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Monday, April 28, 2008

The Hungarian Central Bank Raise Its Base Rate

Hungary's central bank raised its benchmark interest rate to the highest in more than three years today in an attempt to retain credibility for its inflation target and to try to stop second round effects of rising energy prices from spreading across the economy. The Magyar Nemzeti Bank in Budapest, led by President Andras Simor, raised the two-week deposit rate 0.25 percent to a three year high of 8.25 percent. Policy makers, who also discussed holding the rate, had a ``safe'' majority for the increase, Simor said.

The move was not unexpected and a majority of analysts were expecting the Monetary Council to continue its rate hike cycle initiated in March. The last time Hungary's base rate was this high was in March 2005 when interest rates were still on their way down from the extreme highs of 2003.

Six of the world's central banks, mostly in emerging markets including Brazil, Iceland, Russia and South Africa, have raised interest rates this month to stem global inflation. Hungarian consumer prices in March rose more than twice as fast as the central bank's target and wage growth was faster than expected. Policy makers said they may raise the rate further.




The forint rose to 252.17 per euro by 2.44 p.m. in Budapest from 252.66 late on April 25. The yield on the benchmark three-year bond fell to 8.98 percent from 9.12 percent.


The average monthly gross wage in February rose an annual 13.4 percent to 188,629 forint ($1,190). Regular private-industry wages, which exclude bonuses and are one of the central bank's most closely watched indicators, rose 10.4 percent from a year ago. Policy makers last month raised rates for the first time since 2006 to rein in inflation, which has exceeded the 3 percent target since August 2006. Consumer prices in March were 6.7 percent higher than a year earlier.





Commentary

“Today's rate hike is yet another example that the central banks are being “forced" by the global environment to tighten monetary policy despite a gloomy outlook for growth. Hence recently, the Turkish central bank ended its monetary easing cycle and is likely to starting tightening soon - the same can be said for the South African Reserve Bank, which is also likely to tighten monetary policy further."

“This morning the Russian central bank also hiked interest rates. Similarly the Brazilian central bank has recently hiked its key policy. Hence, there is no doubt that despite the outlook for a slowdown in most transitional and emerging economies around the world, the outlook for monetary policy is likely to be twisted toward higher and not lower rates."

“The general trend toward higher interest rates in the Emerging Markets could provide some support to currencies like the forint, the Turkish lira and the South African rand, but it should also be noted that these rate hikes reflect a significantly more negative global financial environment than we have been used to over the last couple of years and hence the rate hikes in that respect simply reflect a re-pricing of risk and hence may not bring long-lasting support to these currencies."
Lars Christensen, Danske Bank, Copenhagen


Basically I broadly agree with Christensen here. The Hungarian economy is stuck in some form of stagflation remember.




As we saw this morning, the number of people employed in Hungary is now dropping steadily:



Retail sales simply fall and fall:



As does construction activity:




and the only leg left is external trade:




But it is precisely the export environment which may now deteriorate as the EU economies gradually slow under the weight of the global credit crunch. So, all in all, not a pretty picture, and it is unclear how the present policy of the National Bank of Hungary - however necessary it may be in the face of extraordinarily "sticky" wages and prices, and however much it may be needed to avoid a wholesale sell-off in forint denominated assets - is actually going to help turn the Hungarian economy itself around.

Thursday, April 24, 2008

Swedbank Profit Falls On Baltic Losses

Swedbank AB, the largest bank in the Baltic region, announced today that their profit in the first quarter of 2008 dropped by a little under 1 percent when compared with the first quarter of 2007 - basically on higher costs and increasing bad loans. Their shares fell following the announcement.

Swedbank net income dropped to 2.9 billion kronor ($494 million) from 2.91 billion kronor a year earlier, the Stockholm-based bank said in a statement today. Costs rose 13 percent to 4.44 billion kronor while loan losses almost gained sixfold to 288 million kronor, the bank said.

Swedbank gets about a third of its earnings from the Baltic states of Latvia, Lithuania and Estonia. These economies had previously been among the fastest growing in the European Union, driven in part by a credit boom that sparked concern that bad debt might increase significantly during the subsequent downturn. All three economies are all now slowing quite quickly, the Latvian economy may have entered recession in the last quarter of 2007 and the Estonian central bank recently loweed its 2008 GDP forecast to 2 percent.


Swedbank shares fell 4.1 percent to 162 kronor at 9:52 a.m. in Stockholm. They have lost 11 percent so far this year.

Net interest income, the difference between what the bank makes from lending and what it pays on deposits, rose 16 percent to 5.24 billion kronor. Fee income fell 4.7 percent to 2.18 billion kronor, because of a slowdown in mergers and acquisitions in Sweden and Norway, the bank said.

Net gains on financial items fell 86 percent to 75 million kronor, because of the ``continued credit crunch in financial markets,'' said Swedbank. The fair value of Swedbank Market's credit bond portfolio declined by 187 million kronor, it said.


Swedbank is currently expanding in Ukraine and Russia in an attempt to offset slowing growth in the Baltic states and it will be interesting to watch whether or not these ventures encounter similar problems. The bank plans to open as many as 75 offices in Ukraine this year to boost volumes and increase profitability at its OJSC Swedbank unit, which the Swedish lender acquired last year. It has 200 branches, 170,000 retail clients and 18,000 corporate clients in Ukraine.


Swedbank may make acquisitions in Ukraine and Russia if opportunities arise there, Chief Executive Officer Jan Liden said in a telephone interview today. The bank believes in ``its stable base in Sweden, significant growth in the Baltic states and exciting growth in Russia and Ukraine''.

``Current economic conditions in the Baltics have affected general sentiment towards the region, however there has been no major impact on the bank's profit for the period,'' the bank said. ``Turbulence from the U.S. subprime crisis negatively affected earnings in the quarter, even though Swedbank directly or indirectly had no significant exposure to this market.''

OECD Warn The Czech Republic on the Economic Impact of Ageing

The Czech Republic must cut public spending, boost the retirement age and raise health-care co-payments to preserve economic growth, the Organization for Economic Cooperation and Development said in its most recent country survey out today.

The Czech Republic needs to be more ambitious in setting deficit targets while economic growth is at its current high levels, the OECD said in its 2008 country survey. It advised the Cabinet to support health-care and pension overhauls as the country's ageing population may start straining state resources as early as 2012.

The Civic Democrat-led three-party coalition this year introduced a flat income tax and medical fees and limited some social transfers to keep the public-spending shortfall below the European Union's threshold of 3 percent of gross domestic product. It also has plans to revamp the health-care and retirement system, though these may be jeopardized by the coalition's thin majority in Parliament, the OECD warned.

``To maintain these high growth rates, further reforms are necessary,'' OECD Secretary General Angel Gurria said today at a Prague press conference. ``If policy is not changed, spending will increase considerably'' amid a ``rapid pace of aging.''


The OECD urged Czech authorities to consider a ``full liberalization'' of rents, take steps to dscourage early retirements and reduce the length of parental leave to boost workforce supply (really I am not in agreement at all with this latter point, but I will need to find time for a longer post to explain why). It reiterated that tuition for university students is necessary to extend the number of people with higher education.



``Most important is a need to ensure fiscal sustainability through public-finance reform to put the economy in a better shape to cope with population aging,'' the OECD said. ``The current government made a positive start'' with ``a fiscal package that includes wide-ranging tax and spending reforms, many of which are aimed as first steps in more ambitious reform.''




``The recent global financial turmoil has so far not affected the economy, although weaker growth elsewhere may have some impact,'' it said. ``There is little sign of overheating so far; underlying inflation has remained moderate.''


The government earlier this month approved the outlines of an overhaul of the health-care system that includes allowing health insurers to make a profit. The Health Ministry's plan to sell all but one state-financed health insurer is opposed by two smaller coalition parties, however.



``The impact of the second phase of reform could be significant in strengthening competition on the quality and cost of services,'' the OECD said. ``Putting legislation through parliament is an uphill struggle because the coalition itself has a thin majority'' and ``as a result, many of these further reforms are uncertain.''


