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Thursday, December 25, 2008

As The Politicians Battle It Out Ukraine's Economy Tunnels South In Search Of Australia

“In Ukraine, the evidence is still that policymakers do not quite understand the seriousness of the challenges they face,”. Timothy Ash, analyst at the Royal Bank of Scotland.

“There is a burgeoning economic crisis in the European periphery,” Krugman said on the ABC network Dec. 14. “The money has dried up. That’s the new center, the center of this crisis has moved from the U.S. housing market to the European periphery.”

Make no mistake about it. What is taking place right now in Ukraine is extraordinarily serious. The IMF have recently agreed a support loan to the country, but the politicians themselves still can't agree on whether or not they are actually going to abide by the conditions attached to it. Meantime, as we can all see on our TV screens, tensions with Russia continue to escalate, fuelled by the conflict-ridden negotiations over Ukraine's gas debt.

And just to add to the nighmare, Ukrain's economy made a dramatic entry into recession in Q4 2008. In fact, so severe has been the slowdown that nobody at this point can even muster enthusiasm for opening up one of those interminable discussions about whether or not what the country is going through really counts as a "technical recession" (in terms of two successive quarters of GDP contraction) or not, since the drop in national output has been enormous, and it it fairly obvious that isn't about to come bouncing back up again. At least not for the next several quarters it isn't, and - to give us an early glimpse of the terrain onto which we are now entering - the World Bank have just forecast a 4% contraction in GDP for 2009.

In a year when you would think little would surprise us the sharp change in real Ukraine GDP dynamics has been astonsihingly swift, with the growth rate moving from the 11% year on year expansion registered in August to the 14% year on year contraction reported in November (according to data put together by the World Bank). GDP for the whole January-November period is now down to 3.6% when compared with the equivalent months in 2007, and this is reall a sharp drop, since the average over the first nine months of the year was a growth rate of 6.9%. For his part the office of Ukraine President Viktor Yushchenko is suggesting that gross domestic product may contract at an annual rate of between 7 percent and 10 percent in the first quarter of next year, and by 5 percent over the whole year, according to Oleksandr Shlapak, deputy chief of staff to the president.

The contraction has been led by sharp falls in manufacturing and construction, while the financial system has been in serious trouble since late September, and the loss of UAH deposits from the banking system has amounted to 14% during October and November. But the real problems Ukraine is facing in confronting this most serious economic crisis, lieas in the political sphere, and the complete lack of the kind of political consensus which is so necessary to see through the measures which can it to an end.

Political Chaos Adds To The Problems

Ukraine’s government - which is laways a chaotic process at the best of times - is once more having a serious identity crisis about who it is and what it wants to do, with one of the exectutive's two visible hydra's heads (Prime Minister Yulia Timoshenko) seeking to respond by manipulating the currency downwards, by boosting social expenditure to an extent which will push next year’s budget deficit up to 2.96 percent of gross domestic product (from an agreed 1.4%) and well beyond the IMF pact level, and by attempting to resolve the trade deficit problem by imposing an administrative tax on imports. The other head of the hydra (President Viktor Yushchenko) is busy opposing all these moves on the grounds that they may jeopardize the second tranche of a $16.4 billion loan from the International Monetary Fund, and obviously, were this to be the case, the country would basically find itself bankrupt, and at the mercy of whatever sentiments the global financial markets wish to express when it comes to Ukraine.

Of course regular readers of this blog will not be surprised to find that this politically split personality crisis goes right into the heart of the central bank (see my Monetary Chaos Breaks Out At the Ukraine Central Bank post) and no one will be really that surprised to find that the two key characters in this round of the saga are (yet one more time, read the linked post, its all explained there) National Bank of Ukraine Governor (and board chairman) Volodymyr Stelmakh’s and Petro Poroshenko head of the central bank council.

Well things are really hotting up at the moment, with Viktor Yushchenko this week threatening to fire some central bank employees (presumeably those who were not implementing the decision to allow the Hryvnia to float), while Yulia Timoshenko was busy demanding the dismissal of National Bank Volodymyr Stelmakh himself - presumeably because he was trying to stop further currency intervention. In an official statement the central bank council responded by accusing Timoshenko of stirring up “chaos” and undermining the nation’s banking system, while Timoshenko, for her part has now taken the matter to the Ukrainian parliament (the Verkhovna Rada - where she may well carry a majority) which will now hold a full debate the role of the central bank next week. It seems not to matter too much here that the bank council is simply trying trying to implement a set of policies which were agreed to (or everyone thought they were agreed to) as part of the IMF loan agreement.

“A hryvnia level above 9 per dollar is unacceptable, it threatens the economy and banking system,” Petro Poroshenko, the head of the central bank council said. “The situation with the hryvnia rate demands urgent measures.”

Volodymyr Stelmakh, Central Bank Governor, the Yulia Tymoshenko Bloc is proposing his immediate arrest.

(Interfax-Ukraine) - Yulia Tymoshenko Bloc has proposed that, based on results of a report by an ad hoc parliamentary commission scrutinizing the National Bank of Ukraine's activities, an address should be sent to the Prosecutor General's Office and that National Bank Chairman Volodymyr Stelmakh should be arrested. "I think that, based on the report's findings, there will surely be an address to the Prosecutor General's Office of Ukraine and other law enforcement agencies, which, by the way, are already conducting inquiries," Volodymyr Pylypenko of the Yulia Tymoshenko Bloc said in an interview with Interfax on Wednesday. "The best gift in this situation can only be an order on taking [National Bank of Ukraine Chairman Stelmakh] into custody for all wrongdoings the National Bank has committed in the past months," Pylypenko said.

President Yushchenko did express the hope last Tuesday that Ukraine's currency market might be moving rightside up, with the hryvnia trading at about 7.8-8.0 to the dollar and level of "stabilising" dollar purchases by the central bankdeclining, but Prime Minister Tymoshenko remained unconvinced that this was a desireable level, and demanded more concerted intervention to move the currency up to a much higher level - around the 6-6.5 to the $ mark. She gave Yushchenko a week-and-a-half apparently, since otherwise she stated the country would face increasing problems with inflation, and in the banking and other sectors. It is not clear (at least to me) why these problems (which are, and will continue to be, serious) should suddenly deteriorate within the time scale of ten days, but presumeably there was another, more political, message behind this choice of words.

Adding to the confusion, Ukraine's parliament, has decided to impose an additional 13% temporary duty on all imported goods - and this despite the fact that Ukraine only recently entered the WTO. A total of 269 MPs from the ruling coalition and the Communist Party voted for the relevant law which amended existing Ukranian lefislation - with, it was said, the aim of improving the state of Ukraine's balance of payments. "Duties have been increased on all imported goods, apart from a [so-called] 'critical' [list of goods]," the head of the parliament's committee for tax and customs policies, Serhiy Teriokhin, is quoted as saying.
"I'm alarmed by the report of my legal department on parliament's decision to impose an additional temporary duty on all imported goods. Parliament's decision puts Ukraine's presence in international programs in jeopardy," President Yushchenko said at a press conference yesterday. "Similar decisions by Russia and Europe might be made against us in three days,".

IMF Taking Large Political Risk

Last month, a point in time which now seems so distant it feels like eternity, Ukraine received approval for a two-year IMF loan intended to help support its banking system and cover the country’s widening current-account gap during what was always seen as being a difficult adjustment process. Under the terms of its agreement with the IMF, Ukraine is expected to have a balanced budget next year. If the Cabinet fails to meet the target, then the Fund may withhold the second tranche of the loan, according to press statements by Balazs Horvath, IMF representative in Kiev. Ukraine received the first installment of $4.5 billion last month, and is due to get the second tranche in February. Obviously the IMF is by now well accustomed to playing the part of the "bad boy" in this type of situation, but what if the country they are trying to deal with should simply "implode", right in its face, I'm not sure even the hardened hand of the IMF are ready for this. So let's just hope I'm exaggerating, and that it won't happen (fingers tightly crossed everyone, please).

Discrepant GDP Forecasts

So Ukraine faces a crisis on three fronts, financial, economic and political. On the real economy side, the Ukraine cabinet currently expects growth in the country’s economy to slow to 0.4 percent next year, compared with a final rate which turn out to be somewhere between 1.8 percent and 2.5 percent this year. As I say the World Bank now expects a 4% contraction in GDP next year, and thus a 0.4% expansion in the budget is potentially a very serious problem indeed for the deficit, if the economy underperforms, as it surely will.

