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Wednesday, July 30, 2008

Polands Central Bank Holds Interest Rate Steady In July

Poland's central bank kept its benchmark interest rate unchanged today as the economy slows and it anticipates inflation falling back. The Narodowy Bank Polski left the seven-day reference rate unchanged at 6 percent, after previously raising it four times this year.

The Monetary Policy Council has been struggling for nine months to bring down the inflation rate, at a four-year high of 4.6 percent in June, to its 2.5 percent target. Slower-than expected employment growth, retail sales and industrial output in June indicate the economy is losing steam and the central bank said this may damp inflation. Annual wage growth in Poland's corporate sector accelerated to 12.0% in June, above forecasts and up from a 10.5% rise in May. On the month,average wages were up 4.8%, following a 2.2% monthly decline in May. Total employment at firms with more than nine employees was running at 5.39 million in June, up 4.8% on the year. That annual rise was below the February peak of 5.9%, and suggests job creation in Poland is now starting to slow.

The economy expanded an annual 6.1 percent in the first quarter, down from 7.3 percent at the beginning of last year and 6.4 percent in the fourth quarter.

The 10.8 percent rise of the zloty against the euro, which has converted the zloty into the world's second-best performing emerging market currency this year, has also helped keep inflation in check. The June inflation rate of 4.6 percent was driven mainly by a 3.3 percent monthly gain and an annual 7.5 percent advance in fuel prices, which policy makers cannot control.

The Baltics - Moving Closer to a Correction?

By Claus Vistesen Copenhagen

Last time I had the Baltics under the spotlight I asked two overall questions. The first dealt with the extent to which the Baltics had entered a recession in the beginning of 2008 and the second question surrounded the risk of the Baltic pegs to the Euro. This time around and with the recent Q2 GDP release from Lithuania it would be nice to revisit the first of these questions. And with the market focus looking to shift from inflation to growth the second question is likely to become in vogue once again.

As the Q1 GDP numbers came in for the Baltics I concluded that it was very likely that the region had entered a recession. In light of the proverbial definition of a recession as a consecutive quarter contraction it seems clear the Lithuania managed to smartly skirt the recession in H01 2008. As far as I can see at this point and from Eurostat's data Estonia was the only one of the three Baltic economies that contracted in Q1 2008 (-0.5% and 0.1% for Latvia).

However and as ever before, the Baltics is increasingly getting stuck in stagflation and one of a particular sinister kind. In the case of the Baltics they may already be seeing the beginnings of a hard landing, whereas others continue to build up steam making it almost inevitable that they too will erupt at some point.

As can be observed, Lithuania just managed to avoid a contraction in Q1 and rebounded nicely in Q2. Yet, in light of the run-up to these numbers and the fact that Lithuania, on a y-o-y basis, grew at its lowest rate since 2004, I have little problem in maintaining my view that this is a hard landing. As for the break up of Lithuania's position it is a bit difficult to tell since the components do not feature seasonally adjusted figures. However, it seems that especially companies paired their investments going in to 2008 while consumers are still going strong. All three forward looking indicators in the form of confidence measures show that the expected trajectory of overall momentum is firmly down.

The other graphs reveal with some clarity I think that the Baltics may now be entering a whole new different growth dynamic with inflation and wages continuing their upward drift at one and the same time as growth is faltering. In this way, it is hardly about the potential recession and slowdown itself but about the economy, and growth rate, which will emerge. This point is similar to one I made recently in the context of the Eurozone and I do think it is important to realize the hole some of the CEE economies are about to dig themselves out of. In fact, depending on the reversion into wage and asset price deflation I would say that this slowdown marks a significant structural break in these economies' growth path.

Consequently, there is simply no way in which these economies can muster the inflows they have been receiving, and many face a decisive need to turn the boat around and become export dependent. The key link will be the extent to which we, absent a currency to devalue, will observe wage deflation to reign in the external position. Consequeuntly, with a fixed exchange rate to the Euro and an extremely wide external position the only way a correction can come is then through severe wage and by consequence price/asset deflation. The alternative would of course be to the abandon the pegs but that would then open up Pandora’s box as the currency most likely would plummet to reflect the external balance leaving Baltic consumers with Euro denominated loans and cash flows in domestic currency (get detailed argument and analysis here, here and here).

Another crucial link here would be Scandinavian banks who are effectively supplying these Euro denominated loans and thus how they, effectively, are financing the external deficits. We have thus on several occasions been hearing faint but rising voices about how, in particular, Swedish banks are exposed to the Baltic slowdown.

In a recent detailed analysis John Hempton from Bronte Capital serves up some nice points on the whole situation. What is particularly interesting is that he takes the time to scrutinize the books of Swedbank who is operating its subsidiary Hansabank which is, by far, the biggest foreign bank in the Baltics.

One of the important points to latch on to was the one conveyed in my last look at the macroeconomic balance sheet of the Baltic economies. In this analysis I showed that while loans in local currency are now falling on a stock basis (i.e. the amount of loans being paid out or written off outnumber the number of new loans taken out) it is still growing in Euro denomination effectively keeping growth in the overall stock of loans in the positive; even if the trend is inexorably down. Once I have Q2 data for all the Baltic economies I will post briefly on the development.

Yet, if you dig into the Q2 accounts of Swedbank (who are operating under the branded name Hansabank in the Baltics) you will see that they are still churning out positive growth rates in lending in Q1 and Q2. Over the course of H01 2008 Swedbank consequently expanded their lending operations with 7% in the Baltics and over the entire year, this number stands at 21%. If we compare this to the growth in deposits in the Baltics the H01 figure is 1% whereas it is 11% over the year. As such, levering of the balance sheet continued in H01 2008. In short, lending growth is still positive and the leverage multiple measured as the value of lending over deposits is growing.

I don't think it is entirely outlandish to draw a line between my initial results derived from macroeconomic data to these results from one of the biggest players on the Baltic finance market. Personally, I don't see how the growth rate can continue to stay in positive territory and this is especially the case since net interest income is now beginning to decline, if ever so slowly.

In the context of cooking, as it were, the books of Swedbank Hempton makes another interesting observation in his piece.

So what happens next?

Well if the Lati devalues (as would seem inevitable) then Hansa Bank has to pay Euro to Swedbank – and as its assets are in Lati it would be insolvent.

