Merry Xmas and A Happy New Year

Well, a Merry Xmas and a Happy New Year to all my readers. Thank you for taking the time and trouble to pass-by. This blog will now - failing major and surprising new developments in the global economy - be offline till the end of the first week in January, or till after the festival of Los Reyes Magos in Spain (for those of you who know what this is all about). Come to think of it, maybe this is just what our ever hopeful central bankers are in need of even as I write - some surprise presents from the three wise men - but I fear that this year if these worthy gentlemen do somehow show at the next G7 meet, the star in the east which draws them will not be the one described in the traditional texts, but in all likelihood the rising star of India.



Credit crunch, did someone use the expression credit crunch?

Latvia Population 2007

Well here's a nice chart I culled from Latvijas statistika.



Basically the central point they make is that even despite a small increase in births this year, the negative population momentum is now so strong that it is very hard to arrest the drift. Blow I reproduce a part of their argument, my own brief look at Latvian demography can be found here.

The data of Central Statistical Bureau show that in 2007 the positive trend in the creation of new families is continuing and the number of newborns is increasing. However, due to the number of deaths exceeding births, as well as due to emigration from Latvia, mainly to other European Union countries, the number of population continues to decrease. At the end of the year it will be approximately 2 million 270 thousand, or less by 11.6 thousand persons than at the beginning of the year.

Statistical data characterizing demographic situation in 10 months of this year and their estimation for November and December allows to forecast that this year the number of born children will be more by 1150 children than in previous year 2006, or more by 2 thousand compared to 2005. The number of newborns might be 23.4 thousand. With the increase of the number of births, the relative birth indicator (births per 1000 population) will also increase, and it could be 10.3 (in 2006- 9.7).

The number of deaths in 2007 will be approximately 33 thousand or the same as a year before. However, taking into account that the number of population decreases, the relative death indicator (deaths per 1000 population) will slightly increase, and will make up approximately 14.54 (in 2006- 14.47).

As the total of deaths exceeds the number of births, in the result the number of population in 2007 will decrease by 9.7 thousand persons compared to 10.8 thousand persons in 2006.

Latvia Trade Balance September 2007

Compared to August 2007, the value of Latvian exports increased in September 2007 by 0.3% or 1 mln lats, but when compared with September 2006 they increased by 16.2 % or 46.9 mln lats, reaching a total of 336.7 mln lats, according to data from Latvijas Statistika.

The value of imports in September 2007 was 1.3% or 8.4 mln lats lower than in August 2007, and 8.5% or 49.7 mln lats higher than September 2006, reaching a total of 633.3 mln lats.

The total foreign trade turnover in September 2007 was 11.1% or 96.7 mln lats higher than in the corresponding period of the previous year and its value was 970.0 mln lats.

As can be seen in the chart, many of the lines in Latvia are down at the moment, including the trade deficit one, which is basically still as bad as it ever was.




The small positive change we can observe in the second chart is that the rate of increase in imports has slowed down dramatically since July basically (on the back of the slowdown in domestic demand growth presumably), while the rate of growth in exports is now no longer slowing, and we can see a small increase in the pace.

Latvia Inflation November 2007

Latvia's inflation continued climbing in November, reaching an annual rate of 13.7 percent, the country's statistics office announced today. It is the sixth month in a row that the consumer price index has risen in Latvia, which now has the highest inflation in the 27-member European Union.



Monthly inflation in November was 1.4 percent, led by food prices, which increased 3.4 percent, Latvian Statistics said. Bread prices alone soared 16.3 percent over the month. The result is another blow for the outgoing government, which in March passed a series of anti-inflation measures to curb bank lending and speculation on the real estate market. The four-party ruling coalition resigned on Wednesday after having lost its credibility over the sacking of a popular anti-corruption chief in October.

The coalition, however, still maintains a majority in the 100-seat parliament and will likely form the next government. Outgoing Prime Minister Aigars Kalvitis said the next head of government would have to tackle economic issues immediately as Latvia's economy continues to face macroeconomic imbalances. I agree. Immediately!

Latvia Retail Sales October 2007

Compared to September, in October of this year retail trade turnover in Latvia fell by 1.1% on a seasonally adjusted basis, according to data from the Latvian Central Statistical Bureau. Compared to October 2006, the turnover grew by 9.1% (data adjusted for the number of working days). So retail sales are slowing in Latvia, and fast. I have prepared a chart comparing the situation in Latvia with that in Estonia.




The slowdown in sales is much more rapid in Latvia, and on a rule of thumb reckoning - take a look at the chart and estimate for yourself - I guess in two or three months we will be looking at zero year on year growth and then contraction. So Latvia is now about to transit from the "Baltic Syndrome" to the Hungarian one.

And to help us see how we might get there, here is the next chart, the industrial producer prices one. As we can see, the rate of increase in producer prices has now peaked, and we are on the way down, but the decline is not rapid as it is in the case of retail sales.



Inflation has really wormed its way into the system, and it may well prove recalcitrant to being flushed out, again as we have seen in the Hungarian case. But there is one big difference with Hungary, and this can be seen in the next chart.




Waht we can see above is that Hungary is achieving, via an efficiency drive and substantial real wage deflation, a real reduction in export prices. Latvia has now peaked on this front, and the prices are coming down (while Estonia is still to correct really). Looking at the chart, I would say Latvia is about where Hungary was around 10 months ago. So this is likely to be a lengthy process, and remember that Hungary is still on a downard trail as far as GDP growth goes, with under 1% GDP growth this year, and my guess is a little less next year. And in Hungary they still have to decide what to do about the currency issue, and all those Swiss Franc mortgages people have. Since this is all going to become such an important problem, and since there is always safety in numbers, I think the governments of Latvia, Estonia and Lithuania should get together with the Hungarian one (and possibly Bulgaria and Romania) and have a high level meeting in Brussels to start to sort out the details of the inevitable bail out. I mean, how much of the "hit" are the Scandinavian, Austrian and Italian banks who are into this up to their eyes (and certainly over their heads) going to stand, and who else is going to come up to the plate and put money in when the inevitable correction on the book value of these debts comes. Call this the European Mega Conduit.