“The draft budget, prepared by the Cabinet, is not realistic,” Yushchenko said today in a statement on his Web site. “The 2009 budget is a tragedy; it is the most irresponsible document worked out by the government. Professionals should plan a realistic budget, not optimistic.”
The government plans to cover the budget deficit by selling bonds in domestic and foreign markets, and is to receive a $500 million loan from the World Bank to cover the budget deficit. Under the terms of the IMF agreement with the Inernational Monetary Fund Ukraine has pledged to keep its 2009 budget deficit under 1 percent of gross domestic product, below the 2 percent initially planned by the government. In October, the government reduced its planned 2008 budget revenue from the sale of state assets to 401 million hryvnia ($59.4 million) from 8.6 billion hryvnia, citing the unfavourability of the moment for selling.

Pressure On The Hryvnia

The Hyrvnia has been falling for a number of weeks, but the rate of decline has really accelerated in the last ten days, and we are really now talking about one of those famous currency crises. The national currency has fallen 50 percent against the dollar since June, and according to Michael Ganske, head of emerging markets in London for Commerzbank, it may well drop another 24 percent in the next few weeks given market sentiment and that the International Monetary Fund package effectively limits central bank intervention to halt the slide. The terms of the IMF $16.4 billion bailout package, agreed to last month, require Ukraine to move toward a flexible exchange rate and place a maximum limit of 4 percent for any reserves reduction during the remainder of 2008 (from the base of around $32.8 billion). Thus while the agreement does allow intervention to stem “disorderly” swings, it places a tight limit on what this means. And this now is just the problem, although before we jump to our guns, we should bear in mind that what is provoking the fall is not the IMF and the bailout, but confidence in the ability of the political system to implement a workable recovery plan. Trying to run a currency corridor, and accepting the inflation that went with it, is how we got here in the first place.

The only real remedy Ukraine’s central bank has at its disposal at this point is to raise its base refinancing rate, and this it duly did last week, taking it up from 18 percent to 22 percent in an attempt to arrest the hryvnia’s decline To give us some idea where we are at this point, at the start of 2008 the dollar bought 5.04 hryvnia, while right now it can purchase around 8.25 hryvnia.

The central bank is currently offering to sell dollars at 8.0 hryvnias and to buy them at 7.8788 on the interbank market. Yushchenko told a news conference last week that the central bank had bought $270 million on Monday and Tuesday, but had been required to sell only $30 million on Tuesday. He informed the assembled journalists, however, that complete stabilisation would need to wait until after the debts for Russian gas and other expenditures had been paid (you should be able to start to smell just how complicated all this is by this point, just who exactly is batting for who here?). "Until debts are paid for gas, and settling the debts of (the national road network) Ukravtodor, it would be madness to talk about steps aimed at a fundamental, professional stabilisation". "Everything is earmarked", he claimed, "$3 billion (for intervention from reserves), more than $2 billion set aside for gas arrears, $1 billion for repayment of a loan to Ukravtodorom, $200 million to (rocket maker) Yuzhmazh, leaves only an additional $400 million to defend the hryvnia."

As a result of the $7.5 billion the Ukraine central bank spent supporting the hryvnia in October and November foreign reserves fell to $32.7 billion as of Nov. 30. At the same time the hryvnia has declined 21 percent against the dollar over the last month alone . Under the terms of the agreement with the IMF, the reserves should not fall below $31.4 billion by the end of this year, so we are talking about a very close call on this front too.

Equities Down And Credit Default Swaps Up

Ukraine’s stocks have also been falling, and the benchmark PFTS stock index is down 74 percent this year, the third-steepest decline among the 22 so-called frontier markets tracked by MSCI Barra. Mariupolsky Metallurgical Plant, Ukraine’s largest steel company by revenue, has fallen 92 percent on the Kiev stock market. On the other hand the extra yield investors demand to own Ukrainian government bonds instead of U.S. Treasuries has increased more than nine times this year to 25.86 percentage points, according to JPMorgan Chase’s EMBI+ indexes, which compares with an average three-fold increase in the main emerging-market index to 7.09 percentage points.

Loan Defaults Coming

And as the currency slides, so too does the ability of the average Ukrainian to pay his or her debts. Another Yushchenko aide, Roman Zhukovskyi, recently estimated that up to 60 percent of foreign-currency loans and mortgages could default given the extent of the decline. Ukraine, which has around $105 billion in corporate and state debt, has the fourth-highest credit risk worldwide, according to credit-default swap data. The cost of insuring Ukraine bonds against default is up more than thirteenfold this year, to an astonishing 31 percent of the amount of debt protected. This puts the country behind only Ecuador, which defaulted last week (59 percent), Argentina, which defaulted on $95 billion in bonds in 2001 (46 percent), and Venezuala ( 33) percent, according to the data from CMA Datavision.

Ukrainian companies need to repay as much as $4.1 billion this month while lenders refuse to refinance debt, according to Dmitry Gourov, an economist at UniCredit in Vienna (oh, no, not Unicredit again, see this post). Dollar denominated loans made up 53 percent of credit issued by Ukrainian banks as of 30 September, according to central bank data.

Thus, with just over half of all bank loans denominated in US dollars, they obviously become vastly more expensive for borrowers who are paid in the national currency.

Aggressive lending by banks that borrowed heavily from abroad has obviously contributed to Ukraine’s ballooning private sector external debt (currently estimated at $85 billion). Official figures indicate that only some 2.5 percent of loans are currently problematic, but this situation is obviously about to worsen considerably next year as the currency is down and the economy contracting.

Earlier this month, Finance Minister Victor Pynzenyk called on banks to refinance loans amid a weakening hryvnia and rising interest rates. Some banks in recent days said they would seek compromises with clients, rather than hike interest rates further. Pynzenyk’s proposal called on the NBU to amend its rules to allow borrowers either partially or in whole to pay back loans in the national currency at the exchange rate which was operative when the loan agreement was signed. The banks, in turn, would be allowed to lower their capital/asset ratios and write off their losses, thus paying lower taxes, which would also require amendments to the tax legislation. Obviously some such solution will need to be found for this problem. (There has already been some move in this direction in Hungary, another of the countries which is strongly affected by the forex loans problem).

Other measures under consideration at the present time include extending loan periods, and the temporary reductions in loan payment installments. If the hryvnia-dollar exchange rate further widens, mass loan defaults are inevitable, according to Yuriy Belinsky, head analyst at Astrum Investment Management. At the current Hr 8 to the $1 rate, “40 percent won’t be able to pay their loans,” Belinsky told Korrespondent, a Russian-language Ukraine newspaper.

And the situation is deteriorating fast, a quick visit to the foreclosure sections on the websites of banks like Finance and Credit Bank or Alfa will turn up plenty of property and cars already listed for sale or soon to be auctioned. But given the slump in the real estate market and falling house prices it isn't clear that banks will find it any too easy unloading any property they do repossess. We are back to the "you owe them a little money and you have a problem, and you owe them a lot of money and they have a problem" situation. Last weekend, the NBU also recommended that banks lower interest rates on foreign-currency denominated loans, but the problem is going to be, as ever, who is actually going to fund these measures?

Industrial Output Plummets

Meantime in the world of the real economy things simply get worse and worse. Industrial production shrank by a record 28.6 percent in November as steel, machine building and oil refining slumped, after a 19.8 percent decline in October.

And as output falls, prices come tumbling behind. Steel production dropped 48.8 percent in November, while the price of the benckmark European hot rolled coil has fallen 47 percent since August and is now at around $425 a metric ton, according to data from U.K. industry publication Metal Bulletin.

World Bank Forecast

The World Bank have predicted a sharp recession for Ukraine in 2009, with GDP being expected to fall by some 4.0 percent. This compares with their July forecast of 4.5 percent growth. The Bank also cut back its forecast for 2008 growth to 2.3 percent from a previously forecast 6.0 percent. It raised its inflation forecast for this year to 22.8 percent from 21.5 percent previously predicted, up from 16.6 percent in 2007. It cut its forecast for inflation next year to 13.6 percent from 15.3 percent.

(please click on image for better viewing)

The Bank take the view that the Ukraine government - in agreeing to the terms of the IMF loan package - have initiated an important programme of macroeconomic adjustment measures, but (with a wary eye on what is actually going on in the Parliament) stress that consistent implementation is essential to avoid a further erosion of market confidence. In their latest report the Bank highlight the shift towards a flexible exchange rate policy, financial sector stabilisation measures , and a more conservative fiscal policy, but as we have seen, these are just the measures which seem to be being challenged by some of the political participants .

So What Does The Future Look Like?

