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Tuesday, December 29, 2009

Hungary's Economic Correction Still Fails To Convince

"Hungary’s potential economic growth should be 2 percentage points over the corresponding EU figure in order to ensure convergence".
Prime Minister Gordon Bajnai, speaking in London in October
Two contrasting pieces of news about Hungary's economic plight have caught my eye over the last week. In the first place, and in an evident sign of the times, retail sales reportedly fell at their fastest annual rate in over ten years in October, whilst secondly, and more surprisingly, I learnt that Hungary’s economic-sentiment index rose to its highest level since October last year, when the gale force wind sent by the fall of Lehman Brothers engulfed the country. How can this be, I thought? These two pieces of information would, at least on the surface, seem to be pretty contractictory, with the former suggesting the deepest recession in living memory is getting even worse, while the latter seems to add backing to government claims that the worst is now behind them.

Gloomy Days Ahead For Consumer Spending

Hungary’s retail sales dropped 0.6% month on month in October, just slightly more than they did in September (-0.5%). In fact Hungary’s retail sales have risen only twice in monthly terms over the past 12 months, and one of these months was June (+0.2%) when consumer anticipation of an impending 5% VAT hike drove large crowds into furniture and household electronics stores. Not unexpectedly this was followed by the July numbers, which saw the largest monthly drop in a decade (-2.3%).

But a glance at the chart below should also reveal that the decline in retail sales is now long term, and not just a product of the recent crisis. Sales peaked in mid 2006, and have since been falling steadily, and while the year-on-year drop was as large as 7.5% in October - another decade long negative record - in fact they are now down nearly 12% from the August 2006 peak, and there are no strong grounds for believing that this trend will now reverse. And the reasons are obvious, since in addition to shrinking personal income levels, and a tighter credit environment credit, Hungary's ageing and declining population is also increasingly acting as a damper on household consumption.

In fact the situation with vehicle and auto part sales (which are not included in Eurostat retail sales) is even worse than the above data indicate, since given that Hungary is in the midst of a fiscal crisis, there is no room for a cash for clunkers type programme, and sales volume fell an annual 40.1% in the ten months to October, with the decline in October alone being 50.5% (following a 52.3% annual drop in September).

And there is worse news to come for the car sector, since even though the government hiked both the excise tax on petrol and the rate of VAT to 25% from 20% in July, sending fuel prices up like never before, yet another excise tax increase is now on its way. The excise tax on fuel is set to go up as of 1 January 2010 driving the price of gasoline and diesel up by roughly HUF 11 and HUF 7 a litre, respectively. As VAT is levied also on the excise tax, the VAT burden will also increase even if the rate itself won't change.

Confidence Rises

On the other hand according to the GKI sentiment index, confidence is now back at its highest level since October last year, when the credit crisis engulfed the country. The rise follows widely publicised government forecasts that the economy is now heading out of its worst recession in 18 years. The GKI sentiment index rose to minus 25.4 in December from minus 27.5 in November and a record-low of minus 46.2 in April. Business confidence rose to minus 16.7 from minus 18.9 and consumer confidence increased to minus 50.1 from minus 51.9.

According to Finance Secretary of State Tamas Katona Hungary’s economic decline bottomed in the third quarter of 2009 and the rate of contraction should ease in the final three months of the year. Katona suggested the economy may shrink 5 percent in the fourth quarter after contracting 7.1 percent in July-September. The economy is likely to contract an annual 6.7 percent this year and 0.6 percent next year before a return to growth in 2011, according to government forecasts (the EU Commission forecast a 6.5% decline in 2009, and a 0.5% one in 2010, while the IMF are predicting a 6.7% drop this year followed by a 0.9% drop next year). In the short term therefore, all are agreed that the economy will keep contracting, even if the possibility of a quarter of positive growth (which would technically mean exiting recession as currently defined) is not excluded.

The real issue facing students of Hungarian economic growth is thus not 2009, but the extent of any rebound in 2010 and beyond. It is on this rebound, and the level of inflation associated with it, that the future Hungarian fiscal deficit numbers, and the even more critical debt to GDP numbers, sensitively depend. The EU Commission currently forecasts 3.1% growth in 2011, while the Hungarian Central Bank is forecasting 3.4% growth in 2011 (see chart below).

The question is, are these expectations for such a strong rebound in 2011 really realistic, and even more to the point, is there any evidence for Prime Minister Bajnai's claim that a large number of analysts share his governments view that Hungary’s long term GDP trend growth potential is around 4%. Or put another way is there evidence for support for such an optimistic view of Hungary's growth future beyond the limited circle of economists who promoted the reform manifestoes (like Oriens, CEMI etc) on which current government policy is based? Certainly I can say that this analyst doesn't share that view, and reading around I have difficulty identifying others who do. Even the reasonable and ever moderate Portfolio Hungary were moved to raise an eyebrow at this claim, saying they "read Bajnai’s statement with a measure of surprise, as GDP estimates for Hungary have been typically way below 4%". The most pessimistic forecast they had seen was below 2% (this would certainly be my view, possibly 1% trend growth would be realistic at this stage), and they stated they were unaware of any "serious estimates above the 3% mark".

What is so striking (and in my view so unrealistic) about the kind of rosy estimates which are being circulated (as illustrated in the Bank of Hungary forecast chart above), is that not only do the median estimates seem to assume a "V" shaped rebound, even the outer limit, worst case type scenarious are based on the idea of a fairly strong rebound, and almost no consideration is given to the possibility that this may not happen, and that the country may be stuck nearer to an "L" shaped non-rebound, where rates of contraction slow, and slow, but growth proves to be surprisingly elusive and hard to come by.

These issues are not new, and I have blogged about then before (in this post - Hungary's Trend Growth And Debt Sustainability - about the scenarios offered for debt repayment in a paper by Lajos Deli and Zsuzsa Mosolygó from the National Debt Agency). Despite protests to the contrary, and despite the IMF's argument that "In emerging market countries with debt overhangs, the “Keynesian” effect of fiscal adjustment is likely to be outweighed by “non-Keynesian” effects related to expectations and credibility" it is really all about growth, more growth, and only about growth.

Non-Keynesian effects have to do with the offsetting response of private saving to policy-related changes in public saving. In particular, if fiscal adjustment credibly signals improved public sector solvency, a fiscal contraction could turn out to be expansionary, as private consumption rises based on the view that future tax hikes will be smaller than previously envisaged.
IMF - Hungary, Request for Stand-By Arrangement, November 4, 2008
The simple issue is, if domestic demand is (for demographic reasons) not able to rebound as the IMF (and the signitaries of the very influential Oriens Report "Recovery, A Programme For Economic Revival In Hungary") imagine, then how is GDP growth going to be strong enough to reduce the weight of debt to GDP?

