high public sector debt and deficit level, absence of strong goods exports competitiveness, labour supply shortages due to migration and long term low fertility, and extensive euroization of the banking sector - heavy capital inflows can come to seriously strain the entire macroeconomic framework. This risk becomes even greater if measures are not taken to drain excess liquidity from the system (by running a fiscal surplus for example), to loosen labour supply constraints by facilitating inward migration of unskilled workers, and to accelerate the pace structural reforms - and particularly those which facilitate the development of "greenfield" investment sites which help channel capital flows towards productivity-enhancing uses and in so doing raise exports.

And it is not just the IMF who has been raising the alarm signal, the Croatian National Bank has also repeatedly expressed its concern over the high rates of credit growth, and indeed has already responded with a series of prudential measures in the course of the last year. The measures include actions to raise private bank Minimum Reserve Requirements and to close loopholes in the system which allowed banks to borrow abroad via local nonbank intermediaries. The bank has also increased risk weights on unhedged foreign-currency denominated and indexed loans, introduced quarterly reporting requirements for such loans and issued new guidelines to banks on managing household and currency-induced credit risk, including a 75 percent loan-to-value ratio limit. Such measures mirror to a certain extent those which we have already seen put into effect by Central Banks in the Baltic countries. As can be seen in the chart the level of consumer indebtedness has risen sharply since the start of 2003.

and a large part of this rise in indebtedness has been mortgage-related:

Now the above chart shows the movement in credit for kuna denominated loans (and I present a chart below for loans which are explicitly denominated in foreign currency) but it is important to keep firmly in mind at this point that the Croatian economy is highly "euroised" and that 75 percent of long-term bank loans to households are index linked to foreign currencies in some way or another (mainly to the euro, though recently loans have been largely Swiss-franc, a feature which was explicitly noted by the Bank for International settlements in a recent study of the extent of Swiss Franc lending in Eastern Europe earlier this year, where Hungary and Croatia where singled out as having a significant penetration of such loans, due presumeably to the strong presence of Austrian banks in both countries).

Of all the transition countries that have joined or are soon to join the EU, Croatia has the highest share of euroised bank deposits, with approximately three quarters of all deposits being in euros. Virtually all loans in Croatia are indexed, and all loans depend on the exchange rate and are thus exposed to exchange rate risk. One way to remove this exchange rate risk would, of course, be to introduce the euro, but when you come to look at the economic stress issues which are emerging in one Eastern European economy after another, then it would seem that this potential solution lies a long way out in the future, at the very earliest. Meantime Croatia has to survive, and to export to live. Prices and wages as expressed in kuna need to become more competitive, and this is begining to represent a major problem. So when you look at the next chart please bear in mind that this only gives an indication (and represents only a small fraction) of the true exposure which the Croatian economy has to any possible future exchange rate adjustment.

Total foreign direct investment (FDI) into Croatia is close to the regional average—but with a high share of this being associated either with privatizations or the financial sector, while “greenfield” FDI remains well below what could be thought to be desireable. This is disturbing, since FDI which exclusively takes the form of privatisation participation is effectively a form of outsourcing state debt, and at some stage all of this has to be repaid in the form of income outflows and thus negative consequences for the current account, as Hungary is currently finding out to her cost.

Net FDI inflows averaged just below 5% of GDP annually during 2001–05, and 1.5% of GDP of this was accounted for by privatizations. The financial sector has received a very large share of FDI (both privatization and new capital), whether we are talking about the longer term (28 percent of total inflows over 1993–2005) or more recently (over 50 percent of FDI in 2005, partly reflecting capital injections to foreign-owned banks). Meanwhile non-privatization, non-financial sector related FDI inflows into Croatia have remained modest.

