Slovenia - Are Things Really As Good As They Look?

This post to accompany Manuel's coverage of this weekend's parliamentary elections focuses on one or two key issues - excessive inflation and the construction boom, and what to do about the problematic combination of the two. A much fuller examination of the main structural issues facing Slovenia's economy can be found in my Slovenia is Different post, written at the time of last October's presidential election.

The content of this post was basically inspired by reading this short paragraph from Manuel's post:

Although inflation has been at times the highest in the Euro zone - Slovenia adopted the Euro as its currency in 2007 - the country's economy has otherwise performed well under Janša's tenure, registering solid growth, the lowest unemployment rate since independence and - according to government statistics (but not those of the EU or the IMF) - a budget surplus.

This paragraph seems, more or less, to sum up the current "received wisdom" on Slovenia, namely that the economy is preforming well, even if the level of inflation is a bit of a nuisance, and needs to be brought down. But how accurate is this picture? And is there more than meets to eye to be worrying about here? These are the questions I would briefly like to ask, even though, I hasten to add, this is not in any way an attempt to question Janez Janša's stewardship of Slovenian society - this is evidently beyond my expertise - although even as I write these words the polling stations are now safely and well-and-truly closed in any event, so I could hardly, even inadvertently, harm his reputation, even if that were my intent, which it is not.


Rapid GDP Growth And Low Unemployment


Well, to start at the beginning, it is evidently the case that Slovenia's economy has been growing very strongly in recent years, averaging just over 5% growth a year between 2004 and 2007, and indeed this has been more or less exactly the rate in the first two quarters of 2008 (Q1 5.4%, Q2 5.5%).

It is also the case that unemployment has fallen to quite low levels. The unemployment rate has fallen from 6.9% at the end of 2005 to 4.2% in August 2008.





Obviously the number of unemployed has fallen commensurately, from 71,000 at the end of 2005 to 45,000 in August 2008. But while this drop in unemployemnt is evidently to be welcomed, we need to ask ourselves a standard economic question: just how far can unemployemnt fall without causing excessive supply side capacity constrants, and producing overheating and the excess inflation which goes with it?





Well, looking at the differential between Slovenia's inflation and that of other members of the eurozone it seems that point has long since been passed, since eurozone inflation is running around the 4% mark (and even that is far too high for the ECB), while Slovenia's inflation was running at a 6% annual rate in August, and this was down from a 6.9% one in July.




Now, I know, I know, we have been living through a period of excessively high food and energy prices, and Slovenia has been struggling to handle the price shock, but the other 14 members of the eurozone group have experienced similar price shocks, yet inflation is in EVERY case lower, so this is not, alone, a sufficient explanation.

Labour Shortages and Construction Booms


Now I raise all of this, since there are two things we need to bear in mind in the Slovenia case. The first of these is the special demographic profile of the East European countries, and the way in which many years of below replacement fertility, and the consequent problem of growing labour shortages in the longer term, have placed definite limits on the rate of inflation-free stellar "catch up growth" that you can run your economy at and beyond which you start to accelerate price increases far beyond the sort of "comfort zone" which the local administration should be happy with.

The second point is, of course, that membership of the eurozone is not simply a "pure good in itself", it has its upsides and its downsides, and the downsides need very careful attention paying to them, since if don't pay them the necessary attention in time then you run the very real and significant risk of creating very large problems which you will need to resolve later - as the citizens of Spain and Ireland are now unfortunately discovering to their costs.

The biggest downside to eurozone membership is that you lose the possibility of running an independent (tailor made) monetary policy, and this creates the problem of possibly having to learn to live with the reality of strongly negative interest rates during an extended cyclical upswing (which is what is happening to Slovenia now, with prices increases of over 6% and ECB interest rates at 4.25% - and possibly about to come down). So this situation needs a policy response, and in my opinion, adequate policy responses were not devised before the euro was put in place (again, as the sorry current reality of the Spanish and Irish economies shows only too clearly, growth is good, but if the growth comes in the form of a "boom-bust", then perhaps you would have been better off without that "extra mile" of growth in the first place).

Basically membership of the eurozone has two consequences for a society with the kind of inbuilt high inflation expectations that Slovenia now seems to have, interest becomes far too cheap for the real expansionary needs of the economy, while membership of the eurosystem (with an ECB that is prepared to accept all kinds of paper securities in exchange for bank funding) seems to offer an "investment grade" kind of feel for all kinds of inherently rather risky financial practices, like, for example, the issuing and purchase of residential mortgage backed securities. The net upshot of all of this, is that what you get is a level of construction activity which is significantly above the soberly evaluated desireable one. Perhaps a couple of years ago this point was rather harder to argue, but in the light of what has happened in the US over the last weekend, I hope it may now seem a little bit more "self evident".