Latvia Industrial Output October 2007

Compared to September 2007, industrial output in October 2007 decreased by 1.7%, according to seasonally adjusted data from the Latvian the Central Statistical Bureau. Manufacturing fell by 2.1%, while electricity, gas and water supply fell by 0.9%. On the other hand in mining and quarrying output increased by 3.7%.


When compared with October 2006, in October 2007 total seasonally adjusted industrial production output fell by 1.6%. Output in manufacturing decreased by 6.7%, while in electricity, gas and water supply there was an increase of 15.4%, and output in mining and quarrying increased by 17.3%. I think the following chart makes the trend reasonably clear.




And then is we trun to the data for manufacturing only, well, here's your slowdown, or at least one part of it, clear for the eye to see I would say:

Latvia Q3 2007 GDP

First off I would like to say that hello to all my blogging friends in Latvia. To Lavian Abroad, to Sam at FotoLat, to Aleks at All About Latvia and to Peteris at Marginalia. Despite all rumours to the contrary, I have not given up on the Baltics. Far from it. But I have been busy trying to improve my understanding of the problems, in part by looking at Romania, and even more to the point at Russia. If Mother Russia catches the Baltic illness, then we will all be in trouble, oh deary me! I have also been peering and peering into what is happening in Hungary, to try and see if anything can be learnt from finding out why Hungary is so different from the rest of the EU10, as well as what the correction in Hungary can tell us about what might happen next in the Baltics. The only definitive conclusion I can offer you is that addressing the domestic demand issue without takling the currency value question raises the danger of making any correction a very protracted and painful affair, and even then the problem may not be solved. So there are clear, and to the point, arguments for ripping off the band-aid in one foul stroke.

I have also been posting extensively about Estonia over the weekend on my Baltic Economy Watch blog, and many of the points I make there are pretty valid in the Latvian context, even if the pace and level of things differs from one country to another. Today I am looking at GDP, insutrial output and retails sales (to follow), but tomorrow promises to be an interesting day, since we shall have inflation data and foreign trade data.

Well, turning now to GDP, and as Latvian Abroad notes in a recent post, the Latvian Economy is slowing lost of signs of slowing. You can see it in the latest GDP numbers, for example.




As we can see, the high point was reached in Q1 2006, and since that time ever so surely and ever so steadily the Latvian enconomy has been slowing down. Compared to the corresponding period of previous year, in the 3rd quarter of this year Latvian GDP increased by 10.9%, according to data released by Latvijas Statistika last Friday. Interestingly one of the parts of the economy which has slowed most is manufacturing indutry, which actually decreased by 0.3% y-o-y in Q3, and mining and quarrying only managed a measly 2.4%. Construction managed a 13.2% y-o-y growth, but this is undeoubtedly due to large base effects earlier in the year, and the execution of previously signed contracts - as we are noting in the US, you need to wait nearly a year to see the full effects of a slowdown in requests for new buildings to execute.

Unfortunately Latvijas Statistika do not have the Q3 breakdon in their database yet, and they only give annualised data in the press release, when what is most interesting at this point are the quarter on quater changes. Still they do produce this reasonably informative chart about movements in some of the key expenditure components over the last year, and some things are reasonably clear (please click over image for better viewing).



As is obvious, final household demand peaked in the 4th quarter of 2006, and is now falling steadily. It is not clear when (ot whether) this component will ever recover to the extent of being able to drive growth, since we get into age related elements (which I know not many people agree with me on at this stage, but still) as Latvia's median age is climbing steadily, and calibrating all of this for Eastern Europe's comparatively low male life expectancy (ie calibrating how domestic constumption loses its relative strength as median age rises, in the way we have seen in Germany, Japan and Italy) is something noone has done at this point to my knowledge. In fact most people you talk to don't imagine that this is important, but then most of them didn't imagine that Hungary would fall into the hole it is currently falling into.



Now as we can see, these two countries (Latvia and Hungary) are pretty similar in the evolution of the relative population median ages. And if we come to male life expectancy, here is a comparison of Hungary, Latvia and Germany.



As we can see, male life expectancy is considerably lower in both Hungary and Latvia, than it is in Germany, and this must have consequences for economic behaviour and performance. Increasing the working life to 67 and beyond as they have in Germany is just not the same proposition at all in a lower life expectancy society like the other two, nor is the issue of getting employment participation rates among the over 60s comparable given the evident health problems of one part of the population.

So while we would not normally expect domestic consumption to run out of steam until the median age reaches 41/42 (this is the sort of lesson we can garner from Germany, Italy and Japan) there may be good reasons for imagining that this median age needs rounding down somewhat in the Latvian and Hungarian contexts. I will certainly stick my head out and say that this property boom, like the 1992 one in Japan, and the 1995 one in Germany is very likely to be the last of its kind we will see in Latvia, high median age societies just don't work like this. They do not ride on the backs of credit driven booms, and I would have thought that the reasons why would be obvious.

Catch Up Growth and Demographics - Evidence from Eastern Europe

by Claus Vistesen: Copenhagen


Performing a simple series of adept Googling exercises around various sources on the internet you can easily discover that certain species of the lynx are able to travel at speeds of up to 50 kph (31 mph). Wikipedia informs us that the Eurasian lynx, on average, commands a hunting area of between 20-60 square kilometers in which the lynx is able to walk and run about 20 kilometers in one single night. All in all, a pretty rugged and constitutional little thing this lynx.

In this way, and perhaps because, at that particular point in time, the Eastern European Economies looked as if nothing could come in their way of economic prosperity and growth they were paired, by the Economist, with the region's sturdy feline coining the notion of 'Lynx Economies.' Thus, 'that particular point in time' was sometime back in the spring of 2006 where the Economist's (and my own) coverage of the CEE and Baltic economies came in hot on the heels of publications by the World Bank and and the Vienna Institute of Comparative Economic Studies speaking favorably of the future prospects of economic prosperity and thus 'catch-up' growth in the CEE and Baltic Economics.

