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Friday, August 8, 2008

The Czech Central Bank Lowers Interest rates

Now this is news. Monetary policy makers at the Ceska Narodni Banka (the CRs central bank) cut what is the European Union's lowest key interest rate to 3.5 percent at today's meeting. This was the first decrease in more than three years, and was evidently an attempt to counter the koruna's record appreciation in order to try to revive economic growth which is fading rapidly.

Rate setters seem to have decisively switched their focus from the current high levels of inflation to countering the koruna's 13-month rally on concern a high Koruna will continue to have a negative impact on exports, investments and employment. Central Bank Chief Zdenek Tuma warned last month that the koruna's recent advance could cause inflation to undershoot the central bank's 3 percent target next year, justifying the then hypothetical possibility of rate cuts. Since then, the koruna has lost 4.1 percent against the euro.

The central bank lowered its forecast for economic growth for this year to 4.1 percent from the previous 4.7 percent outlook. In 2009, economic growth the bank expect growth to decelerate further - to 3.6 percent - which compares with the 6.6 percent rate achieved in 2007. So the bank is worried that the economy is slowing excessively quickly.

In fact the Czech economy expanded at the slowest pace in more than three years in the first quarter as consumer spending weakened. Gross domestic product rose 5.3 percent, compared with a revised 6.3 percent in the previous quarter. The economy's rate of expansion slowed for a third consecutive quarter after peaking at a record 6.8 percent in Q2 2006.

If we look at the q-o-q chart we can see the slowdown even more closely. Basically the economy hit a quarterly 1.8% in Q1 2007, and since that time it has been slowing to Q1s 0.9% (or an annual rate of 3.6%). Clearly Q2 will be weaker and we could see q-o-q of 0.5%, which mean if the rate of de-celleration continued we might get negative growth in Q4. This would clearly be a soft landing, but it is preoccupying for an emerging economy nonetheless.

The inflation rate increased to 6.9 percent in July from June's 6.7 percent, surpassing the central bank's goal for the 10th consecutive month. The CR now has negative interest rates of some 3.4 percent. That is, monetary conditions in the CR are extremely accommodative.

And wages have been rising much more rapidly than prices in recent months, that is real wages have been rising.

Which is not really surprising, since the labour market has been steadily tightening as the number of unemployed has dropped steadily. Which makes the issue of why consumption has been falling back much more of a mystery. This situation is very different from what we are seeing at present in Bulgaria or Romania, or even Slovakia.

Now it is not hard given the sharp rise in the Koruna to understand why Czech exports slowed significantly on a year on year basis in June. They were up a touch on May, but down on April and February, and were only very slightly up y-o-y. Exports rose an annual 1.7 percent, to 215.8 billion koruna and imports totaled 201.9 billion koruna, a 1.1 percent decline in the year.

But why is consumer demand slowing at this point? This is much harder to understand, yet it is. Why are people not simply borrowing cheap money and building houses and buying cars? Seasonally adjusted retail sales, however, only grew at a very moderate rate in May (up by 0.6% month-on-month and by 2.5% year-on-year).

And the construction boom is long since over, with output actually contracting year on year in May. Indeed the last construction boom seems to have blown out in Q1 2007.

Now this is all frankly rather worrying, and it is doubly worrying for me, because I think I have seen this before in Portugal and in Hungary. The rising Koruna may well choke exports but there is no reason whatsoever why it should be choking domestic demand, indeed quite the contrary. So why is domestic demand so weak, that is the question?

If we look at a longer term chart for year on year household consumption growth, we will see that the last "long wave" of this peaked in Q1 2007. We can expect the performance in Q2 2008 to be even worse, and the question, the quite deep theoretical question really, is why this should be happening?

Now here's a rather similar chart for Hungary. As we can see, Hungary had it last local peak in Q1 2006.

And as we can see, Portugal's last big "wave" ended in Q1 1999. So my question is really, is it possible that the CR is now where Portugal was in Q1 1999 and where Hungary was in Q1 2006? My feeling is that it is possible, and indeed this is where we may well now be. The thing is we need to understand the theory which explains the dynamics behind all this much better. But if it isn't like this, then I don't understand why consumption is now simply fading out.