The rise in external debt has been accompanied by a major change in its distribution between domestic sectors. Prior to 2001 foreign borrowing was driven primarily by the public sector. Financing requirements were high due to massive reconstruction needs and infrastructure investment following the regional conflicts of the early 1990s. As a result, the public sector held the largest share of total external debt (44%), equivalent to around 27% of GDP in 2001. Since early 2002 the situation has changed dramatically. The public sector external debt-to-GDP ratio as well as its share in total debt has declined, partly as a result of a deliberate move towards tapping the domestic capital market. At the same time, the external debt of the private sector has started to grow strongly. This trend has been driven, in particular, by a strong increase in foreign borrowing by domestic banks, facilitated by foreign ownership and easy access to financing from parent banks in neighbouring EU countries. As a result, the gross external debt of the banking sector increased from 11% of GDP in 2001 to above 30% in 2006, and its share of total external debt almost doubled. Since 2003 direct external borrowing by firms has expanded rapidly, inter alia in response to administrative measures taken by the central bank to reduce the growth of domestic credit.


As the header to this post suggests, we are thinking here about Croatia's economic situation in the context of general processes which we can observe in operation across the whole of central and Eastern Europe.

The most important of Croatia's problems is undoubtedly constituted by its deteriorating external competitiveness, as reflected both the goods and services trade deficit (see above) and, in particular, in the current account deficit.

One typical feature of Croatia's current account is - as I have said - the significant deficit in merchandise trade, which is offset to some considerable extent by a surplus in services, mainly resulting from tourism. However it is important to note that from 2001 to 2006 imports grew, on average, faster than exports and that the goods trade deficit rose from 20.7% to above 25% of GDP.

During the same period net income from services increased from 14.7% to around 17% of GDP and "financed" about two thirds of the trade gap. The income balance remained negative over this period, with an average deficit of 3% of GDP largely driven by net factor payments on the rising foreign debt and foreign direct investment. However, reinvested earnings recorded as offsetting FDI inflows on the financial account were equivalent to, on average, around half of the deficit of the income balance, thus reducing financing requirements considerably. Also it is worth noting that net transfers from abroad in the form of remittances have been a growing and fairly stable source of financing. Remittances were estimated by the World Bank to have been worth around 3% of GDP in 2006.

Now one of the interesting things about this data on remittances is that it can help us take a first shot at solving another of Croatia's enigmas, the "missing labour force" one, or if you prefer, why the employment participation rate of the Croatian population seems to be so incredibly low (only 42.8% of the over 15 population in the first quarter of 2007).

Now one of the factors here must surely be the very low participation rates of males workers in the 50 to 64 age group (only 55.9% in Q1 2007) , but another feature of this apparently very low participation rate must surely be associated with the fact that significant numbers of Croatians must be working abroad without recognition of this being reflected in the published figures. (This is quite a widespread problem with the East European data, as I explain in this post here). We can get some impression of the extent of the issue if we compare the 3% of GDP number for Croatian remittances with the 4.1% for Romania and the 1.3% for Poland (World Bank data) since in both cases substantial numbers of nationals are known to be working abroad. The size of the Croatian share makes it reasonable to assume that a reasonably large number of Croatians are economic migrants working abroad, but if we come to look at the statistics provide by the Croatian Statistics Office to Eurostat, you would never imagine this was the case, since you would get the impression that Croatia was a small net receiver of migrants.

Now the very large movements of population in the 1990s are undoubtedly associated with the war and political convulsions of the time, but since the turn of the century virtually no movement is observed (apart from the flow of money), and how is this possible I ask myself? Undoubtedly one of the answers is likely to be found in the definition of 'migrant' which is used by the local authorities, who surely, as is standard practice across Eastern Europe, only classify as migrants those who emigrate permanently. The rest simply don't show up in the data, and surely the majority of Croatia's economic migrants who currently work abroad still entertain the hope of returning "one day". But this is not the same as being "ready and available for work tomorrow", and the labour market data we have to go on simply don't reflect this underlying reality, and this is important, if Croatia doesn't one day want to find itself with an inflation bonfire getting steadily out of hand such as the one which is currently to be found in the Baltics.

So, and in conclusion, what we need to draw from all of this, is the idea that inflation in Eastern Europe is a complex issue, and that the sudden appearance of this phenomenon in one country after another should be sending us all warning signals. The combination of high catch up growth, constrained labour supply (associated with out migration and low fertility), strong capital inflows via the banking system and remittances, euro-pegging (or strong linking) and the absence of exchange rate and monetary policy as effective instruments all make for a potentially explosive mixture. When you add to this the steady ageing of the population, and a likely growing dependence on exports rather than domestic demand for growth, then you can begin to get a measure of the scale of the problem Croatia is facing, and it is no mean one.