Obviously Ukraine is heading into a major recession in 2009 fuelled by the nasty cocktail of a credit crunch, a terms of trade deterioration, and a consequent massive slowdown in both internal and export demand. Given the damage to competitiveness caused by two years of double digit inflation, macroeconomic stabilization will require a very large and significant correction, and this will mean a significant tightening of aggregate demand and a shift in its composition away from domestic consumption and towards net exports. The government debt stock is currently low at 10 percent of GDP, and will undoubtedly remain sustainable throughout and after the adjustment, even allowing for the potential costs of bank recapitalization. But the ability of the Ukraine administration to carry out the necessary adjustment hinges critically on the willingness of external creditors to refinance the banking and corporate sector debts, and this willingness in its turn depends on the perception those creditors have of the level of political coherence and stability the country has. And as we are seeing such perceptions must be reasonably near an all time low at the present time.

But even with the best political system in the world, the economic correction facing Ukraine is going to be large and the stresses enormous. The World Bank more or less spell this out in the paragraph I extract below. A 200% contraction in real imports (ie not due to cheaper energy prices or something) is massive, and we are talking about a basically balanced budget (ie very little fiscal stimulus) and monetary policy where interest rates are at the current giddy heights of 22%.

The basic macroeconomic parameters in our forecast are broadly consistent with those of the IMF program. Balance of payments pressures will lead the economy to adjust the composition of growth through 2009. As a result, the current account deficit is expected to improve from over 6 percent of GDP in 2008 to 1-2 percent of GDP in 2009-11. To achieve this adjustment, an over 20 percent real import contraction will be needed in 2009 in order to counter the 7 percent forecast terms of trade deterioration. Real wages and employment are forecast to decline in 2009 to restore price competitiveness of Ukrainian exports in the wake of declining export prices and to support the adjustment in aggregate demand. With this current account adjustment and with the support of the IMF Stand-By, the external financing gap would be closed under our baseline assumptions. Declining commodity prices, tightening liquidity and the forecast decline in domestic demand will contribute to disinflation. However, offsetting this, the exchange rate correction and the adjustment of energy and utilities tariffs will make disinflation a more prolonged process. We assume that the government will maintain a balanced budget in 2009 (not accounting for bank recapitalization costs) and have a small deficit thereafter.

So I think we need to be very clear at this point. The Ukraine position is very difficult, and everything is very delicate. The danger of total financial meltdown (which would be in this case in the private banking sector, not sovereign debt) is real and significant. The economic downturn has only just started and further downside risks are large and depend critically on the size of external shocks and the limitations imposed by inadequate policy responses.

Any further deterioration in the terms of trade (unlikely at this point given how far steel prices have already fallen, but these prices may stay lower for longer than many in the sector can sustain) or further decline in export demand would certainly put almost unsustainable pressure on the real sector. Banking sector vulnerabilities may be further exacerbated by further overshooting of the exchange rate and external debt refinancing difficulties as corporate balance sheets weaken further and household incomes come under strain from rising debt service costs.

Prudent fiscal, monetary, and financial policies (many of them anchored in the program supported by the IMF), accompanied with renewed efforts to deepen structural reforms, can help Ukraine to stabilize its situation and move the economy towards recovery. Conversely, a continuation of the current disorderly response and poor implementation of the agrred policies may easily trigger further financial chaos leading to an even shaper downturn and a postponement of any recovery off into the distant sunset.

But Beyond The Recovery, What About The Demography?

One of the reasons why I think the IMF and the World Bank are taking such a big risk with their credibility in Eastern Europe at the moment, is that I don't think they are getting through to the heart of the problem. One way of thinking about this is to take Paul Krugman's favourite Keynes quote - "we've got magneto trouble" - and ask ourselves whether all we have before us in the CEE countires right now are magneto problems, or whether, to continue with the metaphor, we may not have issues with the cylinder head gasket. And it gets worse, because the cylinder head gasket does seem to have blown (and it will keep blowing) because we have leakage problems in the sump, and the main oil pump isn't working - and who knows, maybe the crankshaft even needs replacing. As they always tell you when you take the car into a garage for "fixing", we won't know till we take the thing apart. What do I mean?

Well take a look at the chart showing the relative size of annual births and deaths in Ukraine over the last twenty years.

I mean to the normal and untrained eye stands the problem stands out a mile, population dynamics went underwater in the Ukraine in the early 1990s, and they aren't coming back to the surface again (not now, not in thirty years, not...... well maybe never is too much of a long time, but certainly not over a time horizon which is going to make any essential difference to anyone who is already alive today.)

And this is without taking any outward labour migration into account, so just think about the negative labour market dynamics that this implies, and already has implied. Can anyone really be surprised that Ukraine has been suffering from acute inflation as its number one problem?

To some extent it is worth stressing here that what really matters is the actual numbers of annual live births, rather than any more complex measure of fertility. In 1989 for example there were nearly 700,000 children born in Ukraine. By 1998 this number was near to 400,000 (ie there was a drop of 40% or so in a decade). In practical terms (and if we take 18 as an average age for labour market entry in a country like Ukraine) next year there are potentially 650,000 people to enter the labour force, but by 2016 this number will be only 400,000. So it isn't simply a question of pushing the fertility rate up towards the replacement rate (a difficult, but not impossible task), we also need to think about what economists term the "base effect" here, that is that with each passing year and cohort you have less and less women in the childbearing ages, so even if those women replace themselves, the base of the pyramid is still much narrower than the top, and it is the people at the top who need caring for and financing.

And even if some of this loss can be offset at the workforce level by increasing labour force participation at the older ages, we would still be talking about a very sharp rise in the average age of the workforce. And productivity improvement alone cannot possibly hope to compensate for the kind of labour force contraction we should reasonably expect, at least not over such a short period of time it can't. So this is just one more reason why, against all expectation, fertility really does matter.

While many continue to believe that falling populations don't actually have any tangible impact on economic performance, it is very striking to notice that when it comes to ageing and declining populations we really lack ANY evidence to substantiate that claim in the affirmative. On the other hand we do have plenty of evidence from countries where the population is either falling or gathering negative momentum to suggest that these countries face some very special kinds of economic problems. The example of Eastern Europe is clear enough I would have thought, but people really do need to take a closer look at what has been happening in recent years in countries like Japan, Germany, Italy and Portugal. And if falling population does produce its own kind of economic problems, well then we should be expecting to see plenty of them in Ukraine, since as we can see in the chart below Ukraine's population peaked in 1993, and has been in some sort of free-fall ever since.

Evidently there are a number of factors which lie behind this dramatic decline in the Ukrainian population, fertility is just one of these (with poor health and net emigration being the others). Ukraine fertility is currently in the 1.1 to 1.2 Tfr range, and, as we can see in the chart below, it actually dropped below the 2.1 replacement level back in the 1980s.

Another major influence on demographic dynamics is health, and one good measure of this is the level of life expectancy, which in the Ukraine case has shown a most preoccupying evolution, since it has been falling rather than rising. The chart below shows life expectancy at birth for both men and women, the male life expectancy is evidently significantly below the combined figure.

This life expectancy situation is, as well as being preoccupying, highly unusual (it is however paralleled to some extent in Russia itself, and some other CIS countries). Apart from the obvious, the deteriorating health outlook which this data reflect places considerable constraints on the ability of a society like Ukraine to increase labour force participation rates in the older age groups, and this is a big problem since this is normally though to be one of the princple ways of compensating for a shortage of people in the younger age groups.

So what about the future? Well, two issues are really starting to worry me at present, the first of these is the short term fertility shock Ukraine will undoubtedly receive on the back of the current crisis. If young people were already rather reluctant to have children, then then will now almost certainly be much more so, given the downward pressure on living standards we are about to see.

The second worry concerns the future of the country itself. A recent study carried out jointly by the Kiev based Democratic Initiatives Foundation and Nova Doba History and Social Sciences Teachers Association found that while more than 93 percent of the Ukrainian seventeen year olds they inteviewed considered themselves Ukraine citizens, only 45 percent said they planned to live and work only in Ukraine, citing Western Europe, Russia and the United States as possible future destinations. When 55% of your potential future labour force are thinking of working elsewhere you have a problem, and one which needs a solution. Simply putting a strip of band-aid over a festering wound won't work, I'm afraid, however much the Ukrainian people may struggle and sacrifice. With or without Keynes, we've got more than magneto problems on our hands here.


A much fuller analysis of the problems presented by Ukraine's long term population implosion (including the issue of out-migration patterns and trends) can be found in this post here.

Monday, December 22, 2008

Why The IMF's Decision To Agree A Lavian Bailout Programme Without Devaluation Is A Mistake

The IMF finally announced it's Latvia "bailout" plan on Friday. The plan involves lending about €1.7 billion ($2.4 billion) to Latvia to stabilise the currency and financial support while the government implements its economic adjustment plan. The loan, which will be in the form of a 27-month stand-by arrangement, is still subject to final approval by the IMF's Executive Board but is likely to be discussed before the end of this year under the Fund's fast-track emergency financing procedures, and it is not anticipated that there will be any last minute hitches (although I do imagine some eyebrow raising over the decision to support the continuation of the Lat peg). The Latvian government admits that some of the IMF economists involved in the negotiations advocated a devaluation of the lat as a way of ammeliorating the intense economic pain involved in the now inevitable economic adjustment. But the government in Riga stuck to its guns (supported by the Nordic banks who evidently had a lot to lose in the event of devaluation), arguing that the peg was a major credibility issue, and the cornerstone of their plan to adopt the euro in 2012.

