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Sunday, May 11, 2008

Serbia, Must What Goes Up Really Come Down?

by Edward Hugh: Barcelona

This post, which is to accompany Manuel's election coverage coming later today, may be considered an update on a previous extensive analysis of Serbia's economic and demographic dilemmas which I carried out at the time of the Presidential election in February (see the post itself for a more details on some of the issues raised here).

The "up" I in the title of this post is, of course, a reference to the recent sudden and dramatic rise in the annual rate of Serbian inflation - which after some years of steady reductions suddenly took off in June 2007, and has been climing sharply since, reaching a high of 15.8% in April 2008.

But it could also be thought of as a reference to the rapid and reasonably spectacular recent rise in the dollar value of Serbia's GDP, or to the rapid rise in consumer demand which has accompanied it.

A key factor in driving these ever higher levels of output and prices has been the ever higher levels of consumption demand produced by the strong acceleration (way beyond productivity improvements) in Serbian wages, which brings us directly on to the "down" part I also refer to, since in true "decline and fall" fashion the rate of real wage increases is now steadily and inexorably heading back to earth, and with it the rate of expansion in Serbian GDP.

As can be seen in the above chart it will now not be too long before the annual rate of increase in real wages hits zero (and in all probability continues its course into negative territory) and naturally in the wake of this sudden deceleration we are now starting to observe a much more general slow-down in Serbian GDP growth as domestic demand begins to weaken.

As can be seen from the solid line in the above chart, the Serbian economy has in fact been slowing since the first quarter of 2007. The components which lie behind this slowdown are also interesting. Agriculture turned negative (partly a result of last years drought I imagine), and construction and services both slowed notably, while the section headed "taxes minus subsidies" - which effectively means the government input (and thus the fiscal deficit) - was up significantly during the year. We thus had by December 2007 an economy which was much less dependent on domestic consumption and much more dependent on government spending than it had been back in January.

Really though a significant part of the reason for the slowdown can be clearly seen in the wages chart. The situation basically became "unsustainable", and starting in June 2007 the rate of real wage increases started to decline. Basically as you head on upwards towards the stratosphere you simply lose momentum - especially if monetary conditions cease to be "accommodative" -and under pressure from the economic equivalent of Newton's law of gravity (which some, especially in Russia, seem stubbornly set to do their darndest to try and prove wrong, although in the Baltics they have now reluctantly had to accept) you eventually, and in time honoured fashion, start to head back to earth. If the current trend continues, and it seems very likely since it will since the central bank has been raising interest rates sharply in recent months (see below), then real wages growth could turn negative (year on year) in, say, June or July. The big question is then going to be will we have a "crash landing" in Serbia, or can this somehow be avoided?

The Demographic Backdrop

It is, however, impossible to understand what is currently happening in Serbia, and adequately assess what may be about to happen next, if you lose sight of the underlying demographics, which are so special, and indeed historically almost unique, and of the fact that Serbia's population, like that of many other countries in central and Eastern Europe, is both ageing rapidly and declining. The official population of the Republic of Serbia - as monitored by the Serbian statistics office - has now been falling since the late 1990s. Of course there is quite a jolt downwards after 2001, but the general trend is clear enough even without this and the natural increase of the Serbian population (births minus deaths) has been negative for many years now (in 2006 it was 31,000) even before taking out-migration into account, and last year the number of live births was the lowest since at least 1970 (which is the earliest date for which I have data).

As well as declining Serbia's population is ageing, and the median age has been rising quite rapidly, pushing onwards and upwards beyond the economically sensitive 40-year-old barrier. The rapidity of the rise in median age in Serbia is undoubtedly the combined product of a low birth rate, a steady increase in life expectancy and the migration abroad of people in the younger age groups. 40 can be regarded as a sensitive population median age since it seems to mark the difference (following life cycle saving and spending dynamics) between an economy which can structurally be driven by internal demand and one which becomes increasingly dependent on exports.

What our experience to date of this relatively new phenomenon of population ageing tends to show us is that as median ages move up beyond 40 the momentum of internal demand starts to slacken, and recent experience seems to be showing (Germany, Italy, Japan) that a country's economy comes to depend increasingly on exports for growth. This is significant, of course, in Serbia's case, since Serbia currently runs a sizeable trade deficit. As a result it is quite probable that the "leaner-meaner" Serbian economy which must eventually emerge from the present downturn will be a structurally very different beast from the one it has been of late, although unfortunately there may well be quite a long hard road ahead in order to get there.

Russia, Ukraine and Bulgaria

Before going further into the current situation in Serbia I would just like at this point to draw attention to one other interesting feature of the present situation, and that is the extraordinary similarity which exists between what is happening (economically speaking) in Serbia, and what is taking place among what might be termed her "cultural half cousins" in Russia, Ukraine and Bulgaria.

Inflation as we all know is now a problem in many countries, due to the pressure from global food and energy prices (see this post for a much longer explanation of all this), and Central and Eastern Europe were particularly hard-hit by a drought last year, but still, other countries in what might be considered to be similar conditions have seen their inflation rate rise, but few have seen it rise in anything like the dramatic way it has been moving in the above mentioned quartet (in Vietnam perhaps, but I will just throw that one out as a little teaser, what on earth might the connection be here?).