As everyone recognises, if domestic demand remains weak, growth will critically depend on exports, but the export potential of the economy will depend on the pace of recovery elswhere in the EU, and on relative prices as expressed through the value of the HUF, but almost no serious consideration is being given to the possibility that either the HUF is overvalued compared to the need to export or that EU growth may also be weaker and harder to come by than most median forecasts are assuming.

And indeed things are worse than they seem at first sight, since Hungary (and Hungarians) are, by and large, not in debt in their own currency, so allowing excess inflation does not sweat down the debt, since it only make export prices less competitive, unless you devalue to compensate, in which case the relative value of the debt is unchanged. But if you refuse to devalue, then, quite simply, you get hoisted on your own petard, which is basically where Hungary is right now.

So, the real question, as ever, is where the ingredients for growth are going to come from. Remember, Hungary's population is now declining steadily.

and ageing

and the working age population is also irredeemably falling.

As I said about the retail sales data above, these have now been falling since mid 2006, so it is hard to believe that we are going to see any significant resurgence (taking retail sales as a proxy for private consumer demand), especially as it seems Hungarian's are not now borrowing to anything like the extent they were two or three years ago (see below), and that (for age related reasons it is unlikely the earlier pattern will return. So I will correct myself: it isn't all only about growth, it is all about how to get the exports which can produce the growth. Anyone not recognising that is living, quite simply, in cloud cuckoo land, and after 40 odd years of Stalinist surrealism one would have thought that Hungarians in general had had enough of all this. But perhaps not. Look at the confidence index, and at how many people are prepared to accept Bajnai's assertion that Hungarian trend growth is 4% per annum.

Where Is The Growth Going To Come From?

"Looking at the structure of the Hungarian economy I frankly have difficulty seeing where the growth is going to come from. Without a major devaluation (and even then given international circumstances) Hungary will have problems attracting FDI in even the reduced quanities it has been doing over the last five years. The domestically owned private sector has enormous problems and is tied closely to the level of state spending. The financial sector and business services suffers from international problems and it isn't as if Hungary's largest bank - OTP - doesn't have some fairly serious problems of its own tied up in Ukraine, Bulgaria etc. Agriculture and food processing? Well, perhaps - but that isn't in that great a state either."

"It is worth pointing out that except for a brief period at the end of the 1990s when privatization receipts and above trend economic growth eased the situation Hungary has had a long term problem with its external debt going back to 1978 that it has never really escaped from. Successive Hungarian governments have prioritised the precise payment of the debt and have refused to seek rescheduling or restructuring on the grounds that this would damage business confidence. One can actually read the history of economic policy prior to 2000 as being about securing Hungary's public financing needs given this policy choice, to the detriment of the needs of the real economy. I read the relaxation of budgetary discipline after 2000 (and especially post-2002) as being about the interaction of mounting frustration at low living standards among the population with the dynamic of party competition."

"That having been said, if one looks at the long view it is difficult to believe seriously that Hungary's debt burden will ever be paid off. Given that servicing these debts will depress the level of economic growth, I think it really is time that the EU, IMF and the authorities in Budapest swallowed hard and accepted reality - a realistic debt consolidation/restructure that takes in both the public and private sector debt is a fundamental condition of stablizing the situation. This is what no-one wants to recognise."
Mark Pittaway, Senior Lecturer in European Studies, UK Open University

Hungary’s third-quarter GDP contracted by 7.1% year on year in the July-September period compared to the 7.5% fall in Q2 .Quarter on quarter the economy contracted by1.8%, the sixth quarter in a row that the economy has shown negative growth.

Quarter on quarter Hungary's export-driven economy shrank 1.8 percent following a revised 1.9 percent contraction in the second quarter. This was the sixth quarter in a row that GDP growth was negative. The rate of contraction is down considerably on the 2.6% rate of fall seen in the first quarter, but the velocity of contraction is still alarmingly high.

In fact domestic demand fell by 13.3% year on year in the third quarter (see chart below), so the fall in GDP would have been much larger if it had not been for the impact of net trade.

As can be seen in the above chart, since the last quarter of 2008 Hungary's net trade impact has been possitive, and imports have fallen dramatically faster than exports. And the effect continues, since the export-import gap rose again in October, to 9 percentage points from 5.9ppts in September, following the high of 13.5 ppts in July, by far the largest seen in recent years.

This impact is not, of course, based on a strong recovery in exports, but rather by the fact that imports fall even more than exports (on an annual basis). Basically, when there is a movement in the net trade balance caused by a drop in imports GDP falls more slowly (following a pattern we have already seen in Spain, Greece etc). In fact, for statistical reasons a fall in imports appears as an INCREASE in GDP because the net trade position improves. But unless this drop in imports is accompanied by a significant improvement in the competitiveness of domestic industry (and hence a trade surplus driven by exports) then all you have is economic stagnation and falling living standards, since, for example, house prices will continue to fall, and everyone will feel worse off. Unemployment will obviously also rise, as those involved in the retail sector selling the imports will lose their jobs. People working in the ports for domestic directed external trade trade ditto.

This is the whole argument for devaluation in these kind of circumstances (Greece, Spain, Latvia, Hungary etc), since the devaluation not only helps export industries, it also helps the domestic sector by making imports more expensive. Thus, if demand was there, then a fall in imports would be compensated by a rise in domestic supply, and your interpretation of the equation would not hold.

The whole problem, however, in the cases of the former current account deficit countries is that the internal demand is now longer there, since it was based on unsustainable borrowing in the first place, borrowing that appeared to be supported by rising property values or state guarantees (in the case of fiscal deficits) as collateral. The property prices are now falling, and the deficits are now being slashed back, and neither are going to rise back again anytime soon and therefore the kind of borrowing we saw before isn’t coming back again anytime soon. So the bottom line is there is a sharp fall in consumption, whatever the headline GDP number says.

In fact the causal mechanism is that the absence of capital inflows leads to a drop in consumption, which in turn means there are less imports. But my big point is that the accounting mechanism used to generate the GDP number (making Net Exports a positive input convention) masks to some extent the actual drop in living standards, since Net Exports was previously negative (and hence a drag on GDP), and the drop in domestic consumption and imports simply makes it less negative.