Demographic Appendix

As a break from my previous practice I am including the demographic data on Croatia as an appendix, in a way which means that it "informs" the economic analysis (in the sense that it is ever present, and should be ever present in our minds) without occupying the centre stage. The demographic backdrop forms the context within which day-to-day policy needs to operate.

Here, then, is a collection of population data, which illustrate how the structure of the Croatian population is in the process of undergoing profound change in the years between 1990 and 2020, indeed, one could say that this is the critical socio-economic window in the history of this nation.

Firstly we have the median age. Claus and I tend to use median age data for a convenient proxy for a variety of economic phenomenon, such as saving and consumption patterns, construction activity, gross fixed capital formation, export dependence, productivity of the workforce as a collective etc. This is still all rather controversial, but one of the purposes of this blog is to test out these connections in real time as the global economy unfolds. As we can see the median age is steadily rising, and is currently in the process of crossing what Claus and I consider to be the critical 40 threshold. This means that, ceteris paribus, the structural characteristics of the Croatian economy will almost certainly change in the coming years, with a decline in construction and an ever more pronounced export dependence, something which is going to be difficult to realise given the relative currency and output prices.

There are basically three drivers of median age and population ageing - fertility, life expectancy and migration. Here we can see that Croatian fertility has been below replacement level since the late 1970s.

At the same time Croatian life expectancy has been increasing steadily.

The combined combination of these two processes is that after hoevering around the break even point in the early 1990s, the balance of Croatian births and deaths decisively turned negative around 1998.

The result of this is of course that the natural rate of growth of the Croatian population has dropped and dropped, and is now well into negative territory.

As far as migration goes, we have seen above that we have no clear data for this, although there is evidence from the remittances data that a significant number of Croatians now live and work abroad, which means that to the negative natural drift in the population we need to add an as yet unknown number of emigrants, as such the population and labour supply data that we are currently working with is almost certainly highly deficient.

All of this means that there have been deep and significant changes in the age structure of the Croatian population, and this does seem to have considerable ecnomic significance. As one example of this I will present the chart for the key 25 to 49 age group. Obviously we get some very strange readings for the years in the mid 1990s, but this is perhaps hardly surprising given what was going on, the interesting point is that this groupd definitively peaked as a population share around 2002, and has now entered decline. Among other things this will mean that obtaining collective productivity growth will now become more difficult year by year, as improvements due to sectoral shifts will be to some extent (and increasingly) offset by declining aggregate input quality in human capital terms. It is also interesting to note that this age group peaked at what is the comparatively low value of 35.9 back in 1982, which is incredibly early and as I say, very low (a phenomenon which we are seeing in one East European society after another due to their particularly unusual demographic history). I am not quite sure yet what significance to put on this feature, but surely it does have some. I guess we are now about to see what.

Finally, I present three population pyramids for Croatia, which give some quick impression of the evolving structural shifts in the age groups. The first pyramid, which comes from 1991, has a structure which is not at all unfavourable to rapid economic growth of the kind Croatia is now having. Croatia's misfortune is that it is trying to have this growth now, and not back then. The final pyramid which is an estimate based on the UN median estimate of population development gives some idea, possibly a rather optimistic one, of what Croatia's population will look like come 2020. Basically it is very hard to see how a population with such a structure is going to achieve economic growth at all.

Monday, November 5, 2007

Swiss Franc Mortgages in Hungary

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 purrposes 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.

So let's look at the extent of the issue in Hungary, and some of the likely implications. First off, here's a chart showing the evolution of outstanding mortagages with terms over 5 years since the start of 2003. As we can see the outsanding 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.

Finally, if we look at the distribution of non-forint mortgages between those in euros, and those in "other" currencies (which may contain some yen, and some USD mortgages, but in the main will be Swiss Franc ones) we can see that those in euro form only a very small part of the total.

