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Tuesday, January 29, 2008

Emerging Market Correction and Pressure on the Forint

Unfortunately Hungary's coming correction seems to be getting very near now. Portfolio Hungary reports this morning on the latest readings on the Calyon Risk Aversion Barometer. Caylon reported on Monday that global equity gyrations continue to dictate the direction of emerging market currencies, with risk aversion remaining high and European equities closing lower again on Monday. Indeed many currencies remained under pressure throughout the trading session yesterday. Budapest Economics also said yesterday that the HUF continued to be the most vulnerable currency in the region, with the currency temporarily hitting 259 against the euro yesterday, although it did finally manage to stabilize at slightly stronger levels by the end of the session.

Mitul Kotecha, head of global FX research at Calyon, confirmed the Budapest economics view, saying Hungary's forint appeared to be highly exposed to rising risk aversion. “Reflecting the vulnerability to risk aversion, correlations between the Calyon Risk Aversion Barometer and some emerging currencies are quite high at present," Kotecha is quoted as saying, adding that Hungary's forint “appears highly exposed to rising risk aversion, with the 1-month correlation between the Barometer and EUR/HUF at a strong 0.85." Of course, the HUF is also suffering from deteriorating domestic fundamentals, an aspect which of course he did not ignore.

Stefan Wagstyl, picks up the theme to some extent, and has another long and relevant piece in the Financial Times this morning, reflecting just how a change in tone is taking place even as I write.

The turmoil in financial markets is turning into a nerve-racking test for the economies of central and eastern Europe and the former Soviet Union. Economists have said the fast-growing region faces a slowdown following the financial shockwaves reverberating around the globe. But the precise impact is uncertain, especially on weaker economies.

The differences are registering in the financial markets. As investors reconsider their strategies, they are becoming more risk averse. Some have turned against emerging markets, including the ex-communistregion. Others are discriminating more between countries.

The spread on five-year credit default swaps (a measure of risk) has widened by 26 basis points for the Czech Republic since last June and by 44 basis points for Poland. But for Serbia and Ukraine the increase is 151 basis points; for Kazakhstan it is 218 basis points.

Given the recent unprecedented credit-fuelled growth surge, this slowdown could be welcome in countries trying to cope with inflationary pressures, including Ukraine, Kazakhstan and Russia, and those facing labour shortages, such as Poland.

The benefits could be even greater in economies facing yawning current account deficits, notably the Baltic states, Romania, Serbia and Bulgaria. As Leszek Balcerowicz, the former Polish central bank governor, told a business conference this month: "We should welcome some amount of a slowdown, especially in the Baltic states, which have been growing the fastest . . . We don't have the information that would make us predict a hard landing. Based on the current information a soft landing in the countries which have been growing fastest is more likely."

I am not as optimistic as Wagstyl is here that we will see soft landings. The existence of virtual currency pegs - which will need to be broken during the correction - virtually guarantees an abrupt change, as does the level of household debt in non local currency .

Wagstyl had an earlier FT piece where he drew attention to the way in which ageing populations and labour shortages were playing their part in this emerging crisis.

Fuelled by strong economic growth and soaring foreign investment, employment is increasing in availability just as emigration has sucked around 5m workers from eastern to western Europe. According to Eurostat, the EU’s statistics agency, labour costs are growing at their fastest rate since the end of Communism – with a 30 per cent increase in nominal costs in Latvia in the year to last September and rises of more than 20 per cent in Romania, Estonia and Lithuania. In Poland, the largest new member, the rise was just under 12 per cent.

In real terms, average gross wages in Poland rose more than 7 per cent in the first nine months of 2007 and in Romania by nearly 16 per cent, according to the Vienna-based Wiiw research institute.

While unemployment levels in western Europe have stayed at around 8 per cent since 2002, in the east they have slid from 14 per cent to under 9 per cent. In the region’s booming capital cities, almost everybody who wants work has a job. Leszek Wronski, head of the central Europe division of KPMG, the accountant and management consultant, says: “We have a job market controlled by employees.”

Even if labour markets ease a little, there will be no return to the super-abundance of workers of five years ago. The region’s populations are ageing even faster than in western Europe and, with the added effects of migration, the number of working-age people is falling in the Baltic states and central Europe. Eurostat predicts that the population of the new member states will decline from 103.6m in 2004 to under 100.6m in 2015, with particularly sharp drops in working-age people.

However, for governments and companies alike, rising labour costs and growing skills shortages raise big questions about the region’s future competitiveness. Everything from decisions on investment location to education, migration and population policies is coming under scrutiny.

So even while he doesn't directly go into how long term fertility may be playing a role in the drama we are watching unfold before our eyes, his mention of "population policy" seems to be a euphemism for this very topic. And if fertility isn't an important determinant in what has been happening, I would be grateful is someone could explain to me why we aren't seeing similar sorts of labour shortages in places like Thailand, Turkey, Chile, Brazil or Argentina, all of whom are growing - or have been, Turkey has slowed recently - very rapidly at the present time.

Back on the 28 August 2007 - just after the financial "turmoil" started - I posted the following, in a piece which still looks extremely good when looked at in the cold light of today, on Global Economy Matters:

"But any looming "credit crunch" is also likely to affect the so called "risk appetite" (that is the willingness to invest in riskier areas or activities) and the place where this is most likely to be felt is in the emerging market area. Those emerging markets which are considered to be most vulnerable will undoubtedly have the hardest time of it, and this brings us directly to Eastern Europe I think and to economies like those in the Baltics, Latvia, Estonia and Lithuania), to Hungary, and then maybe (if there were to be contagion) to the larger economies like Poland and Romania. Alarm driven reports about the dangers of a hard landing in the Baltics have been floating around for some months now (I say alarm driven not because the danger isn't real, but because most of the reports are quite superficial, and don't really appreciate the magnitude of the problem). Whatsmore, as the Bank for International Settlements pointed out in the June edition of its quarterly review , in 2006 Eastern European economies accountedfor a staggering 60% of new emerging market credit:"

At the start of September, and as part of an in depth analysis of Turkey, I posted the extract you will find below. The issue here is foresight, and our ability to see things coming. What is happening now has been obvious for some time, completely obvious, even if many people have had difficulty in seeing it. I completely resist the idea that economics cannot be scientific. I think it has to become much more of a science. But if we are to get from here to there we first need some paradigmatic models which enable us to see things coming rather better than we appear able to do right now.

In a much quoted paper - published back in 2004 by two UCLA economists (Schneider and Tornell) - it was argued that:

"In the last two decades, many middle-income countries have experienced boom-bust episodes centered around balance-of-payments crises. There is now a well-known set of stylized facts. The typical episode began with a lending boom and an appreciation of the real exchange rate. In the crisis that eventually ended the boom, a real depreciation coincided with widespread defaults by the domestic private sector on unhedged foreign-currency-denominated debt. The typical crisis came as a surprise to financial markets, and with hindsight it is not possible to pinpoint a large "fundamental" shock as an obvious trigger. After the crisis, foreign lenders were often bailed out. However, domestic credit fell dramatically and recovered much more slowly than output."

In starting off with this quote I really want to draw attention to two things.

First off, the way in which the current sub-prime liquidity problem in the banking sector of many developed economies is now steadily extending itself into a credit crunch in several emerging market economies. We are now beginning to see a clear and all too familiar pattern. There has been a lot of talk about the Asian crisis, and evidently there are some similarities with the pre 1998 situation, especially, as I shall be arguing over the coming days, in the emerging economies of Eastern Europe.