If the Lati doesn't devalue its only because people (i.e. Swedbank) are prepared to continue to fund it. This is not pretty at all. All in Hansa owes Swedbank over 30 billion Swedish Kroner – all denominated in Euro and which can't be paid. The equity capital of Hansa (roughly 7 billion Swedish Kroner) is also going to default.

This is a very big problem for Swedbank. Swedbank's equity is 68 billion SEK – but 20 billion is intangibles. Swedbank is probably solvent at the end of this – but only just. Swedbank will (at best) lose its independence. Swedbank is in turn wholesale funded – and the chance of it becoming Swedish Government property is not low.

Having lent that much to a country with a phoney fixed exchange rate in a currency they can't print – Swedbank management deserve it. Bad things happen to bad banks and this is a bad bank.

Now, Mr. Hempton certainly does not mince his words and even though he may come off as wing nutty the point being made is actually quite simple and valid. What he effectively is doing then is to move the perspective down a notch from the obvious macroeconomic crunch that would ensue as consumers defaulted on their loans to the predicament which would arise in the context of Swedbank's books.

What it means in macroeconomic terms is if the translation risk issue blows up, which it potentially will in the context of wage deflation (i.e. this would force down the pegs), Hansabank would effectively be screwed. Sorry for my harsh tone, but I cannot see how they could shore up their balance sheet unless the ECB moved in with a kind of 1:1 guarantee which let the Baltics de-facto adopt the Euro with one swoop. Now, if Hansabank goes, and this seems to be Hempton's argument, so could Swedbank and by derivative the inflows used to fund to external deficit to the Baltics. And then we are into the big royal mess.

Also, one could easily imagine a rather advanced game of Old Maid. Consequently, if Hansabank et al. suddenly move seriously into the ropes, de-pegging would almost certainly mean a significant write-off of Euro denominated loans. In this case, the Baltics may neatly shift some of the heat on to Swedbank who, almost certainly, will be running to the Riksbank and then perhaps on to the ECB.

Ultimately, I think the Baltics will fight long and hard against devaluation and much will depend on the severity of the correction. It may end up a perfect storm for them, but I want to stress that this would require the ECB to step in with some kind of de-facto, behind the curtains, guarantee to the currency board. That is to say, the ECB or the Riksbank would need to foresee the chain of events above (or a derivative thereof) and nip it, preemptively, in the b*t so to speak.

Quit With the Dooming and Glooming Already?

Uff that was some outlook was it not? I should immediately point out that much of this represent musings and it is still quite difficult to see where it ends. However, I have pointed out the shaky links between Scandinavian banks and the Baltics more than once before, so it should not come as a big surprise that I am massaging this topic.

If we move up the perspective to macroeconomics, the points above relate to a more general point concerning the Baltics and the manner in which the current imbalances potentially will be corrected. This consequently lays out a path well trodden here at Alpha.Sources. As the rest of the CEE countries, the Baltic economies have quite simply been converging too fast given their underlying capacity (read: demographic) constraints. In fact, given the loop sided nature of almost all CEE economies after two decades worth of lowest low fertility the whole convergence hypothesis was always going to hit shallow waters. As such, and coupled, in the past 5-6 years, with significant outward migration, these economies have quite simply been administering a growth strategy wholly incompatible with their underlying fundamentals.

This obviously does not mean that Eastern Europe will sink into the ground, but it does mean that a correction is due; both in terms of expectations and the trajectory of economic fundamentals. Note in passing here especially how this will affect Germany's ability to leverage its export muscle towards its Eastern borders. In a more broad policy oriented context I have also been amazed, even if I can understand it, with the push to de-peg from the Euro and subsequently raise interest rates. Sure enough, when you have imported inflation you want a strong currency but in administering this kind of policy you are also assuming that the implied process of nominal convergence can be speeded up; almost as if the CEE economies could attain nominal convergence with EU15 in one clean and bold sweep.

Conclusively, my guess is that while Q2 data will tell give us important forward looking indicators Q3 and Q4 may be where the real action is. As per reference to my points above I am watching FX markets in particular and, in the case of the Baltics, the link with Scandinavian banks and the potential ways in which these economies can correct.

Tuesday, July 29, 2008

Construction and Forex Lending Still Booming In Romania

Romanians were awarded 6 percent more homebuilding permits in June than in June 2007 as higher wages and a lending boom continued to drive construction activity. The government issued 6,137 homebuilding permits last month, compared with 5,791 in June 2007, according to the latest data from the National Statistics Institute. Month on month permits awarded were down 2.4 percent from May.

Rising wages, a lending boom and growth in real estate prices have given Romanians more money to invest in housing. Wages increased an annual 23.3 percent in May:

Bank lending continued to drive up debt - both corporate and household - at a very fast annual rate again in June, according to the latest data from the Romanian central bank.

In June 2008, totat non-government credit grew 3.7 percent, or 3.4 percent in real terms, from May 2008 to reach RON 178,180.2 million. RON-denominated loans went up 2.1 percent (1.8 percent in real terms) and foreign currency-denominated loans rose by 5.0 percent when expressed in RON and by 4.3 percent when expressed in EUR.

At end-June 2008, total non-government credit was up year on year by 63.4 percent, or 50.5 percent in real terms, on the back of the 40.0 percent increase in RON-denominated loans (28.9 percent in real terms) and the 89.3 percent advance in foreign currency-denominated loans expressed in RON (when expressed in EUR, forex loans expanded by 62.7 percent).

Romania's construction industry, including commercial and engineering works, expanded an annual 34 percent in May, the fastest pace in the EU.

Hungarian Employment and Unemployment Both Drop In Q2 2008

Employment and unemployment both fell in Hungary in the second quarter of 2008. The solution to this othwise brain-baffling enigma is, of course, that Hungary now has an ageing and declining population, this falling unemployment is completely compatible with very low economic growth and large numbers of people leaving the labour force at the upper end in order to retire.

Hungary's unemployment rate declined in the second quarter from the first to a seasonally adjusted 7.6 percent, which compared with the 8 percent registered in the January-March period, according to the national statistics office (KSH) in Budapest earlier today.