It is perhaps also worth pointing out that the fashion for non-forint loans is not restricted solely to mortgages, car loans and other longer duration personal loans also tend to be denominated in Swiss Francs or other currencies. The reason for this is obvious, the rate of interest is cheaper. But this non forint loan predominance has two important consequences.

In the first place the Hungarian central bank does not have sufficient control over monetary policy inside the country, being to some significant extent influenced by monetary policy in Switzerland, a country we may note which is not even inside the European Union. Secondly, the difficulties which would present themselves in the event of any substantial reduction in the value of the forint would be considerable - the is known as the translation problem, and is ably reviewed by Claus in this post here - and as a result the central bank is one more time a prisoner of others in terms of monetary policy, since it cannot take interest rate decisions which might influence excessively the swiss franc-forint crossover rate.

The fashion for borrowing in Swiss francs really took off in Eastern Europe after the Swiss National Bank dropped interest rates to 0.75% in 2003 in order to stave-off a perceived deflation threat, a move which at the same time converted Switzerland into the cheapest source of loan capital in Europe. External lending in Swiss francs reached $643 billion in 2006, according to data from the Bank for International Settlements . The huge scale of the borrowing in fact drove the Swiss franc to a nine-year low against the euro, and has lead to an accelerating slide in its value over the last two years - even though by this point the Swiss National Bank had been busy raising rates (Swiss interest rates have now been increased 7 times since the 2003 trough). The extreme weakness in the Swiss Franc is in fact rather perverse (shades of Japan, of course, here), since currently Switzerland enjoys the highest current account surplus in the developed world (some 17.7% of GDP in 2006). At the same time the Swiss hold more than $500 billion in net foreign assets, making them in these terms the wealthiest nation on earth.

A recent issue of the Bank for International Settlements publication Highlights of International Banking and Financial Market Activity has some revealing comments on the Swiss situation(the data used for the report came from 2006):

Total cross-border claims of BIS reporting banks expanded by $1 trillion in the last quarter of 2006. After more modest growth in mid-2006, a pickup in interbank claims accounted for 54% of this expansion. A surge in credit to nonbank entities contributed $473 billion, pushing the stock of cross-border claims to $26 trillion, 18% higher than in late 2005.

The flow of credit to emerging markets reached new heights through the year 2006. Claims on emerging markets grew by $96 billion in the final quarter of 2006, bringing the volume of new credit throughout the year to $341 billion. This amount exceeded previous peaks ($232 billion in 2005 and $134 billion in 1996), both in nominal value and in terms of growth. The current annual growth rate has risen to 24%, having surpassed for the sixth consecutive quarter the previous peak of 17% recorded in early 1997.

Emerging Europe overtook emerging Asia as the region to which BIS reporting banks extend the greatest share of credit. Since 2002, growth in claims on the region has consistently outpaced that vis-à-vis other regions. With a record quarterly inflow, emerging Europe received over 60% of new credit to emerging markets, bringing its share in the stock of emerging market claims to 34%. Less of the new credit went to the major borrowers (Russia, Turkey, Poland and Hungary) than to a number of smaller markets, notably Romania and Malta, as well as Ukraine, Cyprus, Bulgaria and the Baltic states.

The currency denomination of cross-border claims on emerging Europe tilted further towards the euro. In the stock of claims outstanding, the euro and dollar shares were 44% and 31%, respectively, but the gap in the latest flow data was more pronounced (61% and 5%). While the sterling share has remained close to 1%, the yen has lost ground to the Swiss franc, thus continuing a trend seen over the last six years. Yet there is little evidence in the cross-border data of unusual borrowing in Swiss francs that might correspond to Swiss franc-denominated retail lending in several countries. Borrowing in the Swiss currency remains on average below 4% of cross-border claims, and exceeds 10% only in Croatia and Hungary.

