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Friday, October 26, 2007

Lithuania's Economy Accelerates in Q3 2007

Lithuania's economy seems to have accelerated in the third quarter, expanding by 10.8 per cent according to a preliminary estimate from Statistics Lithuania. This is the fastest pace in four years, and the fact that the economy is gaining speed rather than slowing down must increase concern that Lithuania's economy may also be in danger of having a hard landing.

Statistics Lithuania informs that based on available statistical data and econometric models, estimated GDP for 3 quarters of 2007 totalled LTL 69946.9 million at current prices and as compared to 3 quarters of 2006 grew by 9.1 per cent (estimated using a chain-linking method in volumes of value added).

This year, the increase in the gross value added (GVA) was conditioned by the value added created by enterprises engaging in agricultural, construction, wholesale and retail trade, real estate, renting and other business, as well as transport, storage and communication activities. In III quarter 2007, GDP reached LTL 26473.5 million at current prices and, as compared to III quarter 2006, increased by 10.8 per cent. In the third, as in the second, quarter, the increase in GVA was conditioned by construction, wholesale and retail trade, transport, storage and communication, real estate, renting and other business, as well as manufacturing and agricultural activities. Value added created by agriculture reached the level of 2005 (in III quarter 2006, a 22.8 per cent decrease in value added was recorded).



Wednesday, October 24, 2007

Catch Up Growth and Demographics - Evidence from Eastern Europe

by Claus Vistesen: Copenhagen


Performing a simple series of adept Googling exercises around various sources on the internet you can easily discover that certain species of the lynx are able to travel at speeds of up to 50 kph (31 mph). Wikipedia informs us that the Eurasian lynx, on average, commands a hunting area of between 20-60 square kilometers in which the lynx is able to walk and run about 20 kilometers in one single night. All in all, a pretty rugged and constitutional little thing this lynx.

In this way, and perhaps because, at that particular point in time, the Eastern European Economies looked as if nothing could come in their way of economic prosperity and growth they were paired, by the Economist, with the region's sturdy feline coining the notion of 'Lynx Economies.' Thus, 'that particular point in time' was sometime back in the spring of 2006 where the Economist's (and my own) coverage of the CEE and Baltic economies came in hot on the heels of publications by the World Bank and and the Vienna Institute of Comparative Economic Studies speaking favorably of the future prospects of economic prosperity and thus 'catch-up' growth in the CEE and Baltic Economics.

Yet, merely 1 year and a tad later things seem to have changed quite significantly with respect to the discourse on the economic situation in Eastern Europe. Many of the contributors to this blog has been pitching on the change in discourse but also some of major institutional actors have been flagging the red banner. Not least the World Bank seems to have changed their attitude somewhat with most notably a recent report on the demographics of Eastern Europe entitled From Red to Gray - The Third Transition of Ageing Populations in Eastern Europe and the former Soviet Union as well as a recent writ with specific focus on the macroeconomic risks prevailing in the region. Yet, also the IMF in their latest World Economic Outlook devotes a chapter to the managing of large capital inflows where Eastern European economies also take center stage of the general tone of warning; in essence this note of warning concerning Eastern Europe seems to be the general talk of the day amongst economic analysts and journalists. As such, perhaps even the lynxes roaming the forests and planes of Eastern Europe are beginning to feel that the otherwise catchy notion conjured by journalists at the Economist is becoming something of a stretch according to the reality of the situation. Sure, things are moving fast now but it is what happens next which might finally serve to make the allegory rather unrealistic. In this entry I set out to explicitly investigate an issue which in fact has been treated several times on this blog and perhaps most often in the context of the CEE and Baltic Economies. Simply put and in the form of one simple question;

  • How do changing demographics and more specifically the final and ongoing stages of the demographic transition affect the notion and principle of economic catch up growth and thus economic convergence as it is stipulated by (neo-classical) economic growth theory?

As I have hinted above in the introduction my main subject of analysis on which the general theoretical argument is based is the current and ongoing situation in the CEE and Baltic economies. A lot has been written about this recently not least from the hands of the contributors to this blog (see also above). As a one-stop overview of the concrete issues at hand this recent note by Edward over at Global.Economy.Matters should provide you with suitable ammunition to get you started. In particular, the following three point overview of the current economic situation in Eastern Europe should always be in the back of your mind as we move forward from this point ...

Basically the principal outstanding issues confronting the EU10 countries are threefold:

  • Labour capacity constraints (which are normally a by product of long-term low fertility and large scale recent migration flows) are producing significant wage inflation and strong overheating.
  • A structural dependence on external financing - which is in part a by-product of the effect of low levels of internal saving, and which is another factor which separates the EU 10 from those like India or China who are benefiting from a typical demographic dividend driven catch up, is leading to large current account deficits, and potentially high levels of financial instability.
  • A loss of control over domestic monetary policy due to eurozone convergence processes which - with or without the presence of formal pegs - make gradual downward adjustment in currency values as a alternative to strong wage deflation virtually impossible. This issue is compounded by the likely private "balance sheet consequences" of any sustained downward movement in the domestic currency given the widespread use of mortgages which are not denominated in the local currency.
Traditionally a rigorous economic analysis in the light of the immediate events would focus a lot on point 2 and 3 but in this note we shall look specifically at number 1 and the issues of labour capacity, its constraints, and what it means of the economic growth of less to medium developed countries. Now, the most obvious caveat in this entry is that I really don't have the time at this point to really lay out the whole theoretical framework of economic growth theory and as such the precise slot in which my argument should be inserted within the wider theoretical framework. This will be the topic of a more rigorous article not suited for the blog format. However, I still need to attach some comments to set the scene where I should also immediately note that my previous note here at DM about catch up growth in Eastern Europe serves as a good state of the game post for what comes next.

Apart from my studies of selected pieces of the economic growth literature one of the best overviews of the concept of economic convergence as a function of the theoretical and practical assumptions vested in the growth models is to be found in an article by Norbert Fiess and Marco Fugazza on economic integration in Europe (PDF). As such it is important to note that convergence of GDP per capita levels is not a holy grail within the fields of economic growth theory. Rather, the process of convergence should be seen as an inbuilt consequence of the fact that as economies mature returns to production inputs decrease; that is to say that this discussion essentially revolves around the concept of increasing v. decreasing returns to scale in our economic model. If we think about decreasing returns to scale and introduce the concept of marginal productivity to production inputs we can then see that less developed countries are likely to exhibit higher rates of growth than their more mature counterparts in the sense that their marginal productivity is higher which then leads to a process of convergence. Now, this argument in its most strict sense is usually applied in the context of capital as a production input and coupled with the properties of an open economy and subsequent free flow of production factors this would lead to a rather rapid process of convergence or absolute convergence as the technical term. As regards to labour as a production input is has also been argued that the universal transition from an agricultural to manufacturing over to service (?) based economy produces a mechanism of convergence in the sense that this process implies a move up the value chain and thus that every unit of labour becomes more productive. Of course and even though we are talking about stylised facts here, this is also where the whole debacle begins in the context of my immediate argument because how certain is this process? Also, we need to take into account the distinction between stocks and flows (of labour) which is a crucial issue to consider when talking about ageing economies.

However and it does not take much of an economist to see that empirical facts do not support the idea of absolute convergence or at least it seems as if the process takes much longer to materialize than predicted by the theory. This has lead, among other factors, to a 'new' strand of economic growth models which allows for persistent growth divergence to exist between countries. The crucial aspect to understand here is the mechanism through which persistent divergences can occur. In this way, one of the widest contributions by economist to this thesis has dealt with the possibility that technological processes and thus accumulation of technological advances exhibits increasing returns to scale. The fundamental brilliancy of this notion is that it allows for a model where there is indeed decreasing returns to labour and capital but where different levels of technological effort leads to internal positive feedback mechanisms and thus explains persistent divergences in growth and 'prosperity' across countries.

Ok, I think that I have already said enough at this point and in order to get us back to track one crucial assumption and conceptual idea needs to be pinned down. As such and if we look at the rudimentary description of the economic growth process above it is not wholly unreasonable to argue that the growth process of an economy is somewhat directly related to the process of the demographic transition. Or as Robert Lucas puts it in a widely cited article ...

