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Friday, August 27, 2010

Estonia's Long Awaited Recovery May Still Be Delayed Yet Awhile

In a recent FT Op-ed, entitled "Estonia’s recovery defies economists and academics", columnist John Dizard argued that "the “internal devaluation” policy, which means cuts in nominal costs such as wages and rents, was very hard on the population, but appears to have worked ahead of even the Estonian government’s schedule".

But as I said to John in a very enjoyable phone conversation I had with him before he wrote the piece (where he was kind enough to descibe me as a "freelance economist", one who doesn't have to answer to a boss before expressing an opinion), perhaps we should just hold on a minute before jumping to too many conclusions, since things are still far from clear. So let's take a look.

As John points out, many macro economists, among them me myself (here, and here, and here) and Paul Krugman (here) have been arguing that if the Baltic countries stick to their policy of having a fixed exchange rate with the euro, they face a long period of low growth and serious internal deflation. At the start of this debate, I pointed out that the impact of price deflation on the bank loan books would be just the same with or without devaluation: not so, said Krugman (and he was right), the impact is worse, since even the Kroon or Lati denominated loans (which in truth are quite few) are affected.

John however, does not agree, since, he tells us, the country is "stubbornly failing to comply with the predictions of what are called the 'third generation models' for currency crises" and "is already seeing a resumption of growth and a fall in its real cost of capital".

Well, as I told John at the time, the Estonian case is a complex one, since in a country with only just over a million people a myriad of special case factors can be at work, confounding results. But still, the idea is abroad that Estonia is a kind of "black swan", a data point which tends to suggest that conventional macro economic wisdom is somehow flawed. So just how valid is this view. Let's take a look at some data.

In the first place, John is undoubtedly right, economic activity has revived (slightly) in Estonia. In Q2 2010 the economy grew by a seasonally adjusted 2%, following an equivalent contraction in Q1 and growth of 2.6% in Q4 2010 (yes these are quarterly, not annual, numbers).

So the first thing to say is that if these numbers are truly well adjusted seasonally (which make be hard given the boom bust background, and the amplitude of the movement in the data) what we have is a lot of volatility out there. And in the second place, we could well ask ourselves to what extent it is valid to use that so-oft maligned expression "recovery" at this point in the Estonian context. If we look at the GDP volume index (which I have put in 4 quarter moving average format), you have to look very hard indeed (go on, squint a bit more) to actually see the uptick.

I tell you what, I'll do you all a favour, and shorten the time series and change the scale.

Well, that's a bit clearer, isn't it. I think what you can say looking at this chart is that the Estonian economy has been stabilised (no mean feat that, with an economy in freefall), but what happens next, well that, it seems to me, you can't discern from looking at the chart. To decide on that, I think, you will probably need to go back to the initial assessment you had of the problem. If, like John, you believed that what the Estonians were trying was doable, then you will probably draw the conclusion that what comes next will (eventually) be a recovery. If, like me, you had severe doubts from the outset that this was doable, then you will probably imagine the Estonians are now in for a long period of slow, "L shaped" semi-recovery, with a lot of pain still to come, further down the road. But as I say, all of these expectations probably depend on your initial theoretical assumptions (more on this later), and in that sense nothing has fundamentally changed.

That being said, there are some things that have improved in recent months. Retail sales for example.

And then there is industrial output, which is up sharply. It even almost looks like the fist leg of one of those proverbial "Vs".

And part of the reason for this improvement in output has been the recent improvement in demand for Estonian exports.

But before we get too excited about all this, we should remember that Estonia still has a goods trade deficit. That is, on balance, the net goods trade is a drag on GDP.

The problem is that the part of Estonian industry which was internationally competitive before the bust still is, but that this part is not large enough to drive the whole economy, now that the economy is export dependent. It just doesn't have a big enough share in GDP to carry the whole economy. As the Estonian statistics office put it: "GDP growth in the 2nd quarter was supported by the industrial sector exports. Due to a small domestic demand, the sales of manufacturing production on the domestic market were in downtrend. In construction, the output of which is mainly targeted at the domestic market, the generated value added showed a continuous decreasing trend".