Concerning a change of the current pay-as-you-go pension system, the OECD recommends that ``mandatory'' transfer of social security payments to private pension funds be adopted rather than implementing the current proposal that would employees to choose between the two systems.

``Providing a permanent choice risks additional public expense because net contributors are likely to switch while net beneficiaries will stay with the full PAYG pension,'' the organization said.


The Czech Republic has dropped the 2010 entry date as a target for euro-adoption and has not set a new date. The government's strategy is to carry out long-term structural changes and allow the economy to close the distance with the richer euro-sharing nations to try and avoid an outcome whereby letting go of the possibility of an appreciating koruna doesn't trigger additional price growth (a problem that may arise in neighbouring Slovakia if the current entry bid is accepted). This government concern is shared by the OECD.

``A consequence of entering the euro area is that, with the loss of the exchange-rate channel, inflation has to do all the work in nominal convergence,'' the OECD said. However, ``delaying entry implies accumulating opportunity costs because it postpones the gains from adopting the euro.''

Wednesday, April 23, 2008

Hungary Retail Sales February 2008

Well there are no real surprises in this months retail sales data since Hungarian retail sales dropped by 0.2% month on month in February, following a 0.1% increase January, according to data adjusted for calendar and seasonal effects from the Central Statistics Office (KSH). I say this is not surprising since there were only two months last year when the KSH reported a month on month rise. At the same time on a working day adjusted basis retail sales fell by 2.5% over February 2007. Sine the annual drop was by 3.0% in January and 4% in December we could say that the rate of decline is now slowing, and that we should expect this situation to continue.




If we look at the volume index for industrial sales chart then the position becomes abundantly clear, with sales having peaked in the middle of 2006 and headed steadily down since that point.



Combined sales of cars, car parts and fuel (which do not a part of European statistical systems) were up, and totalled HUF 163.24 billion in Feb, or an annual rise of 2.6% which compares with a 1.4% fall in January.

Really as I say, I don't think we should expect this situation to change anytime soon, and I hold this view because of the appreciation I have of Hungary's internal consumption dynamics, an appreciation which I would say basically sets me apart from the other analysts working the Hungarian economy.

Hungary's domestic consumption as can be seen from the chart below actually peaked in 2002., and since 2004 it has not be especially strong. It is now in full retreat. Would anyone like to tell me when it will recover, and by how much? I certainly can't tell you, but I certainly strongly doubt we will ever see the 2002 level again, and I am even rather unconvinced we will get back to the 2005 level. My intuition is that Hungary will now become an export driven economy.




Basically I the reasons I hold to my view are based on the differences I have in my appreciation of what the whole idea of "convergence" means in an East European context, and I hold to my view due to the special importance I attribute to demographic factors in the economic growth process.

In order to illustrate what I mean I would like to close this post by taking a quick look at historical German private consumption data. One of the core arguments I am presenting on this blog is the idea that part of the issue facing East European economies like the Hungarian one is the population ageing situation. This argument is being by and large ignored by mainstream analysts, but simply ignoring a problem doesn't make it go away.

Most analysts, as I have been arguing, tend to look at what is happening in Hungary on a "convergence" cyclical basis. But there are reasons for thinking that this view may be inadequate. Hungary's economy grew for ten years up to 2005, and then the growth process started to grind to a halt. Indeed you could argue that the whole wasy that the fiscal deficit got so out of hand in Hungary was a result of the slowdown in domestic consumtion and economic growth. Now Germany also had a very significant consumer boom and correction back in 1995, and if you look at the chart below German domestic consumption has never recovered.

And indeed if we look at the next chart we will see that in 2007 (following the significant VAT rise induced local spike in the 4th quarter of 2006) German private consumption has been steadily declining across 2007, and this despite a very rapid rate of new job creation and a substantial drop in unemployment. I think people should at least think about this carefully, and ask themselves whether or not Hungary may now follow this course, becoming an export driven economy. At least, I would argue, there are prima facie reasons for considering this outcome to be a real and present possibility.


Tuesday, April 22, 2008

IMF Calls For Interest Rate Hikes in Romania

Romania's central bank should raise interest rates further to curb inflation as the economy continues to ``boom'' this year, the International Monetary Fund has said.

``Inflation is now quite high,'' IMF country Mission Head Albert Jaeger said, speaking to reporters today in Bucharest. ``The booming economy is increasingly becoming a driver of inflation. More monetary policy tightening may be needed, principally in interest rates.''

Banca Nationala a Romaniei lifted its monetary policy rate half a percentage point to 9.5 percent last month as the inflation rate to an annual 8.6 percent. The bank, which makes its next interest rate decision on May 6, has raised the key rate at all four meetings since October, when it was 7 percent.



The bank missed its 2007 inflation target of 4 percent, plus or minus one percentage point, as consumer prices surged an annual 6.6 percent. The IMF said in a news release today that inflation will end this year at an annual 6 percent, above the central bank's target of between 3 percent and 5 percent.

Romanian inflation accelerated in March to the fastest pace in more than two years as a weaker leu boosted the cost of services and imports and rising wages and lending spurred consumption.



Romania must cut the inflation rate to 3 percent by the end of 2010 or risk missing its target of adopting the euro in 2014, central bank Governor Mugur Isarescu has said.


Jaeger predicted the economy will grow 6 percent this year, the same rate as last year. He said growth will probably slow to 4.7 percent in 2009 as richer countries import less and international investors grow wary of higher-risk investment.

``The slowdown in 2009 could be much sharper,'' Jaeger said. ``Global financial turmoil will spill over to Romania. External financing, which has been cheap in the past, will become more expensive.''


He also urged the government to refrain from increasing spending or lowering taxes in the near future, particularly in the lead-up to November 2009 parliamentary elections. The government targets a budget deficit this year of about 2.2 percent of gross domestic product although Jaeger said the government ``overestimates'' revenue for this year.

Jaeger said Romania's current-account deficit, which widened in the first two months of this year to 2.19 billion euros ($3.5 billion) from 2.08 billion euros a year earlier, is ``unsustainable.'' Fitch Ratings and Standard & Poor's have both lowered their outlooks on Romania's credit rating, citing the continuing current account shortfall as justification.



IMF Hard Landing Warning

The latest IMF Global Financial Stability report (published last week), warns thata number of Eastern European countires now face a continuing and growing risk of experiencing a "hard landing" as the global financial crisis continues to spread. The fund also drew attention to the possibility of serious of spillover problems arising for the Scandinavian, Italian and Austria banks that have lent heavily in the region, and this warning will not be taken lightly by these banks (whose benevolence and cooperation was, it will be remembered, thought to be the principal lifeline for the Romanian and Baltic economies in times of distress).

At the heart of the IMF's concerns are the large current account deficits being run in certain CEE countries, deficits which have now reached extreme levels in some cases, running to the tune of 22.9pc in Latvia, 21.4pc in Bulgaria, 16.5pc in Serbia, 16pc in Estonia, 14.5pc in Romania and 13.3pc in Lithuania.



"Eastern Europe has a cluster of countries with current account deficits financed by private debt or portfolio flows, where domestic credit has grown rapidly. A global slowdown, or a sharp drop in capital flows to emerging markets, could force a painful adjustment,"


The IMF said lenders in Eastern Europe had built up "large negative net foreign positions" during the boom, especially in the Baltic states. "Liquidity for these banks has all but dried up and [interest] spreads have widened 500 basis points."

Many of these countries concerned rely on credit from branches of West European and Nordic banks, but these foreign lenders are now themselves having difficulty raising money in the wholesale capital markets.



"A soft landing for the Baltics and south-eastern Europe could be jeopardised if external financing conditions force parent banks to contract credit to the region. Swedish banks, the main suppliers of external funding to the Baltics, could come under pressure,"


As the IMF note in their report, awareness of higher risks in the CEE countries has been rising in recent months, and this rising awareness has been been reflected in the performance of bank stocks exposed to the region, in Credit Default Swap spreads, and in the performance of the Romanian leu (see chart below) given that the leu is the only floating currency with a liquid forward market among the group of eastern European countries with large external imbalances. As we have seen it has depreciated substantially since July 2007, as investors have been expressing their negative views on the region as whole The stocks of Swedish banks exposed to the Baltics have underperformed other Nordic bank shares (and here) partly owing to significant short-selling and CDS spreads on sovereign debt have surged since August 2007, as investor demand for credit protection has pushed up prices. The interesting point to observe is how this is now all moving in tandem.