That is, the industrial revolution is invariably associated with the reduction in fertility known as the demographic transition.

As such, why don't we take a look at Eastern Europe where the economies have experienced, quite as expected by the conventional theory of economic growth, economic dynamics tantamount to catch-up or convergence. Especially the economic data since the expansion from EU15 to EU25/27 and, for some countries, the subsequent anchoring to the Euro has been very impressive indeed. Yet as Edward and I have been at pains (see link above) to explain again and again these countries are not your average emerging markets. This follows from the fact that their demographic structures have been fundamentally distorted due to a collapse of fertility in the beginning of the 1990s which has been aggravated by a persistent net outflow of migrants serving to further speed up the decline in the working and essentially also most productive cohorts. In order to capture this development and in order to frame the current situation the following point I made in a previous note is worthwhile to repeat.

In short, we are dealing with countries where the demographic transition by far, and indeed worryingly, has out paced the traditional economic process of economic convergence.

This is exactly what we are talking about here and apart from going to the heart of the imminent issues in Eastern Europe it also strikes right smack into the concept of economic growth theory and how to deal with the fact that the demographic transition does not occur the way it was originally anticipated. Most emphatically, we can see in the context of the Eastern European countries that the final stages of the transition have arrived far before and quicker than the twists and turns of history allowed for these economies to really get on with business. Yet, the general argument can just as easily be expanded into a discussion of the ageing part of OECD where it is painfully clear at this point that conventional economic theories are wholly incapable of explaining what is likely to happen next. In fact, we could stretch it so far as to say that modern economic growth theory is not able to explain what happens when fertility drops to a level below replacement level and stays there!

In Summary

Even though that a lot words have been written in this entry I am afraid that only superficial contributions have been made to the final answer of the proposed question. This entry principally had one main task, namely to initiate a line of reasoning which ultimately and hopefully can lead to a better understanding of modern economic growth processes in a context of the current demographic profile of many developed and developing economies. Specifically, this entry revolved around the concept of catch-up growth/convergence where the countries in Eastern Europe were suggested as an example to demonstrate how demographics can fundamentally alter the principles by which the economic growth process is likely to conform. In this way, the message is not that modern economic growth theory and growth accounting methods are rendered obsolete in the face of changing demographics but rather that considerable adjustment needs to be made; especially in the context of catch up growth/convergence but also crucially in the context of the notion of a steady state of economic growth. Returning briefly to the real world before we sign off it could seem as if the branding of the lynx economies never was more than a quick and essentially expensive make-up which is set to quickly wear off as we venture on. Specifically, recent signs coming out of the ECB and the European commission suggest that expectations are aligning towards an outlook where the process of convergence effectively risks grinding to a halt. My advice would then be not to exchange the carrot too swiftly into a stick since this would only serve to kick those who are already on the ground.

Monday, October 22, 2007

Hungary Construction Output August 2007

According to data released last Friday by the Hungarian Statistics Office, in August 2007 the volume of construction activity in Hungary decreased by 15.3% when compared with August 2006 according to unadjusted indices, and by 14.4% according to indices adjusted for working days. In the first eight months of 2007 output was down by 7.3% when compared with the same period of 2006. In comparison with the previous month production decreased by 0.8%, according to indices adjusted seasonally and for working days.



What is evident from this data is that the Hungarian construction industry is in deep depression, and given what happened in the global banking sector in August, and the impact that this is likely to have on construction activity, this depression is unlikely to come to an end anytime soon.

At the more detailed level the output of complete constructions and civil engineering decreased by 21.2% over August 2006, while building installation decreased year on year by 7.2%. Completed buildings, on the other hand, only went down by 2.3%.

According to unadjusted indices the construction of whole buildings decreased by 5.6% and that of civil engineering fell by one quarter when compared with August 2006.

The stock of orders pending at the end of August was down by 40% on August 2006. Within this total, the stock of orders for building construction decreased by 13.6% while that for civil engineering was down by 54.4%. The volume of new orders was down by 15.1% on August 2006.

Now we really need to take a hard look at the Q3 2007 GDP data so we can see what is really happening here.

Estonia Construction Price Index Q3 2007

According to Statistics Estonia today, in the 3rd quarter of 2007 the percentage change of the construction price index was 1.6% compared to the 2nd quarter of 2007 and 12.1% compared to the 3rd quarter of 2006.



The construction price index was primarily influenced by the increase in the labour costs compared to the previous quarter and also the same quarter of the previous year.



In the 3rd quarter of 2007 the percentage change in the repair and reconstruction work price index was 1.7% compared to the 2nd quarter of 2007 and 12.1% compared to the 3rd quarter of 2006.

The calculation of the construction price index covers four groups of buildings — detached houses, blocks of flats, industrial buildings and office buildings, as well as office buildings covered by the repair and reconstruction work price index. The index expresses the change in the expenditures on construction taking into consideration the price changes of basic inputs (labour force, building materials and building machines).

As can be seen from the charts, while the rate of increases in these prices may have pulled back slightly in Q3, it is still very large indeed.

Estonia Producer Prices September 2007

Statistics Estonia announced this morning that Estonian producer prices rose an annual 9 percent in September, the fastest pace in the last 10 years. In this post I asked the question as to whether Estonia was heading for a soft landing, looking at this data which is now coming in I think the answer can be quite unequivocal: it is not.



As I said in this post about Latvia's August trade statistics:

"The key question to now follow will be the evolution of producer prices in the export sector, since the only way to get out of this mess in the longer term will be to export your way out of it - since all those capital inflows one day or another have to be paid back - and the only way to be able to export is to be competitive."


So why don't we do just that, take a look at producer prices in the Estonian export sector. Here is a comparison of the recent inflation in the export and import sectors.



Now we can see straight away here that there is no significant productivity differential being achieved in the tradeables sector, and rising costs are being pushed straight on through to exports. This now can only end badly, and the only question left is when. My guess is when the Eesti Pank finally bite the bullet and break the euro peg. The situation is impossible, and like this it simply cannot correct. In addition the euro has been trading earlier this morning at over $1.43 per euro, and the Kroon is of course being dragged up with the euro. We are all hoisted on our own petard.

Last months producer price growth compares with an increase of 8.5 percent in August, and 6.4% back in January.

Estonia's export industry has struggled this year to adjust to rising wages, which were up 21 percent year on year in the second quarter, stoked by labor shortages which have been produced by rapid economic growth following a large drop in ferility some 20 odd years ago. The problem - which would exist in any event - is only being added to by Estonian workers leaving to earn the higher wages which are on offer elsewhere in Europe, although it must be said that this end of the problem is much less severe in Estonia than it is in other parts of the Baltics, Bulgaria, Romania and Poland.

Clearly the Baltic countries are being hit by the fact that no-one saw this coming and thus structural reforms of the kind which might make the countries more attractive to immigrants (like multi culturalism) have not been extensively introduced.

Meantime the foreign companies are steadily begining to draw the inevitable conclusions and pack their bags. The latest example, as reported by Eesti Paeevaleht last week is Boras Wafveri AB, a Swedish textile producer, which is now busily seeking a partner for its unprofitable Estonian unit, Kreenholmi Valduse AS. Rumours have it it they are even contemplating selling the whole plant as losses mount due to competition from lower-cost producers in Asia and elsewhere.

Saturday, October 20, 2007

Employment and Unemployment in Poland

This post is essentially a research note on the current state of the Polish labour market. It forms part of a series of posts being prepared by Global Economy Matters to accompany the up and coming Polish elections, which are due to be held this weekend. Alongside this post you can find a general review of the electoral situation by Manuel Alvarez, and I will be writing additional notes on the Polsih trade balance and on migration and remittances in the Polsih context, while Claus Vistesen will be taking a look at indebtedness, capital flows and the current account balance situation. All in all a rather full analysis, which given the key role which Poland may play in any Eastern European emerging markets disarray is probably only fitting.

Now, at the end of September the Polish Statistical Office published its unemployment report for the second quarter of 2007, and very interesting reading it is.