Yet, merely 1 year and a tad later things seem to have changed quite significantly with respect to the discourse on the economic situation in Eastern Europe. Many of the contributors to this blog has been pitching on the change in discourse but also some of major institutional actors have been flagging the red banner. Not least the World Bank seems to have changed their attitude somewhat with most notably a recent report on the demographics of Eastern Europe entitled From Red to Gray - The Third Transition of Ageing Populations in Eastern Europe and the former Soviet Union as well as a recent writ with specific focus on the macroeconomic risks prevailing in the region. Yet, also the IMF in their latest World Economic Outlook devotes a chapter to the managing of large capital inflows where Eastern European economies also take center stage of the general tone of warning; in essence this note of warning concerning Eastern Europe seems to be the general talk of the day amongst economic analysts and journalists. As such, perhaps even the lynxes roaming the forests and planes of Eastern Europe are beginning to feel that the otherwise catchy notion conjured by journalists at the Economist is becoming something of a stretch according to the reality of the situation. Sure, things are moving fast now but it is what happens next which might finally serve to make the allegory rather unrealistic. In this entry I set out to explicitly investigate an issue which in fact has been treated several times on this blog and perhaps most often in the context of the CEE and Baltic Economies. Simply put and in the form of one simple question;

• How do changing demographics and more specifically the final and ongoing stages of the demographic transition affect the notion and principle of economic catch up growth and thus economic convergence as it is stipulated by (neo-classical) economic growth theory?

As I have hinted above in the introduction my main subject of analysis on which the general theoretical argument is based is the current and ongoing situation in the CEE and Baltic economies. A lot has been written about this recently not least from the hands of the contributors to this blog (see also above). As a one-stop overview of the concrete issues at hand this recent note by Edward over at Global.Economy.Matters should provide you with suitable ammunition to get you started. In particular, the following three point overview of the current economic situation in Eastern Europe should always be in the back of your mind as we move forward from this point ...

Basically the principal outstanding issues confronting the EU10 countries are threefold:

• Labour capacity constraints (which are normally a by product of long-term low fertility and large scale recent migration flows) are producing significant wage inflation and strong overheating.

• A structural dependence on external financing - which is in part a by-product of the effect of low levels of internal saving, and which is another factor which separates the EU 10 from those like India or China who are benefiting from a typical demographic dividend driven catch up, is leading to large current account deficits, and potentially high levels of financial instability.

• A loss of control over domestic monetary policy due to eurozone convergence processes which - with or without the presence of formal pegs - make gradual downward adjustment in currency values as a alternative to strong wage deflation virtually impossible. This issue is compounded by the likely private "balance sheet consequences" of any sustained downward movement in the domestic currency given the widespread use of mortgages which are not denominated in the local currency.

Traditionally a rigorous economic analysis in the light of the immediate events would focus a lot on point 2 and 3 but in this note we shall look specifically at number 1 and the issues of labour capacity, its constraints, and what it means of the economic growth of less to medium developed countries. Now, the most obvious caveat in this entry is that I really don't have the time at this point to really lay out the whole theoretical framework of economic growth theory and as such the precise slot in which my argument should be inserted within the wider theoretical framework. This will be the topic of a more rigorous article not suited for the blog format. However, I still need to attach some comments to set the scene where I should also immediately note that my previous note here at DM about catch up growth in Eastern Europe serves as a good state of the game post for what comes next.

Apart from my studies of selected pieces of the economic growth literature one of the best overviews of the concept of economic convergence as a function of the theoretical and practical assumptions vested in the growth models is to be found in an article by Norbert Fiess and Marco Fugazza on economic integration in Europe (PDF). As such it is important to note that convergence of GDP per capita levels is not a holy grail within the fields of economic growth theory. Rather, the process of convergence should be seen as an inbuilt consequence of the fact that as economies mature returns to production inputs decrease; that is to say that this discussion essentially revolves around the concept of increasing v. decreasing returns to scale in our economic model. If we think about decreasing returns to scale and introduce the concept of marginal productivity to production inputs we can then see that less developed countries are likely to exhibit higher rates of growth than their more mature counterparts in the sense that their marginal productivity is higher which then leads to a process of convergence. Now, this argument in its most strict sense is usually applied in the context of capital as a production input and coupled with the properties of an open economy and subsequent free flow of production factors this would lead to a rather rapid process of convergence or absolute convergence as the technical term. As regards to labour as a production input is has also been argued that the universal transition from an agricultural to manufacturing over to service (?) based economy produces a mechanism of convergence in the sense that this process implies a move up the value chain and thus that every unit of labour becomes more productive. Of course and even though we are talking about stylised facts here, this is also where the whole debacle begins in the context of my immediate argument because how certain is this process? Also, we need to take into account the distinction between stocks and flows (of labour) which is a crucial issue to consider when talking about ageing economies.

However and it does not take much of an economist to see that empirical facts do not support the idea of absolute convergence or at least it seems as if the process takes much longer to materialize than predicted by the theory. This has lead, among other factors, to a 'new' strand of economic growth models which allows for persistent growth divergence to exist between countries. The crucial aspect to understand here is the mechanism through which persistent divergences can occur. In this way, one of the widest contributions by economist to this thesis has dealt with the possibility that technological processes and thus accumulation of technological advances exhibits increasing returns to scale. The fundamental brilliancy of this notion is that it allows for a model where there is indeed decreasing returns to labour and capital but where different levels of technological effort leads to internal positive feedback mechanisms and thus explains persistent divergences in growth and 'prosperity' across countries.

Ok, I think that I have already said enough at this point and in order to get us back to track one crucial assumption and conceptual idea needs to be pinned down. As such and if we look at the rudimentary description of the economic growth process above it is not wholly unreasonable to argue that the growth process of an economy is somewhat directly related to the process of the demographic transition. Or as Robert Lucas puts it in a widely cited article ...

That is, the industrial revolution is invariably associated with the reduction in fertility known as the demographic transition.