Of course, there are two ways to make imports less attractive, one is devaluation and the other is structural reform to make the domestic sector more competitive, and that is the Oriens/Bajnai approach, and there is little objection at all to much of what they propose, except that, as we are seeing in one country after another this procedure doesn't act quickly enough to undo the severe distortions that had been produced earlier, but then I doubt, from what they say, that the Oriens signitaries would accept that these distortions were as severe as I argue they are - just look, for example, at the drop in domestic consumtion - 13% - and this after three years of near economic stagnation. Hope against hope.

This having been said, exports, and the current account balance have been improving in recent months, although not by a long way fast enough to push the economy back up towards growth. Hungary posted another huge foreign trade surplus of EUR 471 million in October, according to the latest revised numbers released by the Central Statistics Office. October marks the ninth month in a row when Hungary posted a trade surplus in the EUR 320-550 million range.

Despite this significant improvement in the trade balance the Current Account only just managed to sneak into surplus in the second quarter, largely as a result of the very strong negative balance in the income account, which is a product of the very negative net investment position of the Hungarian economy (ie non Hungarians own a long more of Hungary than Hungarian's own of the rest of the world, and this creates a huge imbalance, and as Mark Pittaway says the bullet will have to be bitten - one way or another - about what to do about this at some point.

In October, exports dropped 11.8% year on year (on a euro basis), while imports plunged by 20.8% year on year.

This gradual improvement in Hungarian exports has also lead to a modest recovery in the industrial sector, mainly due to stimulus-programme-induced stronger demand in western Europe. Industrial output fell 15.6 percent in the third quarter, down from a fall of 20.5 percent in the previous three months, while recent data showed output grew month on month for the second time in a row in October.

Against this background, weak exports, and domestic demand in full retreat it is not surprising that investment has been falling, and dropped 6.8% year on year in the third quarter.

What these continuing declines in investment mean is that the level of investment is now at much lower levels than it once was - below the 2005 level according to the rough and ready index I prepared for the chart below.

Construction activity is also well down, and has been for some long time now, following the sharp drop between summer 2006 and summer 2007 on the back of the first austerity programme (see chart).

Government consumption is also contracting due to the pressure to reduce the fiscal deficit.

All in all, the third quarter GDP data indicate that Hungary's domestic economy is not showing any signs of recovery whatsoever, nor should we expect it to do so. The hike in VAT in July hurt private consumption while capital spending has been continually cut back given the failure of export demand to rebound as strongly as hoped. The need to maintain a restrictive fiscal policy stance will also indirectly weigh on consumer and corporate spending, with the consequence that in my view GDP will decrease by nearly 7% in 2009 and then by around 1.5% in 2010.

Monetary Policy Tangle

Hungary's central bank (NBH) last week cut its base rate by 25 basis points to 6.25%. The move which suprised the market participants (the consensus had been for a 50-bp reduction in surveys conducted by both Portfolio.hu and Reuters) now means the benchmark rate has been cut by 3.25% since July. Not everyone was surprised however, since in an interview on 10 December, Centrak Bank MPC member Péter Bihari had said it would be wise to calm rate cut expectations. "Any overshoot in (rate cut) expectations can backfire later. We (the central bank) need to stay sober, and we also need to communicate this sobriety outside," he said.

Although Hungary’s inflation outlook might have justified a 50-bp cut, the recent weakening in the forint (the HUF hit a 6-week low vs. the EUR last week) and the rise in the 5-yr CDS spread to a 3-month may well have signalled the need for a more cautious move, since following events in Dubai and Greece questions are rising about how long the relatively favourable global investor mood can last. Also, the imminence of elections, and the dangers of fiscal loosening (either before or after the election) urge prudence, especially in the light of what we have just seen in Greece.

The smaller than expected move also suggests that easing will be cautious in the first months of next year, and that the bank will be sensitive to any signs of worsening market conditions (especially ahead of next spring’s elections). Weaknesses in the real economy still argue for lower rates, and without moving towards closing down the interest rate gap forint loans will never become competitive with Euro or CHF ones"

Despite this afternoon’s decision by the National Bank of Hungary (NBH) to cut interest rates by a smaller than expected 25bps to 6.25%, there is a good case for further monetary easing over the coming months. We continue to think that the profile for interest rates priced into the market is too high."

"Both we and the consensus had expected a larger 50bps cut today, although the fact that one member of the Council voted for a smaller 25bp reduction in November did suggest that a slowdown in the pace of easing was possible. The forint gained 0.25% against the euro immediately after the decision."

"Nonetheless, while policymakers may now move in smaller steps than we had previously thought, the case for further monetary easing remains strong. The decision to cut by just 25bps today is likely to have been motivated in part by signs that output in some sectors (notably industry) has started to pick up. But while the prospects for some parts of the economy have undoubtedly improved in recent months, the overall pace of recovery will remain subdued."

"In particular, domestic demand will remain a significant drag on growth. A combination of a fragile banking sector, a high proportion of fx-denominated debt and the continued rise in non-performing loans, means that the overall availability of credit remains constrained."

"And although the bulk of the tightening measures have now been implemented, a public sector wage freeze, and private sector wage restraint needed to offset the recent sharp rise in unit labour costs, means that the pain will linger into 2010 and 2011."
Neil Shearing, Capital Economics

Inflation Overshoots Expectations In November

Hungary’s consumer prices rose 5.2% year on year in November, an acceleration from the previous month (4.7%). Month on month prices were up 0.3% . This was an upside surprise since analysts forecasts had been for a rise of 5.0%.

The main reason for the increase was an increase in the prices of unprocessed food (especially fruits and vegetables), energy and fuel. Disinflation is slowing in tradable goods, driven mainly by the durable goods sector (especially new and used vehicles and televisions), while market services disinflation came to a halt (most service prices increased except for tourism and books).

The impression is that the underlying disinflation process has started to slow and there are risks to the medium term inflation outlook. The seasonally adjusted core inflation has been stagnant at around 5% since July, while the CPI adjusted for tax changes started to accelerate in November (it moderated from 3.7% YoY in June to 0.9% in October and picked up to 1.4% in November).

Which means the NBH’s inflation forecast of 1.9% for 2011 may come under pressure. Inflation may well accelerate to 5.6% in December and peak at around 5.8% in January and can then fall to below 3% by the end of 2010. As Neil Shearing says "Despite the uptick in inflation to 5.2% in November (from 4.7% in October), we support the Central Bank’s view that it will "significantly undershoot" the 3±1% target when July’s VAT hike drops out of the annual comparison." Still maintaining this sort of price range with the present Forint value is simply going to prolong and prolong the economic downturn.

Employment Falling As Unemployment Rises

Unsurprisingly, against this background unemployment is rising and rising, hitting 9.9% of the labour force in October, according to Eurostat seasonally adjusted data.

Total employment has been on a downward trend since the middle of 2006.