Before going into the details of the report, perhaps a bit of background information would be useful. First of all, economic growth. GDP has been growing at a pretty nifty clip in Poland in recent quarters, not as fast as in the Baltics, but pretty fast, as we can see in the chart below. Over the last twelve month the rate has been hovering in the 6% to 7% region.




Now the question is, is this growth sustainable? Stripped to its bare minimum, an economy needs three things for growth - labour, capital and raw materials - pretty much in the same way as a cement mixer needs sand, cement and water, all in the right proportions, of course. The analogy, in the present context, is not completely devoid of significance, since construction activity, and hence the production of cement, is an important part of the recent Polish story in its own right.

So as I say: is this sustainable? Well, capital is at present in pretty plentiful supply, although the danger does exist - since this capital is to a large extent not the product of domestic Polish savings - that this supply could dry up, and even be sucked backwards, as Claus will explain in his post. Raw material are available, but not always at the most favourable price, as we are currently seeing in relation to food and energy.

But what about labour? What is the position with the labour supply situation in Poland? Well this brings us directly to the tricky topic of Polish unemployment, which we will now proceed to explore.

Long Term Unemployment Decline

Historically unemployment in Poland has been pretty high. Most recently it peaked in 2003, and has now been dropping for a number of years, as can be seen from the annual unemployment chart below.




If we come to look at the monthly unemployment data for the last twelve months then we can see that this decrease in unemployment has been accelerating steadily in recent times.





The decrease in the numbers of unemployed is in part, of course, a reflection of an increase in employment, and the volume of employment in Poland has, as can be seen below, been increasing steadily since the end of the contraction which took place between 1999 and 2004.

Here is the annualy % change in the volume of employment:




And here are the numbers of employed on a quarterly basis since the begining of 2004:




The number of people registered with the Polish labour offices as unemployed at the end of June 2007 was 1,895,100 (of which 1,107,700 were women). This constituted a reduction of 337,400 on the number of unemployed in March (the end of Q1). Compared with June 2006 unemployment was down by 592,500 (or by 23.8%). Thus, viewed on a quarterly basis, the decline has been very dramatic, as can be seen below.




Perhaps also worthy of note is the fact that the decline in the numbers of unemployed has been more rapid among men - 322,800 (or 29.1% of the total unemployed) - than among women 269,800 (or 19.6%).

When compared to June 2006 unemployment decreased in all the Polsish voivods, and the declines have been quite dramatic. The most significant declines took place in in Dolnośląskie (30.2%), Wielkopolskie (29.8%), Pomorskie (27.5%), Opolskie and Śląskie (26.8%).

(Please click over image for better viewing)




The unemployment percentage rate at the end of June 2007 was 12.4% of the economically active civilian population, and was thus 2.0 points lower than in Q1 2007, and 3.5 % points lower than in June 2006.

There is still considerable territorial difference in the levels of unemployment in Poland. The highest unemployment rate is to be found in the voivods of Warmińsko-Mazurskie (19.6%), Zachodniopomorskie (17.9%), Kujawsko- Pomorskie (16.2%) and Lubuskie (by 15.8%), while the lowest unemployment rate exists in the voivods of Wielkopolskie (9.3%), Małopolskie (9.5%), and Mazowieckie (10.2%).

(Please click over image for better viewing)




Looking at the two maps taken together, it is very clear that the area where labour tightening is most dramatic at the present moment is Wielkopolskie, since the unemployment rate is already comparatively low, and the pace of reduction in the unemployment rate is also pretty rapid. Wielkopolska Province is second in area and third in population among the sixteen Polish voivods, with a land area of 29,826 km² and a population of 3.4 million. The province's principal cities are Poznań, Leszno, Kalisz and Gniezno. It also hosts part of the Kostrzyn-Slubice Special Economic Zone.


In general terms what we can see is that as the Polish economy has been expanding, it has been consuming labour, and rapidly so. One interesting calculation here is to make an estimate of how much labour is needed to produce 1% of GDP growth with the current proportions of sand, cement and water which are being shoveled into the economic mixer (ie at today's rate of productivity increase). A rough and ready, rule of thumb type, calculation would tell us that to get 6% annual growth the unemployment roll is coming down by about 600,000 peopple per annum, that is that each annual percentage point of economic growth reduces the numbers of available unemployed by 100,000. (This is a rough and ready calculation, but it is a more sophistocated one than first meets the eye, since it does, in approximate way, implicitly incorporate the ageing and withdrawal from the labour force dimension).

What this means quite simply is that, given the relatively low size of the younger cohorts about to enter the labour force, a 6% growth rate just is not sustainable for that much longer. If we imagine that unemployment could only with great difficulty fall below 500,000 without producing spiralling hyper-inflation, then we have an outer limit of 2 years at the present growth rate I think.

After that, what is the sustainable - capacity - growth rate? This is very hard to say without a much fuller econometric analysis, since it depends among other things on the direction and intensity of both migratory and capital flows. Many people, and especially those with a relatively poor understanding of how economic processses actually operate, tend to raise the objection at this point that such a calculation may not be accounting for productivity growth. This would be a mistake, and an elementary one, since the present rate of unemployment attrition already incorporates a certain level of productivity improvement.

So what such an argument normally wants to claim is that some sort of rapid improvment in the rate of productivity growth is on the horizon - rather like Alan Greenspan argued in the late 90s based on the arrival of the internet. A continuing increase in Polish productivity is, of course, to be expected, but it is not clear why people are expecting a dramatic acceleration in the rate of productivity growth. If this expectation is to become more than a simple vain hope it does need some sort of analytical justification. In the meantime we might do well to bear in mind that such improvements are a by product of stocks and flow movements in human capital formation, which is why the age structure of the existing population, and their education level, is such an important topic.

So, if we said that between 2010 - 2012 Polish capacity economic growth might be something in the region of 2 to 3%, then we probably would not be that far from the mark. Post 2012 it is much harder to estimate things, especially since, among other issues, the ageing population component will begin to have an ever greater impact.


Labour Quality


One of the main issues on which we are focusing in this analysis is the rate of reduction of the unemployment level in Poland and the evolution of the future labour supply. It is important to be aware that this future evolution is in great part conditioned by two factors:

1) The very low numbers of live births (in historical terms) which there have been in Poland since the late 1980's and;

2) The relatively high levels of out migration which Poland has expecienced in the last three or four years, which mean certain key groups of workers in the main productive age ranges will not be available to Poland to fuel growth as we move forward.



I have a much fuller (examination of the Polish fertility vackground in this post , but the following graph should make the underlying position pretty clear:



Basically live births dropped from a level of around 700,000 per year in the mid 1980's to around 400,000 per annum in the mid 1990s. That is a net loss of 300,000 potential labour market entrants per year (or a reduction of around 40% in the labour flow, I can hear that cement mixer starting to crunch as I write), a loss which will increasingly make its presence felt between now and 2015.

With these points in mind it is interesting to note that in Q2 2007 the number of people who left the unemployment rolls was 873,000. The largest group who went off the unemployment rolls in Q2 2007 did so as a result of finding a job. In fact 364,000 people left the rolls to take up work in Q2 2007 (or 41.7% of the total leaving) as compared with 425,300 (or 46.8%) in Q2 2006.


It is also inetersting to note that during Q2 2007 264,900 people who were previously registered as unemployed did not confirm their readiness to take a job. This seems to suggest that the Polish authorities are busily cleaning up their unemployment registers - the reduction for "non-availability" constituted some 30.3% of the total reduction in the number of people on the unemployment rolls during the quarter (in Q2 2006 the figures were respectively 259,500 and 28.6%) - and many of the people removed were more than likely already working, whether the work in question was inside or outside of Poland.

So one part of the apparent Polish "reserve army" may in reality simply not exist. Another part may - speaking in plain English terms - be far from serviceable for modern economic growth purposes.

In this context it is interesting to note that the long-term unemployed constituted 65.7% of the Q2 2007 total (1,245,000), and many of these people may turn out to be very hard to "recycle" into the modern world. In terms of the relative age structure of the remaining unemployed, under 25 year olds constituted 18.9% of the total (358,600), while persons aged over 50 were 21.0% (398,1oo thous).

