Facebook Economics

Edward Hugh has a lively and enjoyable Facebook community where he publishes frequent breaking news economics links and short updates. If you would like to receive these updates on a regular basis and join the debate please invite Edward as a friend by clicking the Facebook link at the top of the right sidebar.

Wednesday, July 14, 2010

Biting The Fiscal Bullet In Poland

There is a good deal of speculation in the press at the moment over the tricky issue of whether or not Poland will be able to comply with its agreed deficit-reduction deadline on the basis of the latest budget proposals announced by the government there. Personally, I tend to agree with those analysts who feel the spending and revenue assumptions being made by the Polish government are rather unrealistic, and that they will this be unable to comply with the terms of the Excess Deficit Procedure as laid down for them by the European Commission: difficult territory this in the "post Greek crisis" world, but it would not be the end of the world were the slippage to be justified. Unfortunately, as I will argue below, I don't think it is justified, indeed I think it is just the opposite of what sound economic management principles would prescribe in the Polish case, and seems to respond more to the impact of impending political pressures than to the precepts of good policymaking. So I do agree with the consensus here in feeling that Poland needs to do a lot more to reign in the deficit (which means unfortunately spending cuts, since I think raising taxes which will crimp growth and raise inflation is most undesirable at this point), although my reasons for arguing this are actually rather rather different from those that are normally advanced.

One Fiscal Size Fits All?

The facts of the matter are, more or less, as follows: the European Commission has given Poland until 2012 to meet its deficit limit of 3 percent of gross domestic product, after Poland’s shortfall swelled to 7.1 percent of GDP last year as the impact of the global economic crisis depleted government revenue and increased expenditure costs. Next year’s budget assumes something like 3.5% GDP growth and 2.3% inflation, with nominal wage growth rising by 3.7% employment increase by 1.9%.

The EU Commission expect the deficit to only narrow to 7 percent of GDP next year following a 7.3 percent budget gap in 2010. But given that Poland's debt to GDP level is only around 50% of GDP, and that Poland is one of the few large EU countries to still have dynamic internal consumption, you might want to argue that stimulus should be maintained, if only to help Poland's export dependent neighbours.

I want to argue that this view is basically wrong, and that far from needing more in the way of stimulus, what Poland needs to do is contain an overdramatic expansion of credit based domestic demand, an expansion which, if unchecked, could very easily lead to the sort of structural distortions and competitiveness loss we have just observed in the South of Europe and Ireland.

Poland Largely Escaped The Great Recession

But first, lets step back a bit and see what the problem is.

Poland, as most observers note, escaped the worst of the 2009 great recession.

Poland was basically able to endure without too much bloodletting for three principal reasons.

In the first place the level of household indebtedness is still not excessively high. In the second place Poland had maintained a floating exchange rate which meant that it could let the zloty rise during the heady days of 2008, and then allow the currency to devalue when the crisis hit. An thirdly, the level of Forex lending never rose as high in Poland as it did in some of its East European neighbours, which meant that when the time came to devalue there was not such a threat of increasing the Non Performing Loan rate. As can be seen in the chart, it was starting to take off when the credit crunch came along and (fortuitously) stopped it dead in its tracks.

Interestingly enough then, it has been the very fact of not having gone for early Euro adoption that left the Polish monetary authorities with the flexibility needed to respond to the crisis in an appropriate manner. As the IMF put it in their latest Article IV staff report:

"Staff does not support early euro adoption. While this should remain an important goal, entering ERM2 any time soon would not be advisable in view of the uncertain global outlook and the rigidities in the macroeconomic policy mix discussed above. More importantly, the crisis has underscored the importance of being able to use the exchange rate to facilitate adjustment to external shocks. In staff’s view, the swift change in the real exchange rate was one of the key reasons for Poland’s not falling into recession in 2009".

Indeed, the very rapid way that using currency flexibility to resore competitivenes helped should be evident from the Real Effective Exchange Rate chart below:

As can be seen in the run in to the crisis Poland had been losing competitiveness with Germany, following a well known and well trodden path. But in 2009 the country was able to recover much of the lost ground, simply at the push of a (trader's) button - and the currency is now trading at something like 18% below its pre-crisis peak in real effective terms. This remedy is, unfortunately, no longer available to the likes of Spain, Greece, Portugal and Ireland. Even more interestingly, Poland has been able to carry through the devaluation process without provoking a very strong inflation spike.

