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Thursday, September 27, 2007

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.


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.

Wednesday, September 19, 2007

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.

Saturday, September 15, 2007

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.

Friday, September 14, 2007

And Moody's Make It A Hat-trick

Following in the footsteps of Fitch's and Standard and Poor's (which I reported on in this post), the ratings agency Moody's has now downgraded the Latvian rating outlook from positive to stable.

Kenneth Orchard, Moody's Vice-President and Senior Analyst for the Baltic region said in a press release that:

"Latvia's economy is currently expanding at a very rapid rate.... Very fast growth has brought many benefits, but the risk is that a slowdown could be somewhat sharper than previously thought.....Large-scale foreign borrowing by the private sector has fuelled household consumption and investment in property, which have been the primary drivers of economic growth over the past few years.....The rating agency believes that property markets are exhibiting bubble-like characteristics, although prices have started to decline. Current account deficits, as a percentage of GDP, are now amongst the highest in the world. In the current macroeconomic context, Moody's believes that both these governments may face greater fiscal challenges than they anticipate"

As I argued in this post here, after the criticism to which they have been exposed during the sub-prime mortgages turmoil, it is only to be expected that these agencies are going to be tightening up their assessment procedures. Prime candidates for ongoing problems would seem to me to be Japan, Italy, Hungary and the Baltic States. Everything really depends on how far the credit crunch affects the real economy on the global level, and how rapid this autumns growth slowdown actually turns out to be.

No Change in Latvian Interest Rates

Latvia's central bank, unsurprisingly, left the benchmark refinancing rate at 6 percent today. According to the press release:

The Bank of Latvia Council maintains that substantial risks of economic overheating are still in place and in some sectors even becoming stronger, including an upsurge in inflation rate. At the same time, there are certain trends signalling that consistent implementation of the economic stabilisation measures is likely to result in a gradual further "cooling" of the economy in the upcoming periods, with the so-far buoyant pace of growth slowing down. The anti-inflation or economic stabilisation plan is producing first results and requires further action.

The bank called on the government to continue and intensify its efforts to achieve a budget surplus.

"The efforts to implement other measures under the plan and, in some areas, to render sustainable previous achievements should continue. In the area of fiscal policy, immediate activities should focus on a budget with a surplus in the amount of 1% of GDP instead of the currently projected balanced budget position for the current year and a considerably larger budget surplus (2%) than the projected 0.2% of GDP for the next year. An urgent action is needed to address the measures under the anti-inflation plan related to enhancing export competitiveness and labour market problems. Step by step, this will lead to both adjustments in the country's external imbalances reflected in the current account deficit and internal instability or inflation rate."

Basically the absence of any change in the interest rate is hardly surprising given that Latvia's currency is pegged to the euro, and that most internal credit expansion is driven by non-Lat denominated loans the power of the central bank to influence the situation is extremely limited.

Higher than capacity economic growth, high inflation and a widening current account deficit all prompted Standard & Poor's and Fitch to cut the sovereign debt credit rating to BBB+ earlier this year, and only yesterday Moody's changed the rating outlook for Latvia and Estonia from positive to stable.

Annual inflation was up again in August to 10.1 percent, a 10-year high, from 9.5 percent in July as domestic demand, fueled by rising wages and loans, continued to grow.

Central bank Governor Ilmars Rimsevics said at a press conference in Riga today that inflation isn't expected to slow in the coming months and he ``hopes'' to see a decline in the rate next year. Inflation is being driven by advances in core inflation, Rimsevics said.

Interestingly Rimsevics stated that Latvia should consider importing skilled labor to fill job shortages: ``Urgent action is needed'' to address labor market shortages and competitiveness of the country's exporters.

Economic growth has been driven by a domestic demand boom which has sucked in large quantities of imports, leading to a negative dynamic on the trade balance and widening the current account deficit, which was 25.7 percent of GDP in the first quarter.

The economy is showing signs of slowing (although not very strong ones, see here) according top Rimsevics statement at the press conference. Real-estate prices have stabilized and the current-account gap is expected to have reduced to "only" 21 percent of GDP in the second quarter.

Latvia has the somewhat unusual twin distinction of leading the European Union in economic growth and in the size of its current account deficit.

The economy grew 11 percent in the second quarter, the ninth consecutive three-month period in which gross domestic product expanded more than 10 percent.

GDP Q2 2007

Compared to the corresponding period of previous year, gross domestic product (GDP) in 1st half of 2007 increased by 11.1%, according to data released last week by the Central Statistical Bureau.

In fact in the second quarter of 2007 GDP increased by 2.7% when compared with the first quarter, and by 11% when compared with Q2 2006. Here are the quarterly and annual charts:

As can be seen from the quarterly chart, if there is a slowdown it certainly isn't a very big one.

Looking at the annual rate (quarter on quarter) some slight slowdown is evidenced, but frankly, given the scale of the inflation problems, it isn't very substantial.

And if we come to look at the breakdown of the growth, then we find that as compared to the corresponding period of previous year, in the 2nd quarter of 2007 the volume of the total final domestic consumption increased by 16.2%. This increase in final domestic consumption was due to private consumption of households and non-profit organizations increasing by 18.4%, while, the government final consumption increased by 5.7%.

At the same time export of goods and services increased by 8.7%, while, the volume of import of goods and services increased by 23.0%.

Latvia Inflation August 2007

Latvia's CPI inflation year on year in August reached 10.1% according to data out today from Latvijas Statistika. Since this was largely expected there is little more to add, it is however an extremely preoccupying number.

Here's the chart showing annualized rates by month:

and here's the chart for month on month changes, which doesn't really give much comfort, since while the August increase is not especially high, there is no clear evidence of trend. Since the whole phenomenon is being driven by wage push,we need to see some more evidence of trend in wage and salary growth, and some data on export prices and volumes would no be useful to see how GDP growth is likely to evolve.