"It (the programme) is centered on the authorities' objective of maintaining the current exchange rate peg, recognizing that this calls for extraordinarily strong domestic policies, with the support of a broad political and social consensus," said IMF Managing Director Dominique Strauss-Kahn.
In return for the loan the IMF have agreed a "strong package of policy measures" with the Latvian government and these will involve sharp cuts in public sector salaries, and a tight control on Latvian fiscal policy. The IMF have insisted on a substantial tightening of fiscal policy: the government is aiming for a headline fiscal deficit of less that 5 percent of GDP in 2009 (compared with a anticipated deficit of 12 percent of GDP in the absence of new measures) - to be reduced to 3% in 2010 (thus the Latvian economy will face not only tight effective monetary policy in 2010 - via the peg - but also a less accommodating fiscal environment, frankly it is hard to see where the stimulus to economic activity is going to come from here) . Structural reforms and wage reductions will also be implemented, led by the public sector, and VAT will be increased, all with the longer term objective of further strengthening Latvian competitiveness and facilitating the external adjustment. The problem is really how the Latvian population are going to eke it out in the shorter term.

"These strong policies justify the exceptional level of access to Fund resources—equivalent to around 1,200 percent of Latvia's quota in the IMF—and deserve the support of the international community," Strauss-Kahn said.
The loan from the IMF will be supplemented by financing from the European Union, the World Bank and several Nordic countries. The EU will provide a loan of €3.1 billion ($4.3 billion), the World Bank €400 million ($557.6 million), and several bilateral creditors [including Denmark, Estonia, Norway, and Sweden] will contribute as well, for a total package of €7.5 billion ($10.5 billion).

The stabilization program forecasts that the economy will contract 5 percent next year, the Finance Ministry said in a statement yesterday. Revenue is expected to fall by 912 million lati ($1.7 billion) next year and spending will be reduced by 420 million lati.

Strangely the IMF statement was not very explicit the key topic - the currency peg - in the sense that it was a little short on argumentation as to why it considered - despite its well known waryness about such approaches, and having got its fingers very badly burnt in Argentian in 2000 - that it would be best to continue this arrangement in the Latvian case, despite the Fund's strong emphasis on the need to current the large external balances which exist (see Current Account deficit in the chart below).

All we really know about the background to this decision is contained in the statement the IMF posted on its website on December 7:

Mr. Christoph Rosenberg, International Monetary Fund (IMF) Mission Chief, issued the following statement today in Riga :

"Following the IMF's statement on Latvia on November 21, 2008, good progress has been made towards a possible Fund-supported program for the country.In cooperation with the European Commission, some individual European governments, and regional and other multilateral institutions, we are working with the authorities on the design of a program that maintains Latvia's current exchange rate parity and band. This will require agreement on exceptionally strong domestic adjustment policies and sizeable external financing, as well as broad political consensus in Latvia In this context we welcome the commitment made today by the Latvian authorities. All participants are working to bring these program discussions to a rapid conclusion."

So there seems to have been a trade-off here, between the IMF agreeing (reluctantly I think, but this is pure conjecture since there is little real evidence either way) to accept the peg, and the Latvian government agreeing to exceptionally strong adjustment policies. But the question is: was this agreement a good one, and will the bailout work as planned? I think not, and below I will present my argumentation. But before I do, I think it important to point out that the kind of internal deflation process the Latvian government has just accepted is normally very difficult to implement, which is why economists tend to favour the devaluation approach.

Just how large the competitiveness issue is in Latvia's case can be guaged by looking at one common measure of competitiveness, what is known as the country's real effective exchange rate. The REER (or Relative price and cost indicators) aim to assess a country's price or cost competitiveness relative to its principal competitors in international markets. Changes in cost and price competitiveness depend not only on exchange rate movements but also on cost and price trends. The specific REER prepared by Eurostat for its Sustainable Development Indicators is deflated by nominal unit labour costs (total economy) against a panel of 36 countries (= EU27 + 9 other industrial countries: Australia, Canada, United States, Japan, Norway, New Zealand, Mexico, Switzerland, and Turkey). Double export weights are used to calculate the REERs, reflecting not only competition in the home markets of the various competitors, but also competition in export markets elsewhere. A rise in the index means a loss of competitiveness, and as we can see, Latvia has suffered a huge loss of competitiveness since 2005. There is a lot of "correcting" to do here.

The problems of loss of external competitiveness Latvia faces are not new, nor are they unique. Russia may be a lot larger than Latvia, and Russia may also have oil, but Russia's internal industrial core has become uncompetitive, and there is really only one sensible way of attacking this problem, and that is through devaluation, as Standard & Poor's Director of European Sovereign Ratings argues in the extract I cite below. One of the unfortunate side effects of the fact that currency policy has become almost a matter of national strategic importance in Latvia has been that the necessary open-minded discussion of the pros and cons of the situation has not been possible.
Accompanied by generous government spending, the credit boom also fueled inflation, which weighed on the competitiveness of Russia's noncommodity sector. As wage growth averaged nearly 30 percent over the last two years and the ruble-denominated cost of production rose, domestic manufacturers found it very difficult to compete with cheap high-quality imports. As a consequence, entrepreneurs logically avoided manufacturing and, instead, invested in much more profitable and more import-intensive sectors, such as banking, retail and construction.

The resulting structural imbalances were well camouflaged by the extraordinary growth in energy and other commodity prices. For six straight years, the earnings from Russian oil and commodity exports on world markets have increased much faster than the cost of imports, offsetting the less flattering volume effects. From 2003 through this year, the cumulative difference between export and import price inflation in Russia was a fairly remarkable 74 percent. This put upward pressure on the ruble, encouraging borrowers to take loans in dollars or euros at negative real interest rates, under the assumption that the ruble would appreciate indefinitely. But it also provided an important source of financing.
Frank Gill, director of European sovereign ratings at Standard & Poor's in London, writing in the Moscow Times

So the Latvian competitiveness problem has become evident to everyone, and perhaps the best indication of the severity of the problem is the way that people almost laugh at the suggestion that Latvia must now live from exports (exports, what exports?, they say). However it is clear, and especially given the force of the agreed internal adjustment, that domestic demand is now dead as far forward as the eye can see as an effective driver of GDP growth, and, as can be seen in the chart below, exports are going to have a hard time of it, even after growth in other European countries picks up in 2010 (or whenever).

The competitiveness problem can be seen quite clearly in the above chart, as Latvian wage rises became detached from productivity improvements in the second half of 2005 and the rate of increase in exports shrank rapidly, while imports began to enter at a much faster rate. This process eventually itself in the first half of 2007, with import growth at first increasing rapidly, only to subsequently decline, giving in the process some positive increment to GDP from the net trade effect - as exports once more began to accelerate (creative destruction impact) even while imports fell through the floor. However as the external trade environment has darkened, even this expansion in exports has petered out, and inflation adjusted exports are currently hardly growing, and may even turn negative in the coming quarters. 2009 promises in any event to be a very hard year, but without a truly massive correction in relative prices there will be no recovery in 2010 either, and probably not in 2011. Remember, wages are now about to start falling, unemployment is about to start rising, and government expenditure is about to get pruned, so the only possible area for growth is external trade, and any inbound FDI that can be attracted to build productive capacity for exports. On top of which the correction in the current account deficit means that Latvians collectively - government, companies and households - are going to have to start saving, and a rise in net aggregate savings is basically tantamount to a brake on internal demand. So whichever way you look at it, exports are now the name of the game.

Why Keep The Peg?

Given all the problems that having the peg are likely to create, what then are the arguments for maintaining it? Well frankly, such arguments are hard to find at this point, in the sense that there are relatively few people, at least in the English language, who are willing to stick their neck out and try to justify what, in my humble opinion, is virtually the unjustifiable, and the implicit consensus among thinking economists would seem to be that this is a bad idea. The decision does, however, have its advocates, and Anders Aslund of the Peterson Institute has been bold enough to have a try, so, in the interests of balance and try and get some purchase on what the arguments might be, I am reproducing his argument in its entirety.
Why Latvia Should Not Devalue
by Anders Aslund December 9th, 2008

Latvia has a severe financial crisis, the preconditions for which have long been evident. A fixed exchange rate to the euro led to an excessive speculative influx of capital, boosting Latvia’s private foreign debt to 100 percent of GDP. Inflation soared to 16 percent, and the current account this year to 15 percent of GDP. Latvia’s budget has traditionally been almost in balance.