Of course, there was another factor in Poland's ability to not fall from grace, the fiscal stimulus package. As the IMF put it:

Fiscal policy is providing significant counter-cyclical stimulus. There was a discretionary fiscal relaxation estimated at 1¾ percent of GDP in 2008 and 2½ percent of GDP in 2009, mainly due to tax cuts enacted in 2007 but coming into effect with a delay. While the government initially intended to offset revenue shortfalls to the extent needed to maintain the state budget deficit below the limit of Zloty 18 billion in 2009—through what would have been highly pro-cyclical expenditure cuts—it appropriately changed such plans at mid-year, when it raised the limit to Zloty 27 billion. As a result, the general government deficit increased from under 2 percent of GDP in 2007 to over 7 percent of GDP in 2009. The strong counter-cyclical stimulus provided by fiscal policy—through a combination of discretionary relaxation and the work of automatic stabilizers—was a major reason for Poland’s not falling into recession during the global crisis.

And it is, of course, the issue of just how to withdraw this fiscal stimulus that is the main topic of debate. Unlike many of its regional neighbours, the Polish economy is now in the process of returning to reasonable levels of growth. The levels will surely not be those (possibly unsustainable) ones seen before the crisis, but rates in the order of 3% for 2010 & 2011 do not seem unreasonable.

Monetary Policy In Times Of The Great Immoderation

The problem is, as the output gap gradually closes, the central bank will increasingly have to think how to formulate a response to the inflationary presures which will inevitably follow in the wake. Evidently, in a era of globalised capital flows, conducting monetary policy is not as simple as it used to be, since simply raising interest rates may prove to be counterproductive, and investors look to get the benefit of the increased yield margin on offer.

In fact, the IMF draw exactly the opposite conclusion, namely that if upward pressures on the zloty persist (see chart below), and inflation remains contained, then they argue that the policy rate should be cut. That is they prioritize (correctly in my view) competitiveness issues over the conduct of orthodox monetary policy.

The recovery in global risk appetite, not least in the demand for assets of countries that have weathered the crisis well, suggest that foreign demand for Polish assets could continue to build, resulting in further zloty appreciation. In that case, staff believes that the MPC should revert to an easing bias and cut the policy rate.

In fact with the central banks policy rate at 3.5% there is room for some easing, and room for increased carry too, if the rate stays were it is as risk appetite grows.

The Fiscal Arm Is The Only Effective One

And this is where the real argument for turning the fiscal screw comes in, not in order to simply comply with the EU's 60% gross debt rule (Poland's government debt to GDP is currently around 50%), but rather because in the absence of applying monetary tightening to contain excesses and avoid (further distortions) the government really do need to drain excess demand from the economy by resorting to fiscal policy.

As I have said, the Polish economy is now showing signs of a renewed burst of growth. Industrial output is up sharply (it is now more competitive with imports, among other things):

While retail sales are also strong

And credit growth has once more taken off again:

If this were to remain modest, then it would be a good sign, but continued growth, and monetary loosening, would surely run the risk of seeing the acceleration go too far. And as if to warn us, construction activity has just seen a strong lurch upwards:

Faced with the danger of all of this getting out of hand the authorities can basically do two things. They can tighten loan conditions for the banking sector, by making the deposits required greater (or the Loan to Value ratios lower), and the income criteria stricter, and starting to move people over from variable to fixed interest mortgage rates on the one hand, and by implementing stricter fiscal measures on the other. Some say this will be difficult for Poland in a pre-election period, but are Polish voters really that unaware of what has been happening in other EU countries in recent years that they would willingly go for a bit of extra consumption now at the price of being another Spain five years on down the road?

Once More Those Structural Economic Distortions

Despite, all that improvement in competitiveness Poland is still running a trade deficit:

And it has been running a current account one for more years than anyone cares to remember.