The High Inflation, Construction and Mortgage Boom Trifecta

So the danger signals we should be watching out for are threefold: a significant uptick in inflation, above the eurozone average, a notable uptick in construction activity, and a notable rise in the rate of new mortgage lending to households. Unfortunately in Slovenia we can now see all three. Not that the process has developed - in true Spanish style - a lo grande, but the overheating is there, and if the situation is not reined-in now then the problems are going to accumulate.

We have seen the inflation indicator, now let's look at construction output. As we can see in the chart below, at the start of 2006 the construction share in Slovenian GDP started to tick up, from the long term historic average of about 4.5% of GDP to its present rate of just over 6%. As I say, at this point this increase is modest, and bringing it back down a touch will not be too painful - we are a far cry at this stage from the 11% of GDP which was to be found in Ireland and Spain before the bubble burst, and in the present financial climate lenders are unlikely to allow Slovenia to reach these levels, but the problem does need to be addressed.




And mortgage lending to households, which again is not especially high in absolute terms, has been rising rapidly recently, and is now up around 50% from the level in January 2006 (or in a mere 18 months - see chart below). It is the rate of increase rather than the volume I think that matters here, since it misallocates resources from one sector to another, and distorts prices, and then all of these distortions need to be corrected.





And As Construction Booms, and Inflation Burns, Domestic Industry Wanes

And Speaking of distortions, why don't we have a look at what is happening to Slovenian industry while the construction sector is booming. As we can see in the comparative chart (below) Slovenian industry is suffocating, While GDP was growing at something over 5%, during the first seven months of this year industrial output grew (yoy) at something like a 1.3% rate, while construction activity grew at a rate of 19.44%.




As Do The Trade and Current Account Balances


So the weaight of manufacturing industry in the Slovenian economy is reducing at just the time when we learn from the United States that the consumer borrowing, financial services and construction driven model for an economy has some basic flaws in it. Slovenia, as is well known, runs a goods trade deficit, if inflation continues at the current above-eurozone-average rates for any length of time, then the accumulated drop in competitiveness will only eventually give Slovenia similar problems to those already being faced by Italy and Portugal.

And at the same time Slovenia has developed a current account deficit, which again is another important warning indicator.





So What Is To Be Done?


Well basically the best thing to do here is not to sit back and wait for the problems to happen. Since you have no independent monetary policy you can't use interest rate policy direct, but the Bank of Slovenia does have the regulatory role of supervising credit activities and they can - if they want to - really twist the local banks arms to make the credit conditions tighter (like enforcing lower loan to value rates, lower multiples of earnings, more detailed documentation in support of loans, etc).

In case any of you are sceptical that this type of approach would have any impact the following chart shows what happened to household lending growth in Latvia after conditions were tightened in April 2007 (Latvia also has no independent monetary policy, since the Lat is pegged to the euro).

As we can see lending simply went for a nose dive, and the Latvian economy went hurtling off into a hard landing. Of course, lending was growing at a lunatically high rate (around 90% yoy) at the height of the boom, so the fall was equally dramatic. Fortunately Slovenia's problem is of a much smaller order, and the correction can be of the "soft landing" variety, but remedial action does need to be taken.

The second step that can be taken refers to fiscal policy. Basically, as Manuel suggests in the quote I use at the start of this piece, there does seem to be some confusion about as to whether or not Slovenia has been recently running a fiscal surplus or not. In fact the confusion seems to have come from a statement by Slovenia's PM Janez Jansa in December last year to the effect that "For the first time in history, Slovenia will end the year 2007 with a budget surplus," Actually this statement seems to have been, to the letter, true, since with the data they had to hand at the end of December, Slovenia's statement of account on public finances was showing a miniscule surplus of 30 million euros - or 0.1% of GDP (rather like your monthly credit card account, perhaps, which still isn't showing all those rash purchases you made while on holiday in August). Unfortunately though the bills do come in - and following later data revisions (a constant plague in economics) the 30 billion euro surplus seems to have turned into a 25 million euro deficit (at least according to the numbers published in the Slovenia Central Bank's July bulletin, and this seems to fit in with what the EU Commission said in their April forecast for the Slovene economy:

"The general government deficit narrowed to 0.1 % of GDP in 2007 after1.2% in 2006. This outurn was below the 0.6 % deficit anticipated inthe November 2007 stability programme. The general government deficitis expected to increase to 0.6% of GDP in 2008."

So really we should learn two lessons here. The first that economic data is not of the kind which is most favoured by the positivists, since it is most definitely fluid rather than hard, and constantly being changed for a whole variety of reasons, and the second is that politicians are far more likely to call press conferences and make "historic" declarations when the news is good, than they are to hold them for a subsequent (slightly) negative downard data revision. The headlines don't look quite the same, now do they?

But leaving all this aside, what Slovenia needs to take some of the heat out of domestic demand and the construction boom is not a fiscal surplus of 0.1% of GDP, but rather something more to the tune of 2-3% of GDP. If you can't slow demand growth down using interest rates, then you surely can by attacking the problem directly and running a fiscal surplus.