Secondly there is the "typical crisis came as a surprise to financial markets" argument, since it puzzles me why exactly this should be, or better put, why it should be assumed as a "stylised fact" about currency crises that such major events are in principle not forseeable. I find this very hard to accept. Are we really so inept we are not able to see trouble coming when it finally does come? Is economic theory really so useless in the face of complex "on the ground" facts. Something inside me resists this view. We ought to be able to see things coming, even if we need to distinguish between the where and the when. What I mean is that it should be possible, if the theories you are working with are worth any sort of candle, to pinpoint the areas of likely vulnerability. On the other hand, given that often seemingly random events precipitate the ultimate unwind, it is pretty well impossible to say in advance which random event will turn out to be the detonator on any given occassion.

The sub prime debt issue in the US is a good case in point here, since only at the start of August the Federal Reserve were assuring everyone that problems associated with the US housing market were well under control, while obviously they weren't and aren't, and equally obviously, now, such problems will be seen from the vantage point of hindsight to have played a key role in the events which are now unfolding before our eyes.

So even with this caveat, and with due regard for the well known problem of human fallibility, lets see if this time any of us are able to do just that bit better than normal, and in attempting to see things coming lets see if we can learn something which may make us better able to handle and foresee macro economic problems in thefuture.

For a fuller analysis of the specifics of Hungary's present crisis see "Just Why Is Hungary So Different From The Rest of the EU10?", "Hungarian Central Bank Leaves Interest Rates Unchanged" and "The EU Comission Warns Hungary on 2008 Budget Deficit".

For e theoretical exposition on why fertility matters to the EU10, see Claus Vistesen "Catch Up Growth and Demographics - Evidence from Eastern Europe".

Friday, January 18, 2008

Estonian Property Shares Sell-off

It is very hard to know how to read this news in Bloomberg today:

Estonian builders and property developers, including AS Merko Ehitus and Arco Vara AS, tumbled in Tallinn trading on concern a global economic slowdown may deepen the decline in the Baltic real-estate industry. Merko Ehitus, Estonia's largest builder, dropped as much as 11 percent to 10 euros, the steepest decline this decade. It rebounded to trade 1.9 percent lower at 10.99 euros, the lowest level in almost thee years, by 1:30 p.m. Arco Vara, the only publicly traded Baltic property developer, fell 9.2 percent, its biggest-ever decline, to 1.08 euros. The price is a record low and is 56 percent below its initial public offering price in June last year.

Things are definitely wobbling all over the place at the moment. You need to keep a close eye on what is happening in the stock markets across the EU10 at the moment. Two days ago Bloomberg ran this story about how central european stocks now seemed to be entering a "bear" market:

Central European shares fell for a sixth day, led by OMV AG and PKN Orlen SA, the region's biggest refiners. Austria's ATX extended its drop from a July record to more than 20 percent, a common definition of a bear market.

The NTX Index of 30 companies in the region fell 4.2 percent to 1,716.37 at 1:08 p.m. in Vienna, heading for the lowest close in 10 months.

Austria's ATX Index lost 4.5 percent to 3,833.1, bringing the drop since closing at a record on July 9 to 23 percent. A bear market is widely defined as a decline of 20 percent or more in a 12-month period. Austria followed Poland, Singapore, Hong Kong, Sweden and Japan in entering a bear market after last year's U.S. subprime-mortgage collapse.

The mention of Austria is significant since the Austrian banks are the most exposed should there be any large correction in central and Eastern Europe (all those Swiss Franc and Euro loans). The sell-off continued today:

Central European shares declined for an eighth day, the longest losing streak in two months. Erste Bank AG, Austria's biggest, and Komercni Banka AS led losses.

The NTX Index of 30 companies in the region declined 1.6 percent to 1,694.69 at 10.32 a.m. in Vienna, heading for the lowest close in more than 10 months. The measure has lost 8.2 percent this week.

Austria's ATX Index dropped 1.7 percent, the Czech PX Index slid 3.3 percent and Poland's WIG20 Index retreated 1 percent. Hungary's BUX Index added 0.3 percent.

Benchmarks in Austria, Poland and the Czech Republic dropped more than 20 percent from last year's highs this week, the common definition of a bear market, amid concern that the U.S. will enter a recession.

Erste Bank slid 2.1 percent to 39.05 euros today, while Komercni Banka, the third-largest in the Czech Republic, slumped 4.3 percent to 3,496 koruna. Raiffeisen International Bank Holding AG, Russia's biggest foreign lender, lost 1.6 percent to 79.68 euros.

Telekom Slovenije d.d. fell 1.9 percent to 340.20 euros. The shares have dropped 10 percent since Jan. 14, when the Slovenian government extended the auction of a 49.13 percent stake in its national phone company for a third time, with two bidders left.

The Romanian Leu continues to wobble, and as I note on my Romania blog perhaps the most ominous quote in the press on Romania at the moment is the following one, since it indicates that central bank policy may now become increasingly driven by the need to stem a collapse in the currency, rather than by a need to regulate internal demand conditions. If confirmed, this tendency would not be a positive one.

``Our rough calculations suggest that the main rate should be above 9 percent to fend-off the pressure on the leu,'' said Ilker Domac, an economist at Citigroup Inc. in Istanbul, adding that he expected another 50 basis-point increase in February.

Also I have a summary of the latest construction news from Hungary, together with a brief assessment of where we are in real economy terms there right now.

Basically I think we are all only waiting at this point to see who is actually going to be the first through the door.

Monday, January 14, 2008

Soft or Hard Landing in Lithuania?

By Claus Vistesen

Cross-posted from Alpha Sources

The fact that economic conditions in Eastern Europe are deteriorating is hardly news at this point. The only question which remains to be answered is the extent to which this will be a hard landing or perhaps more specifically which countries will fair better than others? It is fairly easy to get bogged down into details when it comes to Eastern Europe, something which the Eastern European Economy Watch (run by Edward and me) is a testament to. So, in this entry I will continue my review of Lithuania which, apart from my general notes on Eastern Europe, has constituted my anchor when it comes to understanding the details of the Eastern European situation or perhaps more aptly the situation in the Baltics in particular. If you want background on this you should follow the two links above which can lead you to almost everything Edward and I have written on the topic. However, and in terms of more official contributions to the issue the IMF as well as the World Bank have both made some fine reviews of the issues at hand.