At the end of Q2 2007, 1,639,300 people on the rolls did not possess the right to unemployment benefit, and this group represented 86.5% of the total number of registered unemployed, (in the previous quarter it was respectively 1,930,700 and 86.5%). Among this group 43.4% were people living in rural areas.

There were also more female than male unemployed. At the end of Q2 2007 58.5% of the total unemployed were female, and this was up by 3.1 % points on Q2 2006. The highest percentage share of women in the total number of the unemployed is to be found in the Wielkopolskie (65.6%), Pomorskie (64.0%), Kujawsko-pomorskie (62.3%) and Małopolskie (61.5%)vovoids.

One of the key difficulties in evaluating the remaining unemployed labour force in Poland is getting a precise reading on the quality of the labour which remains available. It is hard to get a clear picture here, but one indication which is not without importance can be found in the fact that the majority of the unemployed registered in the labour offices were persons with relatively low levels of education. The share of registered unemployed who did not have any occupational qualification whatsoever was 30.7% of the total registered unemployed (582,000).

In addition the two largest groups among the unemployed were persons having only basic vocational orlower secondary education (30.1% of the total), or persons with only primary or even incomplete-primary education (32.5% of the total number of the unemployed registered at the end of June 2007). Combined these groups constitute 62.6% of the total number of the unemployed.

On the other hand some 22.3% of the total had the certificate of completion of post-secondary and vocational secondary schools, while 9% had completed secondary education and 6.1% were graduates from tertiary schools.

So, in conclusion, and to reiterate. Poland is facing a potentially very acute and imminent trade off between economic growth and inflationary cost push. Some indication of this can already be found in the producer price index, which has been coming under increasing pressure since early 2006:



The earlier interest rate tightening from the central bank seems to have had some sort of short term impact during the March to July period, but, as we can see, the thing now seems to be taking off again. This position is only even more strongly confirmed if we look at the construction producer cost index.



It is also very clear that the steady tightening of labour market conditions is having an impact of Polish wages and salaries.



The annual rates of increase have been steadily picking up speed, and while they are still below those to be found elswhere in Eastern Europe (like the Baltics, Romania, Ukraine) the early warning signs of the "Baltic Syndrome" are there, which is hardly surprising since the underlying causes are essentially the same.

Information for this report comes, by and large from the Polish Statistical Office and Eurostat. In particular the recently publishedunemployment report for the second quarter of 2007 was evry useful, while additional information was taken from the Q2 2007 Labour Report (archive).

Tuesday, October 16, 2007

Magyar Nemzeti Bank in Pessimistic Mood

Unfortunately, for some reason the national bank seem to publish their quarterly report only in Hungarian, so I can only read this brief summary in Bloomberg:

Hungary's outlook for economic growth, the European Union's second slowest after Denmark in the second quarter, deteriorated as the effects of government austerity measures spread, the central bank said.

Growth in the second quarter was 1.2 percent as efforts to cut a record budget deficit, including higher taxes and energy prices, sapped consumer demand and curtailed government spending. The slowdown may be spreading beyond state-controlled industries, the bank said in its quarterly report today.

``Growth prospects changed negatively, despite the continuing favorable international environment,'' according to the report posted on the bank's Web site. ``The larger-than-expected slowdown may also be wider. The decline in construction output suggests a subdued investment outcome, which may risk the longer-term growth path of the economy.''



The current forecast from the Magyar Nemzeti Bank is for growth to be at 2 percent this year, while it expects next year's rate to 2.7 percent and the 2008 figure at 3.4 percent. These numbers seem way too high to me, especially given what is happening in the eurozone, and the risk of a generalized crisis in the EU 10 in the not too distant future. My feeling is that Hungary will have a brush with recession this winter and if the economy manages not to contract in 2008 then this will be a "good" result.

The central bank mentioned construction activity, and here is the latest data we have on that. I really need to do a more detailed analysis of the components of GDP growth to see where exactly we are here.

In the meantime, and on a slightly separate issue, I recently posted on the state of the CA balance (and here), and in particular I put up this chart here:




What we can see here is the importance of payments on equities in the Hungarian CA issue. This provoked Daniel Antal to make the following very interesting observation in comments:

I think you see the problem very clearly....... Your argument is very much valid I think.

However, I think you cannot do too much about it. Central Europe has a huge wealth problem: it always had very small per capita capital stocks compared to Western Europe. Privatization helped in the short-run, because made loss making ill-managed state-owned companies work again, thus giving the population income. However, the wealth problem was not solved: the new owners obviously made investments in order to make profit.

Personal incomes are flows and are much more easier to move up than capital stock. Central Europeans earned less than Western Europeans for centuries. Even if wages will converge in a few decades it takes at least a century for capital stocks to be comparable.

Ironically what makes some convergence possible is that European, especially Western Europeans have destroyed the majority of their inherited capital stocks in the World Wars. Since they had much more to loose, they have lost much more in those wars and Central Europe has only fifty years of very low income to make up.

Another interesting point: at the start of the transition Central Europe had abundant labor supplies and very little capital, so wages were relatively low and capital gains were very high. Foreign capitalists and those few who grabbed capital stocks in the early years made fortunes. Now there seems to be a sort of overshooting: in many countries labor is relatively more scarce than capital and wages are rising.

But if you think about the good old production function, these are just relative measures. We still have fewer labor and less capital than Western Europe.


I think Daniel also understands the situation pretty well. FDI to buy old state enterprises helps with the efficiency situation, but it doesn't resolve the wealth problem. It saves government debt in the short run by giving others a stake in the national wealth - in the absence of members of the nation themselves having this - but in the end, like any other debt it has to be paid back.

In the Western European countries FDI is not an issue, since the accumulated wealth issue means that the country has very similar stocks of external FDI to balance the inflows. But Hungary's problem is a bit like people in the US worry theirs could become in 10 or 20 years if they continue with the CA deficit and the Chinese and others start to buy-up US enterprises with the proceeds of the trade surplus China has with the US. This is a very real concern for the US in the future, since the accumulation of investment stocks would mean that at some point the outflows on income payments (dividends or interest) would exceed the annual inward stock flow. That is why the dollar is going down and the US is trying to correct. But Hungary seems to have already reached that point, and, quite frankly, I am not sure what to do about this. Here is a chart showing the relative stocks of inward and outward FDI as shares of GDP. One is clearly much bigger then the other.



True the proportions of the flows of FDI have changed rather in recent years, and there is more outbound FDI, but the inbound still exceeds the outbound, so the position in the longer run continues to deteriorate. Anyone have a plan 'B' to hand?

Mugur Isarescu Shows Us How Not To Run A Central Bank

Well according to Bloomberg this morning:

Romania's central bank will hold back from any ``sharp and sudden'' reaction to accelerating inflation and a widening current account deficit.

``Don't expect us to react in an unprofessional way or to overreact or be disorderly or push on the brakes,'' Mugur Isarescu, 58, said in an interview in Bucharest yesterday. ``There's no reason. The situation is manageable.''

Isarescu, who has headed the central bank since 1990, after the fall of communism, said there was ``not a good probability'' that the year-end annual inflation rate will be below 5 percent, though it will probably peak in October.

`We expect some impact of the drought on food prices to remain in October,'' he said. The increase may turn around starting in November and ``we hope inflation at year's end will be close to the target. We aren't only looking at one month's data and then to go and shoot a fly with a cannon. We're looking for sustainability and continuity.''


Obviously this is just not the way to handle a tricky and extremely complex situation. The remarks do not convey the level of concern and getting down to business attitude that the markets are looking for - and are right to expect - at this point. Predictably the leu has again been under siege this morning. If the central bank governor conveys the idea that he isn't particularly bothered, then its do what you like time.

Also, and as is being repeatedly stressed here on this blog, by the IMF and by the world bank, the issues which are up on the table go way, way, beyond food prices. The relate to how you can continue to fund an unsustainable current account deficit, and what to do about a fertility and out-migration driven labour shortage. They need to be addressed, and quickly - at least by offering credible policy responses - or all of this is going to explode, and soon.