Sunday, April 20, 2008

Slovakia's Euro Membership Bid

Slovakia has recently taken some important "baby steps" on its path towards future euro membership. In particular the government in Bratislava has now officially asked the European Central Bank and European Commission to assess whether or not it is now ready to adopt the currency on 1 January 2009.

The response of the European Commission to the application will likely be made known on 7th May (with the European Parliament taking a decision shortly after in the event of a favourable decision).

On the surface it is easy to get the impression that what is now involved is a mere formality, with the ECB and the EU Commission coming under considerable political pressure to say yes after their recent cold-shouldering of Latvia and Lithuania, and given all the economic problems now being encountered in Hungary following the application of the Lisbon agenda inspired "austerity programme" isn't someone somewhere badly in need of some sort of success story to inspire the others? This indeed is how most analysts and much of the popular economic press are treating the situation - almost as if what we were now looking at was already some sort of "done deal".

Slovakia has applied to join the eurozone next January, dismissing the concerns of some European central bankers and economists that its economy is not ready for the rigours of membership. If the application at the weekend is successful, Slovakia will become the sixteenth of the European Union’s 27 countries to adopt the euro. It will also be the second former communist country to do so, following Slovenia, which joined last year.
Financial Times
But are we? In recent days doubts have begun to surface. The most recent example perhaps took place last week when Pervenche Beres, chairwoman of the European Parliament's committee for Economic and Monetary affairs, who was leading a "fact finding" delegation to Bratislava rather noticeably dropped-into her on the record press remarks the emphatic observation that the debate about Slovakia's euro membership has now moved on from whether or not the country's economy met the formal euro inflation criteria to the issue of the "sustainability" of Slovakia's current inflation rate. That is to say the EU institutional structure is likely to look well beyond whether or not Slovakia's inflation level as registered during the 12 months to April 2008 meets a set of rather formal criteria to the much more thorn-ridden issue of what might subsequently happen to the inflation rate if Slovakia is given the "go ahead" on May 7.

That Commissioner Beres point was not simply incidental was underlined by the fact that the very same point was re-iterated by the Economy and Finance Commission representative during questions at last week's press briefing on the EU's March inflation numbers. Indeed, despite the fact that Slovakia has for some time now been within the Maastricht inflation criteria, the EU Commission has repeatedly expressed concerns over the sustainability of the current state of affairs, and in doing this not furthest from their minds will be the rate of inflation which is currently to be found in neighbouring Slovenia (Slovenia it will be remembered was admitted to the eurozone in January 2007). In March 2008 Slovenia's annual inflation rate was running at 6.6% - the highest in the eurozone - and rising. Indeed Slovenia's inflation rate has now more than doubled in the year and a quarter since she adopted the euro.






Thus - and quoting Pervenche Beres - the discussion has now moved on from the nominal compliance with the Maastricht criteria - to issues associated with the ongoing sustainability of Slovakia's present economic path, and these concerns about sustainability - taking their cue from what has happened in Slovenia - take us into a much larger arena, one which goes to the very heart of this problems of applicability for a one size fits all monetary policy to economies having the sort of structural characteristics which are currently being exhibited by the Eastern European EU accession members. Surely it is not mere accident, or so the argument goes, that inflation in Latvia is currently running at 16%, in Bulgaria at 13.2% , in Lithuania at 11.4%, in Estonia at 11.2%, in Romania at 8.7%, and in Hungary at 6.7%. Even in Poland and the Czech Republic - the two economies which (not entirely coincidentally) have historically allowed their currencies to float freely against the euro - inflation is raunning at 7.1% and 4.4% respectively and rising (and this despite very sizeable upward movements in both their currencies).


Economic memories may be short, but they are not that short, and most of the policy makers responsible for the current decision will remember only too well that a Slovenia which not so long ago appeared to meet the euro yardstick without difficulty, now faces a preoccupyingly high inflation level, a level which only feeds concerns that the absence of "homegrown" monetary policy may make it impossible to target emerging asset price bubbles (and there is an increasing consensus among central bankers about the need to at least try and do this) in a way which means that one East European economy after another (where they to follow an early euro adopion course) could be sent off down the boom bust path recently followed by Spain and Ireland. In economics, as in other areas, you live and learn.

And that's why EU institutions at various levels are now busily investigating whether a similar situation could also emerge in Slovakia. If the experts from the ECB and EU commission came to a conclusion that what just happened in Spain and Ireland could also happen in Slovakia, then the country will most likely not get the invitation to join the euro zone.


Due Process




The main document that will offer us the European Commission’s current view of Slovakia’s preparedness for Euro adoption will be the Convergence Report, due out on May 7. On the basis of this report, the EC will either propose Slovakia’s membership of the Eurozone or remain silent. Should the Commission recommend membership – and such a decision requires there be a consensus on desireability among all 27 Commissioners – Slovakia’s bid would then need to be approved i) by the European Council, ii) by the European Parliament, and iii) by ECOFIN on July 3. This latter body is the council of EU Finance Ministers, should the application move forward - it is at the ECOFIN meeting that will the final conversion rate for the Slovak Koruna will be decided.

However, as I am indicating, evidence is now accumulating that Slovakia's application - at least for this year - may well not get past the initial Convergence Report hurdle. The most recent piece of evidence suggesting this outcome was offered by a report in Bloomberg this weekend about the existence of a draft version of the ECB document which will accompany the Convergence Report - a document of which Bloomberg reporters seem to have had sight. According to the Bloomberg story (citing two people described as "familiar" with the document)the draft expresses "serious concern" about the outlook for Slovak inflation. The draft, which is effectively a progress report on Slovakia was circulated earlier this month to EU central banks for comments before the final version is approved by the ECB General Council. When approached by Bloomberg ECB spokesman Wiktor Krzyzanowski declined to comment on the content of the draft report, but implicitly accepting its existence. All I can do, he said, is "confirm that we are in the process of preparing a convergence report for all countries with derogations".

The next piece of evidence we will have of EU Commission and ECB thinking on Slovakia's application is likely to come on April 28, when the EC publishes its latest forecasts for all the EU economies - including the Slovakian one. This forecast should help to shed light on many of the key issues surrounding Slovakia’s bid, and in particular the sustainability of low inflation, since the Commission itself will need to offer its own inflation forecast.

Lying at the heart of the present debate is the recent trajectory of Slovakia's EU harmonized inflation rate, which is the index the EU uses to assess euro requirements. Inflation on this measure rose for a seventh consecutive month in March to 3.6 percent, a 15 month high. As can be seen from the chart below, and if you look at the recent trend inflation line, everything now hangs on what you expact to happen next.



Formally, to adopt the euro, applicants must have 12-month average inflation within 1.5 percentage points of the average of the three EU countries with the slowest price growth. The EU target in March was 3.2 percent and Slovakia's 12-month average rate was 2.2 percent, well inside the limit. Slovakia also already meets the other principal euro-adoption requirements including those relating to the size of the budget deficit and level of accumulated government debt.





Consumer-price growth in Slovakia has accelerated from a record low of 1.2 percent achieved last August. The central bank on January 29 forecast a rate of 2.8 percent for the end of 2008 and 2.9 percent for a year later. Coincidentally the Slovak central bank is due to release new forecasts on April 29. I say coincidentally, since with the Commission publishing separate forecasts the day before, in the event that the two forecasts differ the debate is going to be well served.

And in fact differences are already apparent, since while thinking at the Commission and the ECB inclines towards the idea that the rising inflation in Slovakia is a result of demand pressures, the Slovak central bank does not agree, and argues that structural supply side factors like oil and food prices are to blame. Of course, both demand pull and supply push elements are at work, the real issue is in what proportions. Putting his cards straight down on the table is Slovak central bank governor Ivan Sramko, who recently stated that the risks to the forcecast mentioned in the Bank's inflation report are "well known", but not demand driven. He accepted that the Slovak central bank and the EU commission have differing views on whether the current pace of economic growth in Slovakia is inflationary and as well as on the extent of the koruna strengthening effect on inflation.