As I noted above this entry will deal exclusively with Lithuania and thus by derivative the Baltics although I think that many of the issues can be extended to the region writ large. A couple of days ago Edward fired a shot across the bow in the context of the Baltics where he asked whether in fact Estonia was heading for a hard landing? The evidence seems mounting that this might be the case and after having looked at Lithuania I find little reason to disagree with him in a general context. And we haven't even noted Latvia here where arguably the most dramatic degree of excessive capital inflows, growth rates, credit exuberance, and inflation have occurred. My analysis on Lithuania will take a close look at the following factors which cuts across the gamut of issues we need to factor in:

  • General growth rates - To show the general momentum and when/where it might be turning.
  • Prices - This is a natural but increasingly lingering effect of the sizzling growth rates we have seen recently. Basically, we need to think about capacity to grow here without stoking inflation and with the expectations levied on Lithuania (alongside the rest of the region) relative to the underlying capacity (i.e. the labour market conditions mentioned below) we are basically witnessing a huge mismatch which might unwind very rapidly with detrimental consequences to the economy and society as a whole.
  • The labour market - This is a very important aspect and essentially cuts into the point that Lithuania like virtually all other countries in Eastern Europe have moved through the demographic transition too fast and too brutish essentially suffering a severe overshot where fertility has declined (throughout the 1990s and into the 21th century) to alarmingly low levels. Coupled with a steady net outflow of migration this is basically hollowing out the human capital foundation of the economy at a speed which not even Edward and I had anticipated and thus the capacity to grow sustainably as well as to enjoy that much allured process of convergence/catch-up growth.
  • External balance - The Baltics have very large current account deficits at the same time as they are running currency pegs to the Euro through currency boards. This is not necessarily a recipe for disaster but the extent of the imbalances is mounting and if expectations at some point reverse as to the sturdiness of these pegs the situation could get out of hand. As I will show the condition of the situation rests upon the ability to sustain inflows of credits to consumers (and of course FDI) and given a global credit crunch as well as an unsustainable economic environment it appears that we are moving closer to a situation where the current development cannot be sustained. In general, I think it is reasonable to assume that in a traditional currency crisis framework the currency boards would be pretty helpless in defending the domestic currencies for an extended run. Of course this then gets us into the point about the households' balance sheets and what it will mean if the pegs run loose.
Let us get on with it then and begin with a look at the general development in GDP which, relative to my previous notes, now includes Q3.

As we can confirm from the graphs above Lithuania continued to thunder along in Q3 even though this constitutes somewhat of a backward looking focus at this point in time. What should be noted however is that while quarterly GDP rose a seasonally adjusted 5.4% private consumption actually declined. This does not fit the growth path by which Lithuania and the Baltics have grown the past years and may signal that something is changing. Especially, I will be watching private consumption since we see a slowdown from here on it will be very difficult to sustain the inflows needed to finance the current external balance and obviously also the headline growth in GDP. In this light the Q3 figures come off as a bit of a fluke really but coupled with a contraction in the external deficit (i.e. as in Estonia) it may be the first signal that things are about to change for the worse in the sense that whatever these countries are ready or not the imbalances are now set to unwind. In this respect the Q4 figures will be most interesting since they will indicate the direction and even more important the speed by which this is moving.

Having looked briefly at top line GDP figures I turn now to the more nitty-gritty parts of the analysis. In this way, it would perhaps be a good idea to have a close look at the evolution in prices since the very high rate of inflation has been one of the main detrimental effect of current growth spurt and one which has eroded the external competitiveness. The main reason for this is the well known relationship between productivity growth and growth in wages and how the latter by far has outpaced the former in Lithuania and the Baltics. More so, prices become important since if we were to identify a break-point in topline GDP growth inflation should follow down. This is likely to happen sooner or later of course but the flip side of this is the point that with their currencies pegged to the Euro the only way Lithuania can ultimately correct once growth stalls is through price deflation. In fact, you could argue that if the imbalances begin to unwind disorderly it may be difficult to stop this from happening which is why of course we need to make sure we don't get to that.

The first graph is particularly interesting since it takes us into the real world so to speak as it shows us the evolution in monthly prices which confirm that the increase in price growth seems set to linger in Q4. I have chosen to add both the main core index and the core index stripped of headline inflation in light of the order du jour in current economic and financial debates. So, pick your weapon of choice. Either way, the main index running at 8% as we exit 2007 demonstrate the generally elevated pace of things. If we move into the more finer grains of the price developments we see that wage costs increases are still in the >20% ballpark and that construction input prices are also running high up the ladder which is rather significant since the construction sector has been one of the main sectors driving the expansion. As for the PPI I am happy that we are seeing an increase since I have had some issues discerning why it was that low since it marked on of the peculiar ways in which Lithuania differed from its Baltic brethren. As a conclusion, nothing new from the front it seems when it comes to inflation and we will now have to see if growth slows down just what the transmission mechanism will be. However, as I have noted we could run into deflation at some point and really this would only be a matter of how long the pegs were able to hold and thus the 'willingness' to correct through bending the stick too much into one direction (deflation, massive fiscal tightening etc) relative to the other (letting the Litas go).

If inflation is one of the chief effects of the growth momentum we have observed lately what is the course then? Clearly, a high inflation rate is to be expected in emerging markets as higher relative growth rates also lead to higher relative inflation rates following the principles of growth convergence. But why have inflation rates been as high as we have seen in Lithuania? Well, in order to understand this we need to use some basic macroeconomic intuition as I also explain in my introduction above. Essentially, we need to look at the labour market and thus always remember the two stylised facts. 1) the trend of net outward migration in the most productive labor cohorts and 2) the collapse in fertility throughout the 1990s.

You don't need to be a macroeconomic literate to see that the general condition on the labour market is one of some tightness. Depending on the measure you look at and whether it be quarterly or monthly the unemployment rate is roughly running at 4% as we exit 2007 down from about 5% in the beginning of 2007. In numerical terms this corresponds roughly to a decline from 80.000 to 60.000 depending on the figures you look at. Now, this might not mean much but we need to consider a few things. The first thing is of course the relative tightness of the labour market from a general empirical perspective where we know that once we venture into the 3-4% range we get into serious bottleneck and mismatch issues. The job vacancy rate is a good proxy here and as can be seen from the last graph we are soon running into one of those 'does not compute' issues since with 60.000 persons unemployed and 30.000 vacancies it we are looking at a vacancy ratio of about 2 which is very tight. Another thing to take into a account is the net migration rate. Since 2001, Lithuania has 'lost' around 5000-6000 people each year and if we apply this average figure for 2007 we can easily see how the string is getting tighter by the day.

The labour market issues are important for two primary reasons. The first is the contribution of the tight labour market to inflation and wage costs and essentially how productivity increases stand no chance in following the increases in wages. The second point however is the risk that as growth stalls the unemployment rate will rise again. Now, this of course somewhat an argument non-sequitur in the sense that it is a foregone conclusion. An economy cannot 'run out' of labour but what happens to migration flows then? This is big issue for me and if a severe slump intensifies the outward migration of qualified labour (i.e. this is the labour most likely to move first) the human capital foundation of the country will simply get eroded. So, take note! This is something to watch and really I would like to see not only a endogenously generated response within Lithuania and the Baltics but also a EU wide response to this issue since it is a most pressing one and not merely one of how the EU15 can use Eu10 as a labour repository.

The final section of my note takes us to the dark vaults of balance of payment analysis and essentially constitutes an expansion relative to my previous focus on Lithuania in past notes. For an appetizer for what comes next my recent note on Poland's external position might be handy. Let us look at the graphs and then move our way through the argument.

The graphs are divided into two topics. The three first shows the evolution of the overall current account balance in various measures whereas the last two plots information on the net investment position (NIIP) which is a stock measure of the difference between a country's external financial assets and liabilities. If the NIIP is in the red as is the case here it means that external liabilities outweigh external assets.