Translation Risk in the Baltics and other matters on Eastern Europe

by Claus Vistesen

cross-posted from Alpha Sources

Work is piling on my desk at the moment and I fear that events might even overtake my efforts to keep up with them but here is to trying. Basically and if this was not clear back in the beginning of September it should now be readily clear everybody that Baltic and CEE economies now need serious watching and attention. As my regular readers will know I have been slowly and steadily chipping away together with my colleague Edward Hugh. My own catalogue of posts on the subject can be found here and you might also want to check the following three blogs; Baltic Economy Watch, Eastern Europe Economy Watch and Latvia Economy Watch. Also, the group blog Global.Economy.Matters has been the venue lately of some very interesting posts on the issue at hand. In fact, Edward's recent entry over at GEM offers an excellent introdution to the issues in Eastern Europe as they have been dealt with and indeed described regularly in the past months here at this blog. As such and in order not to repeat myself, I reproduce a key quote by Edward below which sums up the current situation quite well and also allows me to get down to business in this post ...

Basically the principal outstanding issues confronting the EU10 countries are threefold:

1/. Labour capacity constraints (which are normally a by product of long-term low fertility and large scale recent migration flows) are producing significant wage inflation and strong overheating.

2/. A structural dependence on external financing - which is in part a by-product of the effect of low levels of internal saving, and which is another factor which separates the EU 10 from those like India or China who are benefiting from a typical demographic dividend driven catch up, is leading to large current account deficits, and potentially high levels of financial instability.

3/. A loss of control over domestic monetary policy due to eurozone convergence processes which - with or without the presence of formal pegs - make gradual downward adjustment in currency values as a alternative to strong wage deflation virtually impossible. This issue is compounded by the likely private "balance sheet consequences" of any sustained downward movement in the domestic currency given the widespread use of mortgages which are not denominated in the local currency.


Now the worrying part about all three of these is that they are not simply cyclical in character. As such they are not problems which will "self correct" as a result of a recessionary slowdown, whether this be of the "soft-" or "hard-landing" variety.

And business, as it were, in this post is basically an extension of the analysis I did a couple of weeks ago regarding the balance sheet exposure of (primarily) Lithuanian households towards a potential rattling of the pegs to the Euro carried by a currency board. To put it more directly, this post will deal with aspects of the topic at hand which ties up to point 2 and 3 above.

In order to frame the discussion a bit before we move into the data I want to emphasize that the risk of a rapid currency unwind somewhere in Eastern Europe is most emphatically not some kind of odd suggestion. The risk is very real indeed! You just need to take a brief look at what has happened the past weeks to see how things are now set in motion towards what seems to be an inevitable loosening of the tight strings attached between the Eurozone and the pegging and also floating currencies in Eastern Europe. Exhibit one is found in two recent publications from the World Bank and the IMF in which specifically Eastern Europe is singled out as a cluster of countries where the economic development as epitomized by the three points above have put these economies in a situation where not only the general macroeconomic environment is in risk of taking a serious blow. However, this is also a situation where the process of convergence with the Eurozone countries as well as of course the final carrot of Eurozone membership have become events subject to eternal postponement for the majority of the countries in the region. Now, this raises obvious questions surrounding political reactions and while I can understand the overall political and economic dynamics which are now set in motion I also need to emphasize why these countries should not be handed the stick at this point since this would not help at all. Yet, this is an issue for another post. What I am really getting at here, and this would be exhibit two, is quite simply the fact that people which in this case mean policy makers and opinion makers at the ECB as well as of course investors seem to be positioning themselves for a collapse of the de-facto fixed exchange rate regime which ties together the Eurozone and most of the CEE and Baltic economies. A notable example of this would then be Danske Bank's Lars Christensen who is also shadowing the unfolding events in Eastern Europe and who recently suggested in a note that the ECB might be growing rather un fond of the close ties to the economies in Eastern Europe with respect to the fixed exchange rate relationships.

The increasing and clear signs of overheating in a number of Central and Eastern European countries – especially the Baltic States and South East Europe – are drawing attention not only from the financial markets, but also from international institutions. Recently the IMF has warned of the dangers of overheating in the CEE and the World Bank has on numerous occasions raised the same concerns. Now the ECB is also stepping up the rhetoric. At a conference earlier this week ECB officials expressed their concern about the in-creasing imbalances in the Central and Eastern European economies.

Now, some of my readers with a special interest in ECB affairs will recognize that Christensen is a keen ECB watcher by his mentioning of a recent conference on Eastern Europe which indeed produced some rather spectacular contributions related to the economic situation in Eastern Europe. The most cited speech from this conference is consequently one held by Lorenzo Bini Smaghi who is a member of the executive board about the risks which pertain to the process of convergence in Eastern Europe. Of course, mentions of the currency pegs were not made explicitly but as Christensen also homes in on, Bini Smaghi did note that there is a clear tradeoff between keeping the pegs and continuing the process of convergence. I will devote more time later to discuss this speech as well as another one along the same lines made by another member of the executive board Jürgen Stark but for now and in connection with the immediate topic at hand we need to understand that the scene is now effectively set for an (potential) economic correction triggered by either/or both an unwind of one of the pegs and an 'attack' one of the floaters.

Moving on to the Baltics

It is thus in this immediate light that I am going to present a slew of graphs below on the Baltics which, as noted picks, up on one of my recent posts on Lithuania which deals with the concept of crossover currency balance sheet exposure or as it has been coined in the literature; translation risk. The following definition is from investopedia.com:

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, the first interesting thing which should be noted in the quote above is of course the notion of how 'companies' are emphasised. Now, I don't have a very broad overview of the literature on this topic but on the back of a superficial glance it seems clear to me that most of the words on this subject has been devoted to the description of companies' exchange rate risk of operating in foreign countries under insecure exchange rate systems and obviously subsequently how this risk can be hedged using derivatives or just by calibrating the denomination of the stock of liquid assets held on the balance sheets. In this way, we need to look at another kind of translation risk and one which is especially important in the case of the Baltic countries and in fact also in many other countries in Eastern Europe. Simply put and as an inbuilt and strongly influential factor in connection to the general economic situation these countries have, as mentioned above, seen a very rapid increase in credit/capital inflows in the past years to cover a ballooning negative external balance helped on its way by boom in domestic demand. The point is moreover that the majority of this credit has been extended to households through loans intermediated by foreign financial institutions and thus in foreign currency (mostly Euros). As an overall point the following point as quoted by a recent report by the World Bank (linked above) is important:

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 last part is rather important for the analysis at hand which basically seeks to present comparable charts for the three Baltic countries according to the following overall analytical principles.

  • The charts will show three things. Firstly, charts will be presented on the evolution of the external balances in order to show the magnitude of the problem. Secondly, a set of charts will seek to show the overall build up of credit measured as the evolution of the total stock of loans with special focus on the households' contribution. Thirdly and as a direct measure for the potential translation risk associated with an unwind of the fixed exchange rate regimes in the Baltics charts will be presented which compares the denomination of loans with the denomination of deposits in financial institutions. In this way it is important to note that we are not comparing the stock of loans with the stock of deposits according to a criterion of how much the latter can cover the former in absolute terms but, as it were, solely with a focus on cross-currency denomination.
  • The charts, which will be presented without many words, denotes what you could call a static analysis of the issue of translation risk. The point is that the charts solely show stocks and not flows. It is thus assumed that in the case of households in particular the cash flows used to service the loans are denominated in local currency (i.e. salaries) as well as it is assumed that households have limited acces to intruments used to hedge cash flows at different points in time.

Now, and if I have been able to hold on to you until this point why don't take a look at the charts. We will begin with the charts showing the evolution of the external balances before moving on to charts showing the evolution of the stock of loans and finally finishing off with charts comparing the denomination of loans with the denomination of deposits in financial institutions. The charts which cuts across all the Baltic countries have been made with the explicit goal that they are comparable. It has not been a complete success but it works.

Current Account (Estonia, Latvia, and Lithuania)


Evolution of total stock of loans (Estonia (million EEK), Latvia, and Lithuania)


Stock of loans and deposits by currency denomination (Estonia, Latvia, and Lithuania)


(Please click on images for better viewing)

As promised I won't say a whole much at this point save of course to point out that the charts above do indicate that a considerable amount of translation risk is present which also conforms with the rather large amount of anecdotal evidence.