Bulgaria's inflation rate rose to a 10 year high of 14.2 percent in March, up from a previous 10-year high of 13.2 percent in February.

Ukraine's inflation rate rose to 26.2 percent in March, in this case the fastest rate in eight years, as global food prices surged, while domestic demand increased as the Ukraine government repaid people who lost savings when the Soviet Union collapsed, and Ukranian workers were out busying themselves all over Eastern Europe filling gaps in local labour markets and sending remittances home. Inflation accelerated from 21.9 percent in February, which had already been the fastest pace in Europe for that month and the quickest in Ukraine since 2001. So rapid is the pace in Ukraine that consumer prices rose 3.8 percent in March from February - basically achieving what many would consider a high annual rate in the space of a single month.

Meanwhile Russia's inflation rate rose to an annual 14.3 percent in April, the highest since April 2003, led by rising food costs. The inflation rate rose from 13.3 percent in March, while prices rose 1.4 percent in the month, compared with 1.2 percent in March, the Moscow-based Federal Statistics Service reported last week. Prices have already increased by 6.3 percent so far this year (January - April).

And Russia's inflation continues to accelerate alarmingly, in the week April 29 and May 5, 2008, Russia's inflation was 0.3 percent (or an annual rate of 15.6%). This meant that in May, inflation amounted to 0.2 percent for the month to date (only 5 days), nudging up the toatl to 6.5 percent for the year to date, compared to 0.2 and 4.2 percent respectively for the equivalent periods in 2007, according to the Federal State Statistics Service (Rosstat).

But if I am singling these four countries out for common consideration it is due to the fact that they have more than a high and rising inflation rate in common. Most obvious of all the underlying similarities which can be identified among these countries is one which is all to often ignored in the economics "to do" hitlist drawn up by multilateral agencies like the EU commission, the IMF or the OECD and involves what might be termed the highly "destructured" state of their population dynamics. In all four cases fertility is now extremely low (with Bulgaria's the lowest in all Europe at 1.14), male life expectancy is very low, the population is declining and basically we don't really know how many people there are in the country in all cases: for Bulgaria, Ukraine and Serbia since we have no accurate numbers for those who have actually left (thus we can surmise that working age population and potential labour forces are declining, but we have no idea at all of by how much) while in Russia's case we do know that working age population is falling, but we don't have any accurate information about the number of permanent migrants living and working inside the country (although again, and just to complicate things even further, we do know that many of these come from Ukraine and Serbia). We thus cannot possibly hope to accurately measure the potential labour force in any of these cases.

And this is not an unimportant issue when it comes to inflation, since in order to try to assess potential growth capacity you need to make an estimate of the non-inflationary unemployment rate, but if you really have little idea of how many people you are actually dealing with this becomes well nigh impossible. So when people tell you that, for example, the current Serbian growth is perfectly sustainable, you might just like to scratch your head and ask how it is that they could possibly know this. Unless, of course, they think that population structure, labour force size, and potential consumers are not important areas in economics.

Employment in Serbia

As I say, in Serbia's case it is evident that there are a lot less people around than there are officially supposed to be, and this becomes doubly clear when you look at the decline in total employment numbers we have witnessed in recent years (see chart below), and when you start to GDP think about this employment decline in connection with the 6 percent or so average growth rate of the last few years. Not only has Serbia been having a "jobless" recovery, it has been having a "job-negative" one, even while unemployment has been actually falling. This is what having such weird and unprecedented (at least in peacetime) demographic dynamics actually means in practice. Serbia may not, in practice, be able to turn the world of Newtonian mechanics upside down, but has certainly been having a good try, especially in the context of all our traditional concepts of economic development and "catch up" growth.

As we can see in the chart above total employment has been heading steadily downwards, while unemployment has been stuck somewhere over the 20% mark. If we think about this, and about the high level of wage increases Serbia has seen over the last couple of years, then something here simply doesn't add up. Among the many various possibilities to explain this rather strange situation is the idea that some at least of the people concerned are not in Serbian employment, and are remaining on the unemployment register, simply because they are no longer in the country. Whatever the explanation, total registered unemployment was at 785.1 thousand in December, down by 131.1 thousand or 14.0% over 2007, and this decline - according to the central bank - is not the result of new job creation, but is largely attributable to the re-registration of around 90 thousand people from the records of the National Employment Service to the records of the Republic Health Insurance Bureau - ie the registers were being "cleaned up". I wonder why?

Total employment in December 2007 was around 2.44 million, which was down 60,000 from the 2.50 million which had been recorded in September. While employment fell sharply in the majority of areas of economic activity in the fourth quarter, it rose in financial mediation, real estate and in some parts of the public sector (education and culture, healthcare and social work).

In the course of 2007, the sharpest drop in employment was recorded in the processing industries (down by around 24 thousand jobs), and there was also notable drop in employment in the construction industry, and in the electricity and gas industries.