For most countries, devaluation would appear inevitable, and some argue that Latvia has to devalue its currency, the lat. But Latvia’s circumstances are peculiar, making the standard cure not only inappropriate but harmful. A severe wage and social expenditure freeze would be a better prescription, along the lines of a preliminary agreement on macroeconomic stabilization reached on December 8 among the Latvian government, the European Commission, the International Monetary Fund (IMF), and the Swedish government.

Now the questions are how much financing Latvia needs, who will give it, and on what conditions? The key outstanding issue has been whether Latvia should devalue or not. But given that Latvia—and Estonia—are experiencing high inflation with close to balanced budgets, devaluation is neither necessary nor desirable. A freeze of wages and social transfers would be preferable for both economic and political reasons.

First of all, thanks to Latvia’s limited GDP, $27 billion in 2007, sufficient international financing can be mobilized. The combination of IMF, EU, and Nordic funding should be sufficient.

Second, devaluation is likely to aggravate inflation and it could start a snowball effect of higher inflation and repeated devaluations. A devaluation would not be less than 20 percent and it would cause greater social and economic disruption.

Third, the great number of mortgages held in euros would force a massive blow-up of bad debt and mortgage defaults, which in turn would seriously harm the population, the housing sector, and the banking sector and thus the economy as a whole. Such a banking crisis is not necessary. One of the three big banks, Parex Bank, has already gone under, but the other two, the Swedish banks Swedbank and SEB, are strong enough to hold, if no devaluation occurs.

Fourth, Latvia’s main macroeconomic problem is inflation. Devaluation would initially aggravate inflation, while a wage and social expenditure freeze would sharply reduce inflation. High inflation has led to the excessive current account deficit. Latvia does not suffer from any structural terms of trade shock

Fifth, a freeze on wages and public expenditures would strengthen the budget, while devaluation is likely to lead to severe budget strains.

Sixth, the Latvian population seems politically committed to the fixed exchange rate, and it seems prepared to take a freeze of incomes and public expenditures, and if necessary even cuts. Therefore, devaluation could lead to undesirable and unwarranted political convulsions.

Finally, devaluation in Latvia would inevitably drag down Estonia as well, and all the effects would be doubled, while Estonia might hold its own without Latvian devaluation. Lithuania, which does not really have any serious financial problems, could also be harmed. I would have recommended that the Baltics abandon their fixed exchange rates a few years ago, but this is the wrong time to do so.

The argument I am making applies only to very small economies with basically sound economic policies. Russia and Ukraine are in a very different situation. Both suffer from major structural changes in terms of trade because of slumping commodity prices, and they should let their exchange rates float downward with their terms of trade.

The main arguments in favour of the peg would thus seem to be as follows:

1/ Latvia's situation is exceptional (is that also true of Bulgaria, Estonia and Lithuania?). It is hard to know what to make of this. Certainly the comparison with Ukraine and Russia does not seem appropriate, since these are ultimately competitor countries as far as manufacturing industry goes, and they are devaluing not because of their raw material exports (agriculture and energy) are too high, but because the price of the products from their manufacturing industries are too high due to all the earlier internal inflation, and the attempts to maintain the currency value via the controlled "corridor".

2/ A severe wage and social expenditure freeze would be a better prescription than devaluation. Well they would be a good prescription, but they simply are not possible, since simply freezing things where we are won't work, the imbalances are too large, so we are talking about sharp reductions in wages and public spending (as nominal GDP goes sharply down, then even a 5% fiscal deficit will mean spending has to contract - by 420 million lati according to the budget forecast - although the IMF has agreed to a policy of protecting social expenditure as much as possible).

3/ Then there is the forex mortgage situation. This I agree is a major problem, as devaluation implies default, and an oncost for Sacndinavian banks. But if we are sending the entire Latvian population through all this simply to attempt to avoid defaults on mortgages we are making a mistake, since obviously the sharp rise in unemployment we can expect and the sharp fall in wages can have a similar impact. I mean, one way or another the REER (see above) is going back to the 2005 level, so the mortgages will be just as unaffordable, and in my view the best solution to this would be for the Scandinavian (and Italian - Unicredit) banks to take a haircut, and receive compensation via their domestic bank bailout programmes. This would be a much more equitable sharing of the costs of the forex lending programme having gone wrong. To take another example, Spain is not devaluing from the euro, yet a hefty round of mortgage defaults (and builder bankruptcies) is now expected. So it is really a case of default through one door, or default through the other one. Which way would you like to go, sir?

4/. That devaluation would provoke inflation. Well this is just the point, devaluation would only provoke significant inflation IF Latvia still didn't have an independent monetary policy (to restrain domestic demand), but since part of the reason for devaluation is precisely to recover control over monetary policy again, this argument seems to me not to be completely valid, and it seems to be forgetting the other problem, deflation, which is much more likely to become Latvia's real problem over the next two or three years. Trying to run some form of Quantitative Easing (which is the new "in" term for how best to handle monetary policy in the midst of a liquidity trap, which may well be where Latvia and several other CEE economies are now headed) without independent monetary policy is quite frankly, completely impossible. If we look at the chart for the producer price index I reproduce below, we will see that the PPI (which is normally regarded as an indicator of coming inflation) is no longer climbing, and seems set to start to come down., and this could easily be an early warning signal for forthcoming deflation.

5/. The Latvian population seems politically committed to the fixed exchange rate, and appears prepared to take a freeze of incomes and public expenditures. This may well be true, and is an impression I get when I look at some of the comments on my blog. Many Latvians (and citizens of other Baltic states) have accepted the peg as some indication of "post-independence" indication of national "seriousness", and that any stepping-back from it would be seen as some kind of defeat. I understand this view, but I think it is a mistake, since sometimes it is better to accept defeat in order to live to fight again another day. I think Latvian politicians are to some extent reacting to this kind of pressure, to some extent thinking about their own invested social capital, and to some extent under pressure from Nordic banks. In any event all three of these seem to have more influence than the rational arguments about the advisability of the peg. There is no doubt in my mind that the coming recession will be longer and deeper if the peg is maintained. Indeed I am almost certain that the attempt to sustain it will fail (and that we will see some kind of rerun of Argentina 2000 - in all three Baltic countries and Bulgaria) and really the sooner the population become aware of this the better. Basically what we witnessed in Argentia in 2000 was basically a process of growing battle fatigue and war weariness, as the population were asked to make one sacrifice after another in support of a policy which couldn't work, and only lasted as long as it could. The end product is that when the peg finally breaks the local population will be severely disillusioned, and the politicians will totally lack credibility, which is a sure recipe for chaos, as we saw in Argentina in 2001.

Indeed, if anything the position is arguably worse in Latvia at the present time, since the optimum conditions for a free and open debate about the alternatives aren't exactly in place at the moment it seems very hard to know what the population at large would decide if they had complete access to all the arguments.

6/. Finally, devaluation in Latvia would inevitably drag down Estonia as well. This is undoubtedly a consideration in the mind of the IMF (and Lithuania, and Bulgaria) but really all of this will have to be faced by all four countries sooner or later, especially since the only way out of their recession will be, as I am saying, through exports, and most of the other competitor countries (look even what is happening to the Polish zloty and the Czech Koruna as I write) will see the partities of their respective currencies well down on the euro as we enter the recovery.

Where Is Growth Now Going To Come From?

Basically the key argument for devaluation is that it is easier to manage an economy with a low level of inflation (please note I am saying low, very low, certainly below 2%, ask Ben Bernanke or the Japanese is you don't believe me) than it is to manage an economy which is in deflation freefall. The big danger in Latvia is not only that there can be a real (ie price adjusted) contraction in the economy of 5% in 2009 (or more, the economy is down 4.9% year on year in Q3 2008, and things are certainly going to get worse), but that this contraction may be accompanied by price deflation (ie actually falling wages and prices) which means nominal (current price) GDP would decrease by the size of the real contraction plus the fall in prices. Thus we could see a very large drop in nominal GDP in 2009 and 2010. If realised this would be a very difficult situation to handle, and I doubt the people currently taking policy decisions in Latvia are fully aware of the implications (although the IMF economists should know better). In particular the deflationary debt dynamics would be very hard to control, and again, especially without independent monetary policy.

It is important to remember that these loans which have been agreed to are simply that, loans, to guaranteee the external financial stability of the country during the forthcoming correction, but they do not, in and of themselves solve any of the real economy problems. And they will need to be repaid if they are used, and will nominal Latvian GDP heading down, the cost of repaying them effectively goes up in terms of real Lat earnings. This is what debt deflation means.