Monday, October 15, 2007

Inflation in Poland September 2007

Well with all that inflation going on all round the EU 10, I guess Poland wouldn't want to be left out, now would it? So just to prove a point, Polish inflation accelerated in September for the first time in three months. As elsewhere the increases were led by food costs, but there was also a sneaky little detail of housing maintenance costs. We wouldn't be short of a Polish plummer here and there would we?

In fact the inflation rate rose to 2.3 percent, after falling to 1.5 percent in August. Consumer prices gained a monthly 0.8 percent after dropping 0.4 percent in August.

Anyway, here is the chart for monthly inflation this year.



Actually, compared with what is happening eslewhere this rate of inflation almost seems saintly. Nonetheless it looks very probable that the central bank will raise interest rates again. The Polish central bank is more likely to raise its benchmark 4.75 percent repurchase rate This would be the fourth time this year that the bank has raised the rate - which is currently at 4.75% - to try to keep price growth under control as inflation threatens to breach the bank's inflation target for a second time.

The Monetary Policy Council of the Polish central bank lifted borrowing costs in March for the first time since May 2005 after the annual inflation rate reached the bank's target of 2.5 percent. The inflation rate fell to 1.5 percent in August from 2.6 percent in June.

Food prices rose 2.4 percent in September from August and 5.1 percent from September 2006. House maintenance costs gained 0.3 percent from August and were up 3.5 percent from a year ago.

The zloty also advanced following a pattern we are seeing in other countries as people react to the idea that interest rates might rise by finding the currency more attractive without reflecting on the long term dimension of where all this is leading.

Typical of the sort of response we are seeing is this one quoted in Bloomberg:


``The data should show the need for further monetary tightening in Poland and is likely to push the euro/zloty to new five-year lows below 3.72 today and toward 3.70 this week,'' a team of analysts led by Gavin Friend at Commerzbank AG in London wrote in a research note.



But the real underlying problem is not food prices by growing labour shortages and wages, as was made clear in separate report which showed that average annual wages climbed by 9.5% in September, down very slightly from the from 10.5 percent a year rate regsitered in August. Again, we are not yet at Baltic levels, or even at Bulgarian or Romanian ones by the curve is ascending and the clock on all those labour shortgaes is ticking away inexorably.





Of course, with delicate situations developing all over the EU10 the last thing Poland needs right now is an election, but that is what we are having this Friday. The latest news on this front is that support for the Citizens' Platform - the largest opposition party - rose to a record 46 percent according to a poll carried out by TNS OBOP and published by the Dziennik daily., This would be enough to create a majority government, but matters are far from clearcut, and rolling survey by PBS DGA published in Gazeta Wyborcza daily showed backing for the Platform at 38 percent and for Law & Justice at 37 percent.

Romanian Current Account Deficit and the State of the Leu

It has been some days now since I posted a leu chart. This is largely due to the fact that the downward slide had started to stabilise to some extent, and even had begun to reverse. Indeed the leu rose to its highest level in a month versus the euro last week after data showed inflation quickened in September, surpassing the central bank's year-end target.

The rate of consumer-price inflation climbed to a one-year high of 6 percent, exceeding the bank's year-end target of 4 percent, plus or minus one percentage point.

Florin Citu, deputy head of financial markets at ING Bank Romania is quoted as saying that "The central bank cannot escape raising interest rates....It will be very hard for the central bank to explain if they chose not to raise rates, as inflation is going to reflect in wage requests too."

Personally I feel that this way of reading the inflation data - as being good for the leu if it is bad for the country - is something of a fools errand at this point, since the global markets are in the process of a major re-positioning, and we are all only waiting for Jean Claude Trichet to finally declare that the next move over at the ECB will be down for the whole show to get into full swing.

The real news of the moment is the Bulgarian inflation. The airwaves are rife with speculation following Bini Smaghi's ECB speech about how long those who are pegged to the euro can actually hang out in the current climate, and recent reports from the IMF and the World Bank singling out the labour shortage and current account deficit issues in the EU 10 will hardly help. So my feeling is that the leu will not be left on one side - in a kind of Ocean of tranquility - here. My only major question is which will come first, a run for cover by one of the peggers - Estonia perhaps - in breaking the peg, or a serious attack on the leu. It is hard to say really, but whichever comes first the other will follow soon behind. This is all what you could call a "done deal" now I'm afraid. The other big question is, of course, once it all starts, where exactly will it stop?

Nearly all the news out of Romania is bad at the moment - in the sense of showing ever increasing signs of overheating. The steadily declining unemployment, which means a tightening labour market and hence even more pressure on inflation, can hardly be called good news at this point, welcome as it would be in another moment.

The International Monetary Fund said earlier in the week after concluding a week-long visit to the Romania that inflation will be at 5 percent by year-end and that "inflation prospects for 2008 are worrying". Inflation prospects unfortunately are not the only thing which is worrying.

Against the euro, the leu touched 3.3298 at 6:05 p.m. in Bucharest on Thursday which was its highest level since Sept. 13. Despite this recent rebound however the leu has been the worst performer among emerging-market currencies in the past three months, dropping almost 7 percent as can be seen from the chart blow.




The reaction to financial market stress since the middle of August can be observed in the second chart.




However this placid climate may well be in the process of experiencing a sudden reversal following the release by the National Bank of Romania of Romania's Current Account data for the January-August 2007 period this morning. Although the deficit virtually doubled over the same period in 2006, there is little here to add to the news on the trade deficit last Friday, since, as the bank say in their press release:

In January-August 2007, the balance-of-payments current account posted a deficit of EUR 10,228 million. This development can be ascribed mainly to the wider trade deficit, which amounted to EUR 10,864 million, up 69 percent from the same period of last year.
Romania's trade deficit in fact increased in August 2007 when compared with August 2006 as the elimination of trade barriers following European Union entry and the impact of a stronger currency encouraged Romanians to buy ever more goods from abroad.

The deficit widened to 1.77 billion euros in August from 1.3 billion euros in August 2006, according to the National Statistics Institute at the end of last week (these calculations are based on preliminary data). The actual deficit remained by and large unchanged when compared with the revised deficit of 1.81 billion euros registered in July.




A strong inward flow of funds into Romania (especially including remittances) since joining the EU last January has strengthened the leu, and this has made imports cheaper. The leu - even despite the recent decline - has still gained 18 percent against the dollar and 4.7 percent against the euro over the past year.

In addition Romania became a net grain importer in the second half of the year after months of record-high temperatures and low rainfall badly affected corn and wheat crops. The drought damaged two-thirds of the 6 million hectares of crops planted this year and destroyed about 1 million hectares.

Imports in August rose an annual 18.6 percent to 3.99 billion euros, while exports increased 7.6 percent to 2.22 billion euros. Imports from other EU countries rose 20 percent as exports to the bloc increased 9.1 percent.




In the first eight months of the year, the trade deficit widened to 13.35 billion euros from 8.38 billion euros in the same period of last year. Imports increased 27.5 percent and exports rose 11.8 percent.


According to the central bank, foreign direct investment in the first eight months of the year fell to 4.06 billion euros from 4.3 billion euros in the same period last year. Long-term foreign debt rose 19 percent at the end of August from Dec. 31 to 33.9 billion euros.

At the same time, those of you who doubt the importance of all those Romanians working abroad, should note that money transfers to Romania, which come mostly from citizens sending money home from abroad, rose to 3.49 billion euros in the period from 2.77 billion euros a year earlier.

Here for good measure is a graph showing those Romanians currently registered with the Spanish authorities and living and working (in the case of those of working age, which are the vast majority) in Spain.





The very tiny bars that you can see in red alongside the main bars are the numbers of migrants that the Romanian authorities recognise as being migrants aboroad in the sense of having "permanently" emigrated. Whether they have left permanently or not seems at this moment in time to be beside the point. They are not available for work in Romania, they are sending money home to fuel consumption, and as a consequence of the combination of these two factors inflation is starting to head for the ceiling.