"Our view is not quite the same as the commission's" he said "We think that the effect of koruna's strengthening isn't as big as presented." ..... the pickup in inflation isn't driven by domestic demand and the economy "isn't overheating".



GDP Growth Surge


One of the reasons for the Commission's unease is the sudden growth spurt that took place in Slovakia at the end of 2007, with the economy expanding by a record 14.3 percent in the fourth quarter, the fastest pace anywhere in the European Union. This was higher than the preliminary estimate of 14.1 percent reported by the Slovak Statistical Office on February 14, and compares with a 9.4 percent annual rate in the third quarter.





Part of the reason for the acceleration was that cigarette producers stockpiled products to avoid a January increase in a tobacco excise tax - according to the Bratislava-based office - but still, if this was the only factor it would mean one hell of a lot of cigarettes going into inventories. Not that the economy hasn't been expanding rapidly in recent times, and in fact it expanded by expanded by 10.4% in 2007, but this suden surge has all the hallmarks of an "overheating burst", and in particular when it is lined up against rising retail sales and falling unemployment.



Retail Sales




Another circumstantial piece of evidence for the overheating hypothesis comes from the retail sales data. Slovakia's retail sales grew at a record annual rate 16.6 percent in February as wages rose steadily.




Sales picked up from a 15.6 percent annual rate in the previous January. At the same time average industrial wages increased by 5.6 percent in February, the fastest in a year, and up from a 4.1 annual rate in January.

One indicator of this newly unleashed consumer purchasing power can be found in the fact that Slovak new-car sales rose 15 percent in February from a year earlier, according to the Slovak Car Industry Association said. Dealers sold 7,375 new passenger cars and light trucks in February, up from 6,421 a year earlier accoring to the association. They also reported that in the first two months of 2008 14,237 new vehicles were registered in Slovakia, up 27 percent from the same period last year.


Employment and Unemployment


Further evidence for the idea that the Slovak economy may be running above its capacity level can be found in the relations between levels of job creation and unemployment, since the unemployment rate fell to a record low of 7.6 percent in March (down from 7.8 percent in February). The number of unemployed available for work in the country (which has a population of around 5.4 million) was down to 198,011 from 204,574 in February.




Thus the unemployment rate has been halved over the past four years as foreign investors such as carmaker set up factories, creating new jobs and driving economic growth. But the decline in unemployment has raised concerns that grwoing labor shortages may begin to push up awages and inflation and hold back economic growth in ways which we are now becoming accustomed to all across Central and Eastern Europe. In fact the numbers of unemployed dropped by 33,000 (or 14%) between March 2007 and March 2008, and with Slovakia's low fertility background meaning that less and less young people arrive on the labour market looking for work questions arise about the sustainability of this process.



If we look at employment growth, this has also been rising steadily, with total employment up about 10% (or 200,000 - from 2.17 million to 2.4 million) between the start of 2005 and the end of 2007.



There is, however, considerable evidence that Slovakia - and some other CEE countries - have a kind of dual economy, with some export oriented sectors receiving strong FDI flows and achieving high productivity and employment growth, while others remain almost stagnant in total employment and productivity growth terms. For example, the production of transport equipment was up by 42% in November 2007 when compared with January 2007, machinery and equipment by 26% and electrical and optical equipment 37%. Meantime output growth in the resource sector and in labour-intensive industries was virtually unchanged – textiles were up by 1%, leather declined 4% and the wood industry by 2%. Moreover, the stronger industries – machinery and equipment and electrical and optical equipment – have tripled their output since 2000.

One good example here are Slovakia's new carmakers, who currently expect to produce some 675,000 vehicles in 2008, up from 572,586 in 2007, and 295,373 in 2006, according to representatives of Volkswagen Slovakia, the Slovak units of Kia Motors and PSA Peugeot Citroen in a joint statement during the AutoSlovakia08 conference held recently in Bratislava. The companies have all recently set up plants in Slovakia for a variety of reasons, including the fact that wages in the country are generally lower than in western Europe and that the strategic location in central Europe makes it easy to deliver cars throughout the continent. Although wages have risen, these increases are still not enough to deter the companies involved. But clearly this can change if the increases continue.




There have been consistent warnings about the growing labor shortages which are accumulating - especially among the relatively more scarce younger workers - and this may start to create a problem for other investors, including the auto-parts companies that are intending to follow the carmakers.

Slovakia's unemployment rate was at 8.1 percent in January 2008, compared with 14.47percent in May 2004, when Slovakia joined the European Union. The average monthly gross wage has risen 39 percent during the same period and now stands at 22,224 koruna ($1,010). The Slovak Economy Ministry expects the number of people employed in the car industry to reach 100,000 in 2010 from some 67,000 in 2007.

Indications that foreign companies now arriving in Slovakia are having difficulty finding employees are now widespread, and local newspaper Hospodarske Noviny daily recently ran a feature story on the issue where the general tenor was a steady flow of complaints that those who could and wanted to work are no longer available, while those who are available are mainly long-term unemployed (50% of the unemployed have now been unemployed for more than a year) with little education. While the situation seems to have been quite different only a year or so ago, companies now increasingly feel have little choice, and are obliged to employ workers who haven't even completed a basic education.

Labour-market experts say that while attention was paid to attracting new investors to less developed areas, hardly anyone bothered to research the local education structure. At the same time, the low salaries on offer are dissuading some people from taking simple manual jobs, while those who do accept are often forced to work overtime and weekends simply so that their companies can meet deadlines.

One of the aggravating factors here has obviously been out migration, although the Poles and citizens from the Baltics have evidently attracted a lot more media attention than the Slovaks. The vast majority of the 765,630 East Eupean migrants working in the UK in 1976 were Poles (505,300 Poles), but these were then followed in importance by 77,000 each from Lithuania and Slovakia. Much smaller numbers in fact came from the Czech Republic, Hungary, Latvia, Estonia and Slovenia. Even in the neighbouring Czech Republic the largest group of foreign migrants with rights to work comes from Slovakia, and at the end of last year 101,233 Slovakians were legally working in there. However even the Czechs are now noticing that labour supply in Slovakia is no longer what it was, since their badly understaffed health service can no longer rely on nurses recruited in Slovakia.

But looking a little beyond the immediate problems caused by out-migration, at the end of the day the reason that Slovakia can't grow for any great length of time at 6 or 7% without sending inflation spiralling up out of control is the age structure of its population, and this age structure is a product of long term below replacement fertility, and a substantial decrease in the annual number of births which produces much smaller "entry level" cohorts and means that the labour market "supply side" component is very tightly restricted. Annual births in Slovakia reached an all time high of around 100,000 a year in the late 1970s. By the late 1980s the number had dropped to around 80,000, and reached a low of around 50,000 in 2000 (or a 50% fall from the peak) where they have stubbornly more or less remained ever since.



This decline in births is reflected in a decline in the total fertility rate, which fell to an all time low of 1.2 TFR (or roughly half population) rate in 2004 before "rebounding" slightly to 1.25 in 2006.



Fiscal Deficit

One of the other criteria for euro membership relates to the fiscal deficit, and the size of the accumulated government debt to GDP ration. On the former count Slovakia has no worries at all, since Slovak government debt was well below the stipulated 60% of GDP level, at 30.7% in 2006 and falling. On the annual fiscal deficit side the situation is rather more complex, since the country has often run what would be considered "excess deficits" (ie over 3% of GDP) in the past, and indeed the EU Commission did open an excess deficits procedure against Slovakia, although in 2007 the deficit was down to 2.2 percent of GDP, 0.7 percentage point less than the original 2.9% target.



Evidently a number of issues raise themselves at this point. The first of these would be the sustainability question. It is one thing to run a deficit below the 3% during the candidate year for euro membership, and quite another thing to hold it there, as we have already seen in a number of rather infamous cases.