If we look at the three first graphs we confirm the general idea that Lithuania is running a large external deficit. Especially the q-o-q measure of the trade balance expressed as percentage of GDP sums up the general picture I think with a trade deficit amounting to >35% of GDP. Another more cyclical thing note is the contraction in the external deficit in Q3 which coincides with the drop in consumption expenditure in Q3. This is not coincidental I think and as I say above we now need to watch closely what happens in Q4 since if the current trajectory continues Lithuania may run into trouble sustaining the inflows needed to cover its external deficit in the sense that we might just be moving into a situation where the trend is breaking with respect to growth in private consumption. So what is this all about then? This is where we need to the NIIP then. As two points should be noted from the graphs above apart from the obvious point that the NIIP is negative by some margin. The first is the composition of external liabilities where especially bank loans need to emphasised. What we basically have here is then the formal evidence for all the stories we have heard about how foreign banks have been entering the Eastern European/Baltic markets through provisions of consumer credit, loans and mortgages often denominated in Euros (in the Baltics) and Swiss Francs in Hungary and Romania. We see clearly then how bank loans have contributed heavily to evolution of the NIIP and if we sideline this with the evolution of private consumption not to mention the whole global credit crunch debacle it is not difficult to see how this link of the chain might be a bit corrosive as we move forward even if it is not yet certain that it will break. The second point is that we see evidence in Lithuania of the same inter temporal correlation between the inflow of direct investment and the income balance as in Poland. Basically, the inflow of direct investment means that foreigners will earn more on their assets in Lithuania than Lithuanians earn on assets abroad. This is not necessarily alarming in itself and quite natural if you factor in the economic dynamics. But in Lithuania's situation with its monetary policy tied to a currency board and with the current state of the external position a structurally deteriorating income balance will make it even harder to swing the external deficit into a comfortable territory.


So, is it crunch time in Lithuania? This is difficult to say but what is certain is a that significant slowdown is now coming. Whether it will be hard is another question. Essentially, a hard landing would entail a sharp stop in the inflows as foreign banks' subsidiaries retreat to their native territories. This could then unravel the whole edifice of a pegged currency regime and the households' un-hedged cross-currency liabilities. The real question is then whether the banks who represent the main life line for an orderly slowdown will stay pat and follow the growth down or whether they will back up their bags and cut their losses. The outlook on this will most likely hinge on two things. The general nature of the slowdown in Lithuania and by proxy the individual countries' relative slowdown in growth and secondly the risk that events in one country will spread to another. As for the first one it is likely to be rather abrupt as we see now that both consumer confidence and consumer spending indices are dropping sharply in almost every country. However, what might end up tipping the boat will be the likelihood that events in one country can spread to another. Here I am particularly looking for the risk that events in Hungary or Romania will act as the well known canary in the coalmine.

It remains to be seen at this point. Q4 will be important for Lithuania I think as well as will the general and ongoing nature of the global financial market turmoil. If things turn to the worse with respect to financial markets in general and if that famous spread between the LIBOR and the nominal rate widens again it could incite some of the banks most exposed in Eastern Europe to cut their losses while they can and if one goes they all go I think. So, this note does not emphasise panic but rather calm oversight. Yet, the risk of a hard landing is not decreasing as we move forward I think which is perhaps the real message to take away here more than an actual call. In this light, I would extent my voice to the fine people at the ECB and EU in general to keep a weary eye on events here since if things turn for the worse timely action will be needed and not a stick followed by some pointless rant about how Euro membership is now postponed for another decade.

Inflation Bulgaria December 2007

Bulgarian inflation eased back ever so slightly in December, from a 12.6% annual rate in November to a 12.5% in December. According to the National Statistics Office today the slight downwrad movement was produced by falling prices for telecommunications and for an easing up in the rate of increase on food and transportations costs.

Nevertheless Bulgaria's rate is still the second-highest in the European Union after Latvia, and this is evidently producing an unsustainable situation. Consumer prices rose 1.1 percent in the month after a 1.6 percent increase in November.

Bulgaria and the Baltic nations of Latvia, Lithuania and Estonia are struggling to slow the EU's fastest inflation because their central banks' so-called currency board systems limit monetary policy options when it comes to stemming price growth.

Costs for phone calls and other telecommunication services fell 0.5 percent in the year, the statistics office said. In September, a 25 percent jump in food prices caused by bad weather and global grain and oil price increases pushed Bulgaria's inflation rate to 13.1 percent as measured on the Bulgarian major groups index, the highest in the 27-nation bloc.

Food prices, which account for 35 percent of the Bulgarian consumer- price basket, slowed to 1.6 percent in December after a 2.4 percent increase in November. Transportation costs, which include gasoline prices and make up 17 percent of the consumer-price basket, slowed to a 1.3 percent gain in December from 3.7 percent in November.

Bulgaria's harmonized inflation rate as measured by the EU rose to 11.6 percent in December from 11.4 percent in November. Prices climbed 1.1 percent in the month, compared with 1.8 percent in November, the statistics office said.

Friday, January 11, 2008

Slovakia Inflation December 2007

Slovak inflation accelerated in December to the fastest pace in a year, driven by higher global food and fuel costs. The rate advanced to 3.4 percent from 3.1 percent in November, the highest since December 2006. Consumer prices rose a monthly 0.3 percent after advancing 0.5 percent in the previous month.

Slovakia is working to try to keep inflation in check to stay on target to adopt the euro a year from now,thus becoming the second former communist country to join the eurozone.

The koruna was trading at 33.301 against the euro at 9:24 a.m. in Bratislava, down from yesterday's close of 33.271. The statistical office also also said today the country posted a trade deficit after two monthly surpluses in November.

Slovakia is scheduled to file its application for the switchover in the first half of this year. To adopt the common currency Slovakia has to keep its 12-month average inflation rate to within 1.5 percentage points of the average of the three European Union nations that have the slowest price growth.

Rising food and oil prices pushed end-2007 inflation above the central bank's October 2.4 percent forecast, after it was revised from the 1.9 percent rate estimated three months earlier.

Food prices rose 0.7 percent in the month, followed by transportation prices, which advanced 0.6 percent.

Czech Republic To Hold Fire On Euro Membership

Monetary policy experts in the Czech Republic are having second thoughts about the advisability of adopting the euro in the near future, based presumeably on the experience of those who have gone for rapid euro convergence. According to central bank board member Robert Holmanhe the Czech Republic is "not ready" to adopt the euro because giving up the koruna could cause the economy to overheat, (he has obviously been looking over his shoulder at what has been happening in the Baltics, Bulgaria, Romania etc).

The koruna's appreciation against the euro has lifted prices near the level of those in countries that have been European Union members longer, Holman wrote in a commentary in Mlada Fronta Dnes newspaper today. Losing the ability to allow the the koruna to appreciate would be reflected in a quickening pace of inflation, he said. This may not be exactly the situation, but he is scratching in the right area, and loss of control over monetary policy - as we are seeing now in the cases of Ireland and Spain - can create special "overheating" problems, which when corrected may produce a mini boom-bust type cycle.

``We would have to live with European interest rates that would undoubtedly be too low with regard to higher domestic inflation,'' Holman said in the article. ``Our economy would overheat, which could have fatal consequences.''

This is basically what appears to have happened in the cases of Ireland and Spain with their domestic housing booms based on long periods of negative real interest rates. Holman said that once the Czech Republic enters the so-called exchange-rate mechanism - which basically offers a pre-entry test of currency stability before the switch, a commitment will have to be made to limit the koruna gains, and this could well lead to an acceleration in price growth which would not be appropriate to the low interest environment. I think Holman has a strong point here, and I think it is one which did not receive sufficient thought before Spain and Ireland were admitted - since they were always liable to have a lengthy period of rapid catch-up growth where a rising currency would have been more appropriate.