This is what I had always expected would be the case.

It should be noted that Estonia runs a substantial services surplus, which at the present time easily cancels out the goods trade deficit. As a result, and this IS the good news, Estonia now runs a current account surplus. Which means that each month now, instead of getting more into debt, the country is steadily paying down its international liabilities. And this is important, since as John points out, Estonia is considerably less indebted externally than many other of Europe's peripheral economies, with net external debt according to IMF data only being some 30% of GDP.

But nonetheless, achieving this positive situation still has a price, and that price is that the economy is being forced to operate at well below capacity level, and the clearest indication of this is the very high continuing level of unemployment. In fact, I think John got interested in his story when he read this report, that the registered unemployment rate in Estonia fell to 12% in mid-July. Since he was aware that first quarter unemployment was somewhere around 19%, this seemed to him like a dramatic drop. But there is a confusion here, since we are dealing with two different measures of unemployment, one of them people who sign at labour exchanges to register as unemployed (and may do so because they have entitlement to unemployment benefit), and those assumed to be really unemployed when measured using ILO compatible (and EU harmonised) quarterly labour force surveys, and as this article points out, according to the latest of these surveys (April - June) there were still 128,000 unemployed, or 18.6 percent of the workforce out of work in June.

Of course, interpreting such data presents its own problems, and the issue is a complicated one, since in the first place there seems to be a large shadow economy in Estonia. According to Professor Friedrich Schneider of Austria's Linz University, based on a study that covered 37 countries, Estonia had the second largest proportion of GDP in the informal economy, with some 40% not paying tax. Top of the list was Latvia, with shadow economy accounting for 42% of the country's GDP, then came Estonia, Bulgaria, Turkey and Greece. So of course, not all those who are not signing the registers are necessarily unemployed, or in the country even, but still people are dropping out of the statistical system, according to the Estonian Health Insurance Fund some 20,000 less people are registered for health cover today than there were in March 2008. At the very least we can assume these people are not working in the formal economy or registering for welfare benefits. Whether they are working in the informal one, or working abroad, we really have no idea.

Be that as it may, according to the Estonian Statistics Office, in the 2nd quarter of 2010 the estimated number of unemployed in Estonia was 128,000 and the unemployment rate was a - seasonally not adjusted - 18.6%. So unemployment did decrease in the quarter for the first time in nearly two years, but by 1.2% (from 19.8% in Q1), and not by the rather large amount it might appear from the labour exchange registration data.

And if you go to the details of the stats office report the situation is more complex than it seems at first sight, since while the number of new unemployed has been declining, long-term unemployment continues to grow. In the 2nd quarter, 58,000 unemployed persons had been looking for a job for one year or more (long-term unemployed), of whom 19,000 had been looking for a job for two years or more (very long-term unemployed). The share of long-term unemployed among total unemployed increased to 46%, while the share of very long-term unemployed rose to 15%. The number of persons who had stopped seeking a job or discouraged persons was also larger in the 2nd quarter than in the 1st (9,000 and 7,000 respectively).

On the other hand the estimated number of employed persons was 559,000, which was up by 5,000 (0.9%) over the previous quarter. According to the statistics office, "employment increased due to seasonal and other temporary jobs typical of the 2nd quarter". Nonetheless there was employment growth, so we should be thankful for any mercy, however small. What remains to be seen is whether this improvement in employment is sustainable as Europe's economies slow going into the second half of the year.

A further bone of contention between the parties evidently concerns the so-called “internal devaluation” policy being applied by the Estonian government. As John Dizzard explains such a policy "means cuts in nominal costs such as wages and rents, (and) was very hard on the population, but appears to have worked ahead of even the Estonian government’s schedule".

