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Friday, March 23, 2007

Japan - What Now?

The first months of 2007 have certainly seen some wobbling in the Japanese economy, or perhaps it would be more accurate to say in the monetary policy of the Bank of Japan; the economy actually has been muddling along quite nicely as per usual in recent months, driven largely by export growth and of course playing the much allured Japanese specialty of a tightrope game with deflation. So we recently saw the BOJ raise the overnight lending rate to 0.5% in a move which was both odd given the shaky character of some of the economic fundamentals and at the same time perfectly in line with the general perception that global interest rates need to move towards 'normalization' in order to scoop up excess liquidity. However, clearly 0.5% does not constitute normal in any meaningful sense of the word, at least not when it comes to the fundamentals for the carry trade it doesn't. So, what now for Japan? Well, If we look at the economic data we have seen so far for 2007 it is tempting to go for a 'steady as she goes' take and although I do believe that this view would not be too far from the truth I still think it is worth taking a bit closer look at the data we have in front of us.

An Economic Outlook on Japan - Watch that In(de)flation!

The first thing to note I think is that Japan entered 2007 with 0% inflation being registered in January, and this it should be noted was before the hike to 0.5% which was itself justified on the back of comparatively strong Q4 06 GDP figures. However it should be noted that the domestic component in the economy shows continuing signs of weakness and both retail sales and industrial production dipped in January. Retail sales in fact fell by 0.8% on a y-o-y basis, and this of course should not be seen as grave drop yet it does as always bring to the forefront the question of whether or not consumer spending in Japan really does stand before an imminent surge. Industrial production also dropped by 1.5% from December, with this fall being mainly due to de-stocking from the pre-January build-up. Expectations point to further de-stocking in February and perhaps even March although of course the widening export surplus may well provide some much needed relief here. Yet, once again there seems little correction in Japan's overall growth path and this of course raises questions about what actually can be done concerning Japan's growth imbalance, and about just how long we can carry on believing in the likelihood of a spillover effect from buyoant capital spending to the household economy.

In all of this the export sector naturally demands special attention since it is, at the end of the day, what drives the Japanese economy forward at the present time. Indeed the data (see link above) reveals a continuation of the impressive Japanese export performance as epitomized by the February figures which show that the Japanese external surplus widened a whopping 7.7% y-o-y on the back of impressive exports which grew at a rate of 9.7% y-o-y in February. Of course the immediate outlook for export performance (and thus also for capital spending) in Japan is in part clouded by continuing questions about the future of the US economy and just how the current slowdown will play out in Q1 and Q2 of 2007. So what should we expect from Japan going forward?

First of all we have the monetary policy question which is pretty sure to be at a standstill for the immediate and forseeable future (which in the present case means over the course of the coming summer).

Earlier this week the BOJ acted according to expectations and held rates at 0.5% on concerns that consumer prices might drop below zero, and this is a risk I also ascribe some weight to in my economic forecast on Japan. Also the recent announcement by the Fed in the US and the apparent move away from a tightening bias should provide an indication that global rates in the developed economies (save perhaps UK) might be getting close to their upper limit given economic fundamentals, and really I do think the ECB should take note here as well.

Another forthcoming data release from Japan may well point to changing sentiment in the Japanese economy as the Tankan business confidence survey is expected by many to fall back from a 2 year high, although it is worth noting here that there is far from a general consensus on this and, for example, Takehiro Sato from MS sees the Tankan survey in a somewhat different light. Once again the outlook of the US economy is bound to have a significant bearing on this.

The second important point to consider concerns consumer spending and more importantly the future course of inflation. Given the inflation data from January it is now almost certain that Japan will be flirting with deflation in February and March given the inbuilt downward trajectory in energy prices on a y-o-y basis. Whether this evolution in prices will be sustained is of course another story, but I am far from happy about potential developments in Q1 and Q2 and the possible feedback mechanisms with business and consumer sentiment that these may bring into play. On consumer spending, we have of course the recent drop in retail sales in January but on a m-o-m basis we should expect a pickup as the weather gets warmer and spring arrives. None of this will, however, change the underlying growth path of the Japanese economy which driven by capex which is in turn driven by foreign demand or, in other words, by exports. Lastly, and this perhaps is something which could modify the outlook I have sketched above, we have just learnt that land prices in Japan have risen for the first time in 16 years as appreciation in urban areas has finally outweighed depreciation in rural and provincial regions. Of course, this is once more prompting vigilance over at the BOJ where it is being interpreted as a potential forerunner of an asset bubble. Now, I think it is reasonable here to attach some qualifiers.

In the first place there seems to some be indication of speculation here, and especially in the big cities where the appreciation in property values is greatest and as such speculation needs to called what it is, namely speculation on further appreciation. Another interesting aspect is that a lot of the appreciation comes from overseas investors who are investing in Japanese property expecting to wheel-in a gain on future appreciation. Now, the overall property price level development is still substantially negative in Japan as shown here in the latest round up by the Economist on global house prices. I am not attempting here to deny the facts, but merely suggesting that the current speculation which is pushing prices up might be building on the back of expectations and a view of economic fundamentals which perhaps are not present in Japan.

The Yen and Carry Trades - Still Exciting

I cannot of course write any note on Japan without also doing a stop-off in FX-ville and take the latest pulse on the Yen and associated carry trade. The first observation to take away from the carry trade debate of recent months is that it is the volatility displayed by the Yen which has been prompting commentators on an on/off basis to hail the end of the carry trade. Yet, they have of course not been reading or not fully understood what Artim noted recently in his brief on carry trade. Of course I am not trying to say that that we should not be keeping a wary eye on the Yen and on the potential for unwind of the carry trade, but we should also do this whilst remembering that the recent day-to-day volatility has basically been driven by stock market and economic data from the US and elsewhere, and that the fundamentals have not really changed and neither have the expectations, at least not decisively. Of course, the minute expectations begin to solidify towards an appreciation of the Yen Japan will be in hell of a bind since an appreciating currency is associated with deflation which is also why I don't see the BOJ moving much further north on rates in a climate where the Fed is likely to be on hold and perhaps even move down on the back of downside risk of a recession in the US. However, none of this has happened yet which leaves Artim's analysis noted above pretty much right on cue. Now, there is more to a yen carry trade than going short on the Yen and as such what is the most likely long position which we can expect from, for example, your average hedge fund? Well, of course the USD is always an option but as Brad Setser notes in his very recent entry there is much more to this than meets the eye in terms of the choice of high carrying currencies which make the flip side of a carry trade.

In Summary

So, on the economic outlook for Japan going forward I would especially like to stress one thing to watch, and that is the substantial risk of Japan falling back into deflation in March (and perhaps February) on a y-o-y basis. If this happens it will undoubtedly cause some ripples between the MoF and the BOJ where the latter will be accused of acting prematurely on the basis of a backward looking hike in February. The other thing is industrial production which almost inevitably fell in February on a m-o-m basis due to de-stocking on the back of the unsustainably high capex seen in Q4 2006. The evolution of the export surplus from March onwards will determine just how much capex can be ramped up in the months to come, and this again depends on how key economic data coming out of the US (and to some extent also China) evolves. On consumer spending, we should expect to see a small pick-up over the next few months on a m-o-m basis but I am not bullish about the evolution of consumer spending on a y-o-y basis. On the carry trade I see no change in the fundamentals and indeed if the US economy edges further towards a recession and the Fed begins to ease I am not sure that this would cancel out the carry trade in any substantial way. The point is that Japan, at this point, cannot muster an expectations driven appreciation of the Yen as this would feedback into price levels with a deflationary impact. As such, I see a distinct risk for the BOJ heading back into ZIRP if expectations begin to drive the Yen up relative to the USD and the Euro.

Finally, I want to end on an open note in terms of Japanese interest rates and whether the BOJ should normalize or not. My impetus is a recent article in Bloomberg which cites forecasters Christopher Wood and Brian Reading, who are both ardent Japan watchers, as saying that Japanese should interest rates and do so rather sooner than later. Wood for example notes that the BOJ should raise immediately from the current 0.5% to 1.5% in one go. But, we could ask, where might the sanity in such move be located?