And there is another reason why Slovenia would do well to be rather more ambitious on the fiscal surplus side at the present time, and this relates to the structural pressures on the Slovenian budget: as the IMF pointed out in its most recent staff report, Slovenia is now one of the most rapidly ageing European societies (see median age chart at foot of the post), and accumulating resources now in the good times would seem to be the prudent way to go about things.

For Slovenia, the main challenge to debt sustainability arise from age-related spending pressures. With one of the fastest aging populations in Europe, and a generous pension system, Slovenia’s debt is expected to rise rapidly after 2020 undermining its long run fiscal sustainability and growth prospects. Long run fiscal sustainability analysis shows that Slovenia will need to run surpluses and build up reserves to offset the future rise in age-related spending, in order to achieve a target debt to GDP ratio of 60 percent by 2050. Indeed, a fiscal adjustment of around 10 percent of GDP would be required to restore the intertemporal balance and each year of delay in adjustment will require additional adjustment by 1/8 percent of GDP to restore the balance, placing a significant debt burden for future generations.
IMF 2007 Article VI Consultation Staff Report

Latvian Inflation Continues To Be A Major Problem

Consumer Price Inflation

The annual rate of increase in Latvian consumer prices was 15.7% in August 2008. Month on month the situation did imporve slightly, since prices decreased by 0.4% when compared with July. The average price of goods decreased by 0.9%, but the price of services continued to increase, and were up by 0.7%. Prices of vegetables and fuel fell, but the price of clothing, catering and rent were all up. Thus while the trend is for annual inflation to moderate, the news is far from unambiguous, with widespread secondary price shocks continuing to make their impact felt.

Food prices were down - by 2.2% - but this was mainly influenced by seasonal decreases in the price of fruit and vegetables and fruit. Bread, dairy products and cheese prices also fell. Fuel prices were down by 4.3%, as were motor vehicle prices.

The widespread presence of discounts meant that the prices of non-durable household goods, individual care goods, bicycles, sports and recreational equipment all decreased. Purchase of new cars became cheaper, as did the prices of data processing equipment, airline tickets, furniture and furnishings, carpets and floor coverings diminished.

Latvian retail sales we should remember were down again in July, both on June 2008 and on July 2007. Compared to July 2007, the seasonally and working day adusted constant price index was down by 8.5%. The largest volume decrease was in non-food products group which were down by 9.4%. There was a slighly smaller decrease in food products, which were down by 6%. The only increases were in mail order business – up by 7.2% and in retail trade in pharmaceutical and medical goods – up by 3.2%. In the face of such a decline in demand the more competition driven sectors have little alternative but to lower their prices.




On the other hand, prices in the non competition driven sectors continued to rise, and rent in municipal flats and houses, the cost of refuse collection and other publicly administered services were up, as were liquefied gas prices.

Alcoholic beverages, cereal products, meat and meat products, fish and fish products, eggs, oils and fats, sugar, sweets and non-alcoholic beverages all went up, as did clothes, textiles, household goods, and school textbooks.


Producer Prices Accelerate In August


Latvian industrial producer prices rose in August at a 13.1% annual rate, up frm the 12.4% annual rate registered in July. Month on month producer prices increased by 0.9%.

On an annual basis it has been the increase in the cost of energy components like electricity and gas, and the price of manufactured food products and beverages which have made the biggest impact on the overall level of producer prices,contributing 4.5 and 4.1 percentage points, respectively.

As can be seen in the chart below, Latvian producer prices are now up over 50% on the start of 2005, and with the Lat effectively tied in value to the euro (which is either used by, or a reference point for, nearly all Latvia's major external customers) this represents a huge loss of competitiveness for Latvian industry and service companies.





Energy Prices

In terms of the outlook for Latvian inflation moving forward we need to think about just when it will be that year on year crude oil turn negative, and when this does happen, what will this mean for Latvian inflation? An interesting question this one since it will really show us the "naked truth" about how resistant Latvian prices are to correcting themselves as the economy continues to languish in recession.


Oil prices have fallen substantially recently, even if with considerable volatility in the process. Last Friday, for example, , the first time oil had closed at over $100 in more than a week. Oil prices in fact shot up by more than $6 a barrel on Friday, with light, sweet crude for October delivery rising $6.67 to settle at $104.55 a barrel on the New York Mercantile Exchange, after earlier rising as high as $105.25. The increase followed the announcement of the sweeping US government financial rescue plan which emboldened investors to re-enter equiity and commodity the markets.

Crude thus climbed over $13 in the space of three days, but prices will more than likely resume their downward trend, at least in the short term, since demand for energy is likely to remain weak as the economic slowdown continues to bite in the US, Europe and Japan, while key emerging markets maintain tight monetary policy (although not Latvia unfortunately, since the Lat peg means there is no monetary policy to implement) in the battle to contain inflation (I am talking here of countries like Brazil and India). So, despite the coming and going, the trend in oil is decidedly down, and crude has now fallen around $43 — or over 30 percent — from its all-time trading record of $147.27 reached July 11.