But one of the impacts of the economic crisis has been that employment in the public sector, after falling under the austerity programme has risen sharply since the spring (due to a number of employment schemes designed to keep unemployment down, especially in the regions), and is now back up above its earlier level.

Real ex-bonus wages (the central banks targeted measure of wage inflation) has been in negative territory (by around 1%) since the summer.

Bank Credit Turning Negative

As is well known a very high proportion of mortgages in Hungary are non-forint denominated (over 85%, mainly in Swiss Francs), but the HUF value of these mortgages has been falling for over a year now.

As has the total value of outsanding mortgages in any currency.

Although the stock of mortgages had not been high by some West European standards (around 50% of GDP), they had been growing at a rate of around 20% per annum over the last several years (see chart) but the crisis brought this to an end, and the year on year increase was down to only 2% by October, and will more than likely be negative by the end of the year. Which means, credit expansion and new house construction will NOT be driving any coming Hungarian recovery.

In the current climate, with unemployment rising, and wages falling, and an economy contracting at nearly 7% a year, it isn't hard to understand why not that much new bank lending is going on. Those who are creditworthy are trying hard to save, while those who need to borrow normally aren't that creditworthy, so pleading to the banks to lend more is rather like asking them to subsidise new bad debts, and that is really not something you can do. What kicked the whole current process off in Hungary was a short sharp credit crunch, but now it is the contraction in the real economy which is following its own dynamic, till someone finds a way to put a stop to it. It is the drop in output that is preventing banks from lending, and not banks being unwilling to lend that is causing the contraction to continue.

Election Chaos Looming

Having seen the shennanikins which have recently taken place in Greece, it was obvious that the run in to the coming election was always going to be complicated, with accusation and counter-accusation being thrown from one party to another. The big problem is that neither party has exactly clean hands in this context, but one thing seems sure, that the 2010 budget is liable to slippage, whether because of the current ruling party moving invoices from 2009 to 2010 (on the assumption that they are going to lose the election, so what the hell), or because the incoming party is going to make promises which will lead to an overspend which they will then blame on their predecessors.

A group of economists close to opposition party Fidesz now claim next year’s budget "is full of tricks", including unrealistic macroeconomic assumptions that will lead to a deficit far larger than the cabinet’s projection. The current Finance Ministry Péter Oszkó played down the criticism as politicking ahead of the coming elections, and this may well be, but some of the points they make to not, for all that, lack validity.

The 29 economists, who promoted a 'no’ vote on the 2010 budget bill in November, include Zsigmond Járai (Finance Minister of the Fidesz government and former Governor of the central bank), Ákos Péter Bod (Ministry of the Industry in the MDF cabinet and former Governor of the NBH), György Szapáry (former Deputy Governor of the NBH, currently responsible for international relations in Fidesz), Tamás Mellár (head of the statistics office (KSH) during the Fidesz government) and Károly Szász (head of financial markets watchdog (PSZÁF) in the Fidesz era).

Zsigmond Járai argues that, on the one hand the 2010 budget is based on unrealistic macroeconomic assumptions - e.g. only a 0.6% economic contraction while GDP may well shrink by considerably more, possibly by as much as 1.5%, while on the other planned austerity measures, like reduced subsidies, will also worsen the balance. Among his list of "overestimation tricks" the former central bank head mentioned VAT and corporate tax revenues. The economists claim that the underestimation of the GDP contraction will result in something like HUF 200 bn less budget revenues, adding that another HUF 200 bn shortfall due to smaller-than-expected revenues from taxes and contributions.

The current official estimate for the general government deficit in 2010 is 3.8% of GDP, a target which is considered to be realistic by both the IMF and the European Commission. The Fidesz economists claim the gap - without supplementary bufget changes - could be as high as 7-8% of GDP. György Matolcsy, a leading Fidesz economic spokesman stressed that such a large deficit would be unacceptable for Fidesz as well, and made clear that they are not saying such a massive budget overrun should be tolerated.

Matolcsy said the 2010 budget included no reforms or system overhauls to jumpstart growth in the second half of 2010 as the cabinet expects, and that in his opinion a sustainable growth path is unlikely to be reached before 2013.

The document has not been slow to attract criticism, and apart from Finance Minister Ozskó, Lajos Bokros, Hungary’s former Finance Minister and PM candidate from the minor opposition party MDF, lashed out at the group saying their argument was "ridiculous".

In an interview with public television MTV, Bokros said that "the only alternative to sovereign default was to cut budget spending, take away welfare contributions, e.g. the 13th-month pension and 13th-month wage in the public sector that spun the economy into catastrophe and that led to (government) debt to surge sky high." "How do you create growth from these (measures)? Only via reforms," he stressed.

A large part of the issue seems to revolve around what to do with the bulging debts of quasi governmental institutions like hospitals, the state-owned railway company MÁV and the Budapest Transport Company (BKV) . Fidesz seems to assume that these debts will need to be swallowed. Bokros does not agree: "If a budget were about consolidating the debts of every (state-owned) companies automatically and without restraint the next year, it would be but a rejection of any reform," he said. "Reforming" according to Bokros means not covering the debt of "inefficiently operating public institutions", because these liabilities had probably been accumulated due to their profligacy."So, what do you have to do then? [You need to implement] reforms and a create a competitive situation that will have inferior companies go bust and good-quality institutions double in size."

While sympathising with Bokros in the spirit, it is not clear to me that things are going to be so easy as he imagines in the letter. One thing is however clear, he is right that if solutions are not found for these issues, especially in the problematic pensions and health sectors, Hungary will go bankrupt.

One thing is clear though, life is not going to be easy in post election Hungary. If Fidesz is voted back to power it will create a new budget, a new tax regime and a new labour policy for as early as July, according to György Matolcsy, and the new government should also sign a new Stand-By Arrangement with the IMF. Matolcsy reiterated that Fidesz has three scenarios for the tax system: one proposing a radical reduction of personal income tax with a flat family rate; another which would decrease rates on the entire spectrum of taxes; and a third which would cut social-security and health-insurance contributions for employers and employees alike. The only thing which doesn't seem clear is how he expects to pay for all these, especially since he doesn't anticipate a serious return to growth before 2013.

Matolcsy also claims that the budget deficit will be 3-4 percentage points higher than the targeted 3.8% of GDP, citing central bank staff projections in their Inflation Report that the gap is likely to be 4.3% of GDP. Fidesz expects the gap to come in at 4.5% and foresees that state-owned enterprises such as the railway company would need debt consolidation amounting to 3% of GDP. Matolcsy also pointed out that there may be other downside risks to next year’s budget beyond the 7.5% deficit he claims it already incorporates, including a larger-than-expected contraction in consumption, unemployment and a fall in lending to households that could lead to smaller tax revenues. All of these points are not without some validity. Further the ongoing drop in investment will continue to eat into tax revenues and lower-than-forecast inflation could decrease budget income next year, he added.