The number of Hungarians employed at 3.87 million was up over the 3.84 million in the first quarter but down when compared with the 3.94 million registered in the second quarter of 2007. The last time the number of employed in Hungary was this low during the second quarter was in 2002. The number of employed was down by over 70,000 since end-June 2007, while there were some 20,000 more unemployed and 50,000 more inactive people in April-June than in the same period of 2007.

Thus we find that more than 50,000 people have “disappeared" from the Hungarian labour force in the space of a year.

So the central bank now has a problem, since as people leave the labour market to retire the labour market also tightens, reducing the room for monouevre in reducing interest rates due to the continuing pressure on wages, even as economic growth approaches stagnation point.

Sunday, July 20, 2008

Poland's June Industrial Output Rebound and Tame Producer Prices Lower Rate Rise Prospects

Expectations the Polish central bank would increase rates in the coming months eased back slightly this week following better than expected producer price numbers, and a rebound in industrial output which was lower than analyst expectations. And this despite the fact that consumer price inflation continues stuck significantly above the banks target.

According to data released by the Polish statistical office Poland's industrial output rose 7.2 percent year-on-year in June (see chart above), while the rate of increase in producer prices held constant at 2.7 percent year-on-year (see chart below).

Folllowing publication of the data Monetary Policy Council member Andrzej Slawinski is quoted as saying that the level of interest rates would now largely depend on the zloty.

"What is going to happen with the interest rate level will largely depend on the changes in the zloty exchange rate," Slawinski, seen as a moderate on the 10-member MPC, speaking to TVN CNBC.

The zloty - which was little changed after the data - has gained almost 4 percent against the euro in July alone and is up more than 10 percent since the start of the year.

Poland's Monetary Policy Council has raised rates eight times since April 2007, bringing the key rate to the current 6.0 percent in response to the booming economy, growing inflation and a tight labour market.

June consumer inflation stood at 4.6 percent year-on-year, above the central bank's 2.5 target.

However, not everyone is convinced about the inflation outlook, and Halina Wasilewska-Trenkner, a hawk on the 10-strong policy panel, told daily Rzeczpospolita during last week that although the zloty was probably too strong it was difficult to determine the level of excess, and hence the bank should continue to tighten monetary policy.

"Maybe growth is not as dynamic as last year but it is still robust growth," she said.... "I think that in the second quarter it could have been at about 5 percent but there is still a chance that the result for the whole year will be slightly higher. I believe that we should tighten monetary policy more,"

Also monetary policy maker Dariusz Filar argued on Friday that the Polish central bank should immediately raise its main interest rate by at least a quarter of a percentage point to cap inflation. The new core inflation rate, introduced three months ago, and which strips out food and fuel prices (thus giving a better reading on the state of domestic demand) - was probably a "bit too high'' in June (at 2.2 percent) and thus Narodowy Bank Polska's 6 percent seven-day reference rate was not enough to adequately cap price growth.

``That's why an immediate reaction is needed,'' Filar said in an interview on Friday in Warsaw. ``Waiting too long with a change of interest rates may cost us in the future in the form of a higher inflation rate.''

Central bank policy maker Halina Wasilewska-Trenker has also added her voice to the debate. Wasilewska-Trenker stated in an interview with a Polish news agency this weekend that Poland's 6 percent interest rate should be raised as slower-than-expected industrial output data last month provided no proof of an economic slowdown. ``Eonomic growth is still robust,'' ....Poland is ``far from a rapid slowdown,'' she added.

Monetary Policy Council member Marian Noga also feels the Polish central bank should raise interest rates even as economic growth slows because accelerating inflation is only going to prompt demands for higher wages. Noga alos expects freeing energy prices as of next year will drive up inflation to almost 5 percent in January before slowing to below 3.5 percent in the middle of 2010.

``The faster-than-expected economic slowdown would have dismissed the need for interest rate increases if wages hadn't risen at such a quick pace,'' said Noga in a July 18 interview. ``Since second-round effects have emerged, policy tightening must be continued.''

``We realize that our decisions impact on the zloty but it can't be an obstacle for us,'' Noga said. ``It's not the zloty behind the slowdown, but the weakening global economy.''

Poland's Monetary Policy Council has ten members in total.

Wednesday, July 9, 2008

Russia's Consumption-Driven Inflation: Will It All End In Tears?

Russia's inflation rate remained tantalisingly frozen at its highest in more than five years in June as energy and food prices continued to move on upwards. Russian consumer prices were up 15.1 percent from a year ago - matching the rate in May- according to data released earlier this week by the Federal Statistics Service.

As a result he Russian government is struggling to bring inflation down towards it's 10.5 percent target after increased income from rising global energy prices boosted domestic demand and made possible 300 billion rubles ($13 billion) of extra government spending on items like pensions and state wages in the run up to last December's elections. The result has been a massive surge in consumer spending and construction activity which has pushed the rate of expansion in the Russian economy above its long term "comfort" capacity level.

In this post we will look at the general macro economic situation of the Russian economy, and we will see that, with output in the resource sector effectively at or near its peak, the main drivers of Russian growth are now construction and domestic consumption. Since long term labour supply issues mean that Russia is unable to comfortably grow at its current rate of expansion the end product is rising inflation and structural distortions in the development of the manufacturing sector. Policy limitations at the level of fiscal demand management and exchange rate adjustment mean that this whole process is only being accelerated rather than contained and as a result the living standards improving boom could easily, under unfavourable circumstances, be converted into precisely its opposite: an impoverishing bust.

Inflation Hits the Poor Hardest

Welcome as the current rises in living standards are in a comparatively poor country like Russia (see dollar wage chart below), inflation running at the rate Russia now has is certainly not to be sniffed at.

The price of bread has risen 41 percent since June last year, pasta is up 51.3 percent, and milk 35.3 percent. Month on month, petrol costs rose 4.3 percent compared to a gain of 3.5in May. World Bank research suggests that the impact of the world food price shock on Russia has been significant, and has greatly complicated disinflation efforts. In particular the poor (and the poorest regions) have been disproportionately affected. Over the past 5 years, food prices in the Russian Federation have grown much faster than non-food prices. Food price rises accounted for some 82 percent of the overall rise in CPI between July 2007-March 2008, with food prices rising, on average, almost 15 percent (see chart below).