Slovakia's government revised has in fact recently revised its budget-deficit targets for 2008 and 2009 to meet EU Commission demands for further spending cuts and the original 2008 deficit target of 2.3 percent of gross domestic product has now been cut to 2 percent of GDP. The 2009 target has also been trimmed to 1.7 percent of GDP from an earlier 1.8%. As I say Slovakia in fact has been subject to the EC’s Excessive Deficit Procedure since 2004, and needs to have this procedure withdrawn before the EC can recommend it for Eurozone membership. This withdrawal seems very likely, but will only be confirmed after the forecasts are published on April 27th.

But there is an additional issue here, and that concerns the possibility that the Slovak economy may be overheating. Given that the Slovak central bank if gradually reducing control over monetary policy, with its key policy rate being now held at only 0.25% over the ECBs refi rate, and the koruna exchange rate being increasingly alinged with the central parity rate being set for euro membership, fiscal policy is basically the only demand management tool which is open to the Slovak authorities, and the European Union has consistently urged Slovakia to cut the shortfall more as the economy has grown at a faster and faster pace. Basically the EU Commission hold that the Slovak government should use tighter fiscal policy to counter inflation pressures, which are set to rise when price growth will no longer be tamed by a strengthening currency. My own personal feeling is that if the Commission and the ECB want a "get-out clause" for postponing Slovak membership this issue will give them the lever they need, since at the present time Slovak still targets a deficit of 0.8% of GDP in 2010 and is only contemplating achieving balance by 2011. Given what happend to GDP growth in Q4 2007, and the present spurt in inflation, there seems little justification for this position.


The Koruna

An additional problem which is likely to influence EU Commission thinking on Slovakia's application is the timing of any possible revaluation of the Koruna, since the Commission feel that a further revaluation of the Crown would complicate the assessment of whether the exchange rate has been stable enough to qualify for Euro adoption, or whether in fact the exchange rate regime was closer to what might best be described as a crawling peg one. This is really the principal reason that the National Bank of Slovakia has been marking time on what virtually all participants now consider to be a virtually inevitable future revaluation. On the other hand this issue is hardly likely in and of itself be a major obstacle to entry - although it could be added to the list of excuses for saying no if Damocles sword does, at the end of the day, fall to that side - since the exchange rate criterion is itself seen as rather obsolete given that it was shaped in the aftermath of a spate of devaluations in the late 1980s and early 1990s and is not really relevant as envisioned to the present circumstances of the catch-up growth countries.


However the koruna issue is relevant to the whole overheating debate, since the disinflation process which occurred in Slovakia during 2007 reflects both currency appreciation and slower price deregulation compared with the previous period. The impact of the exchange rate on inflation is measured by using the exchange rate pass-through coefficient, and it is just here that another thorny issue raises its head since the Slovak Ministry of Finance of Slovakia argues that the coefficient is close to 0.1 (a 10% appreciation reduces inflation by 1 percentage point) while the National Bank of Slovakia (NBS) sees the coefficient as lying somewhere between 0.1 and 0.2. The European Commission view on pass-through coefficient seem to be closer to the NBS estimate. What this effectively means is that the Commission take the view that Slovak inflation has been more restrained by currency appreciation than the government are willing to admit (and hence the underlying inflation rate which would be encountered once the currency can no longer rise after fushion with the euro is accordingly higher). Thus the Commission see the pass-through coefficient as yet more evidence for ongoing overheating, and the justification for the immediate application of a budget surplus as even stronger.

Under the assumption that Slovakia's membership is finally accepted (an eventuality that, as I write this article, seems to me to be getting less and less likely by the paragraph) then the consensus seems to be that there is a reasonable chance of a final revaluation of the central parity (currently 35.4424) to between 32.5 and 33.5 before July, in order to ensure that the conversion rate doesn’t represent devaluation from market levels - and indeed Finance Minister Jan Pociatek said on April 5 he "cannot rule out" revaluation. Any such de-facto “devaluation” associated with EMU convergence (ie if the koruna were not to be revalued, and remained at the current - below market value - central parity) would obviously become a further inflationary factor in 2008 and 2009, simply because the Koruna had been trading around 33.6 to the euro (5.2% higher than the current central parity) since March last year, and in recent weeks it has risen even higher, up towards the 32.30 - 32.40 range.

( Explanatory note: under criteria Slovakia must meet before it can adopt the euro, the koruna is allowed to trade 15 percent above or below the pegged value. This target is one of the five conditions for aspiring members of the euro region must comply with in order to test the stability of their exchange rates for at least a two-year period. There is no formal requirement that the conversion rate should coincide with the peg but it should be near the equilibrium value of the exchange rate to prevent tensions.

The koruna has gained 2.8 percent in the past year, and this has fuelled the speculation that the government will revise the planned conversion rate for the second time in 10 months. Slovakia last raised the central parity rate by 8.5 percent to its current level of 35.442 per euro in March 2007, from 38.455.)


So Will She Won't She?

This I suppose is the bottom line here. I think at the end of the day this decision is a very close one to call, and certainly much closer than most analysts are currently suggesting. My feeling is that the door may well not be opened to Slovakia this spring, and the clinching factor for me would not be the March inflation number, but rather the Q4 2007 GDP growth one and the recent trajectory of wages and retail sales in the early months of this year. In addition the apparent intransigence of the Slovak government on the need to run a budget surplus in an attempt to drain liquidity from the system would worry me, in the light of what might happen in the future. One year out of an excess deficit procedure really wouldn't be sufficient proof of intent from where I am sitting, even if you could argue that this is to make poor Slovakia pay the broken plates occasioned by the earlier behaviour of some larger, and arguably economically more important, existing members. So I would argue that prudence here urges caution, and caution suggests not saying yes, or at least not saying yes right now. But then I am not the one taking decisions, and have no special insight into how their thinking might work at this point.

But if they do say no, then this does leave us with all sorts of very awkward questions about just where the decision will leave those who are still sitting it out in the waiting room. Clearly some East European economies are now hanging on a very narrow thread, a thread which spans the chasm which lies between having a nice orderly slowdown and having a very disorderly "hard landing". It is hard not to imagine that the decision on Slovakia's membership won't have some bearing on which of the possible outcomes we may see here. We might also spare a moment to think that this whole situation may well never have arisen if euro membership hadn't been insisted on by the EU as a membership condition for these countries, but having taken the trouble to have the thought we might then go on to think that equally there is no point in closing the farm door once the horse has bolted. But what we might also like to ask ourselves while we are at it is what exactly the risks are going to be if we do decide to close the farm door even before all the horses wanting to enter the barn are snugly tucked-up inside.


Update

Well since writing this post Bloomberg have come in with yet another "scoop" here, since they have gotten their hands on a copy of a research paper prepared by the IMF for the Slovak government. In the paper the IMF apparently evaluate the exchange rate pass-through coefficient as lying in the 0.2 to 0.25 range (meaning that a 10% appreciation in the currency reduces inflation by 2 to 2.5 percentage points). Bloomberg interpret this as meaning that the IMF is siding with the Slovak government, but this is far too simplistic a way of looking at things. As I note in the post, the Slovak government hold the pass-through coefficient to be near to 0.1(meaning a 10% rise in the currency shaves only 1% off inflation), while the EU Commission and the National Bank of Slovakia hold this coefficient to be nearer to 0.2 (or at least in the 0.1 to 0.2 range). The IMF estimate - which may well be the most accurate one - seems to be even higher, but as such is nearer to the EC and NBS estimate than it is to the Slovak government one.

The point the IMF are probably making - but that the Bloomberg correspondent possibly doesn't understand, and I myself cannot be sure without seeing the report - is that since the koruna has only risen slightly over the last 12 months (about 2.8%, although it did rise around 10% in the year to March 2007, at which time Slovakia was allowed by the EU to raise the central parity of the koruna by 8.5% from the rate which was first set when Slovakia entered ERM-II in November 2005), then this rise cannot possibly carry the burden of explanation as to the earlier reduction in Slovakia's annual inflation - and in this sense the IMF seem to be saying that monetary policy and the reduction in the fiscal deficit must offer a much larger part of the explanation.

Slovakia's inflation rate fell to an all-time low of 1.2 percent in August, according to EU methodology, before global increases in food and energy prices pushed it back to 3.6 percent by March, a 15-month high. The drop in inflation in the 12-month period ending in August corresponded to a 12 percent strengthening of the koruna against the euro.