Nearly 20% of reporting banks’ foreign claims were in the form of funds channelled to emerging market borrowers. Claims on residents of emerging Europe continued to account for the largest share of these funds.
So, although the BIS find "little evidence in the cross-border data of unusual borrowing in Swiss francs that might correspond to Swiss franc-denominated retail lending", they do make an exception in the cases of Hungary and Croatia, where they note that lending in Swiss francs to retail clients reaches over 10% (and of course in the Hungarian case well over 10%) of the total retail loans in those countries. Indeed, as I indicate above, swiss franc loans now seem to account for over 80% of all newly generated housing related credit in Hungary. The reason why Hungary has gone for Swiss franc rather than euro denominated loans undoubtedly has to do with the role of the Austrian banking sector in Hungary, as is explained in my fuller posting on this topic linked to below.

Additional References

For fuller examination of just why it is that Switzerland (or for that matter Japan) have such low interest rates, see my "Swiss Franc Loans and Ageing" post.

For an examination of the potential implications of the presence of all these foreign currency loans across the EU10 in the event of any generalised emerging markets crisis see Claus Vistesen "Translation Risk in the Baltics and Other Matters".

Sunday, November 4, 2007

Employment and Unemployment in the Czech Republic

The Czech jobless rate fell to what for the Czech Republic in recent times was the unprecedently low level of 6.2% in September (or around 5% if we use the ILO rather than the Czech MLSA methodology). This was the lowest recorded level for the Czech Republic since the new data series was introduced in January 2004, and was the result of the rapid rate of job creation which has accompanied the third consecutive year of substantial economic growth. But the rapid rate of economic growth and job creation which has been taking place in the Czech Republic is at the same time starting to give rise to fears about ensuing labour shortages and a concern that these may lead to the sort of wage-increase driven inflation we are currently seeing in some other parts of the EU10. Indeed Czech Central Bank Governor Zdenek Tuma recently explicitly warned that a shortage of available labor may fuel wage growth, and that this in turn would fuel inflation.

In an attempt to maintain inflation under some sort of control the central bank has already raised interest rates three times so far this year, and only really decided to leave it's two-week repo rate unchanged at 3.25% at the October meeting because it took the view that the administrative fiscal-tightening measures the Czech government has now started to introduce following the fiscal expansionary measures of 2006 - and which will themselves not be bereft of some inflationary consequences, since they involve raising taxes and untility prices - were likely to have an overall restraining effect on demand such that it would be both unnecessary and undesireable to further tighten monetary policy at this point in time. This, and of course the increased external risk which follows from the financial market turmoil of last August.

Despite this consideration, several members of the monetary policy committe did voice their concerns that while demand side inflationary pressures seemed reasonably benign, labor market tightening may become a major factor in the Czech situation, and the non-inflationary effect of real wage increases that the comittee in fact took was conditional on fairly optimistic assumptions regarding labour productivity growth. All-in-all there was an expectation that inflation maywell be driven up towards the upper end of the 4 percent target range sometime early next year.
"The tension on the labor market is relatively significant....pressures on wage growth can be expected...If inflation is low, relatively significant pressures on the labor market can be expected."
Zdenek Tuma, Governor of the Czech National Bank speaking in Prague last month

Increases in regulated prices have pushed headline inflation closer to the 3 percent target in 2006, but the underlying inflationary pressures have remained subdued. Lingering slack in the labor market and inflows of migrant workers kept wage inflation moderate, which, coupled with strong productivity gains, helped contain labor costs. There are no apparent signs of the second-round effects from increases in energy and other regulated prices, which, together with well anchored expectations, underscores the strong credibility of the Czech National Bank (CNB).
IMF, Executive Board Concludes 2006 Article IV Consultation with the Czech Republic, February 28 2007

Czech GDP growth - which has hovered around the 6% mark - has certainly been strong, but not excessively so, in recent years, and the problems which currently exist in the Czech republic are certainly a far cry from the overheating issues which are arising elsewhere in the EU10, and in particular in the Baltics and Bulgaria.