As such, why don't we take a look at Eastern Europe where the economies have experienced, quite as expected by the conventional theory of economic growth, economic dynamics tantamount to catch-up or convergence. Especially the economic data since the expansion from EU15 to EU25/27 and, for some countries, the subsequent anchoring to the Euro has been very impressive indeed. Yet as Edward and I have been at pains (see link above) to explain again and again these countries are not your average emerging markets. This follows from the fact that their demographic structures have been fundamentally distorted due to a collapse of fertility in the beginning of the 1990s which has been aggravated by a persistent net outflow of migrants serving to further speed up the decline in the working and essentially also most productive cohorts. In order to capture this development and in order to frame the current situation the following point I made in a previous note is worthwhile to repeat.

In short, we are dealing with countries where the demographic transition by far, and indeed worryingly, has out paced the traditional economic process of economic convergence.

This is exactly what we are talking about here and apart from going to the heart of the imminent issues in Eastern Europe it also strikes right smack into the concept of economic growth theory and how to deal with the fact that the demographic transition does not occur the way it was originally anticipated. Most emphatically, we can see in the context of the Eastern European countries that the final stages of the transition have arrived far before and quicker than the twists and turns of history allowed for these economies to really get on with business. Yet, the general argument can just as easily be expanded into a discussion of the ageing part of OECD where it is painfully clear at this point that conventional economic theories are wholly incapable of explaining what is likely to happen next. In fact, we could stretch it so far as to say that modern economic growth theory is not able to explain what happens when fertility drops to a level below replacement level and stays there!

In Summary

Even though that a lot words have been written in this entry I am afraid that only superficial contributions have been made to the final answer of the proposed question. This entry principally had one main task, namely to initiate a line of reasoning which ultimately and hopefully can lead to a better understanding of modern economic growth processes in a context of the current demographic profile of many developed and developing economies. Specifically, this entry revolved around the concept of catch-up growth/convergence where the countries in Eastern Europe were suggested as an example to demonstrate how demographics can fundamentally alter the principles by which the economic growth process is likely to conform. In this way, the message is not that modern economic growth theory and growth accounting methods are rendered obsolete in the face of changing demographics but rather that considerable adjustment needs to be made; especially in the context of catch up growth/convergence but also crucially in the context of the notion of a steady state of economic growth. Returning briefly to the real world before we sign off it could seem as if the branding of the lynx economies never was more than a quick and essentially expensive make-up which is set to quickly wear off as we venture on. Specifically, recent signs coming out of the ECB and the European commission suggest that expectations are aligning towards an outlook where the process of convergence effectively risks grinding to a halt. My advice would then be not to exchange the carrot too swiftly into a stick since this would only serve to kick those who are already on the ground.

Latvia Construction Costs 3rd quarter 2007

Well there isn't that much evidence of a slow-down in the inflationary spiral in this latest release from Latvijas Statistika.

Year on year construction costs in Latvia in the 3rd quarter of 2007 rose on average by 23.8%, according to the Central Statistical Bureau. The most rapid rise (by 40.4%) could be seen in the labour remuneration of workers. The maintenance and operational costs of machinery and equipment increased by 34.4% and the prices of construction materials rose by 10.1%.

The most notable increases in construction costs were in the renovation of office buildings, in the reconstruction and construction of education, healthcare and sports buildings (by 31.6% and 31.5%, respectively). Costs in the construction of residential buildings increased by 24.8%, in the construction of transport facilities - by 21.9%, in the construction of underground main pipelines - by 19.4%, in the reconstruction and construction of industrial, agricultural and trade buildings - by 19.1%.

Compared to the 2nd quarter, in the 3rd quarter construction costs on average increased by 3.7%. The maintenance and operational costs of machinery and equipment increased by 7.0%, the labour remuneration of workers – by 6.0% and the prices of construction materials – by 0.9%. The most notable increases in construction costs were in the construction of underground main pipelines – by 4.9%, in the renovation of office buildings – by 4.7%, in the reconstruction and construction of education, healthcare and sports buildings - by 4.0%. Costs in the construction of residential buildings increased by 3.7%, in the construction of transport facilities - by 3.4%, as well as in the reconstruction and construction of industrial, agricultural and trade buildings - by 3.0%.

So in the 3rd quarter wages of construction workers were still increasing at an annual rate of 24%. This is slowing but it is still very, very large.

Translation Risk in the Baltics and other matters on Eastern Europe

by Claus Vistesen

cross-posted from Alpha Sources

Work is piling on my desk at the moment and I fear that events might even overtake my efforts to keep up with them but here is to trying. Basically and if this was not clear back in the beginning of September it should now be readily clear everybody that Baltic and CEE economies now need serious watching and attention. As my regular readers will know I have been slowly and steadily chipping away together with my colleague Edward Hugh. My own catalogue of posts on the subject can be found here and you might also want to check the following three blogs; Baltic Economy Watch, Eastern Europe Economy Watch and Latvia Economy Watch. Also, the group blog Global.Economy.Matters has been the venue lately of some very interesting posts on the issue at hand. In fact, Edward's recent entry over at GEM offers an excellent introdution to the issues in Eastern Europe as they have been dealt with and indeed described regularly in the past months here at this blog. As such and in order not to repeat myself, I reproduce a key quote by Edward below which sums up the current situation quite well and also allows me to get down to business in this post ...

Basically the principal outstanding issues confronting the EU10 countries are threefold:

1/. Labour capacity constraints (which are normally a by product of long-term low fertility and large scale recent migration flows) are producing significant wage inflation and strong overheating.

2/. A structural dependence on external financing - which is in part a by-product of the effect of low levels of internal saving, and which is another factor which separates the EU 10 from those like India or China who are benefiting from a typical demographic dividend driven catch up, is leading to large current account deficits, and potentially high levels of financial instability.

3/. A loss of control over domestic monetary policy due to eurozone convergence processes which - with or without the presence of formal pegs - make gradual downward adjustment in currency values as a alternative to strong wage deflation virtually impossible. This issue is compounded by the likely private "balance sheet consequences" of any sustained downward movement in the domestic currency given the widespread use of mortgages which are not denominated in the local currency.