The IMF did however that Slovak inflation wasn't artificially manipulated by the regulation of utility prices - although I'm not sure that anyone has been suggesting it was.

``Regulated prices do not appear to have been artificially suppressed when benchmarked against unregulated prices of similar goods and services, against price levels and developments in the EU, and against underlying price pressures from commodity prices,'' the IMF said in the note



At the same time Slovak Prime Minister Robert Fico is out there and fighting:

Slovakia has met all the euro entry criteria and only a political decision by the European authorities could prevent it from joining the euro zone next year, Prime Minister Robert Fico said on Monday.



"In terms of the numbers Slovakia has met everything it was supposed to meet," Fico told a news conference. He said debate was still going on about inflation sustainability, but added Slovakia should not be disqualified as inflation is rising in all of Europe. "If somebody is thinking that Slovakia should not have the euro, it would have to be political consideration not an economic one," Fico also rejected arguments that inflation was kept artificially low by government pressure on energy prices.




Be all this as it may, the "revaluation" and "pass through" issue is - as I have been arguing - only a small part of the problem here, since in some senses this debate is now backward looking and what matters is the sustainability issue. The sustainability of Slovakia's fiscal deficit position (with ageing population issues looming) and the sustainability of the inflation rate as the labour market tightens and wages march onwards and upwards. I notice that with all the research going backward and forwards virtually no one is commissioning any research to get a NAIRU (non-inflationary natural unemployment rate)type triangulation on any of these economies at this point. The silence on this front is getting to be absolutely deafening. The whole situation would be laughable if it weren't so sad. I mean we are by and large talking about the wrong issues here (like currency revaluation) while in country after country (Ukraine and Russia too if you want to look) the inflation bonfire burns brighter and brighter on the back of structural problems on the labour supply side, problems which - to boot - have no simply and easy labour market reform "bandaid" fix.

Update 2: 25 April 2008


Bloomberg keeps coming up with more useful information about the battle royale that seems to be going on in the background. Today there is a report about the response of the Latvia's central bank who have apparently told the European Central Bank that it is treating Slovakia unfairly:

``We have voiced our concerns to our colleagues in the ECB that their current assessment of Slovakia's inflation performance cannot be regarded as equal treatment,'' said Latvian central bank spokesman Martins Gravitis in an e-mailed response to Bloomberg questions. ``Slovakia is demanded to deliver what other euro zone members have not been asked to deliver a decade ago.''


The Baltic states of Estonia and Lithuania failed in their attempts to take the single currency. Estonia dropped its bid voluntarily because of accelerating inflation, while Lithuania's application was rejected in May 2006 as consumer-price growth picked up. Latvia's Gravitis said a second rejection of an eastern member would ``smack of unwillingness to widen the club.''

Czech newswire CTK also reported today that the ECB and the European Commission will probably back Slovakia's bid, without saying where it got the information.

BRATISLAVA, April 24 (Reuters) - The ECB is facing pressure from some EU central banks to tone down a report in which it notes "serious concern" about Slovakia's readiness to adopt the euro, sources familiar with the process said.Bratislava must now quell doubt among economists and EU policymakers that it can maintain that over time, but analysts say fears among EU politicians that rejecting Slovakia's bid could discourage reforms there and in other euro aspirants will likely result a green light.

The sources, both senior Slovak officials, said an initial European Central Bank draft report sent to the 27 EU central banks expressed "serious concerns" from the euro zone's monetary authority about how Slovak inflation will develop after the impact of a firming crown disappears. But the two sources said several EU central banks had objected to the wording and that a final draft should temper the ECB's worry about inflation.

"There was a reaction from other central banks against the language, against the 'serious' concerns in the report," one source, who asked not to be named because of sensitivity of the matter, told Reuters. "That's why we think the overall tone of the actual convergence report will be more favourable (towards Slovakia)."

During preparation of the convergence reports, several drafts are circulated to EU 27 central banks for comments.The final version of the report is expected to be released on May 7, the day when the European Commission will say whether Slovakia is ready to swap its crowns for the single currency. Neither the Slovak Finance Ministry, nor the National Bank of Slovakia would comment. The ECB also declined to comment on the
matter.



References


Égert, Balázs and Jiří Podpiera (2008), ‘Structural Inflation and Real Exchange Rate Appreciation in Visegrad-4 Countries: Balassa-Samuelson or Something Else?’, CEPR Policy Insight.

Bini Smaghi, Lorenzo (2007), ‘Real convergence in Central, Eastern and South-Eastern Europe’.

Cincibuch, M. and J. Podpiera (2006), ‘Beyond Balassa-Samuelson: Real Appreciation in Tradables in Transition Countries’, Economics of Transition 14(3) 2006, pp. 547-573.

Danske Bank (2007), ‘Traffic Light Analysis’, .

Fabrizio, S., Igan, D. and A. Mody (2007), ‘The Dynamics of Product Quality and International Competitiveness’, IMF Working Paper WP/07/97

The Future Path of the Estonian Economy

Estonia's central bank recently published a "revised overview" of the Estonian economy - with the intriguing title of "Estonia's economy on the way towards a more sustainable development path". At the same time the bank took the opportunity to cut its 2008 growth outlook in half, bringing its annual forecast down to 2% from an earlier 4.3% prediction. If this forecast proves accurate it will, as can be seen from the chart below, certainly involve a rather noticeable stench of burning rubber as the tyres screech to a halt.




"The long-awaited economic adjustment is under way in Estonia, but it is no longer as smooth as expected due to the less favourable external environment," the Estonian central bank said as it presented its lower forecasts.



This current 2 percent forecast compares with the 7.1 percent growth rate achieved in 2007 and the 11.2 percent one in 2006.

The bank also suggest that growth will pick up again to 3 percent in 2009, however, since we still don't really know how low the GDP growth number will - at the end of the day - fall in 2008 it is perhaps early days to start reaching any hard and fast conclusions on this front. In particular we still don't know whether or not we are going to see a hard landing in Estonia (or in the rest of the Baltics for that matter, or in Bulgaria, or in Romania) - and especially in the financial sectors in these economies - so until things are a bit clearer any hard-and-fast speculation about future growth and recovery paths is rather premature in my view, however happy it may make some full-time analysts to keep churning out the numbers regardless.

Returning for a moment to the growth numbers for Q4 2007, perhaps the most important detail to note is that annual growth for the quarter was still running at 4.8% while the seasonally adjusted estimate for quarter-on-quarter growth was only 0.8% - or an annual rate of 3.2%. These numbers - when they were first made public - were of course very low in the Estonian context, but now, given the sort of downward revisions we are seeing (the IMF also recently lowered their 2008 forecast to 3%, and of course there may well be more revisions still in the pipline), they seem quite the opposite. What I think we should thus be taking away with us here is the way in which trend has been showing a very steep and continuing fall over a number of quarters, and the decline has not come to a halt yet. When it does, then we will be in a much better position to start thinking in more detail about what a recovery might look like. For the moment perhaps our time would be better spent looking at just what downside risk we still have in the Estonian context.



The Outlook For Q1 2008

What is quite evident from the above chart is that growth momentum in Estonia has now been declining since the first quarter of 2006. What is also evident is that the loss of momentum is moving in fits and starts. Q3 2007, for example, shows a certain recovery from Q2, but then the decline continues in Q4. We will see moving forward if this "fits and starts" process continues. It wouldn't surprise me to see a Q1 2008 number which was slightly up on Q4 2007. But if it was - at say 1% quarter on quarter - that would mean we had effectively seen more than half the growth anticipated by the Estonian bank in just one quarter, which makes me want to ask myself some awkward questions concerning just what sort of growth we will then see over the rest of the year (ie, are we headed directly into recession in Q2?).

Alternately the downward drift might still continue in Q1 (hard to say looking at things like the industrial output numbers at this point) in which case the whole edifice would be well on its way down towards trawling the bottom.

Industrial output - according to the latest data release from the statistics office - was up in February, on both January (1.8%) and February 2007 (2.6%). This follows on the back of a revised 4.2% increase in January. Manufacturing output was also up, by 5.2% on February 2007, and by 2.4% (seasonally adjusted) on January. As can be seen in the chart below, December was very definitely a bad month, and even seems to have been an exception, so we now need to wait a little to see just where things move from here. Patience, I do believe, is most definitely a virtue in this type of situation.