The International Monetary Fund on Friday said it now expects a net income of
about $11 million in fiscal year 2009, and not a shortfall of $294 million as
previously forecast, as more countries turn to it for rescue loans in a
deepening financial crisis. "The improved income outlook reflects new lending
activity that is estimated to generate additional fund income of about $247
million, assuming all disbursements under the recently approved arrangements are
made as scheduled," the IMF said. Since early November, the IMF has approved
rescue packages for Hungary, Iceland, Ukraine and Latvia as the global crisis
spreads to more emerging economies.

I am citing the above Reuters report, not as a criticism of the IMF - they are simply doing their job as best they can, and under very difficult circumstances - but to remind people that the IMF is effectively a bank, and these are loans, and interest is paid, and there are no "freebees" here, and definitely no "free lunches" - not even in the newly established Latvian soup kitchens.

So we should ask ourselves where growth is going to come from - the growth that will now be needed to repay the capital and interest on these loans. Certainly not from household consumption if we look at the chart below, or from government consumption given the restraint on public spending. The private consumption position can only deteriorate as wages fall and unemployment rises.

Not from manufacturing industry in the short term (until prices correct, and the external recovery starts), and again look at the chart.

And finally don't expect an investment driven recovery (again see chart) until the demand for Latvian exports picks up, and it becomes attractive to start expansing capacity.

Basically I feel the biggest condemnation which can be made of the package which has been announced is that it doesn't seem to contain one single policy for stimulating the economy, and stimulation and a return to growth is what Latvia badly needs by now.

And the worst case scenario outcome of the way all this is being handled (and the issue that actually concerns me the most) is the possibility that young people decide to start migrating out of the country again, in order seek a new future and to start sending money home to help their families confront the difficult circumstances. Since Latvia's population is already declining this would be the cruelest cut of all, and one would have to then ask just what kind of future really awaits this unfortunate country?

Saturday, December 20, 2008

Russia's Macro Data Starts To Confirm The Severity Of The Downturn

The Ruble Devaluation Continues

The ruble fell the most in nine years against the euro this week after the central bank widened its trading band twice and allowed the currency to fall by a further 3.8 percent, following last week's 1 percent devaluation. The currency retreated to a maximum of 5.8 percent over the week, although it recovered somewhat and was up 0.1 percent again today (Friday) over yesterday, trading at 39.1772 per euro at midday in Moscow. The currency has now fallen 16 percent against the dollar since the start of August, and added another 1.3 percent to its losses today, hitting 27.8412 per dollar and falling 1.1 percent (to 33.1020) against the currency basket which is targeted. The ruble thus lost 3.9 percent to the basket this week, in the process experiencing its sixth weekly drop.

Foreign Exchange Reserves Continue To Decline

Russia’s currency reserves fell $1.6 billion to $435.4 billion during the week to 12 December. When compared with the drop of $17.9 billion the week before you could reach the conclusion that the rate of outflow was steadying up, but this does not seem to be the case, since the size of the drop is largely a by-product of the valuation effect produced by the change in the USD-Euro cross, since we need to remember that euro, which constitutes around 44 percent of the reserves, was up 5.1 percent against the dollar during the week. The pound also gained 1.8 percent against the dollar. Hence the dollar value of the euro and pound sterling holdings (about another ten percent of the basket) were up. Vladimir Osakovsky, an economist in Moscow at UniCredit has done some calculations, and he estimates that Russia's central bank probably sold about $12.5 billion in foreign currency last week. Chris Weafer, chief strategist at Moscow bank UralSib, comes up with a similar estimate, and suggests the bank probably sold about $11.5 billion to counter the ruble’s slide, given that the euro component of the reserves increased in value by about $10 billion. (Actually, anyone interested in the somewhat ironic dimension of having so much analysis of Russia's crisis from economists at Unicredit Moscow, while back in Italy the bank's shares are currently falling mightily on a Merrill Lynch downgrade due to their Eastern Europe exposure, may be interested to read this post of mine).

Producer Prices Fall Sharply

So the ruble is falling and the reserves are flowing out at a rather fast rate, but this is not producing inflation in Russia - in fact quite the contrary, disinflation is very strong in Russia right now, and indeed if things continue at this rate (especially given the sharp contraction in internal demand) deflation and not inflation is going to be the big headache. Some evidence to indicate this danger can be found in the fact that Russian producer prices - which are widely regarded as an early indicator of forthcoming inflation - fell sharply again in November, pushing the annual rate to its slowest pace since March 2007 as demand for material for industrial production weakened rapidly. The cost of goods leaving Russian factories and mines fell 8.4 percent between October and November, while the year on year rate of increase dropped to 4.2 percent, according to data out today (Friday) from Rostat. This compares with 17.4 percent y-o-y rate in October, the Federal Statistics Service in Moscow said today.

The November fall follows a 6.6 percent monthly drop in October, and it is clear that the rate of disinflation in producer prices is extraordinarily rapid, and it may be that we will soon enter outright price deflation. The biggest difficulty is the almost complete lack of control by anyone in authority and the with tecnical expertise to adequately handle macro economic management, whether on the upside or the downside. This is quite simply all terribly dramatic.

Consumer price inflation is also slowing, and was down to 13.8% in November, from 14.2% in October. Russia's consumer price inflation rate was running at 0.1 percent in the week between December 9 and 15, according to the Federal State Statistics Service. Inflation was thus 0.3 percent for the month to date and 12.9 percent for the year to date, compared to 0.7 percent and 11.4 percent in the same periods in 2007. So disinflation is already well at work even in consumer prices. Still, these are very - unacceptably - high numbers, and those who so willingly acquiesced in them earlier will now feel the downside of their negligence, although unfortunately it is - as ever - the poor old Russian in the street who will really pick up the bill.

Rapid Economic Slowdown

More evidence for the rapid velocity of the economic slowdown is provided by the index of key economic activities, which has fallen back from a year on year high of 10.7% in April to a 2008 low of 2.6% year on year in October. This would seem to indicate that the economy may well have been contracting month on month between September and October, although as with much of the data which follows we do not have a lot of systematic access to direct month on month comparisons to be able to closely scrutinise what is happening.

Another short term measure of economic activity we have available - industrial production, which is responsible for about 40 percent of Russian GDP - contracted at a year on year rate of 8.7 percent in November, the fastest rate since the 1998 financial collapse. As a result Russia’s Economy Minstry now forecast that the eonomy may contract in the first two quarters of next year, and full year growth of 2.4 percent in 2009.

My feeling is that these estimates may well be too high, and that the economy may well already be contracting in Q4 2008 (in fact Deputy Economy Minister Kelpach more or less admitted that this was the case in his earlier slip of the tongue), so we could easily see an outright GDP contraction in 2009 both in real terms and, much more seriously, in nominal terms (if we hit price deflation, everything depends on how fast the authorities let the ruble devalue). A contraction in nominal GDP would be very hard for the Russian authorities to handle - since we would be into using unconventional tools in an economy where policy managers have not yet learnt to satisfactorily use conventional ones. Month on month industrial output was down 10.8%.

Unemployment is also rising, as are overdue wages, which were up 93% over the previous month. The unemployment rate rate rose to 6.6 percent in November, which is the highest since April, but still comparatively low by historic standards, although experts suggest we could easily see this number rise towards 10% to 11% in 2009.

The total number of unemployed reached 5 million people, compared with 4.624 million in October, or 6.1 percent, according data from Rostat. Wages, however, are still rising at this point, and the average monthly wage rose an annual 7.2 percent in November to 17,995 rubles, while real disposable income fell 6.2 percent.

Russian retail sales also slowed in November and sales increased at an annual 8 percent, still quite strong, but down considerably from a revised 12.4 percent in October. Still this is the slowest pace of expansion since November 2003 and more significantly sales fell 3.4 percent from October. Retail sales have increased at an average annual rate of about 13 percent since 1998. However these have to a large extent been fuelled by unsustainable wage rises, and large scale consumer borrowing. Loans to individuals rose 58 percent in 2007, reaching 2.97 trillion rubles ($110 billion) as of 1 January 2008.

Capital investment has also been slowing, and growth was down to an annual 3.9 percent in November, the lowest rate since January 2005, according to the statistics office. Investments grew 6.9 percent in the previous month.