(Please click on image for better viewing)

Contrary to a widespread perception that food inflation mainly affects the more prosperous regions, data from the World Bank shows that food priceshave increased the most in the Volga region, and least in the Far East Federal Okrug. In general, food inflation in western Russia has been higher than in the eastern regions. But the World Bank’s preliminary simulations of the poverty impact of this food inflation shock (based on the international poverty line of $2.15 per day) suggests that, other things being equal, the food price spike could raise Russia’s overall national poverty and vulnerability rates by 1.2 and 4.3 percentage points respectively—resulting potentially in 1.7 million more people in poverty and an additional 6 million vulnerable to poverty, respectively.

Overheating A Problem

At the same time there is now extensive evidence that the Russian economy is overheating. The IMF in their June 2008 Article IV Consultation Report mention three factors: i) the fact that inflation has almost doubled over the past year and now extends well beyond food and energy price increases; ii) domestic demand is increasing at an annual rate of 15 percent in real terms, while GDP is growing at 8 percent, a rate which is somewhat above the level that can be maintained without causing accelerating inflation, according to estimates by both Russian and IMF experts; iii) resource constraints have now become strikingly evident in labor markets, where shortages are causing real wage increases of about 16 percent annually, well above growth in labor productivity (see chart below), and unit labor costs are now rising steadily. Domestic resource constraints are also evident in the rise in import volume growth to almost 30 percent annually.

The World Bank basically take a similar view, and point out that the Russian Economic Barometer index of industrial capacity utilization has risen from 69 in 2001 to 81 in March 2008 (with 42 percent of the firms surveyed for the index reporting utilization of over 90 percent). Also, an index of labor utilization has increased from 87 to 94 with three quarters of firms showing utilization rates of over 90 percent. Meanwhile unemployment was running at 6.1 percent at end of 2007 - its lowest level since 1994.

Systematic Labour Market Tightening

Unemployment has been falling steadily since 2003, while real wage growth has been accelerating beyond labour productivity growth since 2004. Aggregate unemployment statistics for the first quarter of 2008 present a picture of continued tightening in the labor market. The average unemployment rate (using the ILO definition) was estimated at 6.6 percent for the quarter. This compares with 7.0 percent during the first quater of 2007 (see chart below for a month by month breakdown).

The level of unemployment, however, varies significantly from region to region, and reflects the large differences which exist in the underlying levels of economic activity. In 2006, for example, the lowest unemployment was registered in the Central Federal Okrug (4.1 percent), and the highest in the Southern Federal Okrug (13.7 percent).

At the same time Russia's robust economic growth has been accompanied by double-digit increases in real incomes and wages. According to Rosstat, average real wages and real disposable incomes increased by 13.1 and 11.8 percent, respectively, during the first four months of 2008.

This growth in real wages and incomes, however, significantly exceeda real GDP and productivity growth, giving yet one more sign of the presence of overheating, and indicating the possibility of producing long term structural damage. Almost all sectors of the economy have been reporting increases in real wages well above 10 percent level, with the largest gains taking place in the public sector, and in retail trade and construction (16-17 percent). The average monthly dollar wage was standing at 649.4$ in the first four months of 2008, an increase of 41 percent over the same period of 2007. This massive rise partly reflects real wage increases, partly inflation and partly nominal appreciation of the ruble against the dollar.

Russians have by now become accustomed to very rapid real income growth - of the order of 15% a year. This is more than twice the recent growth rate in labour productivity (see chart above). In one respect, this disparity has been sustainable: since oil prices have risen strongly, rapidly improving terms of trade have allowed real aggregate demand to outpace the growth of domestic production. However, this does not negate or ameliorate the problem of rapidly rising unit labour costs, or the knock on consequences for the real effective exchange rate, or the difficulty presented by distorting Russia's economic development towards resource extraction and away from the development of a healthy manufacturing industrial base. Also Russians, as I say, are becoming accustomed (and ill accustomed) to such ongoing increases, irrespective of whether they are sustainable, or justified by rising productivity, and this "detach" from the underlying reality in the mind of the average worker is in and of itself a worrying development. Thus reports of strikes and other worker protests indicate increasing worker activism in pursuit of higher pay or other benefits are now becoming commonplace. This is not surprising, as shortages of skilled labour are now becoming quite general, and the overall pool of manpower is on the verge of shrinking as Russia's population enters long term decline.

Meanwhile Russia’s short-term economic growth has been steadily accelerating above its long term trend. In 2007, the economy grew by 8.1 percent on the back of higher global oil prices, robust domestic demand and strong macroeconomic fundamentals. Preliminary data indicate an even faster real growth in GDP (8.7%) and industrial production rising by an annual 6.2 percent in the first quarter of 2008. Again the monthly Key Economic Activities index prepared by the Bank of Russia gives us a pretty clear snapshot.

Fiscal Concerns

One of the problems which both the World Bank and the IMF draw attention to is the way in which domestic demand pressures are being exacerbated by the presence of a procyclical fiscal policy. Ideally, with inflation roaring away, the economy showing strong signs of overheating and monetary policy having inherent limitations, fiscal surpluses are the only effective bulkhead available for restricting the long term damage that an extended period of over-capacity growth might cause.

Recent experience, however, raises serious doubts about the ability of those administering the Russian economy to appreciate the importance of this point. Primary expenditures by the Russian federal government were up by 15 percent in real terms in 2007, while the non-oil deficit - excluding a one-off collection of tax arrears from Yukos - rose by 0.8 percent of GDP. And a further relaxation in the fiscal stance is underway this year.

While it might be argued that the relaxation is limited in comparison with the size of the share of taxes from the oil and gas sector that are being saved as reserves against the future, there is little justification for any kind of fiscal loosening at a time when strong private demand and rapidly raising food and energy prices are already sending inflation through the roof.