So we are now hitting prices which were reached on the way up in the middle of February, but how long will it be before we are below the same price y-o-y? Then annual inflation rates will start to notice what is called the "high base effect", and it will be interesting to examine the precise differences between those countries where secondary effects have made their presence felt (like Latvia unfortunately), and those where core inflation has basically remained low.

Latvian Wages Continue To Rise

At the same time Latvian wages, and despite the recessionary backdrop, continue their steady upward march, at a rate which is well above consumer price inflation plus productivity. Compared to the second quarter of 2007, gross hourly wages in Latvia were up by 26.1%, according to the most recent data from the Central Statistical Bureau.



The statistics office noted that the seasonally adjusted rate of increase has been reducing since 4th quarter of 2007, but this is very small consolation for a process that is effectively blowing a massive hole in the side of the Latvian economy's ability to compete internationally. And indeed they also point out that compared to the second quarter of 2007 the most rapid increases in hourly labour costs have been in economic activities like education – up 30.5%, hotels and restaurants – up 29.3%, mining and quarrying – up 27.7%, construction – up 27.4%, and trade – up 27.3%.


Unemployment Rises While Employment Stagnates

On the other hand unemplyment has started to rise, slightly, and according to the labour board there were 56333 people unemployed in August - nudging up the unemployment rate to 5.2%. To put things in perspective, the number of unemployed is still below that registered in August 2007 (57940), when the economy was, to all appearances, still booming.



Employment, on the other hand, has been more or less stagnant over the last 3 quarters, although year on year rates of employment increase have been healthy (an average of 4% during the last three quarters) and total emplyment has not started to decline in any notable form.





Household Indebtedness


Internal demand, as we have noted, has collapsed, and the Latvian economy is in recession.




So what is the answer to this mystery? How can employment be stable, real wages rising considerably, and yet the economy slumping. Well, the answer isn't too difficult to find, it revolves around household borrowing, and the rate of increase in household debt. If we look at the chart below, we can see that the Latvian "boom" was being fuelled by truly massive y-o-y rates of increase in household borrowing. So the high rates of growth were not due to large productivity gains pushing a supply side expansion, but due to rapid increases in domestic consumption fuelled by growing debt, a process which pushed the Latvian labour market (given Latvia's unusual demography) way beyond capacity limits, and stocked-up a huge inflation bonfire.

As we can see in the above chart, this all really became "one big party" after mid 2005. Now I say Latvia has no available monetary policy, but this isn't entirely the case. Had the Latvian central bank imposed very strict credit restrictions starting in 2005 (and not in the spring of 2007), and had the Latvian government operated a large (liquidity and demand draining) fiscal surplus of 5% of GDP or so starting in 2005, then maybe much of the worst of the distress which is now about to come could have been avoided.

But it is always easy to be right after the event, and I am not claiming to have had any better idea than anyone else at that point. Certainly even the IMF staff economists (who seem to me to be normally much more on the ball than their Brussels and Frankfurt equivalents) only started pushing the idea of fiscal surpluses strongly rather late in the day, and I am sure if we could rerun all this they would have acted differently. But then, you know, the owl minerva only flies after dusk, and all that.

But, as we can see, once the credit restrictions were put in place to some extent, the rate of increase in new credit did slow, and what is so remarkable is how quickly the whole economy itself slowed as this increase in credit lost steam. We are still seeing a year on year rate of increase in household credit of around 25%, and yet the economy is contracting, so what happens if credit stops growing is anyone's guess.

So what is the future? Well basically, given what we have just seen about the debt side of the equation, I think we can safely say you can forget about Latvian domestic demand as a driver of growth. And since government spending is not going to be the answer given the impending liabilities which will be hitting the Latvian state from the ageing population phenomenon (health, pension costs etc), exports would seem to be the only way out. But this is where, after all that inflation, we hit a snag.


As can be seen in the chart below, Latvian exports, far from having risen to the role which falls upon them, have rather weakened over the last six months or so.




True, in year on year terms, they have been rising, but the rate of increase has been slowing steadily, even if - due largely I think to an especially weak month in June and a low base effect in July 2007 - they did rebound a bit in July. The weakness in Latvian exports as a growth driver has been rather masked by the much more dramatic decline in imports, which have moved strongly into negative y-o-y territory despite the high level of oil costs, and this has obviouly been a headline GDP growth positive (that is GDP would have been worse had imports not shrunk so considerably). The decline in imports has also prevented the trade deficit from deteriorating further.



But of course, if exports are now to drive growth (and if Latvians are to start paying back all that foreign debt they have been accumulating) then what is needed is a surplus not a deficit. Well, Latvia needs to start selling more abroad, whatever, however, and I think that in order to do this, Latvian relative prices now need a very substantial adjustment, which either means very substantial internal price deflation, or that horrible and unmentionable "D" word. If people sit back with their arms folded and simply wait to see what happens (out of idle curiousity, perhaps?), then the former will inevitably happen, but the thing is the process could become so violent that it provokes the second inevitably in its wake, which raises the question as to whether it might not be better in the longer run to grasp the bull by the horns, and go down the second road now and dircetly. Whatever happens, none of the possible solutions for the current predicament are going to be easy.