Wood and Reading say that higher rates will help banks increase the margin between loans and deposits. Meanwhile, real estate companies should benefit as rising household incomes spur investment in land and deflation's end helps property prices.

``The Bank of Japan should raise short-term interest rates in one go to 1.5 percent now, not incrementally,'' said Wood. ``The normalization of rates in Japan would create a colossal buying opportunity for the stock market.''

So where do I stand here then? Well, first of all I do see the predicament with current monetary policy in Japan since the interest rate pretty much represents a blunt weapon for the BOJ. However, I am not sure I buy the Wood and Reading's chain of arguments. What we need to consider is that any such abrupt move would almost certainly lead to the return of deflation - at least in the short term - and it is hard for me to see how this could push consumer spending higher even if equity markets saw a substantial appreciation. We need to remember Japanese demographics here too (strangely Wood and Reading do not include the marginal propensity to consume vs. saving anywhere in their analysis) and as such deflation coupled with substantially higher interest rates seem to represent a rather strengthened incentive to save relative to consume. Of course, goes the story, property prices would increase as well which together with equity market appreciation would represent enough savings for the domestic economy to put more money into consumption yet once again this is a strange prediction given the fundamentals of the Japanese with a median age of close to 43 and climbing. In the end however I am all for going against the conventional wisdom but even in a best case Wood and Reading's suggestion would represent some gamble not least with the BOJ's credibility and with Japan's ability to service a mounting public debt.

Friday, March 16, 2007

Finland's Economy - Last One Out Turn Off the Northern Lights?

Or still willing to shine?

By Aapo Markkanen: Tampere

If Joseph Schumpeter still lived, he would like Finland. Few other countries in the world have so thoroughly proved his point about creative destruction, which has it that the rise and fall of enterprises at the micro level, and national economies at the macro level is defined by how well and how soon they can adapt to change; by accepting that the operational environment is inherently evolutionary, and that the greatest art you can master is the art of letting go. It’s a lesson worth learning, and not least for the Finns themselves.

Finland, isolated by geography, started its industrial revolution rather late, at the end of the 19th century, and remained largely an agrarian society until halfway the 20th; when it became independent in 1917, 70% of the employed population was working in agriculture. Even if the step to manufacturing took its time, the next ones up the value ladder were less hesitant; yet brought about by the country’s own willingness to move on and to the evolutionary imperative - the dire circumstances of the early-1990s, that is.

Like other European market economies, Finland liberalised its financial sector at the beginning of the 1980s, which launched an intense credit boom, since borrowing wasn’t anymore a luxury reserved to the finest of society. In this case the policy was totally reactive, at best: out of fear of foreign capital, Finland had been Europe's laggard when it came to free its financial markets, and therefore couldn’t have the benefit of gradualism. As a result, the people went credit-mad and the banks, having been under inadequate scrutiny, lent them money for almost non-existent securities.

The boom and bust cycle came to an end around 1991, hence coinciding with the collapse of the Soviet Union - the destination for one fifth of Finnish exports - and doubling the trouble. For firms, bilateral bargaining with the mighty neighbour had been very favourable, so there had been no serious incentive to focus on the quality of products, or think "what's next". To make matters even worse, the Central Bank (previously a culprit of "playing Italian", i.e. granting a devaluation whenever the big exporters, namely the paper mills, and the affiliated trade unions, gestured for one), in search of credibility, had pushed for a stubbornly overvalued Finn Mark, and exports were not only of low quality but also far too expensive. When the recession was finally over in 1994, the country had lost about 14% of its 1991-level GDP and went from full-employment to a 20% unemployment rate.

Luckily, in the 1980s there had been some other issues that Finnish policy-makers had actually got right. As this paper (PDF) stresses, the policy of innovation underwent a healthy overhaul during that decade. The traditional public approach had been one of picking winners and investing money in them, whereas the Finnish government had understood - for reasons unknown, considering everything they did not understand - that innovation has more to do with micro than macro, and can merely be enabled, rather than directed. Following this vision, and along with the other Nordic nations, Finland was the first country in the world to open its telecoms market, thus allowing a company typically linked to the production of pulp, car tires and toilet paper to use it as an everyday laboratory. And as the mentioned conglomerate also took the risk of focusing on a product for which there were no mass market at the time, this all eventually paid off; Nokia was the first to move, and - once the recession had wiped off most of the low-value businesses - could as well find enough human capital to facilitate its expansion. Had politicians bailed out the old industries, this couldn't have been possible.

So if the water is already boiling, the frog (indeed, the Finnish parliamentary race isn't Europe’s only spring election) usually jumps out of the kettle. But that was fifteen years ago. How widely awake is Finland today?

First of all, it should be as awake as possible. Finland's median age is the world's fourth highest, exactly at 41 years. Total fertility is at Nordic levels, at 1.8 children, so the long-term situation is not as alarming as in most parts of Europe, yet the large number of baby-boomers will make it sure that roughly from 2010, and at least until the 2030s, Finns will have to live with the idea of constant austerity and growth levels on par with inflation, at best. If perceived in merely relative terms, the country's current public debt, presently 38% of GDP, may provide some relief - being rather modest by pan-European standards, and down from the 60% recession levels - but this, unfortunately, doesn't make its own straightjacket any looser. The debt level remains after all rather high, owing its shrinking largely to GDP growth rather than to actual debt settling. Hence spending the upcoming decades away won't be an option, and the next four years will be the last "normal years" for governing.

And if you use the mandate that is ending as a yardstick, the normal years have been good years. In 2006, the Finnish GDP grew by 5.5% (approx one per cent is a statistical mirage, due to a 2005 lockout in the paper industry) and is now $32.800, above Belgium and nearly even with Australia. Households saw their real income rise by 1.6%, which is partly thanks to some (arguably generous, considering the future) tax cuts introduced by the incumbent coalition. The overall taxation, in terms of GDP, is now at 43.5% and, if you listen to the OECD's advice, there's no fiscally sustainable way to push it lower; all decreases should be balanced by equal cuts in expenditure. As the safe margin has been exhausted, the OECD suggests instead that Finland should move from taxing incomes towards higher taxes on property (currently among Europe's lowest), yet such a maneuver wouldn't go down well among the electorate. It is a land where seven out of ten own their own homes - and, as you might guess, the remaining three that don't, have no political clout either.

The keenness of Finnish to own their homes, and the government's keenness to sponsor it, have also had their consequences for the labour market. The official, and somewhat fiddled, figures put the unemployment rate close to 7%, yet the regional disparities are dramatic. The prospering south and south-west regions, specifically the one surrounding Helsinki, are already suffering from a chronic labour shortage whereas declining areas in the east and north-east parts of the country sometimes have more than a fifth of their population jobless; and moving is, naturally, difficult if one has to sell property in a place where demand is low and then move to the booming capital.

Housing policy is definitely the only rigidity troubling the Finnish labour market. One myth about the so-called Nordic model is that of flexicurity, i.e. low job protection but high unemployment security. It may certainly be valid in Denmark, but Finland, or Sweden, are rather different cases, as you can see for example in this paper (PDF); in terms of hiring and firing Finland is more or less your average EU country - one that, moreover, has a long tradition of setting wages through collective agreements and universal pay raises. This has arguably contributed to containing inflation, and maintaining low income differences, but - by ignoring varying productivity levels - has also priced many low-skilled workers out of jobs altogether. Generally speaking, all these rigidities have not only led to a high-unemployment rate but also to an increasingly two-tier labour market, where a majority is enjoying well-protected permanent contracts and the worse-off minority has to combine one short-term or part-time post after another; as you can see from this PDF (and Chart 2.6), among OECD's EU members only Spain and Portugal have a bigger share of their workforce under temporary contracts.