"A country that is only going through a process of real economic convergence with the euro zone cannot fulfill the low- inflation and currency-stability criteria at the same time,'' Holman wrote. He also added that once the Czech Republic gives up its own currency all ``economic shocks'' will be transmitted to unemployment and inflation. "That is not a good alternative for our employees and consumers....It's better to have a domestic currency with a flexible exchange rate."

Of course we could call this learning by doing, but I would say better late than never. For a day by day insight into the kind of mess that can result from not heeding Holman's warning can be found by following events on this blog about Spain, and starting particularly with this post.

The Czech koruna rose to a record against the euro for a second consecutive day yesterday as investors bet the central bank will raise the European Union's lowest interest rates to stem accelerating inflation.

The koruna, the best emerging-market performer this year, gained versus 14 of the 17 most-traded currencies as a report yesterday showed Czech inflation accelerated to 5.4 percent in December, exceeding the central bank's target for a second month. Policy makers now seem set to lift the key benchmark rate at some point in the not too distant future, possibly in February.

Annual inflation last month accelerated to the fastest since August 2001.

The koruna was also underpinned by a larger-than-expected trade surplus, which widened in November from the previous month as imports grew at the slowest pace in 19 months. The surplus was at 11.3 billion koruna ($641 million) compared with 8.6 billion koruna in October, according to the statistics office data released today.

Thursday, January 10, 2008

Latvia Inflation December 2007

Latvian inflation accelerated in December to the fastest pace in over 11 years as household expenses and service prices in restaurants advanced, adding to concern the economy is overheating. The rate, the highest in the 27-nation European Union, rose to 14.1 percent from 13.7 percent in November, the Statistical Office said today. Consumer prices rose a monthly 0.7 percent, compared with 1.4 percent in November.

Goods price inflation was 13.2% and services inflation 16.4%. Administered prices were up 16.5% on the year. The price growth of food products and goods and services related to the housing had the greatest impact on the consumer price increase in 2007. During the year the average price level of food products increased by 19.9%. The prices of bread, cereal products, confectionery, milk and dairy products, cheese, eggs, meat and meat products, oils and fats, fruit and soft drinks all had steep increases.

Household costs such as gas, electricity and water rose an annual 21.3 percent in December, the steepest gain of any category in the index. Services at restaurants rose an annual 21 percent.


Really I haven't got a lot more to say about all this over and above what I said in my more substantial analysis of Estonia earlier in the week:

So what happens next? Well obviously all of this is completely unsustainable, especially as most of the EU10 and Eurozone countries (not to mention the UK) are all now themselves likely to slow significantly. So now, to answer my own question a hard, hard landing seem unavoidable. How will this manifest itself? well basically we should expect to see increasing pressure on the Kroon currency peg with the euro, a pressure which, in the short term at least, the Estonian authorities will try and resist.

Basically, if we get the kind of very hard landing I am now anticipating, then we should expect to see inflation gradually ease, since there will be no demand pressure to push up prices. Possibly we will even see the reverse side of the coin, namely price deflation as we get into the second half of 2008, everything here depends on the pace of the "bust".

The only real issue in my mind is which of the group who are nearest to the cliff - Latvia, Estonia, Lithuania, Bulgaria, Hungary, Romania - will be the first to go over the edge. But perhaps the expression "canaries in the coalmine" first used by Morgan Stanley's Oliver Weeks is very appropriate here. Since why did the Baltic canaries start swooning in the first place? Why was there a lack of oxygen to ventilate the mineshaft? Bigger forces are evidently at work here, and we have Poland, Ukraine, Russia and China queueing up (more or less in that order) to put all the various theories to the text. And what is the ECB doing? My colleague Claus Vistesen made the following very valid point yesterday:

Eastern Europe? Could Trichet mention Eastern Europe tomorrow? I would seem strange but my feeling is that this is now set to crack at least in some of the countries. As such, the whole Eastern European situation could very well spill-over into the Eurozone through transmission mechanisms from Germany/Italy to Eastern Europe as well of course those famous Austrian/Swiss banks who have been supplying loans denominated in Euros and Swissies. In general on Eastern Europe you should not miss Edward's recent piece on Estonia which convinces me that this is about to go. The only question is whether we will see an orderly slowdown which I certainly hope but if currency speculation and runs on the pegs start to float on the jungle drums it could get out of hand and this would require the ECB to take action I think. Yesterday evening I updated my charts on Lithuania and despite a rather dubious spike in Q3 GDP growth (I simply cannot find the 5.2% figure in the q-o-q break up figures) I don't like what I see, especially on the labour market where the job vacancy ratio is beginning to signal one of those 'does not compute' (i.e. we have no more people!) moments. Finally, we need to consider which one of Eastern Europe's economies that is likely to (potentially) go first, as I noted recently in a comment over at Saxo Bank's Investor blog in the context of whether one or many of the CEE currencies would outperform the Euro in 2008 ...

At this point in time the silence over at the ECB is becoming absolutely deafening.

Russia Inflation December 2007

Russia's inflation rate rose in 2007 to the highest in four years in December as the government proved unable to put a brake on food prices and wages even while investment soars. The rate for the year rose to 11.9 percent from 9 percent in 2006, the first time that the rate has surpassed the previous year since 1998, the Moscow-based Federal Statistics Service Rosstat said today. Consumer prices rose 1.1percent in December, compared with a 1.2 percent advance in November.

Russia, the world's biggest energy exporter, has struggled to curb inflation as record oil income has boosted salaries and global food prices have increased. In an attempt to try to stop the upward march of food prices the government cut dairy and vegetable oil import duties, sold grain from state reserves and added a grain export duty. A number of companies even agreed in October to freeze prices on some milk, vegetable oil, egg and bread products until Jan. 31.

Food prices rose a monthly 1.6 percent, compared with 1.9 percent in November. Food price growth was led by fruit and vegetable prices, which slowed from November's rate of 6.2 percent to 5.6 in December, according to the statistics service.

The Organization for Economic Cooperation and Development said in a December report that the Russian government's ``massive additional spending'' before elections also helped push up inflation.

Legislators approved additional budget outlays this year as the nation prepared to hold parliamentary elections on Dec. 2 and a presidential vote in March 2008.

Again, my attempt at explaining why all this is happening, and why it is happening right now, can be found in my in depth analysis of the Russian inflation problem.

Ukraine Inflation December 2007

Ukraine's annual inflation rate accelerated to 16.6 percent in December, the fastest since 2000, on rising prices of food and fuel, the state statistics committee reported late yesterday. Ukraine's inflation rate surged from 15.2 percent in November, which was the highest in Europe for that month. Food costs increased 23.7 percent in December from a year earlier. Consumer prices rose 2.1 percent from the previous month.

Really I have very little more to say on all this that hasn't already been said in this post (or in this much longer and fuller attempt at diagnosing the Ukranian issue). Prime Minister Yulia Timoshenko said at a Cabinet meeting in Kiev that ``The government should approve a plan of anti- inflationary measures.'' But this is just the point, since at this stage noone is very clear what can be done about all this, as inflation moves from one Eastern European country to another like a stack of dry timber catching fire.