Hungary: Wages Up and Construction Activity Down In July

Wages in Hungary continued to rise more quickly than inflation in July, though the difference was not as great as in June. Gross wages rose by 7.8% year on year in July, down from the 9.7% rate registered in July, according to the latest data from the Central Statistics Office (KSH). On the other hand, bonus-adjusted gross wage growth in the private sector - which is the Hungarian central banks favourite wage growth indicator - accelerated to 9.3% from 8.9% in June. Given that inflation was running at an annual 6.7% in July this mean that on this measure real wages were up 2.6%. Net real wages including bonuses, in contrast rose by a mere 0.2% yr/yr.

Taking January to July as a whole gross wages were up 8.1% , while net wages increased by 7.2% (year on year) . Taking the private sector alone, gross monthly wages rose by 8.3% year on year in July, down from an 8.7% rate in June, while in the public sector the rate of increase slowed much more significantly, to 7.1% from 12.7% in June. The decline in the gross monthly wage in the private sector follows the recent trend, since year on year growth has been consistently below 9.0%.

In general the central bank will probably welcome the general trend downwards, since wage increases beyond productivity obviously constitute inflationary pressures. There are however still two interesting questions to which we do not really know the answer. The first of these is that it is very hard to assess the impact of any wage "whitening" on the pubished numbers. The second is why it is that even though private sector ex-bonus wages increased by an annual 9.3% in July (over 8.9% in June) bonus payments remained so low. Companies were obviously scaling back on bonus payments in July, and looking at the weak performance in industrial output in the export sector in July might we find the explanation for this? We could also ask ourselves whether this is simply a one of "bad month", or whether, as the Western European economies slow this is actually an indication of what we may see in the future.

Inflation Slowing

Hungarian inflation slowed in August as oil and food costs, which have buoyed consumer-price growth over the past year, started to ease back. The annual rate fell to 6.5 percent from 6.7 percent in July. Month on month, consumer prices fell 0.3 percent over July.



Decreasing global energy and food prices have raised expectations that the inflation rate will now gradually fall back toward the central bank's 3 percent target. Food prices, which jumped 2.2 percent on a monthly basis last September as inflation began to quicken globally, fell by the most in three years in August. They were down 1.5 percent, dropping for a third month. A 9.9 percent increase in household natural gas prices on July 1 added 0.3 percent to the August figure and prevented inflation from slowing further. Oil prices, which have fallen over 30 percent since mid-July, also point in the direction of a furtherdrop in the inflation rate.



The strengthening of the forint, which gained 11 percent against the euro in the past six months has helped contain prices. The price of durable goods fell for a fifth month in August. Hungary's central bank has kept the two-week deposit rate at 8.5 percent for three months, double the rate in the euro region, after following a one percentage point rise to curb inflation and underpin the forint.

Employment Remains (more or less) Stagnant

One thing the Hungarian economy is NOT doing to any great extent is creating employment. The number of employees in companies employing at least 5 people and the public sector combined dropped by 0.5% year on year in July to hit 2.755 million. This followed a 0.9% annual drop in June. This process is only natural as the Hungarian population declines, but of course it does mean that the only real way the Hungarian economy can grow is by increasing productivity, and that in June something like the first 1% of productivity improvement was eaten up by diminished employment. Clearly the answer to this is to increase labour force participation rates, and this sounds fine in theory, but we are a long way from seeing it happen in practice.

The distribution of the labour force is changing, however, since the number of employees in the private sector rose by 0.3% year on year in July but decreased by 3.5% in the public sector. On the other hand, and to put all of this in some perspective, there are now over 100,000 fewer employees in the private sector than there were in June 2003.

Construction Drops Back Again In July

Construction output fell more strongly in July - down by 11.8% year on year, following an 8.1% drop in June. Taking the number of working days into account, the decline was 12.8% in July, and 9.0% in June.



Adjusted seasonally and for working days, output contracted by 2.8% month-on-month from June, following a 5.5% month on month contraction in June. July was the third consecutive month when construction industry output dropped. Output in January-July was down 10.9% over the same period of 2007.



While the index will probably settle down a bit in the autumn, given the base effects due to the strong plunge in output last autumn, we are unlikely to see any short term improvement in construction output, and given the ongoing turmoil in the sector globally the position will more than likely continue to deteriorate for some time to come. Maybe someone will one day wake up to the fact that with an ever smaller and older population in the longer term you need fewer and fewer houses. As can be seen from the chart below, the level of construction activity peaked in Hungary in 2005 (along with domestic private consumption growth), and given the population situation, and that civil engineering will be continuously constrained by government budget commitments to health and pension programmes in an ageing society, it is very unlikely that we will ever again reach that level. Remember here, we are talking about the RATE of output, and not the STOCK of buildings, bridges, motorways etc. I simply can't see why none of this can enter the mindset of those who are sitting stoically, arms folded, waiting for the "inevitable" upturn in Hungarian domestic consumption. Less retail sales, less building, less people working, this is, I think, what you should expect with a declining and ageing population. And, of course, we are about to see this phenomenon repeated in one society after another as the process spreads. Hungary is simply unfortunate enough to be among the first.