Finland's total participation rate is nevertheless 70%, and has been on the rise since the government reformed the pension system in 2005. Prior to the changes, pensions were defined by the final salary of the retiree; in the new system it's the whole career that matters, and the working years from 63 to 68 have been made particularly lucrative. As concluded in this paper (PDF warning, again), for example, the reform can be considered a comparative success (namely in comparison to failed reforms e.g in France or Austria) but even then, it still left many problems unsolved - being "a new-entrant reform" and thus leaving the existing handouts untouched. (It is exactly cases such as this that made Peter Drucker to predict that intergenerational conflicts of interests will bring chaos to the increasingly obsolete political systems everywhere.) So the system has been tinkered with, but not fixed.

You can say the same about the education system, no matter how hard it has been benchmarked after the PISA results. To sum it up: the primary level does a good job with the young minds, the secondary level starts to waste their skills, and the tertiary level provides an equal distribution of mediocrity to everyone whose skills haven't been been wasted so far. You can read about the secondary level here, whereas the main problem of higher education is pretty simple: lack of money.

Universities were still adequately funded about ten years ago, but since then Finland has run into the same trouble as every other country that doesn't charge for tuition; if you don't allow the universities to collect their own money you must increase their public support by sums equal to inflation rates - and do it while the other services are also claiming for more money. It's nearly impossible. Also, if university revenues have no direct link to their own funding they will never get a true incentive to specialise or start competing with each other or, above all, their peers abroad. In other words, Finland has plenty of faculties that are "okay" or "good" but very little pockets of excellence. It can't make knowledge a business.

"Could be better, could be much worse" seems to describe best how Finland is like in the eve of demographic decline. Its macroeconomic prospects aren't as alarming as in most other developed countries (the point made by WEF's Competitiveness Reports year after year - it's the macroeconomy, stupid!) and it has indeed made an effort trying to make its welfare model sustainable. But is it enough? As it appears now, Finland is most likely to keep its head above the water but not much more. It will muddle through but it won't sparkle.

That is, unless it can learn some new tricks. The true lesson for Finland has been, after all, one of letting go. If Finns turn out to be as willing (or as forced) to change their ways as they have been before, they should do alright - assuming that their memory has not begun to fail them once they've grown older. If it indeed has, and Finns have grown complacent, then the future won't be too bright. The next four years will tell a lot.

Wednesday, March 14, 2007

Finland's 2007 centenary election

by Manuel Alvarez-Rivera: San Juan, Puerto Rico

Finland holds a parliamentary election on Sunday, March 18, 2007. A total of 4,292,432 electors - including 208,887 Finns residing abroad - will be entitled to vote for 200 members of the country's unicameral Parliament, the Eduskunta (in Swedish, the Riksdag). However, advance voting in Finland took place on March 7-13, and abroad on March 7-10, and according to the Finnish Ministry of Justice's elections website, 1,193,292 electors voted in advance of the March 18 poll, up from 1,044,607 (26%) in the 2003 parliamentary election.

The Electoral System

Members of the Eduskunta are elected every four years in fourteen multi-member constituencies and one single-member district - the Swedish-speaking Åland Islands; for the 2007 parliamentary election, the multi-member constituencies will return between six and thirty-four members of Parliament. As in most European countries, parliamentary elections in Finland are carried out by proportional representation, specifically by the largest average or D'Hondt rule (except in Åland, whose single representative is chosen by British-style first-past-the-post voting). Nonetheless, the Finnish system differs in a number of ways from most forms of party-list proportional representation.

First, electors in Finland vote for a candidate in a party list, rather than for the list itself, and the number of votes polled by a party list equals the sum of votes obtained by each candidate on the list. Seats won by a party list are then assigned to the candidates polling the largest number of votes within the list. Therefore, electors need not abide by the parties' preferred ranking, and may freely choose a lesser-known figure in a list over a prominent party leader.

Second, political parties may form election alliances - which may also vary (and in fact do vary) from constituency to constituency - to improve their chances of winning parliamentary seats. Although the Finnish electoral system imposes no minimum barrier to participate in the allocation of constituency seats (largely to guarantee representation to the country's Swedish-speaking minority), the D'Hondt rule creates a de facto threshold that makes it more difficult for smaller parties to win seats, particularly in the smaller constituencies. Moreover, this effect is compounded by the application of the largest average method across fourteen separate electoral districts.

Third, parties forming election alliances accumulate votes separately. However, while constituency seats are proportionally allocated among single parties and electoral alliances, seats won by an alliance are not necessarily distributed among its component parties in proportion to their voting strength. This is so because seats won by an alliance are also allocated to the candidates with the largest number of votes among all lists within the alliance, regardless of party affiliation.

The Centenary Election

The upcoming vote in Finland will be taking place on the centenary of the country's first parliamentary election. That poll, held on March 15-16, 1907, came after a major 1906 parliamentary reform, which in a single stroke replaced the ancient Diet of the Four Estates - chosen along class lines under a restricted franchise - with an unicameral, 200-seat Parliament elected by proportional representation and universal suffrage of both men and women, the latter becoming the first in the world to secure both the right to vote for and to be elected to the legislature; the first Eduskunta had a total of nineteen female parliamentarians.

The circumstances under which this political quantum leap took place were even more remarkable: since 1809, Finland had been a Grand Duchy of a decidedly autocratic Russian Empire, which had sought to "russianize" or assimilate Finland in the late 19th and early 20th century. However, the Finnish people vigorously resisted such attempts, and following a disastrous military engagement with Japan - the Russo-Japanese War of 1904-05 - and a failed revolution, Russia had little choice but to placate the restless Finnish.

To be certain, reform had its limits: the Eduskunta initially had no control over Finland's government, the Russian Tsar repeatedly dissolved Parliament, and after a few years the Russians would renew their attempts to assimilate the country. Nonetheless, Finland's democratic institutions proved to be durable, and the Russian Revolution of 1917 gave the country the opportunity to establish the principle of government responsibility to Parliament, and subsequently declare its independence. Just as important, these institutions survived a brief yet bloody civil war, after which the country became a republic under a semi-presidential form of government that retained parliamentary forms, while providing for a strong head of state (whose powers were somewhat weakened by a 2000 constitutional reform).

Survival Under Russia's Shadow

The history of Finland during most of the 20th century has been to no small extent a tale of remarkable political survival in the face of adversity, which more often than not came in the form of a powerful and frequently aggressive neighbor, namely Russia.

After losing two military conflicts against the Soviet Union - the Winter War of 1939-40 and the Continuation War of 1941-44 (in which Finland was the only non-occupied democratic country to side with Nazi Germany) - and suffering the loss of over a tenth of its territory, Finland had no choice but to pursue a policy of neutrality and friendly relations with the U.S.S.R. in the years following World War II. Although a number of far-right organizations were outlawed at the behest of the Soviets after the end of the war - most notably among them the crypto-fascist Patriotic People's Movement - and the Communist Party was legalized once more (having been previously outlawed in 1930), the country retained its democratic institutions and its highly fragmented multi-party political system, which during the postwar years came to be dominated by four major parties - the Social Democrats, the Agrarians (subsequently renamed the Center Party), the conservative National Coalition Party and the Communist-dominated Finnish People's Democratic League - and a number of minor parties, most notably among them the Swedish People's Party (which seeks to represent the country's Swedish-speaking population), the Liberals (under various names) and later on the populist Finnish Rural Party (an Agrarian Party breakaway, eventually superseded by the True Finns), the Christian League of Finland (nowadays the Christian Democrats) and (since 1987) the environmentalist Green League; Elections to the Finnish Eduskunta (Parliament) has a more detailed review of Finland's political parties.

Nonetheless, during the better part of the Cold War years, the Soviets frequently interfered in Finnish domestic affairs, sometimes even influencing the formation of coalition governments to keep certain parties out, or have others included. The dominant political figure during this time period was Urho Kekkonen, a former cabinet minister and head of government who served as President of Finland from 1956 until his retirement in 1981. Kekkonen's long tenure was characterized by an undue readiness to acquiesce to Soviet meddling in Finnish internal matters - a state of affairs that came to be known throughout the West as "Finlandization".

