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Monday, October 8, 2007

Is Estonia Really Heading For A 'SoftLanding'?

by Edward Hugh: Barcelona

Estonian inflation surprisingly accelerated in September to reach a new nine-year high, largely on the back of rises in food, housing and services costs. The Estonian Finance Ministry has said it expects Estonia's inflation rate to remain near the current level for the immediate future. The annual rate rose in September to 7.2 percent, which was its highest level since October 1998, and was up from 5.7 percent in August, according to data released by the Estonian statistics office at the end of last week. Month on month, prices rose by 1.1 percent.

The largest increases were registered in food prices (7.8% annual rate), housing (16.1%) and services (hotels, cafes and restaurants, 12%). Here is the monthly inflation chart.

Now the Estonian central bank and Finance Ministry have been insistent in recent months that the Estonian economy remains on course for a "soft landing" as the property sector cools and credit growth slows. This outcome is far being a self evident one, however, as this and other recent data which will be reviewed in this note make clear.

Overheating in the Baltics?

What is happening in Estonia may seem to be lacking in any great global significance, given the size of the country and its economy, and its lack of general importance at the global level. But such a conclusion might be over hasty, and premature, as I will try and argue here, given how representative what is happening in Estonia now is of processes at work in many EU10 economies (although not of course all, as the notable exception of Hungary shows).

In fact all three Baltic economies show clear signs of overheating, despite the fact that assessing the extent of the overheating in the Estonian case was initially complicated by an overly negative preliminary Q2 2007 GDP relase, which cited figures that were subsequently revised substantially upwards. I have addressed some of these questions in this post, and Claus had dealt with the external balance sheet position in this note here.

Slowing Down Nicely?

When we come to look at the details we can quickly appreciate that the Estonian economy certainly does show some clear signs of slowing, as can be seen from the GDP quarterly growth rates:

Also, and according to data from Statistics Estonia, industrial production increased in August 2007 when compared to August 2006 by only 4.4%, a pace which which was slightly down from the annual 5.2% increase recorded in July, and indeed the year on year rate of output growth has been slowing now since April, as can be seen from the chart.

But other data show if not a completely different picture, at least a more qualified one. If we look at retail sales for example, and again according to Statistics Estonia, we find that in August 2007 retail sales were up 13% year on year over August 2006. This rate is actually down on those registered earlier in the year, but it is still very high.

Actually, compared to July 2007, the level of retail sales in August was more or less stationary:

And again if we look at the monthly annual change figures, the rate of increase is clearly slowing.

Wage Push Inflation?

One big part of the underlying isssue here is undoubtedly strong wage-cost push inflation, of the old school kind. If we look at the quarterly chart we can see that though the rate of annual increase in wages and salaries has fallen back somewhat in the second quarter from the first, it is still very substantial:

Now if we move on to look at producer prices, which is where all the "cost-push" inflation shows up, we can see that these have been rising steadily over the last 18 months, and while they may well now have peaked in terms of the rate of increase, the pace is showing no real sign, up to now, of having eased off to any substantial extent.

The situation is even more problematic if we come to look at the rate of producer price increases in the export sector:

The reason this situation is so problematic is the impact that this sustained inflation on producer prices is bound to have on Estonia's ability to export, especially given that the kroon is effectively pegged to the euro, so prices cannot adjust via a downward movement in the currency.

We can perhaps get a point of comparison if we take a look at what has been happening in Hungary. The Hungarian economy has certainly been undergoing a "correction" since the autumn of last year, internal demand is down very sharply, and while domestic inflation remains stubbornly high - though not as high as Estonia's - export prices show a completely, and much more desirable pattern, since wage deflation has been very significant in Humgary.

Here is the chart for month-on-month changes in domestic sales prices and export prices in Hungary:

and below are the equivalent year on year changes. What we can observe is that there is now a very strong disinflationary process at work in Hungary, a disinflationary process which has yet to be seen in Estonia, or for that matter in the Baltics generally.

Now I think I need to be clear here, since I am certainly not recommending the kind of strong wage deflation they are having in Hungary as a preferred recipe for the Baltics. I am simply trying to suggest that this problem exists, and must eventually be addressed, either by coming off the peg, or by other means. There are even doubts in the Baltic acses that wage deflation as such could be operated, given that omnipresent danger of increased outward migration is bound to make wages and prices more "sticky" than in the Hungarian case (where among other things out-migration has not been present to any significant extent, at least to date it hasn't).

What I am suggesting is that there may well be other ways available to address the problem, even if they do involve "unconventional tools" and "out of the box" thinking. One of these unconventional measures would certainly be a flexibilising of the labour market through a significant and substantial opening to international migrant labour. In order to work this opening would have to be large scale, and should not simply be confined to skilled worker categories. At the end of the day, it is a question of which you prefer, to be flayed alive by systematic wage deflation (and all the problems of out migration that this might produce) or a rapid transition to a modern multi-cultural society. There are not many other options to play around with here I think. And time is pressing.