Is Russia Just Another Emerging Economy, Or Is There Something Special About The Present Bout Of Financial Turmoil?

Russia's President Dmitry Medvedev today pledged $20 billion in financial support for the Russian stock market and cut oil taxes in an attempt to bring a halt to what has now become Russia's worst financial crisis in a decade. Medvedev took this action in order to try to lay the basis for a reopening of Russia's bourses tomorrow, following three days of irregular operation on the back of a 25% drop in the Micex Index. After the announcement Russian shares which are traded in London surged and the interbank lending rate plunged.

The decision followed a meeting between Medvedev, the central bank Chairman Sergey Ignatiev and Russia's Finance Minister Alexei Kudrin. Ignatiev also announced that central bank reserve requirements for Russia's banks would be eased in an attempt to provide more liquidity.

The tax cut for oil exports will come into effect on Oct. 1 and save producers and refiners $5.5 billion, Kudrin said. OAO Rosneft, the country's biggest oil company, climbed 23 percent to $5.76 in London trading at 3:40 p.m., while smaller rival OAO Lukoil advanced 8 percent to $56.20. Moscow's stock exchanges will open tomorrow after being halted by the market regulator.

The central bank cut reserve requirements for banks by 4 percentage points with effect from today, and this should free up an estimated 300 billion rubles. The move is in addition to a Finance Ministry decision yesterday to make $60 billion of funds available to banks, including a three month injection of $44 billion into Russia's three largest banks - OAO Sberbank, OAO Gazprombank, and VTB Group. VTB, the only one of the three that trades in London, had jumped 15 percent to $3.40 by late afternoon trading.

Russian sovereign bonds also dropped to the lowest in four years today, with the yield on the government's 30-year dollar bonds 32 basis points higher this afternoon at 7.3 percent at 1:23 p.m. in Moscow. The cost to of protecting this debt against default jumped 17 basis points to 300, the highest since May 2004, according to BNP Paribas prices for credit-default swaps.


Short Term Triggers and Long Term Issues


The present crisis seems to have been sparked by an almost random event - the default of brokerage firm Kit Finance on a number of repurchase agreements. This rather small scale incident, of limited importance in and of itself - seems to have produced something approaching panic which extended right across Russia's financial markets. Evidently investors had been become increasingly nervous about holding Russian assets given ongoing concerns and the scale of the global financial turmoil. In fact Russia seems to be facing something of a "trifecta" at the moment, with the normal nervousness about holding riskier emerging market assets being reinforced by concerns about the vulnerability of the Russia economy in the face of falling oil prices and issues provoked by Moscow's recent decision to "go it alone" in recognising Georgia's two separatist regions. All these factors have coalesced to produce what is being described as "an especially toxic cocktail" whose effects - and despite Russia's substantial oil fund safety net, and the very large quantity of foreign exchange reserves parked at the central bank - seem to be proving very hard for the Russian financial system to simply brush aside.

The real point I would like to stress right however, is that while Russia's financial markets are currently taking a pounding for relatively fortuitous reasons, the underlying macroeconomic issues were always going to raise their head, as I have tried to spell out in my two extensive recent reviews of the Russian economy, Russian Inflation, Too Much Money Chasing Too Few People? and Russia's Consumption-Driven Inflation: Will It All End In Tears?. Basically Russia is suffering from some sort of modern variant of "Dutch disease", whereby the revenue generated by the sharp oil boom has accelerated the rest of the economy way beyond its short term capacity level (especially given the underlying demographic issues Russia faces) and this has simply produced a very pronounced spike in short term inflation, coupled with deteriorating competitiveness in Russia's domestic industrial sector. So even though it is obvious that we are not about to witness a financial meltdown - or anything approaching it - in Russia at the present time, what has happened over the last week is an early warning sign. Things are not all for the best in the best of all possible worlds here, and even if a resurgence in oil prices during 2009 will once more paper over the multitude of seismic cracks which are emerging, the deep and endemic problems will in fact only worsen if what we are treated to from the Russian administration is simply more and more of the same on the policy front.

Industrial Output Weak Again In August


In many ways the achilles heel in Russia's current development process is not to be found in the financial system - $550 billion or so in foreign exchange reserves and another $160 billion in the SWF should certainly serve to protect the economy from all but the most severe of shocks - rather the achilles heel is Russia's nascent industrial sector, which is being steadily choked into quiesence by a combination of high domestic inflation and long term labour shortages produced by Russia's rather special demographic profile. Indeed Russian industrial production expanded at a slower pace than most observers were hoping for yet one more time in August, according this week's data from the Federal Statistics Service. Industrial output was up 4.7 percent, compared with 3.2 percent in July and 0.9 percent in June. And even the apparent acceleration over July is really only a mirage based on base-effect variations from 2007, since output actually fell 0.9 percent on the month, as foreseen in the VTB Manufacuring PMI survey.