Tuesday, January 8, 2008

Is Estonia Now Definitely Heading for a Hard Landing?

The only really big question about the EU10 economies as we enter 2008 is - among the more vulnerable ones (the Baltics, Bulgaria, Romania, and Hungary) - who will be the first to go.

One obvious candidate is Estonia, although it is far from occupying poll position at this point, as Romania is teetering more and more by the day, and foreign investors look for the door in Hungary as the economy geers up to enter recession.

But today we are focusing on Estonia, which Danske Bank A/S senior analyst Violeta Klyviene - echoing the words of ECB board members Jurgen Stark and Lorenzo Bini Smaghi - recently described as going from "boom to bust". Looking at some of the data I am presenting here, it seems hard to disagree.

Basically we have two sets of curves to look at. One set go up, and these essentially refer to prices and wages. The other set go down, and they refer to levels of domestic economic activity and consumer and producer confidence. First inflation.

Estonia inflation December 2007

Estonia's inflation rate rose in December to a nine-year high, led by food and housing costs, raising concern that price growth will destabilize the currency regime by making exports increasingly uncompetitive at the same time as domestic demand plummets. Estonia's inflation rate jumped to 9.6 percent, the highest since August 1998, from 9.1 percent in November, the statistics office said in Tallinn today. Prices rose a monthly 0.7 percent.

And there is no sign of a slowdown in price increases in the near future. Finance Minister Ivari Padar recently forecast inflation in Estonia would be at least 10 percent in the first half of 2008 because of tax increases on alcohol, tobacco and fuel.

Reail Sales

Estonian retail sales growth slowed in November to the lowest level in more than four years as consumer confidence weakened. Retail sales increased an annual 6 percent, compared with an unrevised 9 percent in October, according to data from the Tallinn-based statistics office last week. It was the lowest growth since September 2003, according to statistics office data.

The statistics office describe the 5% month on month decline in sales as "characteristic of the period prior to Christmas marketing in December". This may well be, but the slope of the downward line in the above chart is remarkably constant. Still, we will soon know when we get the December data.

Banks such as Citigroup and Goldman Sachs have been increasingly saying the Baltic countries, and especially Latvia, face increased risk of a ``hard landing'' because of accelerating inflation and widening current-account deficits, and this has lead to increased speculation about a possible devaluation of the Latvian lats and the Estonian kroon. Finance Minister Ivari Padar forecast last month that inflation, which accelerated to the fastest pace in nine years last month, will be at least 10 percent in the first half of 2008 because of higher taxes on alcohol, tobacco and fuel.

Consumer Confidence

Consumer confidence fell in December to its lowest level in more than 2 1/2 years on worsening expectations for personal and state finances, according to the Estonian Economic Research Institute.

The consumer confidence index fell to minus 10 this month from minus 7 in November, the Tallinn-based Institute of Economic Research said at the end of December. In December 2006, the index was at 7 points.

Consumer spending has weakened in the past months due to rising interest rates and stricter lending terms set by banks, slowing the Baltic country's economic expansion in the third quarter to a four-year low of 6.4 percent. Rising inflation, at a nine-year high of 9.1 percent in November, has also worsened consumer's expectations.

The latest release of the EU Commission Economic Sentiment Indicator for Estonia (published yesterday) gives us a very similar picture.

Copmparing the three charts, and observing how they mark such a very similar line, I would say the position now is very clear indeed.

Industrial Output

Estonia's annual rate of industrial production growth slowed significantly in November, with production falling in areas as diverse as dairy products and wood production fell. Output, adjusted for working days, rose an annual 4.4 percent, compared with a 5.9 percent rate in October. Production fell a monthly 0.7 percent on a seasonally adjusted basis, compared with a 1.3 percent increase in October. The economy is evidently slowing, although it would be hard to draw any definitive conclusion about how rapidly from this data.

Industrial output growth was hampered by a slowdown in manufacturing as companies faced increasing labor shortages with unemployment at a 16-year low while domestic demand has evidently started to cool.

Trade Deficit

Estonia's trade deficit shrank to the lowest level in eight months in October as machinery imports fell from a year earlier. This is not a good sign, as it more than likely reflects a slowdown in investment. The October deficit fell to 3.6 billion krooni ($333 million) from a revised 4.6 billion krooni in October of last year and a revised 4.2 billion krooni in September, the Tallinn-based statistics agency said in an e-mail today.

Basically the big picture is that import growth has stalled entering 2008 as Estonians spent less on cars, clothes and household goods due to rising interest costs and the weakening consumer sentiment. Export growth has also slowed as companies struggle with rising wage costs, which were up 20 percent in the third quarter.


So what happens next? Well obviously all of this is completely unsustainable, especially as most of the EU10 and Eurozone countries (not to mention the UK) are all now themselves likely to slow significantly. So now, to answer my own question a hard, hard landing seem unavoidable. How will this manifest itself? well basically we should expect to see increasing pressure on the Kroon currency peg with the euro, a pressure which, in the short term at least, the Estonian authorities will try and resist.

Basically, if we get the kind of very hard landing I am now anticipating, then we should expect to see inflation gradually ease, since there will be no demand pressure to push up prices. Possibly we will even see the reverse side of the coin, namely price deflation as we get into the second half of 2008, everything here depends on the pace of the "bust".

The first indicator then should be a turnround in the upward movement in consumer prices, and the second should be an end to those famous labour shortages, as the long run trend in declining unemployment turns round, and unemployment starts to rise. We can already see that producer prices (lead by export producer prices which have been falling since the summer) have started to ease in October and November. This could be read as a first indicator for what is to come.

Wages and salaries have been rising rapidly, and we should expect to see this rate of increase decelerate, and probably quite sharply:

Estonian economic growth eased to 6.4 percent in the third quarter from 11.2 percent in 2006, and we should expact to see this rate of deceleration increase.

And finally, and perhaps most importantly, unemployment. This has been trending steadily downwards, and should really expect the trend to reverse itself. This will mean, basically, that the days when Estonia urgently needed to import migrant workers to try and avoid this huge spike in wages and prices is now largely passed. This does not mean that in terms of longer term stability Estonia does not need to focus on raising fertility and attracting new citizens from elsewhere to compensate for those who have simply not been born, but all of this will now take rather a back seat as the short term dynamics increasingly take over. One measure of the difficult situation Estonia will probably find itself in is that the policy priority will now need to switch from attracting migrants to retaining the young workers it already has and avoiding an uptick in out migration. It all depends on the level of distress which Estonia's citizen are faced with at the end of the day, and this depends on exactly how hard this hard landing turns out to be.

Monday, January 7, 2008

Romanian Central Bank Raises Rates Again

Romania's central bank raised its benchmark interest rate today for the second consecutive time after inflation accelerated more than previously expected. The central bank increased its Monetary Policy rate to 8 percent from 7.5 percent.

At the last monetary policy board meeting on Oct. 31, the central bank raised its main interest rate to 7.5 percent from 7 percent after cutting it four times earlier in the year. The benchmark rate was 8.75 percent when Romania joined the EU in January, the highest among the 27 members. The bank cut the rate at the first of its four monetary policy meetings in 2007, citing slowing inflation - which fell to a 17-year low of 3.7 percent in March - and a strengthening leu.