The general government surplus declined to 6.1 percent of GDP in 2007, from over 8 percent in 2005-2006. There is also a growing vulnerability of the budget with respect to oil revenues. The fiscal surpluses continue in 2008, but they are coming down fast, making any disinflation process much harder. According to preliminary estimates for the first quarter of 2008, the Federal Budget generated a surplus of 549 billion rubles, or 6.6 percent of GDP on a cash basis, compared to 7.3 percept surplus during the same period of 2007. Record high oil prices helped the Russsian government generate 1.932 billion rubles (or 23.4 percent of GDP) in Q1, and these exceeded by a considerable margin the revenue target stipulated in 2008 Budget Law (20.7 percent). Federal Government spending has so far totaled 1.383 billion rubles, or 16.7 percent of GDP on a cash basis, compared to 17.7 percent stipulated in the Budget Law for 2008, but pressures are building up to spend additional windfalls on the oil account without paying too much attention to the likely impact on inflation of doing so.

The recent revision to the 2008-2010 three-year federal budget envisages further relaxation in the fiscal stance. In February 2008, the government approved the amendment to the 2008 Budget Law that foresees an increase in noninterest expenditures by 310 billion rubles and a further decline in projected fiscal surpluses to 3.0 percent of GDP in 2008, and to only 1.0 percent in 2009-2010. Non-oil deficit is projected to be about 6 percent of GDP in 2008-2009, and 5.1 percent in 2010, and this will mostly need to be covered by transfers from the oil and gas account.

Structural Distortions In the Economy?

The structure of Russian real GDP growth has shifted significantly towards non-tradeable sectors in recent quarters, partly reflecting booming domestic demand and the appreciating real effective exchange rate of the ruble. There has decline in the relative importance of resource extraction - oil output has stopped rising, and was 1% down year on year in June - and an increasing dependence on imports and construction. In the earlier years of this century, and in particular during 2003-2004, oil and some industrial sectors were the key engines of economic growth. From 2005 onwards, however, the expansion has largely been driven by non-tradable services and goods production for the domestic market, including manufacturing goods. In 2007 the wholesale and retail trade alone accounted for almost a third of the overall economic growth. Booming construction and manufacturing contributed another 30 percent. Within the industrial sector, manufacturing - which is largely directed towards the domestic market - was a key driver, expanding by 7.4 percent in 2007, compared to only 2.9 percent in the previous year. In contrast growth in the resource extraction industry has virtually ground to a halt, reflecting binding capacity constraints and the comparative remoteness (and cost) of new deposits.

The World Bank in a 2007 study entitled “Unleashing Prosperity: Productivity Growth in Eastern Europe and the former Soviet Union” documented how Russia had experienced a strong productivity surge over the period 1999-2005, a surge which significantly increased headline economic growth at the same time as raising living standards. Total factor productivity growth of 5.8 percent was the motive force behind annual average GDP growth in the region of 6.5 percent. In part this productivity surge is explained by the utilization of excess capacity, but it is also attributable to major structural shifts in the economy and the reallocation of labor and capital to more productive sectors. In addition, efficiency gains within firms were found to have accounted for 30 percent of the total growth in manufacturing productivity over the period 2001-2004. Firm turnover (entry of new firms and exit of obsolete ones) accounted for 46 percent of manufacturing productivity growth. The main contribution to manufacturing productivity growth came from the exit of obsolete firms, releasing resources that could be used more effectively by new or existing firms. However, as we have seen, this minor productivity revolution has been steadily losing steam since 2005, and the new growth drivers in the non-tradeable sector are by no means as forthcoming in terms of productivity benefits.

Changes in the output indices by sector paint a similar picture, with the non-tradable sectors - construction and retail trade - growing particularly rapidly. During 2003-2007 construction and the retail trade reported very high average annual growth rates of 14.5 and 13.0 percent, respectively. This tendency accelerated further in the first four months of 2008. The rate of annual increase slowed slightly in April to a provisional 13.2%, but the January to April average is 15.7% (see chart below).

Growth in these two sectors - construction and retailing - have been increasingly outpacing the rest of the economy, and as the tightening capacity constraint factor has locked-in industrial expansion has become less and less driven by extraction industries, with new growth now being almost entirely a product of the manufacturing sector.

The detailed manufacturing data for the first four months of 2008 show robust growth across a whole range of manufacturing subsectors. The leading manufacturing sectors were rubber and plastics, both of which are products that feed directly into the domestic construction and durable goods boom. Rubber and plastics were growing by more than 30 percent per annum in the first four months of 2008, compared to 13 percent a year earlier. The production of machines and equipment also continued to expand rapidy, in this case by more than 20 percent. Some manufacturing industries, however, have been reporting lower growth rates. The production of electro-technical equipment, the food industry and chemical products, for example. While the overall picture shows dynamic manufacturing growth, the World Bank concludes that rising unit labor costs and an appreciating real effective exchange rate may well be behind the lower growth in some manufacturing subsectors, and indeed it would be surprising if they weren't in cases where import substitution is a viable alternative.

Foreign Direct Investment Remains Strong But Excessively Concentrated

Fixed capital investment in Russia has been growing in recent years (see chart below) although investment as a proportion of GDP (21% in 2007) remains relatively low in comparison with those sustained in other emerging market economies. For example, Korea (38 percent), China (42 percent) and India (34 percent) have all maintained significantly higher rates of investment over quite long periods of time (1980-2007). In addition the bulk of investment activity continues to take place in resource industries, and transportation and communication services. The share of the resource sector rose to 17.3 percent of the total in 2007 (up from 15.2 percent in 2005), while manufacturing industries have reduced their share to 15.7 percent in 2007 (from 17.6 percent in 2005).

Simply put Russia does not appear to be investing in industries that could eventually lead to a more diversified economic structure. On the back of the rapid increase in energy prices Russia has received large quantities of direct foreign investment, but the composition of Russia’s FDI has, over the past three years, shifted towards extraction industries. In 2007, for example, extraction industries received around 50 percent of total FDI inflows, while manufacturing received only 15 percent. Recent estimates from Rosstat show FDIs in the first quarter of 2008 running at only USD 5.6 billion, more than 50 percent down on the corresponding period of 2007. The structure of FDI also changed in the first quarter of 2008 with investments in the electricity, gas and water supply sectors shooting forward to receive a third of the FDI inflow (USD 1.9 billion) - reflecting new investments into TGK (teretorialnaya generiruushaya kompania) and OGKs (optovaya generiruushaya kompania) electricity generating companies - while the manufacturing share of FDI continued to decline (falling to 13.1 percent of the total in Q1 2008).