All in all, a pretty bleak situation. Bloomberg again quote Florin Citu, deputy head of financial markets at ING Bank in Bucharest, this morning as saying:

"The deficit this year will be humongous.....The question is whether this will be worked out gradually or by a sudden drop in the leu and a drop in economic growth. If I were a betting man, I would go for the latter."
And I'm afraid I cannot but agree. The leu, of course, was under pressure again this morning, and at the time of writing is down at 3.3397 to the euro. I am convinced that the whole situation in the EU 10 is now unsustainable, and that an important correction is coming, the only real doubt in my mind is whether the correction will start with a run on the leu or with one of the euro peggers - Bulgaria, Latvia, Estonia and Lithuania - making a run for cover and breaking the peg.

Time, as always, will tell.

Postscript


A much fuller appreciation of the imminence of an emerging market correction in Eastern Europe, and the factors which lie behind it, can be found here.

Saturday, October 13, 2007

Is An Emerging Market Correction Coming in Eastern Europe?

According to wikipedia, the noun "correction" comes to us, via the French, from a Latin original corrigěre 'to make straight (again)', and is used to describe an action which can rectify, or make right a wrong. Wikipedia lists a number of possible meanings, three of which are of interest to us here:

  • To set straight an error, clarify a misunderstanding, undo resulting damage; e.g. a correction in a newspaper is the posting of a rectification of a mistake that appeared in a previous issue of the newspaper.
  • To rectify an abnormal state of affairs - e.g. a market anomaly - as occurs, for example, in a stock market correction.
  • A euphemism for a punishment, which may be of various kinds, mainly physical; in institutional terminology specifically used for imprisonment, e.g. correctional facility (prison) or corrections.


Basically wikipedia give us a very reasonable account of the useage of the term "correction", and of its ambiguity in an economic context. "Correction" it seems means both punishment and putting right. What is so unique and so surprising about the coming correction in the East European economies is that it fits the definition of correction in neither of these senses.

In the first, and most obvious case, if there is to be a punishment, then there must have been a crime, right? But where is the crime in the current case of Eastern Europe - unless it is to be some modern variant of original sin - since it seems evident that the only things that policy makers in the EU10 economies have been doing is "following orders", irrespective of whether these came from the EU Commission, the ECB, the IMF or the World Bank. They took the best expert advice available at the time, and they acted on it. Surely they can hardly be blamed - let alone punished - for that. If there have been errors, they are surely human ones, a bit too much public spending here, the odd currency peg or other there, but when we look beyond all this surface detail, and move to the underlying structural level, we find that there is a most depressing uniformity about things. I say depressing, since I do think it is hard to say the Eastern Europe has done much to bring about or deserve the tragedy which is about to unfold and come crashing down upon its head.

If the twentieth century was - for no fault of their own - a bad one for many of these countries, it now seems that the twenty first one - oh horror of horrors - might turn out to be even worse.

Why do I say this? Because many of these countries are quite literally dying, in the demographic sense. And since at the present moment almost all of them - with the honourable exception of Hungary - are working pretty much flat out, it might not be going to far to suggest that they are "dying on their feet" or "dead men running (on empty)" even.

Which brings us back to the second meaning of correction, that of putting straight or "making whole".

Unfortuantely this is just what the coming correction is not going to do. The explanation for why it will not do this will come in the following post, but suffice it to say here that - due to major underlying demographic processes and the impact of migratory flows - the traditional homeostatic mechanisms which operate during economic corrections will not be at work in this one.

That is to say, what is about to happen next in Eastern Europe is about to establish, and I suspect beyond all possible doubt for the company of reasonable men, that the widely accepted neoclassical idea of general economic convergence towards a - even hypothetical - situation of "steady state growth" is quite simply a mistaken and non-valid one. Demography does matter, and fertility with a lag of twenty or so years does seem to be important.

Now lets take a look at why.


The Problem-Set Facing the EU10

Basically the principal outstanding issues confronting the EU10 countries are threefold:

1/. Labour capacity constraints (which are normally a by product of long-term low fertility and large scale recent migration flows) are producing significant wage inflation and strong overheating.

2/. A structural dependence on external financing - which is in part a by-product of the effect of low levels of internal saving, and which is another factor which separates the EU 10 from those like India or China who are benefiting from a typical demographic dividend driven catch up, is leading to large current account deficits, and potentially high levels of financial instability.

3/. A loss of control over domestic monetary policy due to eurozone convergence processes which - with or without the presence of formal pegs - make gradual downward adjustment in currency values as a alternative to strong wage deflation virtually impossible. This issue is compounded by the likely private "balance sheet consequences" of any sustained downward movement in the domestic currency given the widespread use of mortgages which are not denominated in the local currency.

Now the worrying part about all three of these is that they are not simply cyclical in character. As such they are not problems which will "self correct" as a result of a recessionary slowdown, whether this be of the "soft-" or "hard-landing" variety. This problem simply is not being taken into account in many of the current pronouncements on the EU10, and certainly is in no way reflected in the current "fiscal deficit obsession" which we can find in the discourse which exists at EU Commission level (for a consideration of this in the case of the Czech Republic see this post).


The IMF, the World Bank and the ECB


The macro imbalances which currently exist in many of the EU10 economies are substantial, and as I have tried to argue at some length here, they stem from a virtually unique set of circumstances (historically unique I mean, at the present time the underlying dynamic across all the East European EU member states is remarkably similar, with the possible exceptions of Hungary and Slovenia, and in each of these latter two cases for different reasons).

The sad reality is that many of the EU 10 countries (and in particular we are talking here of the Baltic States, Bulgaria, Romania and Poland) are facing, at one and the same time, a very considerable inflow of external funds to fuel domestic consumption (whether this be in the form of the bank flows which drive the supply of cheap credit, or the worker remittances which drive the demand for it), and a very significant reduction in the potential labour supply following a couple of decades of below replacement fertility, and a large and sustained outflow of migrant workers which has accompanied EU accession and which is driven by the very large East-West wage differentials. Put another way, demand side factors are increasing rapidly, while supply side capacity ones not only are unable to keep pace, but are actually shrinking (if we think about the number of people of working age in the total population, and of the proportion of these who are available for work inside the country).

In recent weeks a variety of players on the international economic stage have been active in pointing to the mounting problems which are now only to obvious to the trained macro economic eye.

In the first place the World Bank, in its most recent report on the economic outlook for the EU 10, had the following to say about the labour shortage situation:


Unemployment has fallen substantially in virtually all EU8+2 countries since 2004 due to strong growth in labor demand. This has given rise to skill shortages and associated wage pressures, often amplified by out-migration of EU8+2 workers.....

In contrast to the earlier period of weak labor demand it is now the supply side of the labor market that constrains new job creation. Many persons of working age are economically inactive in EU8+2 either because they lack skills demanded by employers, or because of labor supply disincentives, such as early retirement benefits, generous disability schemes, high payroll taxes, and limited opportunities for flexible work arrangements. These effects are concentrated among the younger and older workers, while the participation rates for middle aged workers are similar to those of the EU15. Hence the main challenge facing now EU8+2 is to mobilize labor supply to meet the demand.


Really anyone seriously interested in this problem needs to read the whole report, but the above, in essence, is one part of the picture.

Then, earlier last week, the IMF published the autumn edition of its World Economic Outlook, and Chapter 3 - Managing Large Capital Flows - to some extent focuses on the current problems of Eastern Europe. According to the IMF the economies of eastern Europe are vulnerable to a reversal in the surge of private capital that has poured into emerging markets in recent years. The IMF says that "large capital inflows are of particular concern to countries with substantial current account deficits, such as many in emerging Europe", as well as countries with inflexible exchange rate regimes (and among these are, of course, to be found four EU 10 members: Estonia, Latvia, Lithuania and Bulgaria).

Eastern Europe is in fact the only region singled out by the IMF in this way as being particularly vulnerable to a change in the direction of private capital flows at this point in time. While the IMF draws the fairly comforting conclusion that most emerging markets now have much stronger and more defensible current account positions than they did in the late 1990s - since they have been steadily building up their foreign exchange reserves during the good times - this is not the case with most of Eastern Europe. Gross capital inflows into the region have reached levels relative to gross domestic product that are "unprecedented for emerging market countries in recent history" while "unlike in other regions…net capital inflows have been accompanied by a deteriorating external position".

So, I would say, we have been warned. It couldn't get much clearer than this.