``The short-term inflation outlook has worsened in the context of heightened macroeconomic risks, especially those related to the income policy and higher public spending in the run-up to forthcoming elections,'' The bank also cited ``a possible significant deterioration of inflation expectations.''
Central Bank Statement

The Bucharest-based National Bank of Romania had already accepted that it would miss its year-end 2007 inflation target of 4 percent, plus or minus 1 percentage point, as the leu continued to weaken and the Romanian government boosted spending on infrastructure and social programs after joineding the European Union a year ago.

The central bank board also left its minimum reserve requirements on commercial bank deposits at 40 percent for foreign-exchange deposits and 20 percent for deposits in lei.

Inflation was an annual 6.7 percent in November as food prices increased after a drought destroyed a third of Romania's crops, and depreciation of the leu raised the cost of imports and many local goods and services.

The central bank has indicated that government spending is a threat to its inflation target, and that to reduce the overgheating in the Romanian economy fiscal policy needs to be tightened considerably. However, at least in the short term one can imagine that government spending will more than likely increase as the country prepares for next November's parliamentary elections.

The leu, after appreciating throughout 2006 and the first seven months of 2007depreciated almost 13 percent against the euro between the outbreak of the sub-prime bust in August and the end of the year. The leu's drop increases inflation by making items indexed in euros and paid in lei more expensive for Romanian citizens. In Romania, rent, gasoline, phone bills and other goods and services are habitually quoted in euros and paid in lei.

The central bank also indicated that its decision to raise the rate today was influenced by the fact that consumption is at an "unsustainable level in the context of rapid expansion of credit to the private sector, especially of foreign currency loans."

Private debt in Romania increased an annual 55.1 percent in November to 141 billion lei ($58 billion) as individuals and companies took out more loans in foreign currencies, the central bank said on Dec. 28. Total outstanding loans in foreign currencies, mostly euros, increased an annual 74 percent while leu-denominated loans gained 38 percent.

The central bank also said net wage growth, which accelerated to an annual 25.2 percent in October, was further pressuring inflation and outstripping productivity gains, emphasizing the `"risks of deteriorating external competitiveness".

The current account gap in the first 10 months of 2007 widened to 13.35 billion euros ($19.7 billion) from 7.75 billion euros a year earlier. Much of the deficit was created by a surge in imports as the leu's gain made goods cheaper for Romanians and the country eliminated import barriers as it joined the EU.

Romania's trade deficit has steadily deepened during the first ten months of this year, and has already reached over 17.2 billion euro, an increase of over 6 billion euro when compared with the same period of 2006, according to data this week from the National Statistics Institute. The overall trade deficit for the whole of 2006 amounted to "just" some 14.8 billion euro.

Over the same period, the total value of exports grew by 13.2%, rising to 24.2 billion euro, while imports advanced 27.2% to 41.4 billion euro.
In October this year, exports exceeded 2.7 billion euro, a 17.2% increase as compared to the similar month last year. On the other side, imports reached in October the total value of 4.9 billion euro.

The leu has been steadily depreciating as the current account deficit widened and international investors grew more and more wary of investing in countries perceived as higher risk amid the U.S. subprime crisis.

Well, the central bank are now trying to react, but in todays conditions I do fear that this is a question of too little too late.

Friday, January 4, 2008

Hungary On The Doorsteps of a Recession?

Hungary Facing Stagflation?

Oh how I do wish I could have something more in the spirit of a yuletide message for the people of Hungary at this point. Unfortunately this is not the case, and entering in media-res as it were, directly onto the topic in hand, things are really begining to move quite quickly in Hungary now, as one external observer after another begins to realise that policy in Hungary may now be well and truly stuck in a cul-de-sac (or even double bind). Indeed, unfortunately, as we will see below, I fear that they may soon start to move even more quickly. The first bit of relevant news in recent days has been the publication by PNB Paribas of an analysis entitled "Stagflation Fears".

Well First There Is the Inflation

Of course, one head of the stagflation coin is the inflation part, and in Hungary's case, inflation has been running at far higher levels than anyone would have hoped for when the austerity package was introduced in the autumn of 2006. As we can see from the chart, it has been persistenly and troublingly high throughout 2007, and although it dropped significantly in September (as some of the earlier one-off austerity hikes started to drop out of the system) it has been on the rebound again since, reaching 7.1% in September.

And inflation at this point is far from having been "bled" from the system despite the apparently tight monetary policy being applied by the central bank, and the auterity package from the central government. One indication that inflationn is far from being purged is provided by the recent agreement reached by Hungarian government with public sector employee representatives to raise wages by 5% on average in 2008. This would seem to me to put in immediate question the realism of the governments notional inflation target of 4.8% annual average inflation for 2008. (Note that the austerity package announced in the autumn of 2006 said wages in nominal terms would not go up in 2007 and 2008., however the government is justifying the agreement by indicating that the fiscal adjustment package remains intact since the number of employees in the public sector has been reduced by 6% (45,000 people) in the past 12 months, and hence the total cost to the treasury will not rise (actually this is a really ropey bogus argument, since you do have to take into account the cost of those who remain unemployed, but even more to the point one needs to know just how many of the people who left public service were offered some sort of early retirement, and again the cost of the pensions which accrue here do also need to be accounted for). But this does not mean that this rate of increase will not become a landmark for private sector workers, in a situation, remember, where the value of real wages - which have been falling as the chart below reveals - have to continue to decline, given that the forint (or if you prefer the REER) can't. Have to continue to decline that is, if Hungary is to be able to attain a significant export lead recovery, which is, I would argue, at this point in Hungary's history about the only path available.

What we can see immediately is that the bulk of the reduction in real wages (which has been real enough, and can be see from the consumption data below) has not been a cost efficiency in Hungarian business activity, but a transfer of fiscal obligations from the government debt onto the individual employee via social security contributions. So really, in a round about way, the cost of Hungary's population ageing problem is being transfered from the government onto the wagearner consumer. And I'm sure it hurts. The thing is, the fact that much of this has been a bookeeping exercise (the whitening of undeclared wages, etc) doesn't get us out of the inflation problem which has been produced at the same time (and one is immediately put in mind here of Germany, and that infamous 3% VAT hike to pay for the health system, and the way that sent domestic consumption shooting downhill in a way which is not un-reminiscent of what has happened in Hungary). So the fact that wages are now set to rise at around 5% in the public sector in 2008 (and the fact that this is only the public sector simply doesn't cut any ice as an argument, given that wages in the private sector have risen consistently faster than those in the public sector throughout 2007) should lead us to imagine that we could easily be looking at headline inflation in the 6% to 7% range in 2008, and at exporters struggling to mantain competitiveness in the face of a high forint and rising internal costs (assuming that is that the forint doesn't tank in the meantime, which may not be a realistic assumption, see below). So you can't just hand yourself out a 5% wage rise and hope that in some miraculous way you can get a consumer "feel good" effect and say 3% headline inflation. Things just don't work like that in the real world, and not when you are in the sort of situation which Hungary is in they don't.