When we come to scrutinise the actual data however, the fall in hourly wages has hardly been dramatic, and they have now fallen about 7% from their peak at the end of 2008. But it should be remembered in 2008 they were up by around 7%, so they are now at about the same level as they were in January 2008, following increases of 17.5% in 2006 and 20% in 2007 - rates of increase which ultimately lead to the consumption bust which followed them, and clearly not sustainable in the longer term. So, unfortunately it is just not the case that Estonia has had a very harsh policy of wage cost reduction implemented. Living standards have fallen sharply, due to the reduced hours worked, and the rapid rise in unemployment - ie due to the recession - but that is not the same thing at all as recovering lost competitiveness.

The Real Effective Exchange Rate data on all this is very clear. Up to 2005 the rise in living standards was more or less in line with sustainable economic growth. From 2006 onwards things really got out of hand, and to date only a very small part of the competitiveness loss has been clawed back.

This intrepretation is confirmed by an inspection of the CPI data, which after 9 months of registering mild interannual deflation is now back in positive territory, and more or less a full percentage point above the Eurozone average, which for a country which is supposed to be in the throes of a substantial "internal devaluation" is pretty incredible, and could be seen as another example of someone or other falling asleep at the wheel, after passing the finishing line for Eurozone membership perhaps.

John Dizzard argues that the Estonians are in position for a relatively rapid recovery (this part I don't see at all, anywhere in the data) because they started out with much less state and private debt than the others. This latter point is certainly true, but we should not miss the fact that while Estonia's state debt is very, very small, private sector debt (at around 100% of GDP, between households and corporates) is not so small, and indeed will continue to exert a significant downward pressure on credit growth for some time to come.

Now one of the points raised by John which does have a certain validity is that of lower capital costs. Given the existence of significant quantities of land and warehouse and factory accommodation which are now surplus to requirement due to the "downsizing" which has been going on (creative destruction) employers do now have access to cheaper premisses, and this can offer them lower unit costs for a given level of technology and output. The key point to get here is where the demand is going to come from, and then we are still back with the same issue: exports.

More than the internal devaluation itself, Estonia is benefitting from the decision to grant the country Euro membership. As a result the cost of servicing oustanding debt has falling, as have credit default swap spreads. John quotes one large shareholder in several Estonian companies as saying, “At the beginning of 2009, the banks were offering our companies loans at 600 to 700 basis points above six-month euribor [the euro base rate]. That’s if the money was available at all; most of the time they were cutting lines. Now the banks are offering the same companies increased lines at 100 to 300 basis points over euribor.”

But if we come to look at the impact of this cheap credit, we will see that, as in other economies where private demand is highly leveraged (the UK, the US, Spain), the uptake on all this ultra cheap credit has not exactly been massive. In both cases the interannual rates of credit growth are still negative, which is one of the key reasons domestic demand remains so weak.

Although we can see the first timid signs of recovery in the housing market, both in terms of sales volume and in terms of prices, but at this point they are just this, timid signs.

So to go back to where we started, and John Dizzard's claim that "Estonia’s recovery defies economists and academics", I would say that rather than economists and academics (or even academic economists) who Estonia's current situation does really defy is the group of people over at the ECB governing council headed by Jürgen Stark, since, as I reported back in April, consensus thinking at the ECB was that Estonia was not coming into the common currency , due to ongoing concerns about sustainability and competitiveness issues.

But that was April, and then came May, when the ECB was forced to do a "U turn" by the crushing pressure of the European Sovereign Debt Crisis, so all these (valid in my view) concerns where simply brushed aside. And anyway, how could anyone argue for keeping Estonia out on these grounds, when you have countries like Spain and Portugal on the inside. Either internal devaluation works, or....

So maybe it was better for them to stay with the line that internal devaluation works, and whether they are right or not is what we are all about to get to see. As I said at that start the post, in this case as in so many others, beauty is in the eye of the beholder. If you believe in the neo classical (academic) theory of "steady state" growth - and the guy over at Swedbank that John cites who is forecasting that Estonian gross domestic product will grow at a 4.5 per cent rate next year evidently does - then naturally Estonia's economy has only been temporarily knocked off its path by this whole unfortnate incident, and will soon be back in it habitual orbit.