Basically one thing that these three countries have in common is declining population (or at least in the Portuguese case declining population at the time when consumption blew, as a result of prior EU freedom of movement related out-migration). Declining and ageing population. As we can see in the first chart, the population of the CR has declined in a variety of ways since the late 1980s. It has started to increase again since 2004, but it seems to me the consumption bust was already in the pipeline by that point. What is really, really surprising to me is just how sensitive the whole system is to what appear to be really quite small movements in population size.

Of course it isn't simply the size that matters, it is more the structure, and as we can see from the median age chart below the CR has been ageing quite rapidly for some time now, and will continue to age as we move forward. Having more children and accepting more immigrants (both of which are very advisable) are the only things which will slow all this down.

Of course you won't read about any of this in the economics text books (yet), but the picture is reasonably clear, and it is also perfectly compatible with life cycle savings and consumption model as presented by Franco Modigliani. You simply need to apply it to population rather than simply to individuals.


Zdenek Kudrna said...

Change in taxes on construction materials explains the fall in construction spending and mortgage market. CZ negotiated temporarily lower VAT with EU and people were rushing to buy houses till it lasted.
More generally, I do not think you thesis about population explains much. Unlike, Balts, Poles and Slovaks, Czech and Hungarians hardly bother to move Westwards for jobs so population sticks to long term trends that really have little to do with short-term fluctuation of demand.

Edward Hugh said...

Hi Zdenek,

Thanks for taking the trouble to comment.

My work about demographic process and the deep underlying structure of economic processes is pretty experimental, so I'm not surprised you aren't willing to swallow it at first glance.

I've been working on this for nearly a decade now, and I am reasonably convinced I'm on to something.

"Unlike, Balts, Poles and Slovaks, Czech and Hungarians hardly bother to move Westwards for jobs "

Yep. I'd picked this part up, and the difference between Hungary and the CR is that in the CR there have been inward migrants, which has helped slow the labour market tightening somewhat.

"so population sticks to long term trends that really have little to do with short-term fluctuation of demand."

Yep. I agree with this, and the long term trend is towards decline, in all CEE cases. One years baby boom is a short term trend, and you need to look at factors going back over 20 years or more here. Also I am not taking about short term - or cyclical - shifts in demand. These I agree are associated with a variety of proximate causes.

I am talking about deep seated structural shifts - long term ones. I am saying that the CR has just seen it's last wave. I am not sure yet whether of not the CR will actually enter recession at the end of 2008 start of 2009, but this is another issue, and largely depends on the export environment, which doesn't look at all healthy right now.

Basically what I am saying is nothing knew. Internal demand in Japan, Italy and Germany (the world's three oldest societies) has been steadily weakening over more than a decade now. All three of these are dependent on exports for growth, and since Italy is uncompetitive and can't generate sufficient exports she quite simply can't get growth, which means that one day or another her state finances will simply go bust.

What is surprising me is how some other countries seem to enter this stage much at much younger median ages, it is this I have been scratching my head about. And this is where the actual population decline does seem to matter, and with some very high level of sensitivity, which, as I say, is a result which has even surprised me.

Basically the CR can become another Germany, and should be able to live from exports. I doubt however that it will ever be driven by internal demand again. Still, there is one way to test and find out: let's go and see.

Also I will be interested to see whether the CR is still able to attract migrant workers even as the economy slows. Also, will wages drift downwards - as happened in Germany between 1995 and 2005, or will the demographically driven labour market tightness make this very difficult, in which case we could see stagnation.

Another strategy could be to get interest rates down to the floor, and follow Japan by turning the CR into a carry trade centre and keep the Koruna down with the outward flow of locally borrowed funds. But maybe you don't have sufficient savings for that.

"Change in taxes on construction materials explains the fall in construction spending and mortgage market. CZ negotiated temporarily lower VAT with EU and people were rushing to buy houses till it lasted."

OK, thanks for this. But what this means is that if even a small change in consumption tax brought it to an end consumption itself didn't have very strong momentum in the first place.

I still don't really understand why consumption should have been falling so early, given that the economy was growing rapidly, employment was growing, interest rates were strongly negative, and real wages were rising. I mean, do you have an explanation for this?



Edward Hugh said...

Also, Zdenek, I see you are interested in emerging economies and institutional reforms. Perhaps this is the issue. I am a big critic of the World Bank and others for the almost exclusive focus on institutional components (which are of course important) to the complete detriment of thinking about the demographic component.