Lastly there have been a number of recent indications that over at the ECB people are not all that calm about what is happening at the moment. The most recent example of this unease is to be found in a speech given by European Central Bank board member Lorenzo Bini Smaghi where he specifically identified the fixed exchange rates in Bulgaria and the three Baltic states as part of the cause of the accelerating inflation and current-account deficit problem which exists in those countries since the currency board arrangement limits the central banks' ability to control the rate of price and credit growth. According to Bini Smaghi:

Keeping nominal convergence on track is the main policy challenge in the region. The problem becomes particularly acute in countries which have given up monetary policy independence by choosing an exchange rate target or adopting a currency board arrangement.

The key question for these countries is: how is it possible to keep inflation under control by pegging the exchange rate, which means adopting de facto the monetary policy of the euro area, especially since the euro area economy is growing at a rate that is less than a third of what a catching-up economy should aim to achieve? In other words, how is it possible to keep inflation under control with very low or even at times negative real interest rates? What are the risks for financial stability of having persistently low real interest rates, much lower than the rate of growth of the economy?......


Bini Smaghi has it right, the key question for the EU 10 countries is how to maintain the levels of "catch up" growth which would enable them to close the gap in living standards which exists between East and West, and how to do it, so to say, when they don't have the raw material (in terms of labour supply) to hand to aid them in this.

So, at the risk of repetition, there are three large and oustanding problems to be faced in Eastern Europe now.

1/ The labour shortages issue

2/ The capital flows, current account deficit, dependence on foreign investment, non local currency denominated debt issue

3/ The currency peg issue, in the case of the four countries which are on a peg, or the rising real exchange rate one in some of the countries which aren't like Romania, Poland and Hungary. Given the dependence on foreign lending for survival, the difference at the end of the day is not significant between these countries, with the possible exception of the fact that any attempt to break the peg by one of the four countries who have one could prove to be a very dramatic event, and indeed could serve as the immediate signal for setting off the whole large scale "correction" which is so evidently in the process of coming. It's in the post, as it were.

In this situation the only real tool left to the domestic authorities is the generation of fiscal surpluses to try and reduce domestic demand, to try, as it were to dredge domestic demand from the system. But if this is not to remain something akin to draining the ocean with a soupspoon these surpluses need to be very large indeed. The IMF has been arguing for a surplus of 4% of GDP in the Latvian case, and it is far from clear that this in itself would have been sufficient (I say would have been, since, of course, the closing down of the credit mechanism which is being already operated by the banking system may well now make this unnecessary, and this closing down is happening very rapidly indeed, as Latvian abroad makes plain here). Naturally the local authorities - not really grasping the gravity of the situation, and who can blame them since who really anticipated the severity of this problem - have flinched in the face of introducing such severely deflationary fiscal surpluses. As Bini Smaghi says:

"I guess the real question to ask is: how large should the budget surplus be to counteract the inflationary effects produced by a pro-cyclical monetary policy and would this be acceptable for a catching-up country? How far reaching, and acceptable to the population, should structural reforms be? All in all, the requirements for the budgetary and structural policies associated with an exchange rate linked to the euro might just be too demanding to counteract the procyclical effects of very low real interest rates. This might lead to boom and bust cycles, with potentially very severe adjustments costs that may delay real convergence."


I entirely agree, and what we are faced with here are a whole new set of problems for monetary policy, ones which were not at all anticipated when the euro was set up, or the new members accepted into the EU fold.

Why Doesn't Homeostasis Operate?

And so to finish where we started. This correction will not correct, at least it will only correct in the punitive sense, since little that is good can come out of the affair. To understand why this is you need to look at the population pyramids of the various countries involved.

To help make this a bit plainer I have comparative pyramids for Ireland and Latvia online here. This comparison basically is to illustrate why a country like Ireland was able to get a demographic dividend which facilitated so much rapid catch-up growth, and why Latvia isn't.

Now if we look at the pyramid for Turkey in 2000:



and if we now compare this with pyramid of Latvia's population in 2000, we should be able to see straight away why Turkey could correct rapidly, and why Latvia will not be able to.




Essentially if we look at the size of the "10 to 14" and "15 to 19" generations in comparison with the "20 to 24" one in both cases. Think of water running down a river, and the recession/correction as a kind of dam you place across the flow. In the Turkish case closing the dam gates causes the water to back up in the system and accumulate, ready to be subsequently released as part of a flood which due to its volume maintains wages at a very low level, which is exactly what we have just seen take place in Turkey post 2000.

If we look at a chart of Turkish GDP growth from the late 1990s we can see this process at work very clearly:



During the years 2000 to 2002 the Turkish economy underwent a correction in the true sense of the word. There was a problem, and it was corrected. The evidence for the effectiveness of this correction can be seen in the subsequent growth rates, and even, as I explain in depth in this post, from the way in which the Turkish economy has rebounded from the currency crisis of the summer of 2006. The Turkish economy is now reasonably robust, and one of the reasons that it is so robust - given that it has made more or less similar structural reforms to all the economies of Eastern Europe - is that it has the demographic winds behind it, and not, as in the EU 10 case, blowing into its face.

In the Latvian case, on the other hand, (and for Latvia here, of course, read any one of the other EU 10 countries which you please) stopping the flow temporarily doesn't correct the problem since in each time period there are progressively less people arriving to the gates of the labour market dam. It could even be that the correction here may only make matters worse, since it could in fact send many more potential workers out of the country in search of work. So far from bringing wages back into line with a competitive level, wages could in fact get "stuck" and only adjust downwards slowly, far too slowly to generate the new employment which will be needed to seriously restart the economy.

This is also why all those comparisons between what is happening in the Baltics now and what happened in Scandinavia in the 1990s miss the central point, since the demographic situations of the countires involved was very different.

Of course the EU10 still have the potential labour force left to get economic growth, what is in question is where they are going to get the labour supply from for the very rapid rates of catch up growth they obviosuly want and need.

And all of this has been a very long and tortuous way of saying that (and to answer my own question) yes, I think a correction is coming, indeed it is already arriving, and it will be a serious one whose impact will be felt right across the eurozone. But at the end of the day it may well not do what corrections by their very nature are supposed to do, namely correct.


References

By the very nature of the limitations of a blog post, a lot of assertions have been made above which are, to some extent, in need of substantiation. Below I list a number of previous posts where some of the issues raised are treated in more detail.

Firstly, the issue of neo-classical growth, and why this is important. A good starting point on this topic would be this post here.

It has been asserted that the EU 10 economies are overheating due to labour shortage problems. This is explained in the Latvian case in great depth here.

Claus Vistesen does a similar job for Poland here, and for Lithuania here.

I have examined Romania in depth here, and Bulgaria here.

As has been argued, in fact not all the EU 10 economies are by any means identical, and the problems do vary. Despite sharing a similar demography with the rest the cases of the Czech Republic and Slovenia seem to be very different. One of the factors at work here is undoubtedly the existence of migratory flows within the EU 10 themselves, and in this sense not all will or need to follow the same trajectory (although of course at the end of the day the numbers simply don't add up, so there will be losers as well as winners). I have made some initial attempt to look at the situation of the Czech Republic here.

Hungary is again a very special case, and is certainly not overheating at the present time. I have a whole blog dedicated to trying to understand what is happening in Hungary and why it is so different, this post and this one might be a good place to start.

One common assumption is that labour shortages in the EU 10 can be met over the longer term by inward migration from other parts of the old Eastern Bloc like the current CIS countries. Immigration may well be part of the answer for the EU 10, but the CIS itself is unlikely to be a durable source of supply here, basically because a large part of the CIS has a similar demographic profile. This post goes into the Ukraine situation in some depth, and here is a link to some work by Russian economists who advise the World Bank, and who argue that Russia may well be already in need of around a million migrants a year if she herself is to be able to maintain current growth rates.

I even went so far as to check out Uzbekistan, since many seem to think that these Asian members of the CIS might be better placed, but unfortunately my conclusion was that with all the demands which are being placed on them, and all the money which is heading back home in remittances to fuel growth it won't be long before they run out too.

Finally, if you have gotten this far, all I can say is thanks for your time, and good luck and good reading.