Fidesz The Likely Winners, But By How Much?

The gap between Hungary’s two main political parties has narrowed slightly of late, according to the latest opinion survey by Medián. While an increasing number of voters reported a lack of strong party affiliation, Fidesz has witnessed some decrease in its supporter base. Support for Fidesz within eligible voters has been gradually melting away in recent months, and is now down to 40% in December from 43% in November and 47% in July. The Hungarian Socialist Party meanwhile saw a only a minor and not statistically significant increase in support. But this change in percentage support is more due to an increase in undecided voters than anything else, since 66 per cent of respondents — all decided voters — would vote for Fidesz in the next legislative election, up one point since October.

The ruling Hungarian Socialist Party (MSZP) remains a distant second with only 19 per cent, followed by the Movement for a Better Hungary (Jobbik) with 10 per cent. Support is much lower for the Hungarian Democratic Forum (MDF), Politics Can Be Different (LMP), and the Alliance of Free Democrats (SZDSZ).

We should not forget that although Bajnai is portraying himself as being the head of a technocratic government, he is in reality the head of a government which is supported by MSZP. It is clear that the 2010 elections are lost. The game is already for 2014 elections. The government now have apparently stabilised the forint, slowed down the shrinking of the economy, and restored some kind of order and feeling of leadership. The price is high, but it seems that the population by and large accepted the situation as it is. The slight increase of popularity of MSZP and Bajnai himself may support this statement. Now, compromises have been made for a short time with major public service sector agents to accept the restrictions. But, somewhere around next August everyone will be up in arms for new financial support. The latest move of the government, to finally accept the long term and symbolic demand of FIDESZ to cut the VAT on the gas-price to 5% is already, I think, a mine for FIDESZ laid down to explode next year. All the messages of the members of the government are now portraying the government as a similar "responsible" stabilisation force as the 1995 Bokros package was, which would propel again Hungary into a "sustained" high growth as was experienced between 1997-2005 (of course now we all see better the price of this decade of growth). So what we are seeing here is a creation of a "new development" discourse, which it is expected will be destroyed by the "incompetence" etc of the Orban government. - Andras Toth, Sociologist

Huge Structural Reforms Gamble

Well, I think I have said more than enough already in this post, so I think I will leave your with the thoughts Gábor Egry (a Hungarian political scientist) expressed in an e-mail interview with me. Basically it seems to me that Gábor is right, the 4% growth target has no scientific basis behind it at all, and is just a hope that has been repeated so many time people now think it has become a reality. What is going on in Hungary now is a huge gamble, a leap into the dark almost, based on the idea that a shift in the tax structure, and a fiscal discipline to reassure would be investors can bring a growth surge, a growth surge which I argue is structurally impossible without doing something about the level fo the forint, the problem of the forex debt, and without getting domestic monetary policy firmly back in the hands of the NBH.

Gábor Egry - Research Fellow, Poltikatörténeti Intézet (Institute for Political

Maybe it is worth taking a look at the history of this idea of 4% trend growth. As far as I can recall it - apart from the constant remarks of politicians that Hungary needs a growth 2 points higher than the EU core states and this was somehow always expected to be 4% - both before and after the last elections a group of economists started putting forward ideas for the renewal of sustainable growth in Hungary and they elaborated a series of - let's put it this way - Slovak-type measures would very soon result in 4% trend growth. As the then government chose another type of policy mix for their budget consodilation, these critics never failed to emphasize that with this Slovak-type set of measures not only would the slow growth period after the budget (austerity, 2006) restrictions have been avoidable, but that these Slovak measures were the only possible way to elevate the trend growth to 4%. Usually it was the same guys coming with the same proposals, just branded differently. (CEMI, Oriens etc). Then, when in 2008 the Reform Aliiance was formed, they recycled these ideas. And even though the Bajnai government is an MSZP supported one at least initially it was the result of Gyurcsány's attempt to compell the party to accept the Reform Alliance program. From this persepctive Bajnai's statement is quite logical: they are implementing measures that were proposed by experts with the promise that they would lead to a 4% trend growth. Anyway, the idea that such measures will restore a higher and sutainable trend growth is deeply anchored in the Hungarian economist's thinking, and most of them - among others Bajnai, who was the loyal but critical supporter of these ideas in the Gyurcsány government - will adhere to it as it was the main component of their criticism of earlier policy and as such it is a core component of their common identity.

Beyond the historical anecdotes I see some serious faults and gaps in the reasoning behind the approach, especially as their reasoning is really causal, but rather based on the use of analogies. The main thrust of the approach is not simply to make production in Hungary wage-competitive by cutting the so called tax wedge, but also through making labor cheaper for local companies and attracting FDI, thus raising the employment rate. So, they work with both a direct causal relationship between tax rates and the employment rate and with an indirect one, but they then connect this second one causally to the tax rates again. I would argue, that such soft factors, as labour mobility have had at least as as important impact in the Hungarian case. According to Oriens, the FDI sector in Hungary is said to be overcapitalized, but I'm not sure whether this is because of the relatvely high labor costs or is a result of the immobility of the workforce. It is really important to observe how unemployment is geographically distributed in Hungary, and how this geographical distribution has not changed in the last two decades, despite efforts to change this situation with methods in principle similiar to the present ones, i.e. giving incentives indirectly through economic policy to market forces.

There really are areas where even near-starvation was not capable of moving people out of their villages and making them go look for employment elsewhere. I know that there are counter-examples in the sense that in huge areas a lot of people remained deliberately unemployed as they have found easier ways of making money in the grey or black economy, for example, near the Ukrainain border. Such people, instead of being moved by the modern dynamic of the market economy, resorted to - let's put it vaguely - pre-capitalist methods of work organization and resource redistribution. I don't really see how any kind of tax cuts will move them out from these places and as they have no significant taxable or taxed income it won't generate surplus demand for local companies either. Otherwise, I wouldn't neglect the fact that the fall of unemployment and the rise of employment in many Eastern countries coincided not only with lower taxes, but with EU accession, making it much easier for people to seek work in the West. And in fact millions did it. (For example at least 10% of the Slovak workforce worked abroad before the crisis.) But this is mobility is more or less lacking in Hungary, and Hungarians by and large never left for the West seeking work.