Monetary Policy and Ruble Appreciation

Russia registered record net capital inflows into both banking and non-banking sectors throughout 2007, significantly raising liquidity in the domestic economy. These flows reflected a mixture of comparatively strong fundamentals, an appreciating ruble, and a low perceived external vulnerability. The also helped maintain dynamic growth in the banking sector, while facilitating an ongoing rise in consumer credit. Despite continuing accumulation by the oil Reserve and National Welfare funds the Russian central bank was unable to fully sterilize the domestic monetary impact of the oil revenues and the capital inflows and there was a rapid growth in the money supply (up 44 percent in 2007) - this is way above the levels of nominal income growth and this has obviously contributed significantly to inflationary pressures.

Russian monetary policy effectively remains hamstrung by an excessive focus on stabilizing the ruble in terms of a euro-dollar basket. At the present time the ruble is allowed to trade within a given band versus the basket - which is made up by 55 percent dollars and 45 percent euros - with the objective of avoiding gains which are thought liable to hurt the interests of Russian exporters. But this policy is now under tremendous strain the rapid rise in the money suppy which this is producing fuels an inflation process which is now increasingly out of control. Indeed it is partly the feeling that the non-sustainability of this position will eventually lead to ruble revaluation which is encouraging some of the inflows - which amounted to a total of $82 billion in 2007 alone.

In order to maintain the trading band the Russian central banks buys and sells the ruble on a daily basis, as a result ruble appreciation has been fairly limited, and the currncy only gained 0.2 percent against the dollar and 0.4 percent against the euro in the second quarter.

The pressure is obviously now on, and central bank Deputy Chairman Konstantin Korishchenko indicated at the end of June that Russia may expand the ruble trading band by as much as 5 in the near future. The aim is explicitly to deter speculation, since Korishchenko's main argument was that the wider range would make it costlier for traders to limit losses should bets go the wrong way.

It is evident that the Russian authorities need to find some way to tighten monetary policy. One route to achieving this object can be to allow for greater exchange rate flexibility, although it is important that this is done sooner rather than later, since the longer the present rate of inflation is allowed to continue the greater the risk of a sharp downward correction in a free floating ruble should we see an easing in the currently very high level of energy prices (which if maintained will almost certainly slow global growth considerably in 2009) and the Russian external balance deteriorate on the back of a non-competitive manufacturing export sector. At that point the win-win dynamic of capital inflows driven by appreciation expèctations could turn into its opposite.

The recent increases in policy rates and reserve requirements does not constitute significant tightening. The commitment on the part of the Russian central bank to move to formal inflation targeting, once it believes the conditions for such a framework are in place, is a positive step (if one fraught with risk in terms of central bank crredibility) under current inflation conditions, but this does not imply there is not an urgent need to refocus monetary policy on immediate inflation reduction. For the sort of structural reasons outlined in this article a major reduction in credit growth and higher real interest rates are essential - and unavoidable - at the present time.

Oil Dependence and An Ageing Population - The Long Term Risk

In the short term the Russian economy only seems to go from strength to strength. Russia's trade surplus is estimated to have expanded again in May (results due out this week) from April as the world's largest energy exporter benefited yet one more time from record oil prices. The surplus is likely to be in the region of $18.6 billion, compared with $15.5 billion in April and $12.2 billion in May, 2007.

At the same time the price of Russia's Urals crude continues to touch all time highs (it averaged $106 a barrel in the year through July 2, compared with $60 a barrel in the same period a year earlier). Russia produced 9.77 million barrels of oil a day in June, more than Saudi Arabia did, thus becoming the biggest exporter of the fuel. Russia also produces the energy equivalent of about 11 million barrels a day of gas. As a result of such factors Russia's trade surplus hit a record $130.92 billion in 2007. So what could possibly go wrong?

Well the central point would be that the strong rise in oil prices we have seen since the start of the century has only served to increase Russia’s dependence on oil and gas revenue and has not been used to facilitate the kind of diversification which could allow for a more stable development path. As such the Russian economy - despite the outward semblance of "you've never had it so good" boom times - has never been more vulnerable to sudden falls in oil and gas prices.

The share of oil income in total fiscal revenue has increased substantially – from 10 to about 30 percent of GDP. Instead of diversifying, Russia has, de facto, been specializing in oil. Oil now also accounts for about 60 percent of total exports. Higher oil revenues allow for additional spending room, but they also complicate macroeconomic management and lead to an increased dependence on a highly volatile and uncertain source of income. While this has not been a problem during the period of high oil prices, it would be a major source of vulnerability if oil prices suffer any kind of rapid descent from the recent levels, and it does put in place a "ceiling" on Russia inflation-free level of growth capacity given the fact that the resources sector seem to have now reached its "peak output" level.

Soaring oil prices, large capital inflows, and high credit growth are all providing the impetus for a virtuous circle of robust growth in investment, real incomes and consumption but such growth has been producing manifest signs of overheating. The situation is only being made worse by a procyclical fiscal policywhich is stimulating rather than easing demand pressures, while the fixed exchange rate policy in the face of rising oil prices and large capital inflows is leading to very high levels of money and credit growth.

And as we move forward the problems identified here are only likely to get worse. Russia’s well documented demographic trends—declining population, aging, and increasing demand for pension and health services and the changing structure of demand for education are likely to become key drivers of major social expenditures such as pensions, health and education expenditures in the years to come. The net effect of these trends is that under any long-term economic scenario, public expenditures on pensions, health and education are likely to increase significantly. The World Bank estimate that the main social expenditure items are likely to increase by 3 percentage points of GDP - from 14.1% in 2008-10 to about 17.3% by 2016-20. Given this situation stable sources of long-term fiscal revenue and moderation in total public expenditure commitments are essential, as is the development of a growth model to make all the numbers add up.

And sustainability of pensions and health spending isn't the only issue that Russia's demography presents us with. Declining levels of productivity growth mean that it is very likely that increases in headline GDP will only be possible via sustained increases in labour inputs, yet Russia now has, as we have seen, a declining working age population. Long term very low fertility (TFR 1.3-1.4 range, see chart above) means that this problem is set to continue at least over the next twenty years (and probably a good deal longer) which means a Russian economy which is increasingly immigrant dependent (the World Bank estimates Russia currently need a million migrants a year) and which suffers from the almost permament inflationary pressure of running a very tight labour market. Under these circumstances it is impossible to contemplate the present very high levels of GDP growth being sustained in the longer term, indeed, if we have any kind of "adverse event" which precipitates an unwind, precisely the opposite might well occur.

