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Sunday, February 24, 2008

Estonia, Between Wage Driven Inflation and a Growing Credit Squeeze

By Edward Hugh: Barcelona

Christoph Rosenberg has a post up on the RGE Europe EconMonitor where he argues he thinks a soft landing for Estonia is both possible and likely, always given, as he says, that the right policy options are adopted.

In fact Christoph is reporting on an academics and policy makers seminar on Baltic Convergence recently held in Brussels. The seminar was jointly organized by the IMF and Eesti Pank, and both he and his fellow blogger Karsten Staehr attended.

The gist of the argument presented by the participants was with the right policy mix a hard landing can be avoided in the Baltics. I have serious doubts about this, and in particular due to the relative time scales of the remedies being proposed and the rate at which the slowdown is taking place. That is, most of the remedies being offered appear to be longer term in their horizon of operation, whilst the crunch is actually coming in the Baltics over the next six months or so, ie in the comparatively short term.

What I feel for the "soft landing" argument to be more convincing is that we would need to be seeing more evidence for it in the data. But if we look at what we have, we can see that the deterioration is continuing, and at a pretty rapid pace.

Noone seems to be addressing head-on the central issue which would seem to be whether or not what we had in the Baltics was a demand bubble inspired by the designation of certain categories of property lending as worthy of investment grade, and a low interest inward flow of funds and loans in non-local currencies which appeared to be underpinned and guaranteed by the condition (ie not the option) of euro membership for all the new EU10 accession countries. What noone seems to have thought about was the impact on the macro economic dynamics in the short run of a rapid transition from win-win to loose-loose as the door has been steadily closed in the applicants face. Slovenia seems to have been the last one in before the door was temporarily closed, with Slovakia poised perilously like a man on a ledge half way up a cliff face, not knowing whether to continue climbing tenaciously upwards (or to jump now before he gets any higher), even as the ever stronger inflation-driven-gusts of wind and rain make his footing weaker and more tenuous with every passing step.

And if the whole thing was a bubble, what can we ultimately expect from the reversal of fortune, and the schocking grip of debt deflation? Obviously any such thing seems a long way away at the present moment, as what we are faced with is an exceedingly hard to eradicate bout of inflation. Just how serious this position is in the face of the continuing slowdown is brought home by the last set of inflation figures, and todays announcement from the statistics office that wages actually rose in Q4 2007 at a year on year rate of 20.1%. Estonia's inflation rate rose to almost a 10-year high of 11 % in January (see chart below) following a 9.6% annual rate in December. So while domestic demand is rapidly slowing, inflation is still accelerating.

This process will not, of course, continue indefinitely, and at some point we will see the reverse face of this, as price deflation gets its grip when demand falls below capacity, as it obviously is going to do. We have two lines moving in opposite directions and at some point they will cross. What we can say is that given the major suplly side capacity constraint has been labour, it should not surprise us if we find the phenomenon of extremely "sticky wages" in the Baltic context. And so, it is, indeed, wage growth in Estonia, as I have said above, remained virtually unchanged in the fourth quarter from the previous one. The average monthly gross salary rose 20.1 percent from a year earlier to 12,270 krooni ($1,161), compared with an increase of 20.2 percent in the third quarter, accdoring to the statistics office in Tallinn earlier today.

Wages have risen due to labor shortages as Estonia's ageing population and an outflow of workers to wealthier countries have steadily pushed unemployment to a 15-year low of 4.1 percent in the fourth quarter. The impact of these ongoing increses in wages can be seen in the continuing high inflation in producer prices , and even more importantly in the continuing increase in export prices. Since domestic demand (ex government spending, and EU fund transfers) may well start to contract at some point, exports are the only real hope for the Estonian economy in sustaining GDP growth in positive territory, but just how far Estonia has to go in putting things into line to do this can be seen from the comparison between export producer prices in Hungary and Estonia shown in the chart below. Export prices have been falling in Hungary for nearly a year now, and as a result Hungary now has a small goods trade surplus. Estonia has still to really start this process.

And remember, with each month that passes and producer prices continue to rise (ie the PPI index remains above zero price growth), the more pressure there is on the competitivity of Estonian exports and logically the more pressure there is on the kroon peg. Enough said, I think.

Strong Growth Slowdown

Estonian economic growth more than halved last year reaching a year on year rate of 4.5 percent in the 4th quarter (according to preliminary data), and this was an eight-year low, in the fourth quarter. A rapid decline in the rate of wage growth is crucial if Estonia is to avoid a sharp slowdown as even central bank Vice Governor Marten Ross admitted earlier this week. If we look at the quarter on quarter growth rate chart, the dramatic nature of the decline is evident. As I keep saying, I don't know what sort of charts the people who argue the soft landing view are accustomed to looking at, but I humbly suggest that the sloe is a lot softer than the one we are looking at here. And the fact that year on year Estonia is still growing at 4.5% is hardly reassuring, since we are only in the early throes of the slowdown at this point, and there is no sign in the line of any significant slackening of pace. When we get to see some "bottoming" then we will be able to make some initial damage assessment, but the airplane is still loosing height, and fast, at the moment.