Now the worrying part about all three of these is that they are not simply cyclical in character. As such they are not problems which will "self correct" as a result of a recessionary slowdown, whether this be of the "soft-" or "hard-landing" variety.

And business, as it were, in this post is basically an extension of the analysis I did a couple of weeks ago regarding the balance sheet exposure of (primarily) Lithuanian households towards a potential rattling of the pegs to the Euro carried by a currency board. To put it more directly, this post will deal with aspects of the topic at hand which ties up to point 2 and 3 above.

In order to frame the discussion a bit before we move into the data I want to emphasize that the risk of a rapid currency unwind somewhere in Eastern Europe is most emphatically not some kind of odd suggestion. The risk is very real indeed! You just need to take a brief look at what has happened the past weeks to see how things are now set in motion towards what seems to be an inevitable loosening of the tight strings attached between the Eurozone and the pegging and also floating currencies in Eastern Europe. Exhibit one is found in two recent publications from the World Bank and the IMF in which specifically Eastern Europe is singled out as a cluster of countries where the economic development as epitomized by the three points above have put these economies in a situation where not only the general macroeconomic environment is in risk of taking a serious blow. However, this is also a situation where the process of convergence with the Eurozone countries as well as of course the final carrot of Eurozone membership have become events subject to eternal postponement for the majority of the countries in the region. Now, this raises obvious questions surrounding political reactions and while I can understand the overall political and economic dynamics which are now set in motion I also need to emphasize why these countries should not be handed the stick at this point since this would not help at all. Yet, this is an issue for another post. What I am really getting at here, and this would be exhibit two, is quite simply the fact that people which in this case mean policy makers and opinion makers at the ECB as well as of course investors seem to be positioning themselves for a collapse of the de-facto fixed exchange rate regime which ties together the Eurozone and most of the CEE and Baltic economies. A notable example of this would then be Danske Bank's Lars Christensen who is also shadowing the unfolding events in Eastern Europe and who recently suggested in a note that the ECB might be growing rather un fond of the close ties to the economies in Eastern Europe with respect to the fixed exchange rate relationships.

The increasing and clear signs of overheating in a number of Central and Eastern European countries – especially the Baltic States and South East Europe – are drawing attention not only from the financial markets, but also from international institutions. Recently the IMF has warned of the dangers of overheating in the CEE and the World Bank has on numerous occasions raised the same concerns. Now the ECB is also stepping up the rhetoric. At a conference earlier this week ECB officials expressed their concern about the in-creasing imbalances in the Central and Eastern European economies.

Now, some of my readers with a special interest in ECB affairs will recognize that Christensen is a keen ECB watcher by his mentioning of a recent conference on Eastern Europe which indeed produced some rather spectacular contributions related to the economic situation in Eastern Europe. The most cited speech from this conference is consequently one held by Lorenzo Bini Smaghi who is a member of the executive board about the risks which pertain to the process of convergence in Eastern Europe. Of course, mentions of the currency pegs were not made explicitly but as Christensen also homes in on, Bini Smaghi did note that there is a clear tradeoff between keeping the pegs and continuing the process of convergence. I will devote more time later to discuss this speech as well as another one along the same lines made by another member of the executive board Jürgen Stark but for now and in connection with the immediate topic at hand we need to understand that the scene is now effectively set for an (potential) economic correction triggered by either/or both an unwind of one of the pegs and an 'attack' one of the floaters.

Moving on to the Baltics

It is thus in this immediate light that I am going to present a slew of graphs below on the Baltics which, as noted picks, up on one of my recent posts on Lithuania which deals with the concept of crossover currency balance sheet exposure or as it has been coined in the literature; translation risk. The following definition is from investopedia.com:

The exchange rate risk associated with companies that deal in foreign currencies or list foreign assets on their balance sheets. The greater the proportion of asset, liability and equity classes denominated in a foreign currency, the greater the translation risk.

Now, the first interesting thing which should be noted in the quote above is of course the notion of how 'companies' are emphasised. Now, I don't have a very broad overview of the literature on this topic but on the back of a superficial glance it seems clear to me that most of the words on this subject has been devoted to the description of companies' exchange rate risk of operating in foreign countries under insecure exchange rate systems and obviously subsequently how this risk can be hedged using derivatives or just by calibrating the denomination of the stock of liquid assets held on the balance sheets. In this way, we need to look at another kind of translation risk and one which is especially important in the case of the Baltic countries and in fact also in many other countries in Eastern Europe. Simply put and as an inbuilt and strongly influential factor in connection to the general economic situation these countries have, as mentioned above, seen a very rapid increase in credit/capital inflows in the past years to cover a ballooning negative external balance helped on its way by boom in domestic demand. The point is moreover that the majority of this credit has been extended to households through loans intermediated by foreign financial institutions and thus in foreign currency (mostly Euros). As an overall point the following point as quoted by a recent report by the World Bank (linked above) is important:

External positions in 2Q 07 in most EU8+2 were financed by FDI. In the Baltic countries they were financed by foreign borrowing through the banking sector. In most countries current account deficits remain largely covered by FDI – fully in the Czech Republic and Poland, in 90% in Bulgaria and 2/3 in Slovakia and Romania. Meanwhile in the Baltic countries, which have the largest imbalances, FDI cover 1/3 of CAD in Latvia and Estonia and slightly more (58%) in Lithuania with banking sector foreign borrowing remaining the primary source of financing.

This last part is rather important for the analysis at hand which basically seeks to present comparable charts for the three Baltic countries according to the following overall analytical principles.

• The charts will show three things. Firstly, charts will be presented on the evolution of the external balances in order to show the magnitude of the problem. Secondly, a set of charts will seek to show the overall build up of credit measured as the evolution of the total stock of loans with special focus on the households' contribution. Thirdly and as a direct measure for the potential translation risk associated with an unwind of the fixed exchange rate regimes in the Baltics charts will be presented which compares the denomination of loans with the denomination of deposits in financial institutions. In this way it is important to note that we are not comparing the stock of loans with the stock of deposits according to a criterion of how much the latter can cover the former in absolute terms but, as it were, solely with a focus on cross-currency denomination.
  