I think it is important to bear in mind here that Russia's economy actually grew at an annual 7.5% in the second quarter, while manufacturing growth was nearer 5%. Which means that in a "newly industrialising country" the weight of industry in the economy is declining. This is obviously unsustainable - and doubly so given what we are now seeing about the flaws to be found in the financial-services construction-activity driven model which some had seen as an alternative to industry - since however resource rich Russia maybe, you cannot live from oil alone, especially when your oil output has a ceiling. Basically the more living standards in Russia rise, the less important oil will become as a percentage of GDP, and the more dependent the Russian economy will become on other sectors. This is why the current consumer price and wage inflation levels are no mere trifle.

Obviously it has been of some considerable importance for the country's future that the Russian authorities get a grip on the inflation problem, and this is just what the central bank has clearly failed to do, with the annual rate rising again to 15 percent in August - up from 14.7 percent in July. So one component in the present financial crisis is clearly a crisis of confidence in the quality of Russia's institutions and in their capacity to handle the very complex problems which present themselves in modern macroeconomic management.

With the central banks benchmark interest rate currently standing at 11%, and inflation at 15%, Russia has negative interest rates of 4% which obviously make it very easy to fuel a lending driven consumer and construction boom, but very much more difficult to communicate to observers that you actually know what you are doing. So while all that foreign exchange reserves muscle that the central bank can put to work in the short term to stamp out the present bonfire will in all probability bring a halt to the present panic, they are clearly not able to prevent the outbreak of the fires in the first place, and we should, therefore, expect more of the same at some point. To make a comparison, Brazil's central bank currently has interest rates at 13.75% while inflation is running at just over 6% (ie Brazil has 7.5% positive interest rates), and the bank is currently justifiably earning for itself a reputation as Latin America's new Bundesbank, an expression I doubt it would ever ocur to anyone to use in reference to the Russian equivalent. And the comparison I am making with Brazil is no idle one, since Brazil is, of course, also an oil-and-resource rich emerging economy.



So it is clear that Russia has special problems, problems which (despite the similarities) set what is happening in Russia rather apart from what is currently happening in a lot of other emerging market economies.

Rout On The Bourses

Both Russia's MICEX and RTS exchanges remained effectively closed first thing this morning (Thursday) following trading being suspended again yesterday - they were in fact open for less than two hours on Wednseday morning - with closure being effected in order to prevent a further sell-off on top Monday's record-breaking falls. The ruble-denominated Micex Stock Exchange did resume some very limited trading at 11:00, but only limited operations were authorised - the decision being effectively to allow participants to close repurchase deals still outstanding from Sept. 16 and Sept. 17.

Russian stocks have now plunged around 60 percent since their May peak, and while the Micex did initially gain 7.6 percent in initial trading yesterday, these gains were very rapidly erased and then turned negative, as the index plunged as much as 10 percent before a halt was called. Russia's dollar-denominated RTS index stood at 1,058 points when trading was halted, nearly 58 percent down from its peak of 2,498 points reached in May.

Emerging Market Woes

In part Russia's problems only reflect more general "risk aversion" issues which are facing all emerging market economies. Emerging-market stocks have fallen the most in 11 years this week, and their currencies have been falling, and the cost of insuring emerging market bonds have been rocketing as rising interest rates and tumbling commodities have prompted investors to sell riskier assets.

Every emerging stock market in the MSCI indexes has been retreating this month, and the MSCI Emerging Markets Index fell 2 percent yesterday to 768.92 a time, its lowest level since October 2006. The index is now down 19.59% since the start of the month, and 29.27% over the past 3 months. Basically, as we can see in the chart below, the trend has been down since May.



The Russian MSCI index, in comparison, is down 36.1% on the month, and 54.2% over the past three months. That is, the fall in Russia has been much steeper, and certainly predated the August "events" in Georgia, which have only served to accelerate a process which was already ongoing.



Of course, to put things in a bit better perspective, the recent fall follows several years of rising stock values, and thus the current stock "correction" is to some extent a cyclical one, as can be seen from the 4 year MSCI index chart (below).




Falling Oil Prices


In the forefront of the fall in Russia share prices have been energy stocks, including Russian oil producers like OAO Gazprom and OAO Rosneft, who have declined substantially following the sharp drop in crude prices. Gazprom, the world's biggest natural-gas producer, lost 18 percent to 158.41 rubles in the latest turmoil, while Rosneft, Russia's largest oil company, sank 22 percent to 132.20 rubbles.