So an incredible trifecta - a unilateral decision to recognise Georgia's two separatist regions, a 66 percent fall in oil prices and the worst global financial crisis since the Great Depression - has been whisked up, and has lead to a sharp spike in investor unease such that around $211 billion has been withdrawn from Russia (estimate by analysts at PNB Paribas) since that fateful day in August when the tanks went though roaring through the Roki tunnel. We now await to see just how sharp "sharp" means when we are talking about the slowdown in Russian GDP in 2009, although the real questions which must be in everyone's minds concern the future beyond 2009. If the ruble devaluation produces - as seems likely - a rise in corporate and household defaults on forex loans, just how long will it take Russian consumption and Russia's banking system to recover from the blow that this will represent? And when oil prices do eventually recover (in 2010?) just what will the Russian central bank and those responsible for economic management have learnt from this most unfortunate "boom-bust" episode.

Tuesday, December 16, 2008

Russia's Economic And Financial Meltdown Continues Apace

Russia's foreign-exchange reserves have been now been declining very rapidly since mid August, and as the money goes so does the faith that the large stock of reserves the country built up during the boom times would be sufficient to see them through any downturn in energy prices. As the money leaves, so it seems does the decade of economic growth and stability which they symbolised. Indeed so rapid has been the decline that Russia's international reserves, which are the third-biggest after those of China and Japan, have now fallen $161 billion, or 27% percent, since 8 August last, and decreased by $17.9 billion to $437 billion in the week to 5 December. Investors have now pulled $211 billion out of the country since August, according to estimates by BNP Paribas.

But just how difficult managing this process is proving to be was illustrated yet again this morning as Russia’s central bank found itself forced to accept a further devaluation in the ruble - for what is now the second time in a only a week - subsequent to which the ruble fell as much as 1.3 percent (to a four-year low of 37.5015 per euro) as Bank Rossii widened the trading band against the basket of dollars and euros used by the bank as the measure for attempting to manage the exchange rate.

Russia has now used some 27 percent of its reserves in these attempts to stem what has now become a 16 percent decline in the ruble following a 69 percent drop in the price of oil and last weeks decision by credit ratings agency Standard & Poor’s to cut its Russian credit rating on for the first time in nine years.

Thus over at Bank Rossii they have been having their work cut out "fexibilising" the trading band, and it this flexibilisation process that has now allowed the ruble to fall against its target exchange rate against a basket of currencies by 8.6 percent, down further from the 7.7 percent level facilitated last week and the 3.7 percent one of a month ago. Thus the currency has now fallen a net total of 5.9 percent against the basket in the series of six "adjustments" to the trading band implemented since 11 November. However this "slow and steady" approach to devaluation is creating uncertainty, as well as fomenting a loss of confidence with Russians withdrwaing a total of 6 percent from their ruble accounts in October alone, the fastest rate of withdrawal since Bank Rossii started collecting this data two years ago, while foreign currency deposits rose 11 percent. Thus instead of reinforcing confidence in the monetary regime, the slow, step-by-step adjustment of the nominal exchange rate may be perpetuating a steady stream of deposit withdrawals and dollar purchases, and some evidence for this can be found in November's 5.9 percent contraction in the money supply.

Apart from the financial turmoil, Russia's economy is really reeling under the weight of the sharp drop in crude prices, and the price of Urals crude, Russia's main export blend, is currently trading at around $44.13 a barrel, down 69 percent from the July peak, and well below the $70 average required to balance the country's 2009 budget.

GDP Growth Slowing Rapidly

It is hard to get a fix at the present time on what Russia's growth rate will look like in 2009, and estimates vary widely. Deutsche Bank recently cut its Russian growth forecast to 1 percent for next year, down from an earlier 3.4 percent, while the World Bank last month forceast a slowdown to 3 percent from what has been an average expansion of 7 percent a year since 1999. At the bottom end of the forecast range we have Oleg Vyugin, chairman of MDM Bank and a former central banker, who suggests the economy may contract by as much as 4% if the prices of raw materials exports do not recover. My own feeling is that the final figure may well be much nearer to Vyugin's estimate than to the World Bank one, especially if we don't get a strong rebound in commodity prices and given the sharp contraction in non-energy industrial output.

Analysts an OAO Sperbank have gone one step further and come up with two possible scenarios for possible impacts of the economic slump on property prices. For the first (or mild case) scenario they postulate a 2.5-3.5% growth in GDP, 11% inflation and a 30 ruble per dollar exchange rate in 2009. In this case, the bank anticipates a drop in Moscow real estate prices of 34.4% in ruble terms and 46.6% in dollars. On the second scenario GDP stagnates (or even contracts by up to 2.5%), there is higher inflation and an even larger devaluation of the ruble against the dollar. On this (worst) case scenario the Bank suggests that Moscow property prices would plummet by 38.1% in rubles and 59.6% in US dollars. You have been warned!

The Inflation Worm Is At The Heart Of The Problem

The real difficulty facing Russia's macroeconomic managers is that after two years of shocking inflation domestic industry is in no position to compete with its overseas competitors while the ruble remains at its present rate, while any sharp devaluation will have a serious impact on the balance sheets of those who took advantage of cheaper interest rates available abroad to do their borrowing using forex loans. This situation is not that different from that which is to be found in many other economies across the region, in Latvia, Hungary, Ukraine and Romania (for example), with the added rider that the IMF representatives who are in dialogue with policy makers in these very fragile economies would do well to bear in mind the potential knock-on effect of any coming downward adjustment in the ruble.

In annual terms inflation is now slowing, and was down to 13.8% in November, from 14.2% in October. Still, these are very - unacceptably - high numbers, and those who so willingly acquiesced in them earlier will now feel the downside of their negligence, although unfortunately it is - as ever - the poor old Russian in the street who will really pick up the bill.

Basically, the credit driven consumer boom which accompanied the commodities one severely distorted the always delicate balance between Russia's commodities and manufacturing sectors, leaving the manufacturing sector strongly uncompetitive. It is this lack of competitiveness which now exaccerbates the severity of the downturn, just as many commentators, including yours truly, where arguing it would do. Frank Gill from Standard and Poor's puts it like this.

Accompanied by generous government spending, the credit boom also fueled inflation, which weighed on the competitiveness of Russia's noncommodity sector. As wage growth averaged nearly 30 percent over the last two years and the ruble-denominated cost of production rose, domestic manufacturers found it very difficult to compete with cheap high-quality imports. As a consequence, entrepreneurs logically avoided manufacturing and, instead, invested in much more profitable and more import-intensive sectors, such as banking, retail and construction.

The resulting structural imbalances were well camouflaged by the extraordinary growth in energy and other commodity prices. For six straight years, the earnings from Russian oil and commodity exports on world markets have increased much faster than the cost of imports, offsetting the less flattering volume effects. From 2003 through this year, the cumulative difference between export and import price inflation in Russia was a fairly remarkable 74 percent. This put upward pressure on the ruble, encouraging borrowers to take loans in dollars or euros at negative real interest rates, under the assumption that the ruble would appreciate indefinitely. But it also provided an important source of financing.
Frank Gill, director of European sovereign ratings at Standard & Poor's in London, writing in the Moscow Times

The critical part of the overheating process was to be found in the evolution of real wages which continuously outpaced productivity growth, thus undermining competitiveness. According to Rosstat, average real wage growth in the first nine months of 2008 was 12.8 percent, down from 16.2 percent during the same period in 2007 (see chart below). Meanwhile unemployment has continued to decline, and reached 5.3 percent in the third quarter, suggesting that at that point the economic slowdown had still not reached the labour market. But this is expected to change quite dramatically now, as the credit seize up and construction slump lead to lay offs in one enterprise after another.

The Russian government has implemented a programme - worth about $200 billion - involving a mixture of loans, tax cuts and other measures to boost liquidity and reduce borrowing costs as the 50-stock RTS Index heads for its worst year since 1998, while the ruble denominated Micex stock index is down 64 percent since 1 August.

``It's a vortex of despair,'' said Julian Rimmer, head of sales trading at UralSib Financial Corp. Russian stocks are weighed down by ``an economy rendered sclerotic by the vanishing of credit, a market paralyzed by margin calls and illiquidity, the opacity of earnings through 2009 and the ruble quivering while speculators circle''.

Finance Minister Alexei Kudrin has said the government has already spent 90 billion rubles ($3.3 billion) out the available total of 175 billion rubles set aside for investing in domestic stocks and bonds. VTB Group (Vnesheconombank), Russia's second-biggest bank, lent 190 billion rubles ($6.9 billion) to companies in November alone as part of the plan following the supply of 120 billion rubles to what Finance Minister Alexei Kudrin termed the "real sector" (or non financial companies) in October.

FDI Drying Up?

Russia's supply of foreign direct investment seems to be steadily drying up. During the first nine montsh of this year the country attracted 2.3 percent less foreign direct investment than it did in the same period in 2007 as the global credit squeeze reduced investor appetite for emerging market projects. Direct investment was running at $19.2 billion over the period, while total foreign investment, including credits and flows into securities markets, was $75.8 billion, a drop of almost 14 percent over 2007, according to the most recent data from the Federal Statistics Service. Foreign investment in stocks and bonds fell 16 percent to $1.3 billion. Foreign direct investment was at a record $27.8 billion in 2007, up 100% over 2006, and thus the fall has not been that dramatic, so far, but the numbers for the last quarter will undoubtedly be much worse than those for the earlier part of the year.