Maybe the deficit has not been large by prior regional standards, but who really wants to go where others have gone before. And with each new deficit the level of external indebtedness simply grows, and is now reaching the 60% of GDP mark. By no means critical yet, but surely it would be more interesting to turn south before it does go critical. And in any event, the presence of the external debt makes the Polish economy unduly dependent on external financial flows, a point highlighted recently when the IMF announced an agreement to renew the country's US$20.43 billion flexible credit line.

Poland is one of the few large EU countries (alongside France) where domestic demand is (for the time being at least) all but dead and buried. Some of the reasons for this are historic ones, some are just quirks of fate (the crunch came before Forex lending got out of hand) and some are demographic. Curiously Poland, like France, is rather younger than many of its regional neighbours.

So for all these, and as they say many other reasons, I think the Polish authorities would do well to think again, and produce a revised set of budgetary projections for the years to come. If not, someone somewhere will one day ask them: "why didn't you see it coming".

Thursday, July 8, 2010

Croatia: On The Brink of What?

As Croatia enters the final stage of its EU membership talks, it is perhaps a fitting moment to review the other half of the picture, namely where the Croatian economy finds itself, and what the outlook might be for a continuing convergence with the requirements of Euro membership. Understandably, EU officials are fairly cautious about the likely shape and progress of the forthcoming talks (the Union has, after all got rather a lot on its plate at the moment), but Croatian Prime Minister Jadranka Kosor is decidedly more optimistic, since while she recognises that this last phase is likely to be "really difficult and demanding" she still believes that negotiations could be concluded by the end of the year, which would mean that membership in 2012 would become a possibility.

Whatever view you take on the likely progress of the talks, one topic on which it is hard to be optimistic in the short term is outlook for the Croation economy. Despite the fact that the country may not have too many difficulties complying with the original Maastricht Euro membership conditions, the newfound interest among those responsible for EuroGroup decisions for sustainability and longer term competitiveness mean that a country whose economy has as many structural distortions in it as Croatia’s does may well find a growing number of new obstacles thrown across its path.

Reeling Under The Shock

Unsurprisingly, the global economic and financial crisis have taken a significant toll on the Croatian economy. Given the background of a large current account deficit, a high level of external debt, and significant balance sheet exposures to interest and exchange rate risks, the pressure from reduced capital inflows was always going to cause problems, and it did: financial asset prices collapsed, sovereign spreads shot up, and the Zagreb stock market plunged.

As a result of the combined impact of the difficult external conditions which prevailed and the ending of the domestic credit boom Croatia’s GDP fell by some 5.8% in 2009, following a number of years of strong (if not sustainable) growth. Even though in the first three months of this year there were been some tentative signs of recovery the economy was still down by 2.5% on an annual basis.

Personal consumption fell by 4.1%, which was not surprising given that new credit has all but dried up, but more worryingly the drop in fixed capital investment accelerated to an annual 13.9% during the three month period. Government consumption fell for the third consecutive quarter and was down by 1.1%, and the only positive point was the net trade impact, since the export of goods and services rose by 3.6% (following five consecutive quarters of decline) goods and services imports fell by 4.8%.

Exports The Only Realistic Way To Pay Down The Debt

Given the high level of external indebtedness of the Croatian economy (net external debt is currently running at around 95% of GDP) and the sensitivity of the financial markets to fiscal deficits, there is likely to be little in the way of a revival in domestic demand, depending as it does on the availability of credit.

Which leaves exports to pull the cart. But this is where the high level of euroisation of the economy becomes a problem since obtaining export growth after many years where the country has run a substantial trade deficit is hardly going to be easy.

In fact financial euroization even increased during the crisis, and at the end of 2009 about 70 percent of the total bank credit and over 65 percent of bank deposits were either denominated in or indexed to foreign currency. As the IMF note in their latest report price and cost indicators suggest that competitiveness has been deteriorating in recent years and Croatia’s real effective exchange rate is surely overvalued. Yet all those Euro denominated loans make it very difficult for the authorities to contemplate outright devaluation of the kuna, while the prospect of having to manage an internal wage and price correction is hardly an attractive one, as we can see in the Latvian and other cases.