In all fairness, Finland and Kekkonen had no practical alternatives, and the fate of the countries in Eastern Europe under Communist rule, or - closer to home - the Soviet-annexed Baltic republics served as reminders of how things might have turned out otherwise. That said, contemporary criticism of Kekkonen centers around the fact that while he may have been "a prisoner on probation" of the Soviet Union - as one prominent Finnish politician once put it - he developed an excessively close relationship with the Soviet leadership, going further than what was warranted by circumstances, and proving all too willing to get in the sauna with the Soviets, figuratively as well as literally (holding informal discussions in the sauna is a Finnish tradition). Although Kekkonen was not a Communist (he belonged to the Center Party), within a few years of his death in 1986 it was alleged the Kremlin had bankrolled his presidential campaigns.

A Quarter-Century of Cabinet Stability

Until 1983, Finland had a very serious case of Italian-style cabinet instability, in which governments succeeded each other at short intervals, at an average rate of one every year. However, since then Finnish cabinets have developed a remarkable degree of stability, and in the last quarter-century all but one of the country's successive governments have completed their four-year term of office.

Several factors appear to have played a role in this turn of affairs. The Communist-controlled People's Democratic League began to suffer a marked electoral decline after 1979, in large measure brought about by an internal struggle between reform-minded and Stalinist factions, which eventually led to a damaging split. Although the warring factions subsequently regrouped under the post-Communist Left Alliance, the new party has never been able to match the electoral success of its predecessor, and Finland now has only three major parties. Meanwhile, the Liberals went into terminal decline and in a matter of years were a spent force. As a result of these changes, the party system was somewhat simplified. This, combined with the fact that the country's political parties gradually moved in the direction of essentially centrist political positions, made it easier to form stable coalition governments.

Just as important, Soviet interference in Finnish domestic matters declined noticeably after the emergence of Mikhail Gorbachev and the advent of glasnost ("openness"), which led to improved relations between Finland and the Soviet Union. Consequently, the National Coalition Party - which had been previously viewed with extreme suspicion by Moscow because of its business-oriented views - returned to government in 1987 with very little controversy, after having spent more than two decades in opposition. In due course, the demise of the Soviet Union opened the door to Finland's entry into the European Union, and the proposal - which would have been unthinkable just a few years earlier - was decisively approved by voters in a 1994 advisory referendum.

For many years now, coalition governments in Finland have often been broad-based and consensus-oriented alliances that bring together parties that would normally be political adversaries. For example, from 1987 to 1991, and again from 1995 to 2003, the right-of-center National Coalition Party and the center-left Social Democratic Party were partners in government. In fact, the 1995-2003 administration of Social Democrat Paavo Lipponen - the longest-serving prime minister in the history of Finland - was a "rainbow" coalition that also included the Left Alliance, the Green League and the Swedish People's Party.

During the course of the 20th century, Finland's Swedish-speaking minority declined from nearly thirteen percent of the country's population to less than six percent. Nonetheless, the Swedish People's Party has not only been continuously represented in Parliament since 1906, but has also taken part in coalition governments for fifty-one of the past sixty-two years, including every cabinet formed since 1979 - up to the "Red-Earth" Center Party-Social Democratic coalition governments that have ruled Finland since 2003, first under Anneli Jäätteenmäki (Finland's first female head of government) and then under Matti Vanhanen, who replaced Jäätteenmäki as head of government when she was forced to resign after only two months in office, in the aftermath of the "Iraq-gate" scandal (she was subsequently found not guilty of charges against her arising from the scandal).

Interestingly, electoral alliances had comparatively little impact in the outcome of the 2003 Eduskunta election. Had there been no alliances, and had voters cast their ballots the same way, the Center Party would have had a net gain of two seats, and True Finns would have lost two of its three seats, but the remaining parties would have had a net gain or loss of no more than one seat, and the Christian Democrats, who would have lost most of their seats in the 1995 and 1999 parliamentary elections without electoral alliances (mostly to the benefit of the larger parties), would have retained the same number of seats they won in the election.

In fact, the result of the 2003 parliamentary election in Uusimaa (Nyland) constituency - the largest electoral district - presented a clear example of seat allocation disproportionality within electoral alliances. In that constituency, an alliance of the Christian Democrats, True Finns, the Ecological Party and Pensioners for the People secured 22,753 votes, which entitled the group to one of the constituency's 33 seats at stake. Although the Christian Democrats were by far the largest party within the alliance, with 15,936 votes, their vote was split among twenty-one candidates, and consequently the seat went to True Finns' party leader Timo Soini, who won the largest number of votes among all alliance candidates, although his party polled only 5,263 votes.

Ironically, if the Christian Democrats had run alone in the constituency and if their list had obtained the same number of votes, the party would have captured that seat (although the gain would have been offset by a seat loss in another constituency); however, had the electoral alliance polled an extra 764 votes, it would have secured a second seat, which would have gone to the Christian Democrats. Not surprisingly, the Christian Democrats won't be taking part in electoral alliances in Uusimaa for the 2007 parliamentary election.

Consensus Frayed?

Earlier this month, the Central Organization of Finnish Trade Unions (SAK), which represents primarily blue-collar workers, was forced to drop a controversial television advertisement which depicted a cartoonishly callous and gluttonous businessman expressing contempt towards workers' rights, and satisfaction about the supposedly lower election turnout of working-class Finns. SAK claimed the advertisement (which can be watched here) was intended to promote voter turnout among blue-collar workers, but many politicians, including some Social Democrats found the tone strayed too far from the long-accepted consensus based on negotiated wage agreements between capital and labor. Meanwhile, a couple of Social Democratic Party advertisements, in which a child and a senior citizen are denied care for want of money, have also generated some controversy, although the party has refused to withdraw them so far.

The ads in question may or may not be indicative that the long-running principle of consensus is beginning to wear out. If that turns out to be the case - and at this juncture that is a very big if - Finnish politics may well revert to more adversarial styles in the years to come.


Finland's Ministry of Justice's elections website reports definitive results of the March 18, 2007 Eduskunta election were as follows:

Center Party of Finland - 640,428 votes (23.1%), 51 seats
National Coalition Party - 616,841 votes (22.3%), 50 seats
Social Democratic Party of Finland - 594,194 votes (21.4%), 45 seats
Left Alliance - 244,296 votes (8.8%), 17 seats
Green League - 234,429 votes (8.5%), 15 seats
Swedish People's Party in Finland - 126,520 votes (4.6%), 9 seats
Christian Democrats in Finland - 134,790 votes (4.9%), 7 seats
True Finns - 112,256 votes (4.1%), 5 seats
Communist Party of Finland - 18,277 votes (0.7%), no seats
Others - 49,205 votes (1.8%), 1 seat

65% of the electorate (including Finnish citizens resident abroad) turned out to vote in the election, down from 66.7% in the 2003 election; it's also the lowest turnout in a Finnish parliamentary election since 1945.

Detailed 2007 election statistics are also available at Elections to the Finnish Eduskunta (Parliament), and Aapo Markkanen's blog has additional commentary on the election result. Meanwhile, Statistics Finland offers a definitive election results summary as well as analysis.

The most notable developments in this election have been the remarkable rise of the conservative National Coalition Party - which gained ten seats and became the country's second largest party for the first time in twenty years - and the just as spectacular setback suffered by the Social Democrats, who fell to third place and polled their second-worst election result since 1945. Although the National Coalition Party gains weren't record-breaking - in 1970 and 1979 it scored even larger seat gains, and in 1970 it had a larger vote percentage increase - the party still had its second-best showing since the end of World War II (and its best result since 1987), coming within two seats of becoming the largest party in Parliament.

As for the Social Democrats, this is only the second time in the history of Finland the party has been relegated to third place. However, it should be noted that when this previously occurred in the 1962 general election, the party faced competition from not only a still-strong People's Democratic League, but a splinter group as well - the Social Democratic Union of Workers and Small Farmers, which polled its highest vote ever in that election. Moreover, at the time the Social Democrats had been at odds with Moscow for several years, which adversely affected their electoral fortunes.

Incidentally, electoral alliances had even less effect on the distribution of seats this time around than in the preceding election. Had there been no alliances, and had parties polled the exact same results, the Center Party and the Social Democrats would captured one extra seat each, at the expense of the Greens and True Finns, which would have lost one seat apiece; the remaining parties would have obtained the same number of seats they actually won in the election.