On the question of the deficit, it wouldn't surprise me if there was some accountancy massaging going on behind the scenes. The government may well have put a part of this years deficit on last year's one, raising that from 3,2 or 3,4% to 3,8 and they try to convince the state railways not to reclaim their VAT this year etc. Oszkó conveys self-assurance but he is paid for that. I wouldn't be surprised to find out at the end that this year deficit will be higher than forcast, but I don't see too much room for the IMF to protest, either.

They let Latvia raise its deficit a number of times, Romania is not only doing the same but may even finance the deficit (or in a more populist tone, this year's pensions) from IMF money and - at least as far as I can see - even accept political arguments regarding government incapability to implement unpoular measures before specific elections as arguments to support non compliance. Maybe Hungary will overshoot the deficit, but at least on the surface - in terms of measures implemeted - it is adhering to the terms. The government can simply tell them, ok, guys we did what you proposed, a slightly higher deficit was the result, accept it. Moreover, with the animal spirits currently prevailing around the world I really don't think the news of a 4,1% deficit will do any harm as long as markets are in love with recovery, while even a surplus can not prevent a collapse if their mood changes fundamentally...

Thursday, December 24, 2009

Latvia Is Back In The News, And Expect More To Come

The Latvian government is getting nervous about the level of lending coming from Swedish banks. According to the Financial Times, "Latvia’s prime minister has warned Swedish banks they risk choking off recovery in the Baltic state’s crisis-hit economy unless they resume lending". The Latvian authorities are complaining, it seems, that banks such as Swedbank and SEB, which dominate the Latvian market, have reined in credit as they struggle to contain rising bad loans amid the deepest recession in the European Union.

“The . . . abrupt stopping of credit is a very problematic issue,” said Valdis Dombrovskis, the prime minister. “We expect Swedish banks to start [lending] again. “Of course you can say that Latvians were borrowing irresponsibly but to borrow irresponsibly you need someone to lend irresponsibly,” he said. “We had very easy credit in a very overheated economy. Now we have almost no credit in a very deep recession.”
Well, here is some of the background. After an extended period when private credit was rising at nearly 60% a year, the Latvian credit bubble suddenly burst, with very unpleasant consequences for everyone. Since mid 2007 the annual rate of new credit has been falling rapidly, and turned negative in June this year. In fact total credit has been falling since October 2008.

Lending to households alone has also fallen back, after shooting up dramatically over several years.

And Latvian base money (M1) has also been falling.

In fact, and unsurprisingly (given that it is what we are seeing everywhere in the exploded bubble economies) the only sector which isn't deleveraging at this point is the government one.

So it seems hard to me to simply blame mean banks for not doing enough about a situation which many saw coming, but few were willing to do anything to avoid. Sure, the banks made a lot of bad decisions, but so did many other people, and each and every party is trying to extricate themselves from the mess as best they cab. In fact total Latvia debt is not in fact falling at this point in time, since while many individual Latvians have been frantically deleveraging, the government has been borrowing at a faster rate than ever, in part to bail out Parex bank, and in part to fund the ongoing fiscal deficit. In the meantime Latvian GDP has dropped sharply, falling back again in the third quarter at an even faster rate than in the second one. Which means that despite the fact that private indebtedness is falling, the level of private debt to GDP is still probably rising.

This unfortunate situation is only further reinforced by the fact that prices are falling - not too fast as yet, only an annual 1.4% in November, but they are falling, and they will fall further, and this means that the percentage of debt to GDP will again rise, and this is especially bad news for the Latvian government (even though the drop in prices is a desired objective, no win-win strategy left to use now) since any fall beyond that anticipated is likely to push up the total debt level of 60.4% of GDP currently being forecast by the EU Commission for 2011.

And the pain doesn't stop, since having cut 500 million lati ($1 billion) in spending in its 2009 supplementary budget, the government initially resisted the idea of finding an additional 500 million lati of savings in the 2010 budget arguing that with no policy change the deficit was expected to be lower than the 8.5 percent target. Valdis Dombrovskis said in October his government could cut only 325 million lati in the 2010 budget and still meet the 8.5 percent target agreed with international lenders. The lenders did not agree, and Swedish Premier Fredrik Reinfeldt even intervened to tell Latvia it “must correct” its deficit. Following the rebuke further measures were passed equal to 500 million lati for 2010, and the country now targets a deficit of 7.6 percent of GDP. This is to be followed by a budget deficit target of 6 percent of gross domestic product in 2011, in order to finally arrive at the magic number of 3 percent deficit in 2012.

But considerable doubt exists over the ability of the Latvian authorities to fulfil these objectives. Which is why Mark Griffiths, IMF mission head in Latvia, describes the situation facing the government as challenging, and why the EU Commission base their Autumn forecasts on much higher deficit levels. The problem is that with domestic prive deflation (which is, remember, what Latvia is aiming for, the so called "internal devaluation" what is called nominal GDP (that is current price, unadjusted GDP) is likely to fall faster that the so called "real" GDP (adjusted for inflation) and this has two very undersireable consequences. In the first place debt to GDP goes up even faster, and the revenue which government receives (which is based on actual prices) drops faster than GDP, causing more instability in public finances. The deflator has shown falling prices since early this year and the EU commission is forecasting a drop of 5% for 2010.

So basically, in this climate, with unemployment rising, and wages falling, and an economy contracting at nearly 20% a year, it isn't hard to understand why not that much new bank lending is going on. Those who are creditworthy are trying hard to save, while those who need to borrow normally aren't that creditworthy, so Dombrovskis' plea is rather like asking the bank to subsidise new bad debts, and that is really not something you can do, and especially not when you are going along the course you are following because you wanted to, and against one hell of a lot of external advice. What kicked the whole process off was a short sharp credit crunch, but now it is the contraction in the real economy which is following its own dynamic, till someone finds a way to put a stop to it. It is the drop in output that is preventing banks from lending, and not banks being unwilling to lend that is causing the contraction to continue.

But there is another point in the FT article which should give food for thought.

Mr Dombrovskis...ruled out devaluation of the lat. While breaking the currency’s fixed exchange rate with the euro would help Latvia’s exporters, it would increase the burden of euro-denominated loans, which account for 85 per cent of lending, he said.

“We would not see much benefit from devaluation because we are a very small and open economy which means that any competitiveness gains we may get would be very short-lived,” he said. “We would redistribute wealth from pretty much all the population to a few exporters.”