If, however, like me you suspect that neo-classical steady state growth is some sort of metaphysical hocus pocus (or what they call a "necessary assumption to get the argument going") with little empirical support, then you will not be terribly convinced by all those numbers blindly and slavishly churned out by the current generation of models, and will look more to the facts on the ground. In particular, when we come to the neo classical growth theories which normally underpin the sort of optimistic analyses we see of the Estonia situation (yes John, there are academic economists on both sides), I tend to think these are flawed due to some initial erroneous assumtions Solow himself made about the impact of population dynamics on growth (see this extended argument here), and I think it is important to remember here that Estonia, along with Hungary, Latvia and Bulgaria, is one of the countries on Europe's Eastern flank where population as well as ageing is actually falling. So I suggest you treat any analysis which talks about a steady recovery in internal demand but does not explicitly explain how this point has been taken into account....... well I suggest you treat it with more than a pinch of salt.

And then, of course, there is the idea of "export dependence" and ageing, and what this all means for the future trajectory of the Estonian economy. This argument, which Claus Vistesen and I have been advancing for some years now (and is one of the reasons so many of those famous "predictions" turn out to be valid), shot to the financial headlines recently when Dominic Wilson and Swarnali Ahmed of Goldman Sachs drew the obvious to everyone's attention - namely that balance of payments current accounts are significantly driven by life cycle savings. Maybe you can argue about the validity of the age group classifiaction they use (an empirical calibration issue), but the obvious is obvious: the relative proportions of different age groups across different countries goes a long way to explaining the pattern of global savings and capital flows. And as Claus Vistesen illustrated in the chart below, this helps us understand how societies (Germany, Japan...) become increasingly export dependent as they age.

So, as I said earlier, your expectations about the future outlook for the Estonian economy will largely depend on the initial theoretical assumptions you make at the outset. If you assume that neo classical steady state growth really exists, and that all this stuff about ageing, capital flows and export dependence is exaggerated, then you will see the recovery coming in the here and now, and if you don't.........

Saturday, August 21, 2010

The Shape of Bulgarian Things to Come

As the IMF say in their most recent staff report on the country, the aftermath of the recent severe economic crisis leaves us with the question as to whether potential output growth in Bulgaria in the years to come is going to be markedly lower than it was during the boom years. As the IMF point out, the current recession was preceded by an investment boom in construction, real estate and the associated financial sectors. Now that the boom (which was always unsustainable, Bulgaria's current account deficit in 2007 hit almost 27% of GDP) is well and truly over in these sectors, the strong associated decline in investment could have large negative effects on output. Moreover, it will take considerable time before the excess labor and resources that are no longer needed in these sectors can be absorbed by other sectors, which suggests that the rate of unemployment may rise yet further and remain higher for some considerable time. Not a uniquely Bulgarian story, but none the less important for that.

Following several years of strong increases (around 6% a year) Bulgarian growth declined sharply in 2009 when the economy was hit hard by credit squeeze which formed part of the global economic and financial crisis.

Capital inflows, which had been keeping the current account deficit afloat, dropped from a peak of 44 percent of GDP in 2007 to less than 10 percent of GDP in 2009. As a result, investment, which had risen by over 20 percent annually during the previous two years, fell by nearly 30%. And as the investment flows dried up, the Current Account deficit closed rapidly, as imports (and domestic consumption) dropped back sharply.

Employment also started to fall, while the unemployment rate rose rapidly, hitting a seasonally adjusted 9% in March and April this year, according to Eurostat seasonally adjusted data.

The question the IMF ask, about whether Bulgaria will be able to return to the high growth rates of 2001–08 is no idle one, since with a shrinking and ageing population, and an external debt which stands at around 110% of GDP, sustainability in the medium term means finding a level of growth which can enable to country to pay down its debt and support its pension and health systems.