EU Economic Sentiment Index

The EU Composite economic sentiment index for Estonia is also interesting, since while it shows a steady and constant decline from August 2006, since December 2007 it seems - for the moment - to have stabilised, a reading which is consistent with the idea that growth in Q1 2008 may not be dramatically down when compared with Q4 2007.




Inflation

Inflation - which has really been hitting the highs of late - was seen by the central bank as speeding up over whole year 2008 to 9.8 percent from 6.8 percent in 2007, and then falling back again to 3.0 percent by 2010. Estonia's inflation rate in fact fell back slightly in March from what had been virtually a 10-year high in February as the growth rate in food and housing costs eased back slightly. The annual rate dropped to 10.9 percent from 11.3 percent in February, according to data from the statistics office. Prices rose a monthly 0.8 percent.





Unemployment and Wage Inflation

Although the situation is far from dramatic at the present time, Estonian unemployment is ticking up steadily, and in March 2008 there were 17181 registered unemployed in Estonia - this was the ninth consecutive monthly increase - and unemployment was up 441 or by 2.6% from February. Nonetheless the unemployment rate remains extremely low at 2.7% according to recent data from the Estonian Labour Market Board.



So the labour market remains extremely tight, and as a result the adjustment process is very slow. Wages and salary increases peaked in Q2 2007 (see chart below) but they were still rising at an annual rate of 20.1% in the fourth quarter, and at an annual rate of 18.1% in December (which is the latest month for which we have data) or in real terms (subtracting the monthly 9.6% CPI inflation)by 8.5%, which is hardly the normal conditions for an economic slowdown and correction. We can reasonably draw the conclusion that this tight labour market and difficulty in getting wage inflation under control is going to make the correction a longer and more drawn out affair than it otherwise would be.







Exports

Estonia's trade deficit narrowed in January, reaching its lowest level in almost two years. A large part of the reduction was a result of a rapid drop in imports - which fell year on year by 4% in January, and this undoubtedly reflects the rapid contraction in internal consumer demand, but exports did also bounce back nicely, although the level of growth - at 4% - was still well below the 12% year on year growth rates achieved in October and November.





So while - looking at what has been happening in Germany and other CEE economies - we might reasonably expect that the uptick in exports may be sustained in February, the rather volatile nature of Estonian exports makes it hard to draw any worthwhile lasting conclusions at this point. We should however note that the improvement in the trade balance will impact positively on GDP, so this would argue in favour of a slight temporary improvement in growth in the first quarter.



The bank see Estonia's current account gap - which is one of the points most cited by ratings agencies as a key worry in terms of the overheating problem - falling to 7.5 percent of GDP by 2009 from 17.4 percent in 2007. The IMF currently forecast a CA deficit of 11.2% of GDP in 2008.





Meantime the slowdown is making itself felt on the Estonian government, which faces a revenue shortfall and needs to cut spending. Estonia must cut spending this year by 3 billion kroons ($303.4 million) to avoid a budget deficit this year, the central bank said. This fiscal tightening on the government's part will obviously be a negative as far as 2008 growth is concerned.


IMF Hard Landing Warning

However, if we look beyond the current quarter it is evident that things look rather bleak, and the risk of the slowdown becoming rather more disorderly is evident. Indeed, according to the the latest IMF Global Financial Stability report (published this week), a number of Eastern European countires now face a continuing and growing risk of having a "hard landing" as the global financial crisis continues to spread. The fund also drew attention to the possibility of serious of spillover problems arising for the Scandinavian, Italian and Austria banks that have lent heavily in the region, and this warning will not be taken lightly by these banks (whose benevolence and cooperation was, it will be remembered, thought to be the principal lifeline for the Baltic economies in times of distress).

At the heart of the IMF's concerns are the large current account deficits being run in certain CEE countries, deficits which have now reached extreme levels in some cases, running to the tune of 22.9pc in Latvia, 21.4pc in Bulgaria, 16.5pc in Serbia, 16pc in Estonia, 14.5pc in Romania and 13.3pc in Lithuania.



"Eastern Europe has a cluster of countries with current account deficits financed by private debt or portfolio flows, where domestic credit has grown rapidly. A global slowdown, or a sharp drop in capital flows to emerging markets, could force a painful adjustment,"


The IMF said lenders in Eastern Europe had built up "large negative net foreign positions" during the boom, especially in the Baltic states. "Liquidity for these banks has all but dried up and [interest] spreads have widened 500 basis points."

Many of these countries concerned rely on credit from branches of West European and Nordic banks, but these foreign lenders are now themselves having difficulty raising money in the wholesale capital markets.



"A soft landing for the Baltics and south-eastern Europe could be jeopardised if external financing conditions force parent banks to contract credit to the region. Swedish banks, the main suppliers of external funding to the Baltics, could come under pressure,"

One interesting indicator of potential risk for the financial sector comes from the inventory overhang in the property sector (see the chart below). Basically if important building and construction companies steadily accumulate unsold properties and then are forced into bankruptcy then the outstanding loans can all fall back into the banking system, causing all kinds of problems in the process.





As the IMF note in their report, awareness of higher risks in the CEE countries has been rising in recent months, and this rising awareness has been been reflected in the performance of bank stocks exposed to the region, in Credit Default Swap spreads, and in the performance of the Romanian leu (see chart below) given that the leu is the only floating currency with a liquid forward market among the group of eastern European countries with large external imbalances. As we have seen it has depreciated substantially since July 2007, as investors have been expressing their negative views on the region as whole The stocks of Swedish banks exposed to the Baltics have underperformed other Nordic bank shares (and here) partly owing to significant short-selling and CDS spreads on sovereign debt have surged since August 2007, as investor demand for credit protection has pushed up prices. The interesting point to observe is how this is now all moving in tandem.



Convergence and Growth


Finally, looking beyond immediate risks, it may also be useful at this point to consider some of the basic structural characteristics of the Estonian economy in the future. Now one of the underlying assumptions in the Estonia central bank forecast is that at some point Estonian domestic demand will recover in a fairly predictable manner. But there is no apriori reason why this need be the case. Part of the justification for the central bank view is what is known as "convergence theory". But in fact the evidence on convergence is quite contradictory, and really there are so many things we don't know and don't understand about the factors which condition economic growth that there are good reasons to be cautious here.

To give just one example I will take the cases of Ireland and Portugal. I do not do this randomly, since Ireland and Portugal form two quite contrasting cases, but then if we understood better why Ireland has been on one growth path while Portugal has followed quite a different one, then we would certainly be a lot wiser than we currently are. These two cases are interesting since both countries were founding members of the eurozone and both have experienced since the turn of the century one and the same monetary policy. Yet the results, as we can see in the charts below, have been very different. If we first look at the comparable growth rates the situation is clear enough.



While Ireland's growth rate dropped by from the very high levels of the late 1990s - which were never accompanied by the kind of inflation we are currently seeing in the Baltics - they comfortably settled into the 4% to 6% range, while Portugal's growth rate dropped steadily following the 2000 "correction" and has subsequently remained in the 1 to 2% range.

The result of this has been that Ireland's per capita income has first overtaken that of Portugal, and then soared way above it. If we look at the chart below, which is based on data prepared by Eurostat, we can look at the volume index of GDP per capita as expressed in Purchasing Power Standards (PPS) (with the European Union - EU-27 - average set at 100). If the index of a country is higher than 100, then this country's level of GDP per head is higher than the EU average and vice versa. Basic data is expressed in PPS which then effectively becomes a common currency eliminating differences in price levels between countries and thus making possible meaningful volume comparisons of GDP between countries. Please note that the index, since it is calculated from PPS figures and expressed with respect to EU27 = 100, is valid for cross-country comparison purposes rather than for individual country inter-temporal comparisons. Nonetheless this chart is extraordinarily revealing, since it is quite clear that Irish and Portuguese GDPs per capita are far from converging.