Well, we haven't advanced too far in all these months, now have we, if we are still wheeling out the argument that "external" devaluation will hit holders of euro denominated loans, since it should be generally recognised that the (very painful) internal devaluation which is now taking place is hitting Euro loan and Lati loan holders alike. And the argument is a strange one to use just shortly after the statistics office announced that due to the rapid reduction in the number of those employed and to the fact that many of them changed their working conditions from full-time to part-time, the number of hours worked in the 3rd quarter of 2009 fell by an annual 27.3%, while labour costs fell during the same time period by 30.1%. This fall in disposable income, and the continuing prolongation thereof, poses a far greater threat to the continuity of Latvian loan payments than the 15% reduction in the value of the Lat as compared to the Euro which the IMF proposed in the autum of last year would have done. Indeed, it is, in and of itself, one of the pernicious consequences of having resigned yourself to an "L" shape non-recovery. Stress on the banking system only goes up and up, as incomes and employment fall, and the government has less and less ammunition left to counteract the contractionary pressure.

It is like sitting it out in freezing weather at the North Pole, in the vain hope that help will arrive. But help will not arrive, and the cruel truth about the post-crisis shock world we live in, is that nobody is coming to help you if you will not help yourself. In this sense, what Latvia doesn't need is more international borrowing (hasn't there been enough of that already) but some kind of meaningful strategy to start paying back the debt. But this means putting people back to work, and selling abroad, and financing Latvian lending from Latvian savings, and not pleading for yet more capital inflows to finance non-productive activities (attracting investment would be another matter, but as things stand right now the environment is far from "appetising", and according to the latest data from the Statistics Office, non-financial investment in Latvia was only 402.8 mln lats in the third quarter, a fall of 39% on the 3rd quarter of 2008).

And just to be clear, what we have seen to date is not a 30% drop in unit labour costs (which would, of course, mean a great boost to competitiveness), rather it is a drop in earnings due to the fact that the output people could have produced just isn't needed, since no one is willing and able to buy it. In fact according to the data of the Statistics Office to hourly labour costs fell by only 3.9% in the 3rd quarter when compared with the same period a year earlier. Hardly a massive drop, and especially not when the large annual increases of ealier quarters are taken into account (see chart below). The internal devaluation has a long course still to run!

Pensions Dilemma

But Latvia is back in the news today for more reasons, since the constitutional court has just ruled against the government pension cuts, drawing a question mark over Latvia's ability to meet the terms of its international lending commitments.

"The decision to cut pensions violated the individual's right to social security and the principle of the rule of law," the court said in its judgement, which cannot be appealed. The pension cuts - in place since July - formed a vital part of the Latvian government's list of austerity measures, as it struggles comply with terms of the IMF-lead bailout, and the constitutional inability to implement them is another hammer blow against the credibility of the current Latvian administration.

According to the Baltic Course, Valdis Dombrovskis told Latvian State Radio that the Constitutional Court's ruling on pensions must be carried out, and not debated. I am sure this will really come as music to the ears of people in Brussels and Washington. Basically pension reform forms a key part of the mid term strategy for sustainability of Latvian finances, and without the ability of the Latvian government to carry these out, then frankly the coherence of the whole strategy falls apart. If the Latvian constitution does not permit pension changes, then the Latvian constitution has to be changed, and the only surprising thing is that all this wasn't forseen when the initial loan negotiations took place in late 2008. Basically, it is impossible for the EU Commission and the IMF to accept any other view, since if any state could ring fence a whole part of social provision before entering debt negotiations, then non of the structural reform programmes could possibly work. This may seem harsh, but it is the price you have to pay for becoming insolvent as a society. Latvia's problems are NOT short term liquidity ones, but problems of the sustainability of an entire economic and demographic model, and, as in the case of Greece, these problems will not be solved by two or three years of (rather painful) fiscal deficit cosmetics. Real changes need to be made, and especially in raising the long term growth potential of the country, and frankly it is these changes which we have yet to see evidence for.

The issue is not simply one of limping into the Euro in 2012, even if as Mark Griffiths, the IMF’s mission head in Latvia, said in Riga last week the Latvian government does face a lot of “hard work” in trimming the budget deficit enough to qualify for euro adoption, and how much more so if they cannot constitutionally implement the cuts they agree to.

“The key is meeting the deficit targets, and meeting the Maastricht criteria and euro adoption, that’s the path,” Griffiths said. “The government needs to work hard over the next year to find the measures which will deliver that adjustment to meet those targets. It’s going to be a challenging task.”
Oh yes, and Latvia was also in the news yesterday for another reason, since Latvian stocks dropped the most among equity markets worldwide as small investors sold stocks before the government starts to tax investment gains. The OMX Riga Index fell as much as 4.3 percent to 271.55, its lowest intraday level since August 21. In dollar terms, the drop was the biggest among 90 benchmark indexes tracked by Bloomberg. The reason for the sell off was that Latvia’s 2010 budget includes measures which will impose taxes on dividends, gains from trading stocks and bonds and interest income. These measures were agreed to in order to ensure the continued transfer of the 7.5 billion-euro bailout from the European Commission and the International Monetary Fund.

Latvian investors have increasingly sold their holdings ahead of the Dec. 31 deadline. Dividends and interest income will be taxed at 10 percent, while tax on gains from trading stocks and bonds will be 15 percent.

As Unemployment Climbs, Latvians Start To Pack Their Bags

Finally one that wasn't in the news, but should have been, since while everyone knows that at 20.3% Latvia's unemployment is the highest in the European Union (see chart below), what they don't know is that more Latvian's than even are now being forced to leave their country in search of work.

According to a report by Oļegs Krasnopjorovs, economist with the Bank of Latvia, during the first half of 2009 8,300 Latvian residents left for Great Britain, a twofold increase over the year earlier period. 3,600 people emigrated to crisis-ridden Ireland in the first 11 months of 2009 - 3% more year-on-year. Among the new EU member states, Latvia has seen the sharpest increase in emigration to these two countries.

According to Krasnopjorovs, the data (which comes from the UK and Irish social security systems) confirm the trend identified by the Latvian Statistics Office, who examined data on long-term migration. In the first ten months of 2009, the number of long-term emigrants was 6,300, up 18% more year-on-year; moreover the steepest rise took place in the last few months, reaching a ten-year peak. For several years now the number of emigrants has exceeded that of immigrants in Latvia, with the exception of the second half of 2007 when a sharp rise in salaries and a steep drop in unemployment were fuelled by the credit and construction boom, leading to labour force shortages and the expectation that incomes would rise even further.

Exports Still The Key

The real problem here, of course, is that the Latvian economy remains mired in deep recession, and shows few signs of real recovery, something which is not surprising given that domestic consumption is in limbo land (where it is likely to stay), while the Prime Minister seems to attach little priority to boosting exports, and regaining competitiveness. Indeed, the contraction has rather gathered than lost momentum in recent months, and on a seasonally adjusted basis Latvian GDP fell another 4% between the second and third quarters of 2009. This was much faster than the 0.2% contraction between Q1 and Q2.