And this will be no easy task, given that the early strong revenue flows from domestic consumption (VAT) have now fallen sharply and are unlikely to rebound as the country becomes increasingly export dependent for growth, and exports don't have VAT attached. Again, this isn't only a Bulgarian problem, but it is there as an issue.

Recent changes in pension system parameters and contribution rates have also put significant pressure on Bulgaria's pension finances. During the years 2003 to 2007 total revenue surged by about 51 percent and Bulgaria experienced the strongest rise in its revenue-to-GDP ratio among the new EU member states (about 4½ percent of GDP).

This sudden increase in income encouraged the Bulgarian authorities to offset part of the additional revenue by lowering social security contributions. Rates were cut by 6 percentage points from 2002 to 2007 (for the pension and unemployment funds) and there was a further 2.4 percentage points reduction in 2009.

As a result budget financing of the pension system has risen sharply during the recession. Before 2008 budget transfers to close the financing gap of the pension fund had averaged about 3 percent of GDP. This increased to about 5 percent of GDP in 2009 and for 2010 the budget anticipates a transfer of more than 6 percent of GDP. And if there is not a sharp rebound in domestic consumption (which in all probability there won't be) these shortfalls become structural, not cyclical, and solutions will need to be found.

Hoisted On Your Own Peg

Apart from the obvious demographic impediments the country faces, there are other reasons to think that getting back to moderate sustainable growth may be more difficult that it initially appears. In the first place, Bulgaria operates a currency peg with the euro, yet during the boom years the country had very high inflation rates.

As a result a sharp loss in competitiveness occured, a loss which, as the IMF point out, was not accompanied by any substantial corresponding productivity gain.

The other evident consequence of this loss of competitiveness was that the country developed a trade deficit, a deficit which though it has reduced following the collapse of imports still exists. In order to return to sustainable (export lead) growth, this deficit needs to become a surplus.

Growth during the boom years was driven by large capital inflows that fueled strong growth in the non-tradable sector. As future capital inflows are likely to remain at a level well below that of the boom years, with growth in the non-tradable sector remaining weak at best, future growth will only be rebound if the tradable sector takes over as an engine of growth. And with lower investment, the robust employment growth the country saw during the years 2001–08 will be difficult to reproduce. Much of the strong employment growth was driven by strong growth in the non-tradable sector. Total employment rose by 20 percent during this period, and three quarters of this came from the construction, real estate, wholesales and financial service sectors.

So the country (like so many others in the East and South of Europe) must now make a major shift from non-tradeables to tradeables, and this in the context of a currency peg (and a significant level of external indebtedness) is not going to be an easy task.

Signs of Recovery?

Bulgaria does not publish seasonally adjusted quarter-on-quarter growth numbers, but given that the economy only shrank by 1.5% year-on-year (according to the flash estimate published by the statistics office on August 13), which was the lowest figure recorded since the country entered a recession in the first quarter of 2009 (and down from an annual drop of 5.9% in Q4 2009), the economy does at least seem to have stabilised.

As for the details agriculture contributed to the improvement, with an increase of 1.6 per cent year-on-year, while the services and industrial sectors only declined by 1.7 per cent and 0.3 per cent, respectively. Private consumption, which was one of the main drivers of economic growth in earlier years, was down an annual 7.6 per cent for the quarter, while investment was 1.4 per cent lower. So there has been no real improvement in private consumption, nor should we expect to see any in the near term.

Retail sales seem set on a long steady downward path (similar to that seen in other countries in the region with declining populations) and again, this is unlikely to turn around in any sustained way.

Domestic demand is likely to remain flat to downwards for some considerable time, as the numbers for household and corporate borrowing (which are not moving upwards at all) tend to confirm.

Despite an increase in exports (up 11.4% on the year) and continued decline of imports (down 1.2%), the trade gap for the second quarter was expected to be 4.2 per cent of GDP.

Long Term Growth Trend Headed Way Down

As the IMF stress, potential growth in Bulgaria is surely set to decline further in the longer term, since as I keep saying Bulgaria faces a serious ageing population problem. The median age is now through the critical 40 barrier, and headed on up towards the 45 range, in a country where male life expectancy is some 10 years below the West European average.