Now, returning to what I said above, the reason why all of this producer price inflation is so problematic for Estonia is the corrosive impact that it has on Estonia's ability to export its way out of difficulty. This impact is evident enough if we take a look at the recent evolution of the external balance in goods and services for Estonia:

Not a pretty picture, is it? And again, the dimension of this problem becomes even clearer when we come to look at this deficit as a share of GDP:

Well, according to Eesti Pank (Estonia's National Bank, see link above):

The average goods and services export growth rate has been fast, although the situation varies by groups of goods and by markets. Although the growth rate of merchandise exports slowed considerably at the end of 2006 and at the beginning of 2007, we are mainly speaking about the so-called transit goods. When we leave aside transit and the subcontracting sector, there are no reasons to assume the competitive ability of other sectors has substantially declined.

This assessment of the situation seems fairly reasonable when we take into account the impact of accelerating producer price inflation and its impact on competitivity. As we can see from the chart below, both exports and imports "peaked" back in May, and this peak in exports occured despite an extraordinarily favourable environment from an external point of view. This is not what should be happening in the case of a "correction". Domestic demand should, of course, be weakening, but exports should be beginning to play an increasing part in maintaining aggregate demand, otherwise this situation simply shows us that Estonia is moving steadily off into a recession, but since the currency cannot adjust, it is not clear where the actual correction to bring her out of the recession again is to come from here. Unless, of course, the recession produces a very sharp deflation in wages, but isn't that exactly what everyone would mean by a hard landing? (ie a strong recession accompanied by a long and sustained period of wage deflation). As I say in my original post I am simply not clear what kind of vocabulary register is being used by many of the participants here. Indeed, I would venture to say that the people who are using this vocabulary are themselves no more clear than I am.

Labour Shortages The Core of the Problem

Again according to Eesti Pank

In spite of slower economic growth, the number of jobs increased, although more sluggishly than before. In the second quarter of 2007, 1.3% more people worked in Estonia year-on-year. Employment increased to 62.9% of Estonia's workforce and the unemployment level fell to 5%.

This is precisely the problem. Even though the growth rate is slowing, the process of labour market tightening continues. This is due to the fact that there is no inbuilt correction mechanism in the labour market due to the shape of Estonia's population pyramid.

What do I mean by this? Well let's look at some more of those charts. Firstly annual unemployment rates in Estonia:

As we can see, these have been steadily coming down since 2000. Now lets look at the numbers of available unemployed:

As we can see the numbers of people registering as unemplyed and seeking work has dropped steadily since the end of 2000. At the same time the number of people working has steadily risen, as is only to be expected given the strong rate of economic growth.

So it is this path which is not sustainable, especially when we take into account that participation rates have also surged strongly.

As we can see the participation rates for older workers is now quite high by international standards, especially when we consider the compartaively low male life expectancy of around 67. Now if we come to look at youth unemployment:

We can again see that the rate of youth unemployment has been declining steadily since the start of 2005. And it is important to remember that these percentages are on a reducing total youth population as can be seen from this, the last chart in this series, which shows how the 0 to 14 age group - or if you like tomorrows young workers and labour market entrants - has been steadily declining as a proportion of the total population since the early 1990s and it is the impact of this steady reduction that is now about to make itself felt.

So there we have it. I basically don't see how - whether you talk in terms of hard landing or soft landing - the Estonian economy is ever going to "correct" unless this structural issue is addressed.

The macro imbalances we are refering to here are substantial, and as I have tried to argue at some length here, they stem from a virtually unique set of circumstances (historically unique I mean, at the present time the underlying dynamic across all the East European EU member states is remarkably similar, with the possible exception of Hungary). Estonia is facing, at one and the same time, a massive inflow of external funds, and a significant reduction in its potential labour supply after years and years of below replacement fertility. Put another way, demand side factors are increasing rapidly, while supply side capacity not only is unable to keep pace, it is actually shrinking (if we think about the number of people of working age).

So there are two problems to correct here, and they are both large and important. Essentially Estonia needs:

a) more labour supply, both skilled and unskilled
b) a lower rate of inflow of structurally distorting funds, whether these be bank credit, remittances, or even (possibly, this needs investigating further) EU funding for projects which Estonia cannot reasonably expect to carry through in the time horizon outlined, given the capacity constraints.
c) more Foreign Direct Investment to create value creating jobs, especially in manufacturing and services areas with export potential
d) increased spending on education and training projects to upgrade the human capital of the existing population

In this post I have been talking about Estonia, but we could just a well have been speaking about Latvia or Lithuania, about Romania and Bulgaria, and - if nothing is done of an international level to address the problem - in the not too distant future about Poland and Ukraine. If we simply sit back and wait for the crunch to come here, then quite frankly it will, and the end product of all that negligence will be much more significant than many seem to currently appreciate.