The Czech economy grew at exactly an annual 6 % rate in Q2/07, with this growth being principally pulled by increases in domestic demand. Household demand is estimated to be likely to grow at around 6% this year, and investment at around 19%, while government demand is only forcast to grow at around a 1% annual rate. According to central bank estimates GDP is currently growing at roughly 1 % above its noninflationary potential, while overall monetary conditions remain broadly neutral. What all this means is that the Czech economy is now moving into tricky territory, with what is known as the output gap - which is really a rule of thumb measure of how fast an economy can grow without producing inflation, since the "gap" in question is a general measure of spare capacity - having turned negative around the end of 2005, as can be seen in the chart below which was prepared by a staff economist at the Czech National Bank. So basically the Czech economy is now dependent on flows of funds, and in particular on FDI (to pay for the current account deficit) and on inward migration of workers to meet all the labour supply needs.

Nominal wage growth has accelerated up towards 8 % mark in recent months while nominal uniit labour costs are now growing at around 3 %. This - if you like - is the "productivity gap". What it means is that real wages are no longer in "anti-inflationary" mode, since the ongoing decline in unemployment (which is now evidently below the level which any reasonable estimate of NAIRU ought to give us) means that supply side pressures emmanating from the real economy have become pro-inflationary.

I have commented separately on the fiscal situation in this note, but it is evident that structural reforms in government spending are essential if Czech finances are to achieve longer term sustainability. Even making full allowance for the impact of the new fiscal reform introduced this year, the government deficit is likely to be around 2.5 % of GDP in 2008, which is a strange posture to find in an economy running a negative output gap, ie in an economy which is already expanding at a rate which on many estimates would seem to be above its real capacity. However, it should be stressed that such measures of capacity are only that, estimates. Given the ease and facility of capital and migrant labour flows in todays global economy, a judicious leveraging of such a position can allow an economy to grow at well beyond what might seem to be the normal capacity rate. But this possibility is conditional on simply this, a judicious leveraging of the available resources.

One part of the current fiscal adjustment measures are, however, only temporary in nature, since further tax cuts are already envisioned for 2009. So without further measures, the government deficit will start to increase again in 2009. The previous government record here does not inspire excessive confidence, since fiscal gains which were achieved in 2005 were then relinquished in 2006, when fiscal policy turned expansionary, with the general government deficit having risen to something like 3.75 percent of GDP, reflecting pre-election tax cuts and increases in social transfers for pensions and health care. A large social spending package in the budget for 2007 is expected to raise mandatory spending in the coming years.

The procyclical fiscal stimulus which was implemented in 2006, at a time when the economy was set to register another year of robust growth, was untimely to say the least. In particular, the decision to increase mandatory social spending in the 2007 budget worsened the longer term fiscal position, and an opportunity was lost to consolidate fiscal gains in what were effectively the good times. The authorities have declared, however, an intention to achieve an annual reduction in the structural deficit by 0.25 percent of GDP per annum in their forthcoming Convergence Program.

Nevertheless, weaknesses have emerged in the process of implementing the medium term budgetary framework. The upward revision of the spending limits in the medium term budget during the 2006 and 2007 budget process and the abandonment of the 2005 Convergence Program targets suggests that the fiscal framework needs to be strengthened to increase fiscal discipline in good times. Given the current environment of political uncertainty, the fiscal framework takes on added importance as a disciplining device.
IMF Selected Issues, February, 2007

Certainly the current rate of growth in the Czech Republic - as elsewhere in the EU10 - is creating jobs and reducing unemployment at an unprecedented rate. In Q3 2007, total employment in the Czech Republic grew by 102,800 year-on-year and reached the highest level of employment achieved at any time over the last ten years, according to data from the Czech Statistics Office released at the end of last week. The number of employees rose by 87.3 thousand, and the number of self-employed by 17.5 thousand. The number of unemployed according to ILO methodology was down by 98.3 thousand year-on-year, the number of long-term unemployed dropped by 62.3 thousand. The general unemployment rate fell by 1.9 percentage points to the lowest level since the end of 1997 (5.2%).

The employment rate (the proportion of first (main) jobholders in the number of persons aged 15-64) reached 66.3% and was 0.9 percentage points up year-on-year. The male employment rate grew by 1.3 percentage points to 75.2%, while the employment rate of women grew by 0.5 points to 57.3%.

The seasonally adjusted average number of employed persons increased by 25.5 thousand (+0.5%) quarter-on-quarter.

