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Monday, September 22, 2008

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

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