Oil prices were down again this morning, after bouncing back somewhat yesterday. Light, sweet crude for October delivery fell 97 cents to $96.19 a barrel in electronic trading on the New York Mercantile Exchange midafternoon in Singapore. The financial turmoil of recent days has lead to some volatility in oil prices, and the price did sneak briefly back above the $100 mark at one point, but the trend is decidedly down, and crude has now fallen more than $50 — or over 35 percent — from its all-time trading record of $147.27 reached July 11.




Urals crude prices are slightly lower than the light sweet prices quoted above, and peaked at $140.80 a barrel on July 3. Since that time they have fallen about 36 percent and today were at $90.01.


Foreign Exchange Reserves


Evidently the Russian economy is in no imminent danger of short term default, and foreign exchange reserves, which stood at $560.3 billion on September 12 (according to data from the Russian central bank) - the third largest globally, after China and Japan - are evidently ample to handle any forseeable crisis. In addition Russia has a $163 billion SWF (the National Welfare Fund), which is split into two parts, $130 billion in a reserve fund, and $33 billion in the National Wealth Fund (the SWF proper). The reserve fund especially can be used to support any additional government fiscal spending which may be produced by the need to inject cash into the banks and the equity markets.




Nonetheless - as can be seen in the above chart - Russia's reserves have been dropping quite sharply since early August, and are now down some $37 billion since their August 8 peak. Reserves declined by $13.3 billion to $560.30 billion in the week ended Sept. 12 alone, after falling $8.9 billion in the previous week. About 47 percent of Russia's reserves are held in U.S. dollars, 42 percent in euros, 10 percent in GB pounds and 1 percent in yen, according to the most recent figures released by the central bank (June 30, 2007).

Part of the recent reduction in reserves has been the result of central bank intervention in support of the ruble, since Russia operates a policy of trying to maintain the currency steady within a trading band set against a basket of euros and dollars. Evgeniy Nadorhsin, a senior economist at Trust Investment Bank in Moscow, estimates that the central bank sold approximately $3 billion in fx reserves last week.


So Where Do We Go Now?

This is very hard to say. Clearly we should expect the economy to slow substantially in the last quarter of 2008 and the first quarter of 2009, as credit conditions tighten for households, and the decline in oil prices restricts revenue flows to the corporate sector. As just one indication of the worsening credit conditions we could note that Russian 5-year credit default swaps are trading with a spread of around 253-255 basis points, little changed this week but more than double the level seen before the start of the conflict with Georgia.


On the other hand Russia is hardly the Baltics, so we should not expect the economy to go into a nosedive. A lot depends on the view you take about the future of energy prices. Since my own view is that the global economy will slow considerably - in addition to the reduction in growth rates alreadty seen so far this year -in the aftermath of the most recent bout of financial turmoil, and this will serve top bring oil prices down even further, but we should reach a floor at some point, at around $80 perhaps.

More importantly when it comes to the future of oil prices, I am not expecting any kind of long and deep global recession. Many of those developed economies who are significantly affected by the bursting of their construction booms (and the banking issues which have gone with it) will probably have weak domestic consumer demand for some time, but a solid core of emerging economies may well take off again quite rapidly as we move into 2009, and these should give significant impetus to the global economy as a whole and especially to export dependent economies like Germany and Japan (who by and large are not reeling under the impact of the construction bust), but who are noting the slowdown in their key emerging markets.

As we can see in the JP Morgan EMBI+ index (see below), emerging economy bonds have taken one hell of a battering in September. Looked at the other way round, the extra yield investors demand to own developing nations' bonds instead of U.S. Treasuries has been rapidly going up, and today rose an additional 2 basis points to reach 4.24 percentage points, the widest spread since September 2004, according to the EMBI+ index data. So EM bonds have been taking a battering but they have taken a battering because of nervousness about the implications of a financial crisis in the developed economies, rather that as the result of any inherent problems in their own ones. That is what sets this crisis apart from the 1998 one, and that is what means that the financial markets in these economies will in all probablilty bounce back again quite substantially once all the nervousness dies down. Basically most of these markets are neither "oversold" nor are they "maxed out". Au contraire, the prices of their bonds and equities may well soon start to look pretty attractive as the nervousness passes.

What is interesting about the EMBI+ chart (see above) is the way in which things seem to have really taken a decisive turn for the worst in late August, and it is curious to note on the chart below that the Russian MSCI index also started to deteriorate further starting on or around 2 September (see chart below which is from May 2008 to date). So while the Georgia factor may have made people nervous, other, deeper, structural factors are obviously at work.

And while I am on deep structural factors, and the MSCI Emerging Markets index, I would like to conclude by pointing out that the decline since mid May has been pretty generalised, and in some sense the process involved is obviously a cyclical one. But this fall will at some point hit bottom, after which time we should be ready to see a rebound, as investors move in and snap up what will obviously be seen as very attractive buying opportunities. So while some key developed economies seem to be clearly heading for an extended period of pretty sub-par growth, a number of emerging ones may well be gearing up again for another bout of ongoing super-par expansion.