The average number of unemployed according to the ILO methodology decreased by 17,900 quarter-on-quarter (seasonally adjusted). The number of unemployed fell to only 266,700 (of which 146.900 were women), and this is the lowest level of unemployed which has been registered since the end of 1997. In comparison with Q3 2006, the total number of unemployed decreased by 98,300 and has dropped by more than a quarter year-on-year (26.9%). Generally, unemployment dropped faster among persons in the young and middle productive age. Unemployment dropped more among the female population (by 53,600), especially in the five-year age group 20-24 (by 13,700). The total number of unemployed men fell by 44,700 year-on-year, most of this in the 20-24 age group (by 14,100). A majority of the unemployed (71.1%) are persons either with secondary education without GCSE (the leaving certificate) or with only basic education.

According to the Labour Force Survey results, the general unemployment rate according to the ILO methodology (derived for the 15-64 age group) reached a ten-year minimum of 5.2% in Q3 2007. Compared to Q3 2006 it decreased by 1.9 percentage points.

The different methodology use in the Labour Force Survey is what gives rise to the difference between the general unemployment rate using ILO criteria and the registered unemployment rate by provided by the Ministry of Labour and Social Affairs of the CR (MLSA CR), but it is important to note that the development trend is the same whichever rate you use. The registered unemployment rate by the MLSA CR reached 6.3% in Q3 2007 and decreased by 1.6 percentage points year-on-year.

The regional unemployment rate ranged from 2.3% in the Hl.m.Praha Region and 3.2% in the Jihočeský region to 7.9% in the Karlovarský Region and 9.0% in the Ústecký Region. The drop of unemployment showed itself in all of the regions of the CR, with the greatest declines being registered in areas with high or above average unemployment rates i.e. in the Moravskolslezský, Karlovarský and Ústecký Regions.

Much lower unemploy­ment rates are being recorded for university graduates (2.1%) and persons having full secondary education with GCSE (3.1%). A high unemployment rate continues to be observed among persons with basic education (18.8%) and an above-the-average unemployment rate (5.6%) is still in the large group of persons with secondary education without GCSE including those with vocational education.

Czech inflation accelerated to the fastest in 13 months in September, closing in on the central bank's target and suggesting interest rates may rise again as early as this month. Consumer prices rose an annual 2.8 percent, up from a 2.4 percent in August, according to the Czech statistics office.

Obviously a number of factors are at work in the way the Czech economy is assimilating this drop in numbers of unemployed without stoking inflation, but could one of the important details which "mark the difference" between the Czech Republic and some of its neighbours could be the fact that the Czech Republic far from losing workers on a net-basis through out-migration, has actually been acting as a magnet which attracts inward migrants in significant numbers.

The number of foreigners legally working in the Czech Republic grew by 38,000 at the end of September 2007 in comparison with December 2006, with the total rising to 223,000, and most of the newcomers arriving from either Slovakia (100,000), Ukraine (57,000) or Poland (22,000), according to statistics issued by the Labour and Social Affairs Ministry. Tens of thousands of non-Czech nationals also work in the country illegally, according to numerous estimates.

Lingering slack in the labor market has helped contain wage inflation. Despite strengthening demand for labor, suggested by rising vacancies, wage pressures have remained subdued, as rising inflows of immigrant workers have helped offset the impact of population aging on labor supply. Recent employment gains have been concentrated in industry and private services, including real estate, and do not yet appear broad-based. Unemployment has fallen, but remains around 7 percent, as continued geographical and skill mismatches have kept structural unemployment high.
IMF Selected Issues, February, 2007

Many Czech companies would be unable to operate without the foreign labour force according to HVB Bank analyst Pavel Sobisek. The share of foreign workers in the total labour force already exceeds four percent. The share of value added created by them is around 3 percent, according to Sobisek, while in some sectors, like construction and retail, the share is much higher.

So while some Czechs have left their country to work elsewhere since the turn of the century, the Czech Republic has been more than able to compensate for this by attracting workers from elsewhere. Obviously all of this is not completely problem free, in that wage pressures are nonetheless building up. But the situation is certainly strikingly better than in many other EU 10 countries. So, is there a lesson here for anyone?