Friday, July 4, 2008

Romanian Construction Output Surges Again In May

Romania's construction industry, which is currently the fastest-growing in the European Union, gathered additional steam in May as investors built offices and shops and rising wages spurred homebuilding. The value of construction works rose an annual 34 percent in May, compared with 31 percent in April according to data released by the National Statistics Institute this morning. Construction output was up 10.5 percent month on month.

Homebuilding jumped an annual 36 percent in May as rising wages and a lending boom encouraged Romanians to invest more in residential property. Net wages rose 25 percent on the year in April.

Private debt grew by 61 percent in May, the central bank said on June 24.

Construction in the first quarter contributed strongly to a year on year economic growth rate of 8.2 percent pace, the second-fastest in the EU after Slovakia. Construction accounted for 1.5 percentage points of the growth.

Sharp Slowdown In Latvian Industrial Output in May 2008

Well the May industrial output reading is really quite a shocker, since when compared to April 2008, industrial output in May 2008 at constant prices (i.e. allowing for the influence of the price change) was down by 3.1%, according to the (seasonally adjusted data) accoring to the Latvian Central Statistical Bureau. Of this there was a volume decrease of 3.3% in manufacturing, 3,4 % in electricity, gas and water supply, and in mining and quarrying the production volume was up by 7.1%.

Compared to May 2007, industrial output in May (according to working day adjusted data) was down by 8.5%. Of which there was a volume decrease of 8% in manufacturing, a 9,6 % decrease in electricity, gas and water supply, and a 3.1% increase in mining and quarrying.

According to the statistics bureau the decrease in industrial production is related to a drop in demand and a decrease in orders in the following economic activities: food, textiles and wearing apparel, manufacture of wood, paper products, printing, chemicals and chemical products, rubber and plastic products, construction materials and furniture.

I don't know where all the people are right now who were predicting a "soft landing" (in hiding to conceal their shame I hope, or at least doing public "mea culpas" and correcting the flaws in their methodologies), but it really does look as if the Q2 2008 GDP result could be something of a shocker, if the Industrial Output readings and the retail sales data are anything to go by.

The only saving grace at this point would appear to be external trade, and this could be more of a positive element due to the statistical impact of the slowdown in import growth (caused by the drop in domestic demand) rather and real robustness in exports. Still the May 2008 extrenal trade data is due out next week, and at that point we should get a much better idea.

Exports werte up a healthy 24.7% year on year in April.

Although it is important to remember that Latvia still runs a substantial trade deficit dèspite some recent improvement.

Wednesday, July 2, 2008

Hungary's Q1 2008 Current Account Deficit

Hungary's current account deficit came in at EUR 1,160 million in the first quarter of 2008, according to preliminary figures. This was up from a slightly downward adjusted EUR 1,094 m in Q4 2007, according to data from the National Bank of Hungary (NBH). The seasonally adjusted EUR 1,274 m current account gap is down from the 1.3billion euro deficit recorded in the fourth quarter of last year.

In Q1 2008 Hungary’s net external financing requirement (i.e. the balance on its combined current and capital accounts), fell compared with the last quarter. Hungary needed 367 million euros (92 billion HUF) and 729 million euros, or 2.2% of GDP, (after adjusting for seasonal effects) compared with 4.6% of GDP in Q1 2007. The net financing requirement, derived as the combined current and capital account balance using the bottom-up approach, amounted to EUR 1,375 million (equal to HUF 353 billion).

Current account

In Q1 2008, the current account deficit was 1,160 million euros (1,274 million euros seasonally adjusted). The seasonally adjusted deficit continued to fall compared with the previous quarter. Improvements in the combined balance on the income and transfer accounts accounted for most of this fall, and these were, in turn, mainly explained by an increase in funds from the EU. In terms of the real (rather than the financial) economy, the goods trade remained in surplus, at 681 million euro seasonally adjusted (and at 744 million euro unadjusted. The surplus on services was 269 million euros, seasonally adjusted, (and 139 million euros, unadjusted). Compared with the previous quarter, the trade balance improved and the surplus on services increased on a seasonally adjusted basis.

In terms of services themselves, the seasonally adjusted travel surplus was 294 million, while other services registered a seasonally adjusted 71 million euros deficit.

Looking at the balance on the income and transfer accounts, the seasonally adjusted deficit on income on debt amounted to 684 million euros, and negative income on equity was 1,452 million euros. The deficit on income on debt continued to rise, while the deficit income on equity fell slightly compared with 2007 Q4. A significant surplus was registered on compensation of employees, due largely to the introduction of a new methodology. I would say one of the structural difficulties with the Hungarian balance of payments is the growing detach we can see in the chart below between the growing surplus on the goods and services side and the increasing deficit on the income side.

Looking at fourth-quarter transactions with the European Union, the balance of current transfers was a deficit of 52 million euros, while capital transfers were in 795 million euro surplus. The balance of capital transfers to and from EU institutions was in a surplus of 743 million euros.


There was a net inflow of 1,699 million euros in inward and outward non-debt capital transactions. The value of outward direct investment transactions in equity capital by Hungarian residents was 84 million euros and reinvested earnings amounted to 342 million euros. Inward transactions by non-residents amounted to 292 million euros and reinvested earnings amounted to 1,366 million euros. Portfolio investment transactions in equity securities showed a net inflow of 468 million euros. Purchases of shares abroad by Hungarian residents amounted to 521 million euros (outflow) and purchases of Hungarian shares by non-residents amounted to 989 million euros (inflow). The balance of debt generating financing was 324 million euros. For other FDI – included in foreign direct investment flows – related to direct investment by Hungarian residents there was an inflow of 82 million euros and other FDI related to direct investment by nonresidents in Hungary showed an outflow of 864 million euros.