In theory, the Center-Social Democratic-Swedish People's Party coalition government of Prime Minister Matti Vanhanen could have remained in office, but it would have commanded a parliamentary majority of only ten seats, down from thirty-two in 2003, and on that account it would have been the weakest majority coalition government in Finland since 1945 (although it should be noted that Kalevi Sorsa's first administration in 1972-75 managed to hold on to power for almost three years on the basis of a four-party, fourteen-seat majority, at a time when Finnish governments usually collapsed within a year of taking office).

As it was, Prime Minister Vanhanen chose instead to form a four-party coalition government of his Center Party, the National Coalition Party, the Swedish People's Party and the Green League. Vanhanen's new government, in which women hold a majority of twelve out of twenty Cabinet positions, has a comfortable majority of 125 seats in the newly-elected Eduskunta.

Thursday, March 8, 2007

The Eurozone - Continuing the Hike

By Claus Vistesen Copenhagen

If there is one thing you can be sure of as an ECB watcher it is that Trichet and co. almost always delievers as expected, a virtue of credibility which of course is very dear to any central banker's heart. Consequently, the ECB today upped the main Eurozone interest rate 0.25 base points to 3.75%. The rate hike comes pretty much as expected but it also comes at time when markets seem a bit more jittery than usual on the back of rising probability of a recession in the US as well as the fact, and in the light of more recent data to be presented below, that the Eurozone's stellar performance in the 4th quarter is now little more than a glimmer in the rear-view mirror.

A Rough Start to 2007

It is of course still difficult to say anything conclusive about the Eurozone's performance going forward in 2007, and especially since the 1st quarter almost certainly will show a marked slowdown on a q-o-q basis relative to Q4 2006. However, especially the initial signs from the Eurozone's biggest economy Germany suggests that the party might well be coming to an end. First of all we of course have the overall drop in European retail sales which was extended in February for the second consecutive month (-1.0% in January). Of course the overall drop masks notable differences across the zone, since for example retail sales continued to grow at a healthy clip in France.

However, in Germany there were notable signs of a strong drop on the back of the rise in the VAT effectuated January 1st 2007. Further evidence for this is to be found in the recent German consumer confidence survey which recorded a marked drop in February. Especially however, the monthly figures are telling in a German context; in December 2006 retail sales grew 2.6% from November but in January figure was a whopping decline of 5.1% which of course indicates that the notion of forward pushing purchases to avoid the tax hike seems evident. Yet, this notion of forward pushing also has an inflation story and part of the reason why the ECB has remained vigilant is precisely because the VAT hike was believed to be inflationary as retailers might pass the increase on to consumers. I have been persistently critical of this analysis and in a recent piece over at AFOE I argue why we should not expect the VAT hike to be inflationary. In terms of data, the recent inflation figures from Germany do seem to support my analysis. So consumer spending does not seem to be about to pick up in Germany which is not exactly a new story, but more worrying perhaps is the January drop in factory orders which was led by a decline in foreign demand. Of course, the January decline needs to be taken with a pinch of salt since there is a rather large discrepancy between the January and December figures. As such, if we level out the December and January figures we have a less substantial decline going into 2007 than the headline numbers suggest. However, German capex needs to be watched very carefully since a lot of it is dependent on foreign capacity and given net exports' high contribution to German growth rates even a slight decline here would be directly transmitted into domestic growth rates since we should not expect private consumption to compensate, and the fiscal environment has become more restrictive.

A Re-acceleration in the Cards?

As I stated initially above, even the most optimistic proponents of the goldilocks recovery also went out of 2007 with a bearish outlook on Q1 2007 an outlook which indeed seems to be moving steadily towards a more realistic appraisal of the whole situation. So should we expect to see going forward? In a recent note over at Morgan Stanley which seeks to test the resilience of the Eurozone to systemic shocks transmitted by any potential significant sell-off in global equity markets the MS analysts cite the underlying economic fundamentals of the Eurozone as being healthy ...

Going forward, we anticipate a re-acceleration of growth in the second half of the year, when the negative impact of fiscal retrenchments starts to fade away. Depending on the resilience of domestic demand, which so far has been more robust than expected, euro area economies seem relatively insulated against external risks.

Now, who am I to say what the difference between goldilocks and 'healthy' is, but I would like to see and hear where this expectation of a re-acceleration of growth in the latter half of 2007 comes from? Another point here is of course my lecture about the errors of looking at the Eurozone as one integrated economy and in terms of the general scenario plotted above by MS. I think we really need to take a long hard look at Germany and Italy, for example, and especially if the ECB continues its rate-hike process much further. Most importantly here we need to think about the exports picture, since exports are very important for e.g. Germany and, as is also noted by MS, a drop in the rate of increase in exports to either China or the US would have a significant impact the Eurozone's largest economy. Finally, MS outlines the ultimate risk scenario which incorporates an administrative clampdown on investment in China, a subprime (systemic) meltdown in the US, and a subsequent large selloff in global equity markets. Such a 'worst case' scenario would of course lead turmoil in the entire global economy and as MS notes would increase the risk for deflation in the Eurozone whilst immediately prompting the ECB to lower rates. However, once again we need to stop looking at the Eurozone as one single homogenous economy and for example home in on Italy and Germany and look at these economies in a world where the ECB continues to raises rates and the US begins to slow - whether moderately or considerably; in short a watered down version of the ultimate doom and gloom scenario... what would this mean for growth and inflation in these two countries? What I am of course focusing on here is consequently not so much whether the ECB should raise or not but more so the issues pertaining to the single interest rate policy itself. Ultimately, I guess you do need a specific call, so given today's comments from Trichet I would put the chance for another hike at 60/40 in favor of a hike. This relative uncertainty should of course be seen in the ligth of the near certainty of today's move and as Munchau argues today at Eurointelligence, the ECB tightening cycle is fast coming to an end and on that I think he is right on cue.

Thursday, March 1, 2007

India's Retail Revolution

by Arjun Swarup: Washington

In 1984, Arthur Hailey wrote a novel called Strong Medicine, which described the American pharmaceutical industry. Two thirds of the way through the book, the main protagonist goes off, along with her family, on around the world trip. In the space of a couple of pages she describes her experiences and impressions of the different places she sees. These descriptions obviously mirror Hailey’s own impressions, thus the Middle East is described as 'oil rich', Greece is described as 'idyllic', and India is described as "that giant subcontinent, the land of savage contrasts, pictures of wealth and beauty contrasted with scenes of appalling filth and degradation”.

22 years on, that description probably remains the most apt summary of the sub-continent everto have been written. In 2005, India had more billionaires than any other region in Asia, and yet at the same time, 1 in 5 children could not get access to clean drinking water. The economy was growing at some 8% per year, yet 380 million Indians continued to live on less than a dollar per day.

Since India opened up its economy in 1991, our GDP has doubled in size to some $745 billion, and per capita income has now reached the dizzying height of $728. Today, the Indian economy stands poised on the threshold of what many (with the honorable exception of the Economist) see as being a spectacular take-off. Yet, despite this startling turnaround in fortune, the issues associated with taking the benefits of the new economic growth out into the hinterlands, in order to create the much needed mass employment, and to create a layer second and third tier cities of international standard, remain significant and pressing challenges. Organized retailing is India’s one clear example of these challenges, and the changes which are presently occuring in the retail sector in India represent one of the best opportunities in decades to aggressively tackle smoe of the big picture problems, and really begin to broad-base India’s development.

As is generally known, India’s economic boom, and especially since the turn of the century, over has largely remained restricted to a few large cities scattered across the country. The recent dramatic rise in GDP growth rates has been mainly by driven by IT,IT related services, and to a more limited extent manufacturing (and especially capital intensive manufacturing) .Three factors have driven this boom – the talent and expertise which is to be found within the country in these sectors, the global demand for such products, and particularly for such products when they bear the 'made in India' trademark', and and finally the relative lack of regulation inside India itself of these new 'sunrise' industries.