The two are both very important. So for my taste the wb growth models are rather lop sided.

Take a look at my India and Brazil blogs. In the right side bars I have a list of thirteen economies that I think will outperform based on a combination of institutions, demography and resources. We will develop performance indicators and put all this to the test.

At the end of the day I am an empiricist, and a lifetime admirer of the work of Sir Karl Popper. If economics is ever to become a truly empirically grounded science it needs to be capable of predicting, and of being falsified.

hfilip said...

Edward, I understand that you see no good explanation for the quite rapid drop in consumption here in the Czech Republic. Perhaps I could offer one: For the past two years at least, there has been quite some discussion re growing indebtedness of Czech households. Historically, Czechs have been very reluctant to finance their spending through debt, and now almost everybody is well aware of the risks associated with going to the nearest bank in order to get cheap money. On top of that, Czechs have always been experts at hoarding cash, most especially at bank accounts or under their pillows. Now, most of us here have heard that there might be difficult times ahead, and thus we tend to swiftly resort to the good old ways - save cash, do not spend and do not borrow. Apart from other businesses, I run a very small online consultancy for people in financial distress. I am very surprised how many people are contacting us with a simple request - I do not need your help now, but if there is trouble ahead, please let me know. I would not say that people here are downright scared, but those with money to spend are becoming very very careful about how they are actually spending.

Edward Hugh said...

Hi hfilip,

You raise an interesting and valid point, and I am sure this is one part of the picture.

But it does leave us with the question as to why in some countries people become nervous about credit and in others they don't. My question is, could the median age of the population be a factor. ie do people get more cautious as they get older?

Look at Bulgaria and Romania (possibly Poland) right now for countries where people don't seem particularly nervous about contracting debt (although the first two do seem to be entering their corrections now) and seem to believe - despite all that has happened in countries like the US and Spain - that property prices can only rise.

The Czech Republic won't have a dramatic property correction, simply becuase it never had a boom of the magnitude of these other countries.

So what makes the difference? Well clearly cultural factors make a difference. But obviously from a macro economic point of view we cann't be happy with this as giving a complete explanation, since otherwise economics would become a simple sub discipline of anthropology and sociology, and while I tend to give more importance to these disciplines than economists habitually like to, I doubt they have sufficient importance as to be able to explain ALL observed macreconomic structural phenomena, so there is still a place for economic yet awhile.

Now, fortunately there is one major piece of macroeconomic theory which can help us to some extent, and that is Franco Modigliani's theory of life cycle saving and borrowing. People do exhibit differnt patterns across their life cycle, and although these differ slightly form one country to another (for cultural type reasons) there are also clea cross country patterns. Japan, for example, had been a notoriously high saving society, but that didn't stop them having a huge indebtedness driven stock market and property boom in the late 1980s early 1990s. Total Japanese household, corporate and government debt hit around 250% of GDP in 1992, and of course they have spent the last 15 years trying to recover from the dead weight that all this debt placed on domestic consumption, and Japan is now, as is well known an export driven society. I would hazard the conjecture that all the EU 10 countries are currently in a transition to being export driven economies (this is only a hypothesis at this point, but it will be testable) and that those who can't export sufficiently (Bulgaria, Romania, Latvia???) will become like Italy and Portugal, permamnently struggling to get headline GDP growth.

My feeling is that Hungary, Estonia and the CR are the best candidates in the group to achieve this - although either wages and prices will need to deflate internally, or the currency will need to drop substantially without producing internal inflation (and this will be very painful for Estonia since they have been on a peg) for this potential to be realised.

Claus Vistesen and I have been following all of this in the case of the OECD economies - the important points to get is that populations age just like individulas do, and that countries have their major property boom as they approach a median age of 40, and after this they have no more construction driven booms, ever.

This is again only a hypothesis, but it is on pretty firm ground, since we have not had a single case of a country wih median age of 41 plus having the type of boom which has recently been found in the US, the UK, Spain or Romania. These latter two rule out that this is simply some sort of "silly" Anglo Saxon phenomenon, as do the booms in Shaghai and Kazakhstan.

As I say, Claus and I now more or less have the measure of this in the OECD, but we are trying to pin down the details of how it works out in Eastern Europe, since there are obviously important specific details, and this is what this post is about really.