• The charts, which will be presented without many words, denotes what you could call a static analysis of the issue of translation risk. The point is that the charts solely show stocks and not flows. It is thus assumed that in the case of households in particular the cash flows used to service the loans are denominated in local currency (i.e. salaries) as well as it is assumed that households have limited acces to intruments used to hedge cash flows at different points in time.
  

Now, and if I have been able to hold on to you until this point why don't take a look at the charts. We will begin with the charts showing the evolution of the external balances before moving on to charts showing the evolution of the stock of loans and finally finishing off with charts comparing the denomination of loans with the denomination of deposits in financial institutions. The charts which cuts across all the Baltic countries have been made with the explicit goal that they are comparable. It has not been a complete success but it works.

Current Account (Estonia, Latvia, and Lithuania)


Evolution of total stock of loans (Estonia (million EEK), Latvia, and Lithuania)

Stock of loans and deposits by currency denomination (Estonia, Latvia, and Lithuania)

(Please click on images for better viewing)

As promised I won't say a whole much at this point save of course to point out that the charts above do indicate that a considerable amount of translation risk is present which also conforms with the rather large amount of anecdotal evidence.

August Foreign Trade Numbers

I haven't forgotten about Latvia, but with the recent news on inflation, and especially in Estonia and Bulgaria, I have my time cut out writing at the moment.

So really the trade news is certainly not the big news this week, although, of course, it is not without importance, but with people all over the place speculating about the advisability and sustainability of the currency pegs, and the whole situation in countries like Romania and Bulgaria now seeming to be hurtling along almost out of control, I hope you will forgive me if I plead pressure of time.

Well, according to Latvijas Statistika:

Compared to the July 2007, the value of exports in August 2007 increased by 2.3% or 7.4 mln lats, but in comparison with August 2006 it increased by 15.6 % or 45.2 mln lats, reaching 335.7 mln lats, according to Central Statistical Bureau data.

The value of imports in August 2007 was, in turn, 10.6% or 75.8 mln lats lower than in July 2007, but 12.9% or 73.1 mln last higher compared to August 2006, reaching 641.7 mln lats.

The total foreign trade turnover in August 2007 was 13.8% or 118.3 mln lats higher than in the corresponding period of the previous year and its value was as high as 977.4 mln lats.

Basically I'm afraid none of this is very good news. Exports have increased over the months, but these have been more than compensated for by rising imports, until recent months that is, when the rate of increase in imports has slowed, as, of course, the rate of increase in domestic consumption has itself started to slow.

Here's the goods trade deficit to illustrate the point:



The key question to now follow will be the evolution of producer prices in the export sector, since the only way to get out of this mess in the longer term will be to export your way out of it - since all those capital inflows one day or another have to be paid back - and the only way to be able to export is to be competitive.

Latvia Industrial Output August 2007

According to data released this week by Latvijas Statistika, compared to July 2007, Latvian industrial production in August 2007 increased by 2.6%, according to seasonally adjusted data (seasonal and working day influence is taken into account). Within this total there was a rise of 12.9% in mining and quarrying, 2,4% in manufacturing, and 2.4% in electricity, gas and water supply.

Compared to August 2006, industrial production in August 2007 increased by 3.3% according to seasonally adjusted data. Within this total there was a rise of 1% in manufacturing, 6.2% in mining and quarrying, and 11% in electricity, gas and water.


So year on year manufacturing industry is barely moving, despite general overheating in the economy. This is not good news. Here is the movement in the total index:

And here is the chart for % change year on year. Remember the lions share of the increase is in electricity and other utilities.

Latvia Inflation September 2007

Well, Latvijas Statistika have just published the September inflation number, and the news is not good. Year on year inflation rose to 11.4%, the second highest rate in the EU (Bulgaria's annual inflation rate was 12 percent in August). I have just published an extensive post on the recent Estonia inflation data, and since the issues are essentially the same in both cases, I will simply report the data here.

Firstly here's the chart:



As can be seen, inflation is accelerating, and not reducing. On a year on year basis the big items are food and drink, entertainment, education and housing. As these are year on year data, the housing component may cool considerably as we move forward now, after several months of steady easing, although even on housing the statistics office record a month on month increase of 1.4% from August.

At the same time we have new data which shows that industrial output in August by 2.6% over July, and by 3.3% on a seasonally adjusted basis over August 2006.

World Bank Report on EU10

by Claus Vistesen

cross posted from Alpha Sources

As my regular readers no doubt will have noticed I have been very preoccupied with Eastern Europe and the Baltics recently in the light of the rather peculiar and unique situation some of these countries might end up finding themselves in given the ongoing uncertainty in financial markets and in fact also the global economy. Now, I intend to stay preoccupied as it were and e.g. at some point soon I will be expanding my ongoing analysis of Lithuania. However, this time around I am not presenting my own analysis but rather pointing towards a recent report by the World Bank on EU10 (get main points in PDF here) which also takes on the recent economic development in the Baltics and Eastern Europe both from the point of view their own individual developments but also in the light of recent events in financial markets which, as I have argued, have tended to bring the region's issues rather more quickly to the front end of the debate than perhaps could have been expected.

The report progresses with great vigour and data sampling although of course I feel tempted to launch my traditional reservation regarding the fallacy of not, even with the faintest sentence, mentioning the underlying demographic dynamic of the region. This is especially odd given that, at least, part of the report's emphasis is on the region's labour market dynamics. On this, the report does not add much to the general story we get from the media and other economic analysis sources save perhaps one important point which relates to the underlying (un)sustainability of the growth in wages on the back of dwindling capacity as labour markets tighten not only overall but also crucially in key sectors. In this way the report puts numbers and words on something which I guess we all knew but have rarely emphasised ...

In all countries apart from Slovakia and Slovenia, wages are growing faster than labor productivity. Rising unit labor costs (see Chart 28) provoke central bankers in the region to tighten monetary policies (Poland and the Czech Republic). Apart from inflationary pressures, excessive ULC growth may undermine competitiveness and prospects for sustained long-term output growth and further labor market improvement.