Put another way, in these 'pocket-sectors', India has taken rapid strides towards becoming a market economy. In the much larger, rural, sections of India, the presence – and benefits of a market economy are currently perceived to be virtually non-existent. The key to creating a market economy in rural India lies in creating a demand for the products of rural India, as well as in creating a far more efficient agricultural sector. One symptom of the malaise is to be found in the fact that 28,000 crores worth of fruit and vegetables, the core output coming from rural India, is left to rot every year, This is largely due to the absence of cold-storage infrastructure and the inability of the farmer to get the product to market place in time, and sell it at prices which are remunerative of the effort needed to achieve this, or simply due to a lack of buyers or demand for the products in question.

Now one thing is clear. The arrival of FDI in substantial quantities in the Indian retail sector has considerable potential for addressing some of the problems in rural infrastructure and supply chains, and thus has the potential to substantially changing the face of Rural India

The bulk products approach of point-of-sale of retailers - such as Wal-Mart , Metro, Carrefour,etc - has important implications for the evolution of agricultural value-added products such as jams, sauces, and packaged soups. In the case of Wal-Mart these constitute as much as 60% of the annual sales total, and if this could be sourced internally, through the leveraging (and intensification) of India’s agricultural output, then the benefits to India's farmers could be immense. The big retailers will inevitably enter into contracts with farmers for sourcing agricultural produce and part of the answer to India's lamentable agricultural productivity performance undoubtedly lies in just such contract-based farming

So this is an area of HUGE opportunity for India, yet at one and the same time it is also fraught with risk. The Indian farmer, the bulk of whose output is currently wasted, would be assured of a buyer for his product, at stable prices. He would not be subjected to the vagaries of seasonality and volatility of market prices as he is at present Most importantly the big retailers will set up cold-storage infrastructure thereby reducing wastage. In addition, given India’s existing capital intensive industrial manufacturing base, and thus the comparatively high levels of technology already in place there, much of the value-addition industry will be based inside India itself. Thus the ancillary benefits for India would be tremendous.

FDI in retail would create wealth in Rural India, thereby broad-basing India's growth and creating huge job opportunities in India's villages. One fact which cannot be emphasized enough here is that value and wealth is created by sectors. IT and related services directly impact on only a small minority of India's population, and this sector by its very nature can only take Indian developement so far up. If India wants to really become a fully developed economy, regional disparities need to disappear, and a wealthy hinterland is an absolute must .

However, one question that needs to be addressed is – "what happens to the Indian consumer"? On one account, if a Wal-Mart feels that there is more to be gained from exporting the value-added products, could India not be faced with the situation where its own people are deprived of cheap, high-quality products. Looking at the huge wastage issue which exists at the present time, and the enormous potential which exists for improving productivity, this does not seem to be a justifiable fear.

Moreover, the Indian middle class, which is now moving towards international standards in terms of consumption levels, is already at 400 million strong, and is growing very rapidly - by an estimated 40 million every year. To put this number in some sort of perspective, the current size of the Indian middle class is equal to the entire combined population of the United States and Japan, while the 40 million addition is like adding the equivalent of a population like Spain or Poland's every year.Thus the most probable outcome is that for all these big retailers India would continue to be the principal market. Indeed the key problem for the agricultural sector is still going to be meeting the needs of this growing market without producing price inflation in agricultural products.

As India's middle class population grows, and as towns and second and third tier cities grow, many people will have the economic power to buy agricultural products in the cash sector, and this means more demand for fruits and vegetables, as well as for a whole range of other retail products like cosmetics, household goods etc. The the organized retailing sector in India may begin to assume immense importance.

Why? Because retail has the capacity to affect every single Indian, in more ways than we can begin to imagine. The prices we pay for goods right now affects directly just how much disposable income we have, and the availability of goods implicitly determines productivity as well as living standards, and above all, the cheaper and more available goods are, the more we are able to consume, and the more we consume, the more employment and wealth we generate.

Organized retailing can lead to lower prices, greater availability of goods, and trigger anew and growing cycle of consumption and wealth creation. India’s biggest strength lies in the fact that the bulk of its markets are domestic, and consumption from within India alone can drive rural growth. However a facilitator is needed, to connect the buying power of urban India with the selling power of rural India, and organized retail could be just that facilitator.

Worldwide, organized retailing is big business. Four out of ten of America’s richest people are from the Wal-Mart family. Wal-Mart is as much a symbol of the American landscape, as the chai-walla and the sabzi wala are dots on the Indian one.

Organized retailing can do for India what electronics did for Japan, low-cost manufacturing did (or claims to have done) for China, and what gold and oil did for the Middle East. It can help the weaker and poorer sections of society leapfrog years of conventional development, and create large amounts of wealth. Challenges remain, but organized retailing offers India an important opportunity. It is one we must be ready to grasp with both hands.

Estonia's 2007 e-lection

by Manuel Alvarez-Rivera: San Juan, Puerto Rico

Estonia will be holding a parliamentary election on March 4, 2007, with advance voting taking place on February 19-23. The election will be the fifth legislative poll since 1991, when the country, along with neighboring Latvia and Lithuania, recovered its independence following fifty-one years of annexation by the Soviet Union. But voters in the smallest and northernmost of the three Baltic republics didn't need go to the polls to choose members of the country's 101-member unicameral Parliament, the Riigikogu, since on February 26-28 they were able to cast electronic votes, or e-votes, using Internet-connected personal computers equipped with an ID card reader.

E-voting also allows voters to change their vote by re-voting electronically, or by voting in a polling place. In either case, only the last vote cast by the elector will be counted, and any previously cast e-vote shall be deleted.

Internet voting was introduced in Estonia for the first time in the 2005 municipal elections. However, only 1.85% of the voters - 0.88% of the electorate - cast an electronic vote in the event, whereas 3.4% of the electorate cast e-votes in the 2007 parliamentary election, according to preliminary figures published by Estonia's National Electoral Committee.

Members of the Riigikogu are elected for a four-year term of office by universal suffrage and proportional representation (PR) in twelve multi-member constituencies, where electors vote for a specific candidate within a party list. Nonetheless, the overall distribution of parliamentary mandates is determined on a nationwide basis: Riigikogu seats are apportioned among parties polling at least five percent of the vote (electoral coalitions are not allowed since 1999), according to a modified form of the largest average method, which replaces the traditional d'Hondt divisors (1, 2, 3 and so on) with the series 10.9, 20.9, 30.9, etc. This procedure, mathematically equivalent to elevating the number of votes polled by each qualifying party to the power 1.111111... - 10 divided by 9, that is the reciprocal of 0.9 - and then distributing the seats according to the standard d'Hondt rule, favors the largest parties at the expense of the smaller ones: simply put, the increase brought about by exponentiation becomes larger as the number of votes increases.

In practice, the application of this unusual formula hasn't had much of an impact in the composition of successive Estonian legislatures: compared to the traditional d'Hondt method, the larger parties have usually picked up between one and three extra seats each, while smaller parties have lost no more than one seat apiece.

The five percent threshold and the modified PR rule notwithstanding, Estonia's post-independence party system has been characterized by a high degree of fragmentation and volatility, and the country has been ruled by a succession of shaky coalition cabinets which have lasted on average just over a year in office - a problem common to all three Baltic republics during both their present and preceding periods of independence. Nonetheless, center-right governments have been the norm in post-independence Estonia, except from 1995 to 1999, when the now-defunct, center-left Coalition Party was the country's dominant political force.

The results of the last Riigikogu election, held in March 2003, gave some tentative indications of increasing party stability. In the election, the minority center-right coalition government of the Estonian Centre and Reform parties that had been in power since the beginning of 2002 managed to improve its parliamentary standing, in stark contrast to the 1995 and 1999 legislative elections, when the incumbent parties at the time were soundly rejected at the polls. Nonetheless, the ruling alliance ended up being replaced by another center-right coalition comprised of the new, anti-corruption Res Publica, the Reform Party and the People's Union. However, the new government, headed by Juhan Parts of Res Publica, lasted only two years in office: in March 2005 it lost a parliamentary vote of confidence and was subsequently replaced by yet another right-of-center coalition government of the Centre Party, the Reform Party and the People's Union, led by Andrus Ansip of the Estonian Reform Party.