Reserves and debt

Central bank foreign exchange reserves were 16.8 billion at end-March 2000. Whole-economy gross foreign debt was up`3.8 billion euros over the opening stock reported for 2008. Gross foreign debt, including other investment capital recorded within direct investment, rose by 3.6 billion euros. Hungary’s net foreign debt rose by 1.0 billion euros, and by 0.2 billion euros including other FDI capital recorded within direct investment. Non residents’ holdings of forint-denominated government securities amounted to 11.7 billion euros at the end of Q1, down 0.9 billion euros on the opening stock for 2008.

Whole-economy net debt, excluding other capital recorded within direct investment, was 47.8 billion euros at end-March 2008 (46.8% of Hungarian GDP). Including other investment capital recorded within direct investment, Hungary’s net foreign debt amounted to 49.0 billion euros (48.0% of GDP). Compared with the opening stock calculated using the new methodology, the net debt of general government and the MNB was down 1.3 billion down at the end of Q1 2008.

Romanian Producer Prices Shoot Up While New Forex Loans Slow

Romanian producer prices rose at the fastest annual pace since November 2004 in April as rising energy prices and a weaker local currency increased the cost of imported materials. The cost of goods leaving Romanias factories and mines rose at an annual 16.8 percent rate in May, compared with 15.5 percent in April, according to dat from the National Statistics Institute today. Prices rose 1.7 percent on the month, after a gain of 1.1 percent in April.

The leu has weakened almost 15 percent against the euro in the past year, making imports of capital goods and raw materials more expensive. Higher global energy prices also increased costs for producers. Producer-price growth is an early indicator of inflation, which in May was 8.5 percent, more than twice the pace of the euro region.

Prices of manufactured goods rose an annual 19.6 percent in May, compared with 17.7 percent in April, while price growth in the mining and drilling industries slowed to 11 percent from 13.2 percent. The costs of electricity, natural gas and water rose an average of 3 percent, compared with 2.9 percent in April, the statistics institute said.

In another indication of the growing stresses and strains which are now accumulating in the Romanian economy, we learnt today that overdue private debt almost doubled in April from a year earlier as the local currency weakened, making loans in euros more expensive to repay. Loan payments that are more than 30 days overdue rose to 691 million lei ($300 million) in April from 380 million lei a year earlier, according to the Banca Nationala a Romaniei.

Private debt in Romania rose an annual 61.3 percent in May from a year earlier in a lending boom spurred by rising wages and competition among banks, the central bank said on June 24. Borrowing in euros accounted for most of the lending.

In May 2008, non-government credit grew 1.8 percent, or 1.3 percent in real terms, versus April 2008 to RON 171,834.3 million. RON-denominated loans went up 2.4 percent (1.9 percent in real terms) and foreign currency-denominated loans rose by 1.4 percent when expressed in RON and by 2.9 percent when expressed in EUR. At end-May 2008, non-government credit climbed year on year by 61.3 percent, or 48.8 percent in real terms, on the back of the 41.7 percent increase in RON-denominated loans (30.6 percent in real terms) and the 82.6 percent advance in foreign currency-denominated loans expressed in RON (when expressed in EUR, forex loans expanded by 65.0 percent).

If we look at the annual rates of increase in loans and forex loans (see chart below) we can see that the rate of increase in RON denominated household has been falling slowly now for some time, but that the rate of increase in Total Forex loans and Household Forex was very very fast, but peaked in January, and is now declining. This could mean that the lending boom has now past its peak, and that we are into the downside, if so we should start to see some reflection of this in real economy data in the not too distant future.

Tuesday, July 1, 2008

Estonia Heads For A 2008 GDP Contraction On The Back Of A Decline In Domestic Demand

Estonian retail sales declined in May for the second time in three months, suggesting the Baltic nation's economy is on the verge of contraction. Retail sales, excluding car and fuel sales, fell an annual 3 percent, after remaining unchanged in April and declining 4 percent in March, according to the latest data from the Tallinn-based statistics office. Sales were up however when compared with April, by 4%, but we need to remember there are a great many seasonal factors at work here, and we also need to remember that in May 2007 we were at the height of the consumer boom.

Year on year retail sales reached a record 23 percent in March 2007 and then started to decline as the economy began to slow as banks tightened lending to avoid overheating as inflation accelerated. As a result the economy only grew at an annual 0.1 percent in the first quarter.

Following a gross domestic product expansion of 10.1 percent in the first quarter of 2007 we may now well see a full-year contraction this year, the first since a 0.1 percent decline in 1999, when exports dropped dramatically following the 1998 Russian default. Certainly an annual contraction in Q2 would seem to be very much on the cards at this point.

Adjusted seasonally and for working days, the economy actually shrank 0.5 percent from the fourth quarter of 2007.

Household spending which accounts for 55 percent of gross domestic product fell by an annual 0.4 percent in the first quarter, and this decline now seems set to continue, although exports, are on the upside at the present time.

In fact in April 2008 Estonian goods exports were up sharply, to 12.2 billion kroons during the month. Compared with April 2007 the increase in exports was 1.8 billion kroons or 18% in nominal (non inflation adjusted) prices. The main increases were in metals and products thereof and of machinery and equipment. This performance is promising, but it will probably be insufficient to offset the sharp decline which is now taking place in domestic demand (in particular since the Estonian government cannot run a deficit to give a stimulus), and exports may well become increasingly difficult if the economies of those who receive the exports themselves in turn start to slow.

Estonian Consumer Confidence, which was boosted by entry into the European Union in 2004, has all but collapsed after reaching record highs in January 2007. According to the Tallinn-based Konjunktuuriinstituut confidence bounced back slightly in june to -16 from the four-year low of -19 registered in May.

The EU Economic Sentiment Index for June has also now been published, and here is the principal chart for the Baltic countries. As can be see the composite index for Estonia remains steady at a very low level, while Latvia just shot below them.

Industrial Output Drops

More evidence of the sharpness of the slowdown is to be found in the fact that Estonia's industrial production fell the most in nine years in May, providing us with the latest evidence (following yesterday's retail sales data) that the Baltic economy has slipped into what now seems likely to become a pretty deep recession. Output, adjusted for working days, decreased an annual 6.7 percent, the biggest decline since May 1999, compared with a revised 0.1 percent fall in April, according to data from the Estonian statistics office released today. Production fell a monthly 4.8 percent on a seasonally adjusted basis.

Industrial output, led by food production and wood procession, has now fallen for three straight months.