More evidence of the way things are slowing down comes from industrial output data. Output is in free fall downwards (see chart below, as are retail sales which is showed in a chart above), until we can see some sign that this rapid rate of deterioration is slowing it is far too premature for people to start arguing they have evidence of a soft slowdown (rather than expressing their hope that his will be the case, but here as ever, hope is one thing, and evidence to justify the hope quite another).

The important point to grasp here is that this is now all about timing, the whole drama looks likely to be played out over the coming six months, and unfortunately many of the remedies being advocated by Brussels and the IMF, including facilitating the switch of production and investment from non-tradable sectors to tradable sectors, and the strengthening financial supervision are longer term measures. And in any event are so obviously commendable (I mean, who at the end of the day would disagree that the violent husband SHOUL stop beating his wife) that they risk being platitudes: the question is the how.

And one of the recommendations, that "wages should be flexible and remain in line with companies’ competitiveness and productivity conditions, just went out of the window, at least as far as this downturn is concerned".

Which leaves us with the fourth recommendation, that "fiscal policy should not seek to offset a contraction in demand, even if the Baltic economies enter a period of slow growth". Being very contrarian, even here I have my doubts. We need to take into account that the recommendation to increase the fiscal surplus was issued in one situation, and we are now very rapidly entering another one. Before the problem was excess demand, and now the problem is going to be lack of it (again in the short term). Unless the Estonian authorities plan to do something more radical than I am contemplating they will do in the short term about the peg, Estonia will effectively be without conventional monetary policy tools in this situation (as it was in the situation which lead up to it). To deny the Baltic economies fiscal alternatives given the gravity of the sitiuation they face would, to my mind, be unduly conservative. Demand management is about just that, slackening demand when there is too much of it, and increasing demand when there is insufficient. So for exactly the same reasons the IMF were argeuing for fiscal tightening one year ago (that there was no effective monetary policy tool available) I would suggest we could consider the opposite policy now, especially since the global credit crunch is now steadily tightening its vice across Eastern Europe. Basically if it makes sense to brake at the end of the straight as you enter the curve, it also makes sense to accelerate and not hit the brake even harder as you go round it. You don't have to be Fernando Alonso to know that. And of course we are only talking about short term stimulus here, not long term structural policies, but since the Baltic economies - unlikely Hungary and Portugal, have comparatively low levels of debt to GDP, then they could well permit themselves this option I feel (according to Eurostat data, accumulated government debt as a % of GDP - ie not the annual deficit, the entire sovereign debt - for Estonia in 2006 was only 4.1% of GDP, for Latvia it was 10% and for Lithuania it was 18.2%, ie this is a pittance, and there is leeway for demand management cushioning, which is why I did not look so negatively on the proposal from the Latvian government to change tack at this point, of course they should have been braking hard six months to a year back, but we are now past that point, and it really isn't useful at this stage to be simply crying over spilt milk. There will be plenty of time for post-mortem's later).

And doubly so, since one of the other favoured arguments about why the Baltic countries can avoid a sharp slowdown - namely that the Scandinavian Bakns will help them manage the situation - is looking wobblier by the day. Cristoph advances what is a very common argument:

In particular, the financial sector is de facto owned and operated by Nordic banks. Since these banks have a strong stake in the Baltics’ economic future, a sudden Asian-style stop of funding seems unlikely. By the same token, however, these close ties put the fate of the Baltic banks into the hands of just a few Nordic parents and their ability to weather the global financial turmoil.

What this argument tends to forget, however, is that these banks themselves are not charitable institutions, but have their own balance sheets and credit ratings to think about. This point was brought home ealrier this week by Moody's Investors Service that it is cutting its ratings for Estonian banks on concerns of weakening asset quality due to high exposure to the cooling property market. Moody's assigned a negative outlook to Estonian banks, including AS Sampo Pank, fully owned by Danske Bank A/S, and Balti Investeeringute Grupi Pank AS.

Virginie Merlin, senior analyst with Moody's in London and author of the report, is quoted as saying that the move ``naturally'' follows the decision on Jan. 18 to lower the outlook of AS Hansapank, the top Baltic lender and a fully owned unit of Swedbank AB, to ``negative'' from ``stable.'' Hansapank accounts for more than half of Estonia's banking industry assets.

According to the report "Moody's primary concern is that the rapid loan growth has led to unseasoned portfolios with high concentration on the mortgage and real estate sectors....We therefore see a growing risk of a deterioration in the banks' asset quality if the economic outlook continues to soften"

And I think this is hardly unsurprising news, these banks cannot simply sit bank and watch their credit rating and asset quality deteriorate simply because it would be the "politically correct" thing to do.