The ruling coalition went on to poll strongly in municipal elections held later that year, but Res Publica (Latin for "Public Matter"), which had emerged as the second largest party in the 2003 legislative vote (when it tied with the Centre Party as the largest parliamentary force), fared poorly and subsequently merged with an older conservative party, Pro Patria Union. As a result, there are now only five parties represented in the Riigikogu: Union of Pro Patria and Res Publica, Estonian Centre Party, Estonian Reform Party, Estonian People's Union, and the Social Democratic Party.

Like neighboring Latvia, Estonia has a sizable number of ethnic Russian inhabitants (as of 2006, just over a quarter of the country's declining population), but many of them do not have Estonian citizenship and cannot vote in parliamentary elections. In the 2003 Riigikogu election, the largely Russian-speaking Estonian United People's Party (now the Constitution Party) fell below the five percent threshold and lost its legislative representation. As in Latvia, the integration of what remains a significant Russian minority continues to be a major problem that has called the attention of Amnesty International. This issue also has foreign policy repercussions: Russia routinely accuses Estonia of discriminating against ethnic Russians, and relations between both countries remain tense, all the more so since Russia stubbornly clings to the fiction that Estonia (along with Latvia and Lithuania) voluntarily sought annexation to the Soviet Union in 1940.

Despite frequent cabinet upheavals since regaining independence, Estonia has consistently pursued a foreign policy strongly oriented towards the West in general and the European Union (EU) in particular. In light of its poor relations with Russia - not to mention the painful memories of the 1940-91 annexation to the U.S.S.R. - it came as no surprise that Estonia eagerly pursued membership in the EU as well as the North Atlantic Treaty Organization (NATO), securing both in 2004.

Likewise, Estonia has re-oriented its trade towards the West, forging a particularly strong relationship with neighboring Finland - a country with whom Estonia shares a linguistic affinity, as the Estonian and Finnish languages are closely related. Although the Estonian economy has been performing strongly in the years since independence, the country remains among the poorest members of the European Union.

All the same, Estonia has become the first country in the world to hold a national legislative election using the Internet as a means of voting - a high-tech initiative that may be a harbinger of things to come.


Estonia's National Electoral Committee reports complete preliminary results of the March 4, 2007 Riigikogu election were as follows:

Reform Party - 153,044 votes (27.8%), 31 seats
Centre Party - 143,518 votes (26.1%), 29 seats
Pro Patria and Res Publica Union - 98,347 votes (17.9%), 19 seats
Estonian Social Democratic Party - 58,363 votes (10.6%), 10 seats
Estonian Greens - 39,279 votes (7.1%), 6 seats
Estonian People's Union - 39,215 votes (7.1%), 6 seats
Estonian Christian Democrats - 9,456 votes (1.7%), no seats
Constitutional Party - 5,464 votes (1.0%), no seats
Others - 3,527 votes (0.6%), no seats

Voter turnout stood at 61%, up from 58.2% in the 2003 parliamentary election.

The Estonian Reform Party of Prime Minister Andrus Ansip emerged as the election's big winner, increasing its parliamentary representation from 19 to 31 seats and displacing the Centre Party - which picked up an additional seat - as the country's largest political force. However, the Union of Pro Patria and Res Publica suffered a major setback, losing sixteen seats with respect to the overall total won by its component parties in 2003 (when they ran separately); nonetheless, the merged party retained significant electoral support.

In all, six parties are represented in the new Riigikogu: Reform, Centre, the Pro Patria and Res Publica Union, the Social Democrats (who increased their representation from six to ten seats), the People's Union (who lost seven of their thirteen seats) and the Estonian Greens, who secured parliamentary representation on their electoral debut.

Although the Reform-Centre-People's Union coalition government won re-election with an enlarged legislative majority, the ruling parties didn't form another government, due to differences between Reform and the Centre Party over Estonia's flat tax system. In April 2007 - one month after the election - incumbent Prime Minister Ansip formed a new center-right coalition government composed of his Reform Party, the Pro Patria and Res Publica Union, and the Social Democrats.

Estonia's Economy in Perspective

by Aapo Markkanen (Tampere) and Edward Hugh (Barcelona)

Estonia is a land of apparent contradiction. At one pole it is a budding centre of new technology initiatives, as typified by the much lauded presence of Skype, and at the other it is at the front end of one of Europe's most modern problems, population ageing and decline. So Estonia is a kind of living contradiction: a rapidly ageing society apparently run by young people (although it is worth bearing in mind that, when it comes to the economy, the entire software industry of the country employs a mere 2,500 people out of a total population of 1.35 million). As an example of the 'youthful side' of Estonian life it is worth noting that Mart Laar, who may well be the most visible 'personality' of the last decade in Estonian politics, was only 32 when he became prime minister in 1992, and the ministers of defence and intererior in his cabinet were even younger -26 and 27, respectively. Things are already changing here, however, since candidates for this month's elections have and average age of 46.7 which is still rather juvenile by some standards, but is, for example, three months older than their equivalents in Finland, which is in fact about to choose its own parliament two weeks from now. So everyone ages, even in Estonia.

Part of the explanation for this early 'youthful' phenomenon can be found in the nature of Estonia's transition to independence and full EU membership. Prior to independence Estonia's Russian speaking population (which constitutes some 400,000 of the present total, although not all of these, by any means, are full Estonian citizens) had a rather disproportionate influence in the country's affairs. With the arrival of the independent Estonian state in 1991 this group became rapidly discredited, and as a result a gap opened up into which a group of young ethnic Estonians entered enthusiastically, and with some fresh vision - when Mr Laar was sworn in fifteen years ago, Milton Friedman's Free to Choose was the only book of economics he had ever read. Many of these people were indeed only in their twenties and early-thirties at the time, and symptomatic of this new generation and its reach is the fact that the current mayor of Estonia's capital city - Tallinn - is still only 29. Yet do not forget either that Estonia enjoyed here some of the benefits of hindsight, since it only started its transition two years after the post-socialist states in Central Europe, and thus was able to critically examine some of the lessons which had already been learnt.

These facts perhaps explain why the 'reform process' went so far and so fast in Estonia, and this in many ways sets Estonia apart from its Baltic cousins Latvia and Lithuania. Perhaps the most evident single indication of just how far the process went is to be found in one single fact: in 2005 total government accumulated debt (yes debt, not the annual deficit) constituted just 4.6% of GDP. And the transition hasn't been only an economic one since it has also involved important canges in the legal system and civil service as witnessed by Estonia's ranking in the newest Transparency CPI which at 24th positition is more or less remarkable among the post-socialist regimes. Regardless of what are the perceptions from the Kremlin, Estonia has also made extensive efforts to integrate its Russian speaking minority, as can be seen from this (pdf) report.

So on the face of it all is well. Estonia's GDP grew in 2006 at an annual rate of 10.7%, and over the 5 year period from 2002-2006 averaged something in the region of 8.5%. Indeed, as can be seen from the chart below, Estonia has even been doing comparatively well when compared with its other East European EU accession counterparts.

And the people are living much better than they were. In expenditure terms, domestic demand constitutes the principal driver of growth, rising by 11.5% year on year in 2006. Of this total consumer demand continues to grow very strongly, with consumer expenditure up in 2006 by 14.5%.

Consumer price inflation - which is one of the principal present obstacles to Estonia's Euro membership - has not been dramatically high (given the rise in oil prices and the very rapid growth rates) when compared to many actual zone members (Spain and Greece, for example) and has been running in the 3 to 4.5% range (see chart above), and while this issue needs to be addressed it is hardly a case of having the house on fire.