Bulgaria's population has been falling for a decade now, and is projected to decline by a further 28 percent between 2008 and 2060, while the old age dependency ratio would exceed 60 percent in 2060.

This population drop is already affecting the working age population, which is already in decline, and is forecast to fall by an additional 25 percent over the next 50 years.

As a result, the EU 2009–12 Convergence Programme is forecasting a steady decline in potential growth to an annual 0.3 percent in 2050, and this meagre growth is only obtained by assuming a - totally unrealistic (in what will then be such an old population) - labour participation rate of 70 percent. Personally, I think these numbers are way, way to optimistic, and all of this is badly in need of a current calibration based on what is already happening in ageing societies like Germany and Japan. Bulgaria's sustainable growth rate doesn't start to get affected in 2050, it is already on its way down now.

And Bulgaria has another handicap: the large number of Bulgarians who now live and work abroad. The worrying thing is that we don't know how many such workers there are, since the migration data from Bulgarian statistics hardly acknowledges they exist (same situation in Latvia, see this study), using the argument that only those who officially inform them they are emigrating count as migrants.

So how do we know they exist? We know they exist because these migrants send home remitances, and the World Bank attempts to track them. According to World Bank data (and my calculations), migrants sent home remittances to the order of an estimated 5.3% of GDP in 2009. Not small beer this at all. And we also know from the national data of resident foreigners in other countries that large numbers of Bulgarians habitually live and work away from their homeland. According to the Spanish INE, there were some 170,000 Bulgarians registered as living in Spain on 1 January 2010, and the Italian Statistics Office (ISTAT) report 41,000 Bulgarians resident in Italy in 2008.

But what, you may ask is a country with rising external debt (the IMF is assuming the CA deficit continues to 2015, at least)and falling and ageing population doing exporting its workforce? A good question. And why is no one seemingly concerned about this issue? Another good question. And why are neither the EU Commission and the IMF raising the problem in their respective studies of the country. Oh, there are no shortage of questions here.

So, Bulgaria as a country is certainly not short of problems. What with the evident demographic ones, and the limitations of the currency peg, it is hard to see how they are easily soluable. To put it bluntly, Bulgarian industry only accounts for some 18% of GDP (in value added terms). If we assume as a rule of thumb that about 50% is geared to the domestic market, then this means that Bulgarian GDP is going to have to leverage itself forward through growth in about 10% of its output, while other sections shrink. A difficult, if not impossible task.

And there are more problems. As the IMF point out, Bulgaria's fiscal situation is challenging, since the earlier revenue boom has come to an end, while expenditure pressures are considerable. The pre-crisis revenue boom, was fuelled by higher receipts on goods and services on the back of Bulgaria's rapid domestic demand growth, but returning to pre-crisis revenue levels will be a major challenge, not only because the economy is expected to recover slowly but also because the growth pattern will need to shift, with less contribution from domestic demand and more contribution from the external sector, which will result in lower tax revenues. Put simply, since Bulgaria's treasury is stongly dependent on VAT, and exports evidently don't attract VAT, the situation becomes even more difficult.

Of course, in the short term the government debt to GDP ratio is pretty low (15% only in 2009), but any faltering in the peg at some point, and that could change quickly. So the risks are there, and difficult spending decisions will have to be taken, since, as the IMF point out "Sustaining the built-up public buffers is important because private sector vulnerabilities remain considerable. Private sector external debt stood at 102.7 percent of GDP at end-2009, while gross foreign currency debt of the non-financial private sector amounts to 80 percent of GDP". Put another way, Bulgaria doesn't have a public debt problem, but it does have a private debt problem. And neither of the options which faces the country is very appetising: sustaining the peg would seem to condemn the country to years of deflation and low growth, while letting it go would expose the public balance sheet to all the problems which have been accumulated in the private sector in recent years. They are caught, as we say here in Spain, between "la espada y la pared".