And Then There is the Stagnation

In addition to the inflation problem, the Paribas analysts also stressed Hungary's weak consumption and investment activity, and pointed to the type of economic gridlock which results from needing to apply at one and the same time stringent fiscal and monetary policy, while in the background internal demand simply collapses, and exporters, who are doing a valiant job under the circumstances let it be said, struggle under the weight of the high value of the forint, which cannot, let it be noted, be allowed to drift downwards (which would be one sensible move under the circumstances) due to the problem of private indebtedness and all those Swiss Franc loans. I think the consumption problem is clear enough:

and if your not convinced by this, then you could try looking at retail sales, which tell a very similar story:

And if you are interested in Gross Fixed Capital Formation (investment) try this chart for construction:

As Paribas indicate, the only driving force of economic growth in Hungary in the near future is likely to be exports, but since the external demand situation is deteriorating by the day Hungary this may be insufficient to prevent Hungary falling off into recession (think Japan here).

This is the second report issued about Hungary by a major investment bank in quick succession (the other was Merill Lynch), and both of them have drawn attention to the combination of stagnant growth and high inflation under which Hungarian policy is labouring. The difficulty is that the need to maintain the value of the forint at or near its present levels (or otherwise all those with external debts - mainly households - will start to experience what they call in the parlance "distress". So no one anticipates drastic moves in monetary policy - which the situation surely merits, just look how the Fed is responding to a much milder problem in the US - and interest rate easing moves are expected to be limited. Paribas si - even in the face of the near recession call - sticking to its outlook for an interest rate reduction to 6.5%, while Merrill Lynch is predicting an even more aggressive reduction to 6.25%. None of this, of course, will be to the liking of yield driven financial investors, and the forint will certainly become rapidly vulnerable as monetary policy steadily moves down this path as it surely has to.

Large November Sell-Off In Forint Denominated Assets

In addition we have just learnt from the Magyar Nemzeti Bank that foreign investors sold-off vast amounts of forint denominated financial assets in November. The curious thing is that the forint only weakened slightly, despite the fact that approximately HUF 750 billion of instruments were virtually dumped onto the local market in very short order. One explanation for this curious situation may well be the high demand for euro and Swiss franc denominated consumer loans in Hungary, a demand which has possibly even accelerated during the pre-Christmas shopping season. But if this is the explanation it does leave us with the very awkward question of what exactly happens when the demand for such loans slackens, and the associated flows start to dry up.

The trend towards forint divestment really got going in October, but the monthly rate was not extraordinary (approximately HUF 70 billion net). As a result the forint remained reasonably stable against the euro at around 251 throughout the month.

During the period from the end of September to the end of November, foreign investors sold a huge HUF 800 billion worth of Hungarian instruments in the short term forex market. Of this, increased swap positions accounted for HUF 500 billion (new synthetic short forint positions), while stock and government bond sales amounted to HUF 200 billion and HUF 100 billion, respectively. At the same time, even if on a smaller scale according to MNB, foreign investors were busily opening positions against the forint in the options markets.

The growing unease about higher risk instruments in the context of the ongoing global credit squeeze is undoubtedly the main driving force behind the sale of the Hungarian instruments, this and a growing wariness about Hungary's vulnerability in the face of a global downturn.

Hungary's recent macroeconomic performance and the absence of any sort of optimistic outlook have undoubtedly also played a role, and in particular the high level of external indebtedness of individual Hungarian citizens, the high current account deficit, the weak internal demand situation and the general concerns about ongoing and long lasting slow economic growth.

The central bank's figures reveal that foreign investors divested large amounts of Hungarian stocks in November (continuing a trend that really got started back in August). According to Portfolio Hungary - who have examined the available information on ownership structures and share prices, OTP and Magyar Telekom are likely to have borne the brunt of the sell off.

What was new this time round though was the divestment of Hungarian government bonds (mostly in the secondary market), which accounted for a significant part of forint sales in November.

In this way HUF 750 billion was pulled straight out of the market in November. As I say, the really striking thing is how this major capital transfer was only slightly reflected in the EUR/HUF rate.

One possible explanation for this surprising situation is the rage for foreign currency denominated consumer loans that continues to grip Hungary. The volume of new mortgage loans climbed to the previously unseen level of HUF 130 bn in October, and this increase was almost exclusively attributable to the increase in CHF-denominated loans (HUF 120 bn). Detailed data from the National Bank show that while the monthly amount of new CHF-denominated housing loans rose to the exceptional level of HUF 55-60 bn, mortgage loans for consumption purrposes (ie "refis" or liquidity extraction, not to buy houses) became almost inexplicably fashionable, rising by 30% month-on-month to reach the unprecedented level of HUF 62.5 bn.

Naturally such transactions create a large increase in demand for the forint (the banks flows coming in), a trend which is in and of itself more than likely powerful enough to have offset the negative impact of lost investor confidence on the exchange rate.

Moral Hazard and the Coming Correction

Clearly this situation is now really very very delicate, one strong push and a whole pack of cards can come tumbling down. Borrowing today to pay back yesterday is a dangerous policy at the best of time, but when your currency might be about to fall of a cliff (think what happens when the demand for new loans dries up) it has to border on recklessness if you are borrowing unhedged in another currency. And remember, when the bonfire starts (not the one of our vanities I hope) in Eastern Europe (and it may not start in Hungary at all in the first place) it will undoubtedly rapidly spread from one of the "at risk" countries to another.

What all this suggests to me is that a lot of Hungarians are trying to maintain current consumption by borrowing forward aginst their homes (ie some sort of "consumption smoothing) in the hope and expectation that rising property values in the future will help them sweat off the debt. If this rise does not materialise, then the very least that can be said is that all of this will need, at some point, to be clawed back from current consumption. All of this also represents a new form of moral hazard for the central bankers over at the ECB and indeed for the EU Commission itself, since all this borrowing in Swiss Francs has to be based on the assumption that with so many people doing it the Hungarian authorities will never dare to let the forint slide (you know, there's safety in numbers) or, pushing the buck back one stage further, the EU Commission and the ECB won't let the worst things come to the worst.

But this is very dangerous thinking, since in the first place there are a lot of people now out there riding around on the back of the same idea (think Italian government debt, for eg), and people may be seriously overestimating the ability of the political and monetary authorities to contain such a large and complex set of problems. It should also not go un-noted that the whole weight of the ECB is currently not able to stop the spread of the growing credit crunch across the entire eurozone and beyond (even if the most recent massive injection has temporarily stopped the rot). Thus they may well not be able to stop Spanish homeowners (some 75% of whom are on variable Euribor related mortgages) from really feeling the pain, and believe me if they could do this, they would, since having the Spanish economy well and truly down and out as we enter the next downturn is the last thing in the world they want.

Lastly and just as importantly, as I have been arguing, all of this puts the Hungarian central bank in a real double bind, since they cannot ease monetary policy at this point without precipitating a tremendous weakening in the forint, so interest rates are high and need to stay high, and meanwhile Hungarian domestic demand gradually gets strangled, at the same time as the ongoing internal inflation and the negative external environment act as a strong brake on export growth.

Now, as I said at the start of this post, my impression is that the recession Hungary is now entering is likely to be a protracted and difficult affair. In order to justify this assumption (which we will have time enough to think about in due course) I would need to get into Hungary's very special demography - which I have attempted to do in my Just Why Is Hungary So Different From The Rest of the EU10? post. But, as you may have noticed, I have managed to write all the above with barely a mention of this contentious topic, so I think I will leave it at that for now. As they are want to say over in San Diego "Sufficient Unto the Day is the Evil Thereof". Reputedly that is just before they "whack" you, so, exercising caution as the better part of valour, I will now take my leave of you.