Indeed part of the problem here stems from the Estonia's very Euro membership ambitions themselves, since the existence of Estonia's currency board regime (which is the guarantee that the kroon remains pegged to the euro at the rate of 15.6466:1) effectively limits the ability of the central bank to influence the economy through monetary policy. Instead, the BoE is reduced to attempting to influence monetary conditions through regulation of the banking sector and lobbying of the government to ensure they run a restrictive fiscal policy. As a result bank lending, and especially for property, has been growing strongly (see chart below).In response to this situation, the BoE raised reserve requirements on Estonian banks from 13% to 15% in September 2006, but the results of this are still effectively to be seen.

So the short term outlook is indeed reasonably healthy, but it is in the longer term, and particularly in the context of the capacity constraints imposed by population ageing and decline, that the doubts start to arise. As is by now reasonably well known Estonia's is in decline, and has been for some years. According to the CIA factbook, the population fell at a rate of 0.64% per annum in 2006. Part of the problem is that there are less children being born, and part is that there is a negative net balance on migration (which was thought to have been at a rate of 3.2 people per thousand leaving in 2006). This is not an entirely recent phenomenon, since deaths became greater than births in Estonia in 1992, and fertility remains stubbornly low in the 1.3 - 1.4 range. To be sure Estonia has made some effort to address this situation with a kind of cash-for-children policy, and live births were up in 2005 and 2006, but, if international experience is anything to go by, such policies can only affect numbers on the margin, and a more substantial shift requires a much more systematic approach, and of course only has effects in the long term.

Indeed in the short term the only big change which may be on the horizon is a kind of 'death displacement' effect, since life expectancy in Estonia at 72.04 is still comparatively low by West European standards, and hence there is a lot of room for medically and technologically driven improvement, but while these will only be welcome from a human point of view, the economic consequences of such an increase in life expectancy are far less clear.

To be sure with the low level of public debt there is plenty of slack which can be absorbed by improving the quality of health care, but it will be necessary to find revenue streams to pay for this, and it is noteworthy in this context that there are already proposals on the table to start to modify the 'flat-tax' for which Estonia has become so famous.

Estonia's median age (39.3) is still not especially high, but it is set to rise rapidly. As such we might expect the Estonian economy to come to rely increasingly on exports as this process works its way through, and indeed Estonia does have a very open economy, with exports of goods and services constituting some 80% of GDP by value in 2006 (and imports some 86%, hence the trade deficit), so it is possible for them to make this structural shift, and indeed once the presnt 'growth spurt' wave comes to an end, this is what we should expect to happen. However to make the potential a reality there are a number of important issues which Estonia will first need to address, and the most important of these is the long term capacity problem associated with labour supply.

If we look at the present situation we will see that investment spending has been strong - with gross fixed capital formation running at 31% of GDP in 2005 - although it does seem to have lost some of its momentum of late. Part of the problem which arises in maintaining this very rapid rate of domestic capital formation is the availability of labour, and especially labour with the appropriate skill set. The Estonia unemployment rate is still comparatively high (in the 6 - 8% range), but it has been falling steadily (and if the current rates of growth are sustained it will fall substantially in the next few years), and there are evident signs of shortages of skilled workers in key areas. Estonia!s growing labour shortage has already hit machinery
production, and especially in the area of communications equipment. Elcoteq, the Finnish mobile telephone assembler - which is Estonia's largest exporter - has often complained about difficulties in recruiting skilled labour. Although Elcoteq denies that it has any intention of shifting its activities away from Estonia, the company has now stopped expanding production in its Estonian plants. And as Estonia strives to move up the value chain employment in wage-sensitive industries - such as textiles and leather goods - has been in decline for some years now, with even domestic firms moving production to cheaper locations abroad. Another evident by-product of the growing labour scarcity is the rate of annual increase in monthly salaries, which is now in the 12 - 14% range.

Now evidently the rapidly falling unemployment rate is a result of a number of factors, most important among which are the high rate of economic growth and a declining population, and it is the combination of these which raises all the questions about longer term sustainability. Clearly Estonian companies can overcome labour supply difficulties by outsourcing activity elsewhere, and this to some extent is already being reflected in outward capital movements (see below), which of course negatively impact the external balance in the short term since the inward income stream generated is initially significantly less than the outflow.

As Claus has been indicating time and time again, the implications of such structural shifts are also important in terms of their impact on domestic consumer demand, and few, at this stage, seem to be focusing on the implications of all this.

Another of Estonia's big ongoing worries is the level of the trade deficit -which in recent years has been hovering around 12 per cent of GDP (see graph below), and this is estimated to reach around 19% of GDP in 2007. Insofar as this trade deficit is fuelled by demand for new machinery and equipment (which constituted 31% of imports by value in 2005) then the situation is neither surprising or especially troublesome, but the problem is that the consumption-driven boom has also been increasing the demand for consumer imports, whereas the continuously rising wages have been leading foreign manufacturers, mainly from Finland and Sweden, to outsource further afield. Salaries are expected to continue their rise as unemployment - which is forecast to fall to around 4% in 2007 - comes down; the average salary, 573€ a month at the end of 2006, is expected to reach the 700€ mark by 2009.

Another aspect of the external account position (in addition to the trade deficit) is the widening of the current account deficit and, in particular, the fact that the deficit on the income account has increased substantially. The rapid growth of the Estonian economy has led to a sharp rise in corporate profits, especially among foreign-owned firms. As a result, the deficit on investment income rose by USD107m y-o-y to USD224m y-o-y in the third quarter of 2006. This worsening of the income stream situation has also been accompanied by a deterioration in the capital flow balance.

Estonia continues to be a net recipient of foreign direct investment (FDI), but, as we have noted, investments by Estonian firms abroad are rising. As a result, the net inflow of FDI in the 12 months to September 2006 was USD254m, or just 16% of the current account deficit over the period. With investment in portfolio assets continuing to record a net outflow, the substantial current-account deficit was, in effect, financed by a further large inflow of "other investment" - mainly foreign borrowing by Estonian banks.

Emigration has played its own part, of course, and some 11.000 Estonians, out of the total population of 1.35 million, were working abroad last year -which sounds negligible when we compare this for example with Lithuania (which has more than 400.000 EU expats out of a total population of 3.4 million). The overall migration picture in Eastern Europe is a complex and worrying one, as Claus has already indicated here.

In fact Estonia's loss of workers to richer EU states following accession in 2004 has been estimated by the World Bank at 1% of the working age population, which is the lowest rate for any of the Baltic states. Yet, in interpreting these numbers, one has to also consider the already high median age of 39.3 years and the fact that those leaving have mainly been badly needed young vocational professionals. Next-door neighbour Finland opened its labour market fully just last year, so the flow is likely to only become stronger. Moreover, Estonia suffers from the same malaise as many of its more western couterparts, it has a skewed education system that delivers too few vocational graduates and too many academics (for example, during the years 1995 and 2004 the number of vocationals - per 10.000 people members of the population - increased from 205 to 222, whereas in the tertiary level the leap was from 191 up to 502) and, as an overall result, the country is predicted to face a serious shortage of such workers by year 2015.

One obvious solution, since the salaries and living standards are now catching-up rapidly, might be for Estonia to start attracting workers from other EU countries. The sustainability of its flat-rate tax model is - as has been indicated - debatable, but one advantage (besides the IT-readiness stressed in Manuel's post) that Estonia certainly does have is its geography. Tallinn is only a 80km ferry trip away from Helsinki and, economically speaking, these two regions are already highly integrated -and then there's also St Petersburg lying out there to the East. The future and wealth, to a large extent, of the whole Baltic region depends on how well these centers of growth can network together.

So can Estonia pull it off? This, as in so many other cases, depends. Certainly we are now entering unknown territory. At some point the growth catch-up spurt will come to an end, and the capacity constraint problem will begin to take hold. Whether of not Estonia's leaders will still be young enough and agile enough to respond to the challenge remains to be seen. Certainly a sustainable path is there - via a leveraging of inward migration, outsourcing, networking and a move towards higher value work. When we speak of reform in the Estonian context it is these issues we should be thinking about. The future has that intriguing dimension that is always and ever an unknown entity. Let's just hope that in Estonia's case the upside potential has a greater impact than the downside risk.

Source: Finpro, Finnish Trade Center; Estonia country report 2006