Apart from this and as a general qualifier to the general discourse on the labour market I would clearly also add that we need to factor in demographic trends in the form of a sustained drop in fertility since the beginning of the 1990s which is now taking its toll as well as a sustained process of outward migration from many countries to Western Europe.

There are of course a lot of other interesting points and charts and I can widely recommend you to visit the report for a closer look. However, before I leave you I want to point one more interesting point from the report which relates to the financing of the current account deficits of some of the countries in question in Eastern Europe. Now, I know that this might seem to be a technical detail but in fact it is not in this case but rather pretty important. Here is the key quote ...

External positions in 2Q 07 in most EU8+2 were financed by FDI. In the Baltic countries they were financed by foreign borrowing through the banking sector. In most countries current account deficits remain largely covered by FDI – fully in the Czech Republic and Poland, in 90% in Bulgaria and 2/3 in Slovakia and Romania. Meanwhile in the Baltic countries, which have the largest imbalances, FDI cover 1/3 of CAD in Latvia and Estonia and slightly more (58%) in Lithuania with banking sector foreign borrowing remaining the primary source of financing.

This point links up quite well with my recent analysis of the risk of so-called balance sheet exposure in Lithuania in connection with the risk that the currency peg could come under pressure. The main venue of my analysis is of course the stock of credit expansion to households and cooperations and not so much a flow analysis as is the case with the World Bank's report. However, as we can see these two things (stocks and flows) are of course related and as such we see that especially in the Baltics the hefty increase of the stock of credit/loans outstanding (using Lithuania as a proxy) is closely tied to the flow composition which finances the three countries' current account deficit. Coupled with the exchange rate exposure which could potentially emerge if the pegs were tested the Baltic countries seem to be harboring a rather nasty mix of fundamentals in the context of the external financing. Finally, it should never escape your attention that all this of course is closely tied to the ongoing turmoil in financial markets since, as per definition given the situation described above, a substantial part of the increase in credit stocks has been supplied by foreign banks and as we have all witnessed in recent weeks risk aversion is set to rise significantly among those banks who have been most aggressive in the cycle which now seems to be ending. In the case of Lithuania the first shot already seems to have been fired across the bow as Swedish owned Hansabank for example already seems to be seriously contemplating its positions in the Baltics ...

(Quote Bloomberg)

AS Hansapank, the biggest Baltic lender, will diversify its credit portfolio in Lithuania after an economic boom in neighboring Estonia and Latvia caused credit to soar dangerously high, Chief Executive Officer Erkki Raasuke said.

Hansapank, owned by Stockholm-based Swedbank AB, will ``at some point'' have to set credit growth restrictions in Lithuania, the biggest of the three Baltic countries, Raasuke said in an interview in Tallinn yesterday. It has not done so yet because Lithuania's expansion trails growth in Latvia and Estonia.

The economies of Lithuania, Latvia and Estonia are among fastest growing in the 27-member European Union, creating a boom in credit and raising warnings that growth may be overheating. The global credit crisis adds to concerns about a Baltic regional ``meltdown,'' prompting banks to take steps to limit lending.

``We don't have any signs or confidence at this point that in Lithuania we would avoid the need for credit restrictions, but we would do it differently there,'' Raasuke, 36, said. ``Instead of setting internal limits for absolute credit growth, we should rather set targets on diversifying the credit portfolio. These are the steps we didn't take in Estonia and Latvia.''

(...)

In April, Hansapank's Estonian unit raised the minimum monthly income requirement for granting a mortgage to 7,000 krooni ($607) from 5,000 krooni, compared with the average gross monthly salary of 11,549 krooni in the second quarter.

Two joint applicants would need a combined income of 10,000 krooni, compared with 7,500 krooni required previously. The bank last changed the requirements four years ago.

Raasuke said it was ``obvious'' from Hansapank's business that lending behavior had changed within the last four to five months in Latvia and Estonia, citing a ``clear decline'' in new loans, compared with peak monthly levels and the average levels of the last three to four years.

So, the lemon is getting squeezed as I type; let us hope indeed that the wring won't suck out all the juice.

World Bank Report on Labour Shortages in the EU10

The European Union's 10 eastern members must take concerted action to increase employment participation levels to avoid a serious short-term slowdown in economic growth and important supply-side structural problems in the longer term according to a report published today by the World Bank.

"Addressing the emerging skills shortages is particularly important, because failure to do so will constrain job creation and future economic growth"

You can find the report summarized here, or you can download direct here.

Claus and I will prepare a full summary and review over the weekend, but for now here are some revealing extracts.

The report in fact says the following:

In this atmosphere of short term turbulence it is important not to lose sight of the longer term trends and the fundamental challenges the EU8+2 continue to face. With the exception of Hungary, growth remains high throughout the EU8+2 and in the case of Latvia represents serious overheating. This growth is sustained largely by consumption and investment. With tightening labor markets, large increases in real wages and employment and very rapid credit expansion, a moderate slowdown in growth may in fact be desirable in the countries showing signs of overheating.

They also have this to say, which is IMHO very important, and to the point:

Unemployment has fallen substantially in virtually all EU8+2 countries since 2004 due to strong growth in labor demand. This has given rise to skill shortages and associated wage pressures, often amplified by out-migration of EU8+2 workers. However, employment/working age population ratios remain relatively low.

Really this is the very point that Claus and I have been making. They then continue:

In contrast to the earlier period of weak labor demand it is now the supply side of the labor market that constrains new job creation. Many persons of working age are economically inactive in EU8+2 either because they lack skills demanded by employers, or because of labor supply disincentives, such as early retirement benefits, generous disability schemes, high payroll taxes, and limited opportunities for flexible work arrangements. These effects are concentrated among the younger and older workers, while the participation rates for middle aged workers are similar to those of the EU15. Hence the main challenge facing now EU8+2 is to mobilize labor supply to meet the demand. Addressing the emerging skills shortages is particularly important, because failure to do so will constrain job creation and future economic growth. To increase the effective labor supply EU8+2 countries need to: (a) improve labor supply incentives through reforming the social security systems, (b) improve worker skills through reforming the educational systems and improving domestic mobility; and (c) import labor with skills that are in short supply by opening labor markets to foreign workers. The weights assigned to each policy depend on the nature of the most binding constraint to labor supply, which vary across countries.

also this is very important, even if I am nowhere near as optimistic as the World Bank is about the possibilities of Eastern Europe staying out of the firing line, especially as the eurozone itself is slowing fast.