Now if we start to think about the EU10, we could look at the case of Hungary. Hungary's domestic consumption as can be seen actually peaked in 2002., and since 2004 it has not be especially strong. It is now in full retreat. Would anyone like to tell me when it will recover, and by how much? I certainly can't tell you, but I certainly strongly doubt we will ever see the 2002 level again, and I am even rather unconvinced we will get back to the 2005 level. My intuition is that Hungary will now become an export driven economy.


And so we come to Estonia. As we can see domestic demand has been in massive retreat since the start of 2007. Will this recover, and by how much will it recover. The Bank of Estonia is reasonably happy to give an optimistic response. Personally I think there are good theoretical and empirical reasons for being rather more cautious at this point.

Finally, and at the risk of pushing my point just one bridge too far, I would like to take a quick look at German private consumption data. One of the core arguments I am presenting on this blog is the idea that part of the issue facing the Baltic economies is the population ageing one. This argument is being by and large ignored by mainstream analysts, but simply ignoring a problem doesn't make it go away. As we have seen from the Irish case, rapid economic growth is both possible and sustainable over long periods of time. But do the Baltic countries have the demographic profile to be able to follow the Irish path (and remember Ireland's growth has in part been possible as a result of migration there on the part of some - at least - Baltic citizens).

The Bank of Estonia, as I have been arguing, simply look at what is happening in Estonia on a "convergence" cyclical basis. But there are reasons for thinking that this view may be inadequate. Germany also had a very significant consumer boom and correction back in 1995, and if you look at the chart below German domestic consumption has never recovered.

And indeed if we look at the next chart we will see that in 2007 (following the significant VAT rise induced local spike in the 4th quarter of 2006) German private consumption has been steadily declining across 2007, and this despite a very rapid rate of new job creation and a substantial drop in unemployment. I think people should at least think about this carefully, and ask themselves whether or not Estonia may now follow this course, becoming an export driven economy. At least, I would argue, there are prima facie reasons for considering this outcome to be a real and present possibility.


Eesti Pank now estimate private consumption growth for 2009 at 3.8% and for 2010 at 4.5%. I think this view is unduly optimistic, and really puts the whole forecast in doubt. In the meantime we might perhaps like to ask ourselves whether Estonia's economy really is "on the way towards a more sustainable development path" or not. As I say, exports not domestic consumption are now likely to be the key, and with the inflation fire still burning away, and the rate of increase in global trade now slowing notably on the back of the credit crunch we may well ask whether the forecasted real (ie inflation adjusted) export growth of 4.8% for 2009 and 6.5% for 2010 are really all that realistic. It is one thing to pull numbers - like rabbits - out of a hat. It is quite another to make realistic forecasts.

Thursday, April 17, 2008

Hungary's Wages and Salaries Rise Sharply in February 2008

The forint fell again in Budapest this morning following a government report from the statistics off that showed that monthly average gross wages rose far more than expected in February, adding to the case for the central bank to raise what is currently the European Union's second-highest interest rate (after Romania). The data stoked speculation higher borrowing costs will damp growth in an economy that's already growing one of the slowest rates in the entire European Union (Latvia and Italay would be other candidates here for the "reverse poll position".

Hungary's monthly average gross wages soared by 13.4% year on year in February, according to the latest data from the Central Statistics Office (KSH). This increase follows a 1.5% decline in January. Net wages went up by 11.5% yr/yr in the second month of 2008, against a drop of 0.2% in Jan.



The forint weakened to 158.895 per dollar by 1:35 p.m. in Budapest, from 158.753 yesterday, when it had climbed to its highest level since December. It was little changed at 253.11 per euro, after gaining to a six-month high of 249.27 on April 14.

The slight moderation in inflation in February (down to 6.9% from 7.1% in January) and this substantial jump in wages mean that Hungary's real wage decline has come to a sudden stop. The 6.8% decline registered in January became a a 4.3% rise in Feb, which means that the rate of real wage decline is 1.7% for January-February taken together. In terms of net wages the 7.3% annual decline in January became a 4.6% annual rise in February. As can be seen from the chart below the turnround in pretty dramatic.





“This is a shockingly high number and points to wage growth acceleration in 2008, instead of the slowdown that the NBH was hoping for. Looking at the details the increase is fairly widespread, and cannot be explained by the minimum wage increases for employees with higher education."
István Zsoldos, Goldman Sachs, London


Perhaps it would be better if we strip the January data out of the picture altogether here, since the apparent decline in January was due to bonus payment distortions in the public sector.

Basically January wages in the public sector do not contain the entire 13th month bonus payout, but only its monthly proportionate share (one twelfth), as this bonus is now being distributed fractionally, and indeed some monthly instalments wrere already paid last year. According to the statistics office, they paid four of the 12 monthly wage bonuses last year and the remaining eight will be paid as of January this year.

If we look at the private sector alone, we get a more representative picture, and find that the gross average wage in the private sector rose by 14.4% year on year to HUF 187,350 in February, up from a 9.7% increase in January. In real - inflation adjusted - terms this means that year on year wages were up 2.6% in the private sector in January and 7.5% in February.




Gross average wage in the public sector was HUF 193,990, up 11.8% yr/yr, against a decline of 14.6% in Jan.

Recent comments from the MNB have highlighted the importance attached to this year's wage data in shaping monetary policy and so today's data will be hard for them to ignore and retain credibility, since they suggest - according to the logic of policy as it currently stands - more rate hikes rather than less. In light of this further 50bp rate hike to 8.5% could easily be on the cards at a meeting in the not too distant future.

"In our view, the current strong wage data clearly increases the chance of an April rate hike........the MPC will be ready to act in April and hike rates by 25bp due to the unfavourable developments in the underlying factors to inflation, such as private sector wages and market service prices. We expect 25bp rate hikes in April and May, increasing the base rate to 8.50%, while the rate cutting cycle is likely to be delayed until 1H09."
Eszter Gárgyán, Citibank, Budapest


The acceleration in private sector wage growth was largely driven by the financial services sector, where total wage growth jumped to 58% YoY in February, while regular wages accelerated to 13.2% YoY up from 4.5% in January. Eszter Gárgyán ( Citibank, Budapest) argues that the strong February financial sector data is partly the consequence of base period effects of previous bonus payments and an earlier wage hike and that calculating annual wage growth over a five-month period (October to February would give a milder, 5.7% YoY growth in the financial sector).

"In the financial sector, there was a major acceleration in wage payments ... and there was also a jump in the real estate sector. Looking at ex-bonus figures, real estate sector wages jumped most sharply. This is in partly due to the whitening of the economy. Many white collar workers were brought properly onto the payroll. Gross wage growth in the financial sector was almost 34 percent while real estate sector wages rose 15%."
Erika Molnárfi, KSH Statistician, Budapest


Of course viewed in another light the uptick in financial services wages should not surprise us at all in the light of the growing importance of the financial services secor in terms of GDP share - since this component has gone up from 16.64% of GDP in Q4 2005 to 20.99% in Q4 2007 (or over 4 percentage points in 2 years).



And this at a time when construction activity has been in almost total retreat. Naturally all those nice swiss franc mortgages people have been selling will have helped swell the bonus payout:



As will all those CHF personal loan mortgage refis, which have been busy running a horse and cart through the domestic credit monetary tightening plans over at the NBH:




Regular wages also accelerated in industry, mining, construction, tourism, restaurants, and real estate and business services in February, and remained above 10% in the retail sector. Bonus payments unexpectedly jumped in most of the service sector.


Perhaps even more significantly with all this wages growth taking place the number of employed in the whole economy dropped by 1.3% year on year to 2,736,900 in February following a 2.0% drop in January. Even in the private sector with 1,940,200 people employed there was a 0.1% year on year decline, while in the public sector employment was down 5.5% year on year to a total of 715,100 in February, which compares with a 5.8% fall in January.



This is why I earlier spoke of the Hungarian economy being in a condition of stagfaltion, since we have very little - if any, let's wait and see - GDP growth, negative employment growth, and yet significant wage and consumer price growth, which may well mean that even as the economy contracts - if we actually get to enter recession as the year advances (what out the decline in German investor confidence this week) - then the NBH may find it is still in a tightening and not in a loosening cycle.