S&P Downgrade

Russia’s long-term debt rating was lowered earlier this month - for the first time in nine years -by ratings agency Standard & Poor’s, who cited capital outflows and the “rapid depletion” of the foreign currency reserves as their justification. Russia's rating was cut one level to BBB, the second-lowest investment grade, and down from BBB+. The last time S&P downgraded Russia was in January 1999, when the country had a rating of SD (or ‘selective default’) following the government's decision to default on $40 billion of debt. Russia’s outlook remains “negative.”

“The rapid depletion of reserves in order to resist a more substantive adjustment of the nominal exchange rate increases the chances of discontinuous exchange-rate movements later, at a lower level of international reserves, with even more severe consequences for the private sector,” said Frank Gill, S&P’s primary credit analyst in London, in the statement.

S&P said it expected Russia’s current-account surplus to swing into a deficit equivalent to 2.6 percent of gross domestic product next year, compared with a surplus of 5 percent in 2008 due to a “sharp deterioration in the country’s terms of trade”. Russia’s GDP growth is expected to decline “sharply” in 2009, according to the agency.

Energy, including crude oil and natural gas, accounted for 73 percent of exports to countries outside of the former Soviet Union (not counting the three Baltic states), in the first 10 months of this year, according to data from the Federal Customs Service, while the federal budget is likely to “shift into deficit” as the government implements emergency tax cuts, commodities prices remain low, and a weaker economy generates less tax revenue, according to S&P. Russia’s budget surplus amounted to 7.8 percent of GDP in the first 10 months, according to Finance Ministry data, but so sharp is the turnaround that Russia may need to use most, or even all, of the money in its two oil funds to cover the budget deficit and recapitalize banks should oil prices stay at about current levels. These funds - the National Wellbeing Fund and the Reserve Fund - held a combined $209 billion as of 1 December.

Moody’s Investors Service also changed Russia’s rating outlook at the end of November - to stable from positive - citing their opinion that the defense of the exchange rate has been "ineffective and extremely costly for official reserves".
“Russia is now facing a perfect storm of falling commodity prices, weaker external demand, tighter credit conditions and slower real incomes growth for which no amount of currency adjustment can compensate,” Neil Shearing, an emerging-markets economist at Capital Economics Ltd. in London, said in a research note today.

Russia's response to the crisis seems to be what might be termed a "process in development", with new measures being continuously announced. In one of the latest such "developments" Finance Minister Alexei Kudrin said the government is thinking of using some of the funding to buy bank mortgages and will also provide 300 billion rubles ($11 billion) to guarantee corporate loans in a bid to boost liquidity. “In order to strengthen guarantees for loans, including loans for two and three years, the state must be ready to provide 300 billion rubles,” Kudrin said in a televised broadcast on the Russian state channel Vesti-24. “If necessary we can increase this limit.” Thirty billion rubles in loans are also to be provided to large airlines like Aeroflot and Transaero, according to First Deputy Prime Minister Igor Shuvalov, while Vnesheconombank, Russia’s state-run development bank, has now requested a total of 950 billion rubles ($34 billion) in government funds. To put all this in perspective, the latest amount requested by VEB represents more than 7.5 percent of Russia’s foreign-currency reserves.

Services And Manufacturing Contraction

Russia's real economy is shrinking very rapidly under the weight of all this. Russian service industries shrank in November at the fastest rate on record, and the VTB Bank Europe Services Sector Purchasing Managers’ Index was in contraction mode for a second consecutive month (registering 37.2, a sharp acceleration in the rate of contraction from the 47.4 reading in October). On such indexes a reading of 50 is the dividing line between expansion and contraction. The contraction in service industries was “by far” the biggest since the survey began in October 2001, according to the VTB statement. “Activity, new business, employment and backlogs all registered much steeper contractions than in October.”

VTB Group’s Manufacturing Purchasing Managers’ Index also showed a decline in November, this time for the fourth consecutive month, and the index registered a record low of 39.8, even lower than that of September 1998, when Russia defaulted on $40 billion of domestic debt and sharply devalued the ruble.

The manufacturing reading is also confirmed to some extent by the November industrial output data from Rostat, since output contracted year on year by 8.7 percent after a 0.6 percent rise in October. Production shrank for the first time since new methodology was introduced in 2003 and, again, this was the biggest decline since 1998. Manufacturing fell an annual 10.3 percent compared with growth of 0.3 percent in October. Steel pipe production dropped an annual 36.9 percent and coking coal output fell 38.7 percent. Truck and car production dropped 58.1 percent and 7.2 percent respectively. Russia’s largest steelmaker, OAO Severstal, have announced they are cutting output by half and plan to reduce spending 20 percent in 2009, while Ford Motor announced on 8 December it was closing its St. Petersburg factory between 24 December and 21 January.

Is Russia On The Brink Of Outright Recession?

Russia may well already be in its first recession since 1998, according to what may well have been a slip of the tongue by Deputy Economy Minister Andrei Klepach while Evgeny Gavrilenkov, chief economist at Troika Dialog, estimates that the word's largest energy exporter may already be running a current account deficit.
“The recession has already begun and, I’m afraid, it won’t end in two quarters,” Klepach said in comments made in Moscow today that were confirmed by his press secretary.

Klepach added that the economy would grow by less than the ministry’s current forecast of 6.8 percent for 2008, and that industrial output growth will slow to around 1.9 percent for the whole year.

Gross domestic product growth dropped to 6.2 percent in the third quarter, and this was already the slowest pace in three years. Russia’s last economy fell into recession in the first quarter of 1998, and only returned to growth in the second quarter of 1999. Growth has averaged over 7 percent a year since 2000.

As I said, Klepach's declaration may well have been a (Freudian?) slip of the tongue (or tongue twister) since he later qualified his statement, saying there had been some linguistic confusion given that the Russian words “retsessiya” (recession) and “spad” (decline, slump) “mean the same thing". "This isn’t a technical recession in the American sense.” he said - referring to the fact that a recession is often defined as two consecutive quarters of negative growth. Actually the sticklers among us will note that the two quarters negative growth rule of thumb is not in fact the US criterion (since the NBER business cycle dating committee use their own "in house" methodology, as I explain in applying this methodology to Spain here), but he may be right, and what we have on our hands may best be termed a "slump" rather than a recession, but which ever it is, of one thing I am sure: the contraction has already started.

Whatever the confusion, what Klepach did make clear is that he expected Russia’s economy to grow by only 2.6 percent year-on-year in the fourth quarter (giving total growth for the year of 6 percent) and this does seem to suggest that the economy is already contracting on a quarter on quarter basis.

Equally worrying is the evolution in the current account deficit. The full impact of the fall in oil prices will only be noted in the trade and external current account data in the fourth quarter, when export deliveries based on the new lower oil prices will be effectd. But to this evident oil price impact we need to add the fact that the non-oil external current account deteriorated significantly in 2008 as import volumes shot up considerably faster than non-oil exports (the competitiveness problem). In the second quarter of 2008, the non-oil external current account deficit reached almost US 60 billion, and this was followed by a further USD 62 billion in the third quarter, making Russia’s balance of payments position particularly vulnerable to a continuation in the low level of oil and gas prices.

We also need to consider the problems Russia may now have in financing any such current account deficit (remember this one one of S&Ps concerns). The World Bank estimates Russia’s external debt maturing in the third and fourth quarters of 2008 at around USD 100 billion, of which about USD 45 billion is due in the last quarter of 2008. After including on-demand deposits held by the banking sector, the total debt that requires repayment or refinancing may well exceed USD 120 billion. The external debt maturing for the entire 2009 fiscal year is slightly less, at around USD 100 billion. It is clear, however, that some sectors, especially private financial corporations, are going to face challenges in rolling-over their external debt under current conditions. Further, higher prices for debt refinancing are inevitable, and to all of this you need to add-in the sharp drop in the stock values used as loan collateral which will have resulted in sizeable margin calls on lending facilities with 1-2 year maturities.

All in all the World Bank reached the conclusion that the total debt due in the fourth quarter of 2008 could amount to about USD 60-65 billion. Even so, they concluded that systemic risk to the banking sector, while rising, remained limited due to the government’s resolve in supporting the systemically important banks and the sizable package of measures taken to date. It is hard to assess whether or not they are right in this evaluation, but in any event we are all just about to find out, so those of us who don't especially like mysteries won't have too long to wait.