Year on year Latvian GDP fell by 19.0% in the third quarter.The decrease was largely due to a 28.7% drop in external trade (share in GDP 15.6%), a 18.2% one in transport and communications (12.5% GDP share), an 17.4% fall in manufacturing (10.2% GDP share, incredible) and by a 36% drop in construction (7.5% GDP share, not far below manufacturing).

Private final consumption fell by 28.1%. Government final consumption decreased by 12.4%, while expenditure on gross capital formation fell 39.4%. Goods exports (68.2% of total exports) fell by 11.7% and services exports by 20.5%. Goods imports (82.1 % of total imports) were down much more sharply - by 36.6% -and services imports by 29.1%. Which meant net trade was positive, otherwise the fall in GDP would have been greater, and nearer to the levels seen in domestic demand.

And entering the fourth quarter there were few signs of any real improvement. Retail sales fell in October by 1.3% from September (on a seasonally adjusted, constant price basis).

As compared to October 2008 sales were down by 29.1%. The drop was even larger in the non-food product group – 32.3%. According to Eurostat data, sales are now down nearly 35% from their April 2008 peak.

Industrial output, however, seems to be holding up a little better, and output has stabilised since the spring. The problem is that manufacturing industry is now such a small share in GDP that it will be hard to pull the entire economy on the basis of anything other than very strong rates of increase. Industrial production was up in October by 0.1% over September, marginal, but at least it wasn't a fall. Unfortunately most of the increase was in the energy sector, with electricity and gas up by 10.3%, mining and quarrying contracted, by 2.1% as did manufacturing, by 1.9%.

Compared to October 2008 industrial output was down by 13.5%, Output in manufacturing fell by 15.8%, in mining and quarrying by 11%, while in electricity and gas output was only down by 2%. Output is now down around 21% since the February 2008 peak.

There is one positive glimmer on the Latvian horizon at the present time, and that is, of course, exports which were up by more than 4.4% (or 31.7 mln lats) when compared with September.

As a result, the surplus in the current account of Latvia's balance of payments reached 10.1% of gross domestic product (or LVL 327.9 million) in the third quarter. The surplus is however rather smaller than in the second quarter, which was 14.2% of GDP.

With export growth exceeding that of imports, the combined goods and services balance was positive for the second consecutive quarter, standing at 0.3% of GDP (or LVL 11.2 million). This effect is more due to services than to goods exports, since the goods trade balance is still in deficit (see chart), so there is still a long road to travel.

The largest third quarter capital inflows registered under the capital and financial account were the result of government borrowing from the IMF-lead support programme. There was some new foreign direct investment in Latvian companies to the amount of LVL 370.2 million, which to some extent offset direct investment outflows. Net external debt shrank by LVL 0.5 billion in nominal terms, but due to the fall in GDP (as I explained earlier) the ratio of net external debt to GDP posted only a tiny drop, reaching 56.4%, and gross external debt to GDP (excluding foreign assets) was up, reaching 145.8%.

So, as I say, a start has been made, even if there is still a long, long road to travel. Internal devaluation is the chosen path of the Latvian people, the best thing I can suggest at this point is to get it moving in earnest (in fact there is some evidence from November producer prices that the rate of price fall is now accelerating), and that Latvia's leaders start to value what they have (that is, export potential) instead of dreaming of what they can no longer have (dynamic domestic consumption driving growth). Living in the past is never a good idea, not even in the sentimental moments of Yuletide. A Merry Xmas to you all!

Friday, December 4, 2009

Russia's Economy Slows In November

As doubts grow that in the post Dubai world Russia's central bank will be able to sustain a great deal of momentum in its ongoing programme of interest rate reductions, we learn this week that the pace of expansion in Russia's economy slowed back in November, following two months of steady advance in September and October. This time services activity also weakened its advance while manufacturing activity registered its second month of contraction. Yet the central bank may well show increasing restraint in lowering interest rates, even as the economy slows, the ruble rises, and bank retail lending continues to fall, having declined for nine consecutive months up to and including October, while corporate lending dropped for a second month in a row and hasn’t risen for six months (for more on the particular topic see my recent post - Are Russia's Consumers Getting "Carried Away" With Themselves?).

While the seasonally adjusted VTB Capital Total Activity Index remained in positive territory for the fourth month running in November, the latest figure of 52.8 indicated the weakest rate of growth in three months.

The VTB Capital Monthly GDP Indicator, based on the PMI surveys for both the manufacturing and service sectors, continued to show an annual economic contraction in November, even if the the rate of decline eased for yet another month. At an annual minus 2.5%, down from a revised minus 4.0% in October, the indicator stood at its highest level since December 2008. Over the third quarter as a whole, the GDP Indicator suggested that the economy contracted by a revised 8.7% year-on-year, a better outcome than the record 9.9% fall posted during Q2. Data for the first two months of the final quarter show an average contraction of 3.3%.

By contrast the quarter-on-quarter rate slipped back to a bare 0.2%, treacherously close to the dividing line between contraction and expansion.

The outcome is not surprising when we take into account that November saw an overall deterioration in business conditions in Russian manufacturing for the second month running. Output rose only marginally, while incoming new orders fell for the first time since June. Growth of purchasing activity was maintained, but at a slow pace, while employment continued to fall. Thus the headline seasonally-adjusted Russian Manufacturing PMI remained below the no-change mark of 50.0 for the second month running, and although the November figure of 49.1 indicated only a marginal rate of deterioration, it was still slightly worse one than the 49.6 posted in October. The fall in the PMI primarily reflected slower output growth and falling new orders.

Business conditions in the Russian service sector, on the other hand, continued to improve during the month, albeit at a weaker pace than previously. The easing primarily reflected slower rates of growth in business activity and new business, which both remained well below pre-crisis levels. Meanwhile, inflationary pressures remained subdued, with input prices rising at a relatively weak rate and charges falling slightly for the second month running.

The headline seasonally adjusted Russian Services PMI came in at 53.3, down on the 54.3 registered in October, and well below the historic average of 56.9, highlighting the fragility of the Russian recovery. Restricted credit continued to be a theme in this months survey responses, although sector data pointed to a stronger rise in financial intermediation activity. The rate at which incoming new business increased slowed during the month and contributed to additional spare capacity at service providers and a faster decline in outstanding business. Backlogs of work have contracted every month since September 2008, and the latest rate of decline was at the most rapid rate since July.