The effects of deepening financial turbulence would potentially be more serious for the EU8+2, but are more difficult to predict. The greatest risk is that the countries that have large current account deficits – the Baltics, Romania and Bulgaria – are suddenly less able to finance them through capital inflows and are forced into an economic contraction. This is particularly true for countries like Hungary that are highly dependent on more volatile portfolio inflows than on FDI. Banking sector foreign borrowing which is the main financing source in the Baltics is generally less volatile than portfolio flows, but the extreme surge in the Latvian CAD (to 30% of GDP in the 12 months to end July ) clearly cannot be financed in this way in a sustained manner. There are other potential risks as well. A general retreat from mortgage lending provoked by US experience would lead to broad based credit tightening and weaken the booming construction sector in the EU8+2. Moreover, the increased risk sensitivity may cause the unwinding of carry trades making external finance more difficult for higher interest, carry trade destination countries.

Finally:

In the latest quarters unemployment rates have either continued to fall or have remained fairly stable despite upward seasonal pressures. In several countries unemployment rates declined to historical minima (the Baltic States, the Czech Republic, and Poland). Employment rates in Latvia, and also in Estonia reached the highest levels since the start of transition and are around 68% for people aged between 15 and 64 years, which is close to the Lisbon strategy target of 70%. Nevertheless, further employment increases may be limited because of structural nature of joblessness due to skills mismatches and unwillingness to relocate or retrain, which is particularly relevant for those who stayed out of the labor market longer.


The recent trends have undoubtedly strengthened the power of employees in the wage bargaining process. Real wages have begun to grow rapidly in Poland where their expansion had been moderate so far. The highest growth is occurring in sectors which suffer most from shortages of workers (for example, construction). Rising employment and strong dynamics of real wages are pushing the growth of the wage bill into double digits. Nevertheless, demands of higher wages for public sector employees come into sight in most countries in the region. In Bulgaria and Poland, trade unions are prepared to resort to strikes or the threat of strikes in wage setting negotiations.

In all countries apart from Slovakia and Slovenia, wages are growing faster than labor productivity. Rising unit labor costs provoke central bankers in the region to tighten monetary policies (Poland and the Czech Republic). Apart from inflationary pressures, excessive ULC growth may undermine competitiveness and prospects for sustained long-term output growth and further labor market improvement.

Too Little Too Late?

Bloomberg reports that Latvian Prime Minister Aigars Kalvitis was on the Latvian Independent Television program 900 Seconds last night. His message, that "new government measures to slow inflation and cut the current account deficit will mean ministries must trim spending and plan for larger surpluses". Ministries, he said, will have to ``tighten their belts'' and the budget surplus will have to be ``much bigger'' than the planned 0.5 percent for next year.

The government is apparently planning to introduce a (another) stabilization plan. At the end of the day, I cannot help having a certain sympathy for the Latvian politicians and bankers concerned. Not that they couldn't have been doing more, but this situation - which is way beyond the "know how" of even the IMF and the EU commission - it seems, certainly can only find them wanting before the challenge. They are, at the end of the day, only human, and they should not be blamed for that fragility.

No one could really have anticipated the extent of the problems Latvia was destined to face back in 1990 when the wall came down and fertility suddenly plummeted. Now we all know better. There will be a lot to be learnt from what happens next, unfortunately the on-cost of the education process will be paid for by the Latvian and other East European peoples, who, lord knows, have already suffered enough.

History is far from kind in this case. In fact it seldom is.

Latvia Wages and Salaries Q2 2007

Well Latvijas Statistika had the latest wages and salary data up last week, and they don't make especially pleasant reading, even if you do consider that Latvians are basically much poorer than their Western European counterparts, and that wage (and productivity) convergence in the longer run would be a thoroughly good think. The question is, can we get from here to there, and if so, how? Since one thing is plain enough, the present situation just isn't sustainable.

According to Latvijas Statistika compared to 2nd quarter of 2006, in the 2nd quarter of 2007 the average hourly labour costs increased by 31.6%. Hourly labour costs in this period increased from 2.46 lats to 3.23 lats or by 78 santims per hour.Quarter on quarter this was a rise of 6.2%.

Here are the charts. First the development of the annual rate, which is, quite simply, horrific.




Now here is the quarter on quarter rate. And we can, of course, notice some very slight slowdown in the second quarter, and this is consistent with other data - GDP, housing - that we have been seeing. The question is now how rapidly and how far this will slow.




Clearly these wages increases subsequently have a knock-on impact on costs, and this impact can be seen in the producer price index. This can be seen in the charts that follow. First the index itself.




Now the annual rate of increase each month. This has now been accelerating since about July 2005, although the rate of acceleration has slowed recently.



Then we have the rate of increase in export prices component. As we can see these prices have also risen considerably, although the rate has now, fortunately, been slowing down since April. The damage, however, is being done, and it is considerable.



The impact of all of this is reasonably predictable, Latvia is finding it harder and harder to export:



as we can see, since May the value of Latvia's exports each month has been falling. If we look at the monthly trade balance we get a similar picture:



As we can see, the deficit is not reducing in any systematic way, and indeed deteriorated a little in July, which is the last month for which we currently have data.

So all of this is unsustainable, and the end result will probably be an impact on the peg. Why?

Well economics isn't such a difficult subject as it sometimes seems really. Basically you have two key drivers of economic growth, domestic consumption and exports (in this sense both government spending and investment are secondary variables). Now if at some stage domestic demand is going to be reduced - as it has to be - then Latvia will have to live from export growth. But if you can't increase exports because your prices are too high, then the only real move left is to change the value of your currency. Its as simple, or as hard, as that really.