Croatia’s unit labor costs have risen significantly faster than those of its principal trading partners in recent years, due largely to the fact that wages in the private sector were pushed up by rapid wage growth in the public sector. As a result, the overall wage level is high relative to Croatia’s productivity following non-competitive wage setting in a public sector which employs around a quarter of the labor force, not counting public enterprises.

As the IMF note, rigidities in the Croatian economy are substantial, with strong labor regulations constraining labor market flexibility, resulting in high employment in the gray economy, a proliferation of temporary work contracts, both of which reduced employers’ incentives to expand employment during the boom years. The impact of the grey economy is clearly reflected in the disparity between the official unemployment rate (of around 19%) and the EU harmonised one accepted by Eurostat (which shows unemployment to be nearer 10%).

And Then There's Population Ageing To Worry About

Another factor to be taken into account is the rapid ageing of the Croatian population, following many years of very low fertility, and a steady increase of life expectancy. Croatia’s working age (16-65) population peaked in the early 1990s, and is now in long term decline, while the old age dependency ratio is set to rise and rise. Indeed about a quarter of Croatian population are now retired, a fact which also reflects the presence of relatively generous pension and social benefits conditions, benefits which were available during the years of increasing borrowing, but which are surely now hardly sustainable as the time comes to pay back some of the accumulated debt.

Looking ahead to the remainder of 2010 the contraction will most likely continue. The IMF forecast in April a miniscule 0.1% growth, but since that time optimism for the global expansion has waned, and in particular demand from many of Croatia’s trading partners is likely to be more muted than anticipated. Investment is unlikely to recover its earlier momentum, burdened as it is by an indebted private sector and a public sector looking to make cut-backs. Private consumption will also remain under the influence of the contraction in consumer credit. While exports should remain supportive, with imports continuing to remain low given the weak domestic demand, goods trade exports may not be as strong as some expect given the weaknesses in the European recovery, while tourism may well be affected by the high levels of unemployment which still exist in many of the relevant countries. Rising fiscal concerns will only add to the slowdown of the EU recovery (given the negative demand impact of the harsher fiscal policies) so a contraction of between 1% and 1.5% in 2010 does not seem unlikely.

In addition Croatia remains vulnerable to contagion risks from adverse market sentiment in the region. This contagion could take the form of tightening financial constraint such as a rise in borrowing costs, or a reduction in cross-border flows. On the other hand the absence of Greek banks in Croatia and the limited real sector linkages with Greece should minimize the risks of direct spillovers from that quarter. The real threat would come from a more generalised crisis across the EU’s Southern and Eastern periphery.

On The Brink Of What?

So, after living for many years on borrowed money and borrowed time, running a significant current account deficit and accumulating a large external debt, Croatians are now likely to be faced with the harsh reality of living in a rapidly ageing society at a time when external competiveness has been severely undermined.

In the short term the economy may have stabilised, but in the longer term the challenges are immense, and should not be underestimated. Like many economies across Eastern Europe, Croatia is going to have to straighten out the structural distortions and pay down its external debt at just the time the oncosts of societal ageing are going to start to bite deep.

In addition a rigid labour market and an overweight public sector pose serious problems for the transition to a dynamic and competitive economy. Many changes are needed, and most Croations are only all too well aware of this fact. But one factor which doesn’t seem to get the attention it deserves is the continuing threat to long term economic stability posed by having such a low (tfr 1.4 – or only two thirds of replacement) birth rate.

To make matters even worse, the wage differential with Croatia's West European neighbours means it is an attractive proposition for many young people to go abroad to work, and while the remittances all those migrant workers send back may be very welcome back home - especially given the difficulties Croatian industry has in selling abroad - a country with fertility well below the replacement rate should not be exporting labour to pay down a current account deficit. The way to settle the debts is to provide work in export industries so people will stay at home, and contribute to the maintenance of the health and pension systems.

Like most societies in Eastern and Southern Europe the Croatia needs to address this other imbalance, and it needs to start to do so soon, since the clock is ticking, and it won’t stop doing so. At this key moment in the country’s history it is hardly difficult to recognise that Croatia is effectively on the brink of something, but whether that something is going to be long term sustainability rather than something that it is better not to think about, well, the answer to that question can only be given by the Croatians themselves.