Despite the fall in employment the official estimated unemployment rate (Serbian emthodology) was 24.3% in December, down by 2.4 percentage points from the same period a year earlier.

Central Bank Monetary Policy

Serbia's central bank raised its benchmark two-week repurchase rate by three quarters of a percentage point to 15.25 percent on April 24. This was the fourth increase since the start of February, according to central bank Governor Radovan Jelasic in order to ward off inflation in the absence of stable and determined government.

``Two weeks ago we had a collapse of the government, a drop in the credit rating, an increase oil and agricultural product prices and accelerating inflation,'' Jelasic said, in an interview in Belgrade on April 1. ``As we now have a caretaker government, we cannot count on their support in combating inflation in the next three to six months.''

The credit rating decision Jelasic was referring to was the one take in March by Standard and Poor's to lower their outlook for Serbia's credit rating to "negative'' from "stable.'' based on the growing uncertainty about reforms associated with the current election.

The Narodna Banka Srbije has now lifted its benchmark rate a total of 5.25 percentage points since 1 January 2008 (see chart above). This is strong tightening indeed, and taking into consideration the fact that the economy was already slowing substantially in Q4 2007 we should expect to see a rather dramatic additional slowdown in Serbia over the coming months.

Appreciation in the Dinar

Bank Governor Jelasic has also said he is prepared to spend the bank's reserves and raise interest rates further if need be to support the dinar until stability returns to the political system. Jelasic added that the central bank has 9.6 billion euros ($15 billion) in available reserves to shore up the dinar, which lost as much as 1.5 percent against the euro following Kosovo's declaration of independence. Since the March 13 rate increase, the currency has gained 2.5 percent.

On March 31, the bank changed foreign currency reserve requirements to boost the use of the dinar. As of May 17, 10 percent of the mandatory 45 percent minimum deposit requirement for commercial banks will have to be in dinars.

``Most banks look at dealing with dinars as a nuisance, but the dinar is our national currency,'' Jelasic said. ``We expect that these measures will increase the dinar's share in bank balance sheets, show borrowing costs more realistically
and boost dinar deposits in commercial banks"
This assertion by Jelasic to the effect that the dinar is, after all, "our national currency" may seem strange until you take into account the degree of euroisation in the Serbian economy, which, as can be seen from the chart below which compares the levels of household indebtedness in euros, is - at around 80% and along with Latvia and Estonia - among the highest in the whole CEE .

In Q4 2007 the dinar/euro exchange rate moved within a very broad band of RSD/EUR 76.81 to 84.75, with exceptionally high daily oscillations in November and December reaching as much as 3% on some occasions. In October the dinar continued its steady long term appreciation against the euro (see chart below) and reached a record high since November 2004 (RSD/EUR 76.8). November and December, however, saw far more volatile exchange rate movements and two episodes of sharp depreciation. The appreciation of the dinar was the result of the high foreign exchange inflow and the intensified demand for dinars which followed the announcement of another round of privatization. On the other hand, the sharp weakening in the dinar which took place in late November and early December can be attributed primarily to the impact of global developments and simmering internal political instability, while the depreciation in late December was basically triggered by a mismatch in foreign exchange supply and demand.

Since August of last year the ECB has, of course, kept its basic policy rate unchanged while the FED has embraked on a significant loosening in interest rates. As a result the U.S. dollar has tended to depreciate against the euro, and as consequence, the dinar has appreciated significantly against the U.S. dollar - by somewhere in the region of 10% in nominal terms (see chart).

Thus during Q4 2007 the dinar depreciated by 0.5% against the euro and appreciated by 3.6% against the U.S. dollar. As these two currencies make up the basket of currencies used by the Bank of serbia for calculating the effective exchange rate, the nominal effective exchange rate for the dinar strengthened by 0.8% over Q4.

Serbia has continued to benefit from substantial capital inflows and official foreign exchange reserves have more than tripled since 2004, reaching USD 14 billion or 7.5 months of imports in 2007 — one of the highest levels in the CEE region. However, it is important to bear in mind that this rapid reserve accumulation has in part been the result of the yield differential created by the significant monetary policy tightening carried out by the Serbian central bank and the increased reserve requirements placed on commercial banks’ foreign exchange liabilities by the central bank in 2006. The combined effects of these tow factors has boosted the commercial banks’ foreign currency deposits to about USD 5 billion. But it is important to keep in mind that these deposits represent commercial banks’ obligations to the domestic and foreign private sectors, and thus the central bank cannot fully rely on them in times of distress. That is to say, those 7.5 months of imports cover are not as substantial a cushion as may appear at first sight.

Serbia's Trade Balance

As I have been suggesting, the very high credit euroization which has evolved in Serbia and the accompanying significant external vulnerabilities suggest that — even after allowing for the low debt to GDP ratios — a rather lower debt-carrying capacity for Serbia’s households when compared to regional neighbours. The share of forexdenominated and forex-indexed domestic credit exceeds 70 percent and is among the highest in emerging Europe and is exposing borrowers in Serbia to undesireably large currency risks. Which is another way of saying that while it is not so difficult for the Bank of Serbia to raise the base interest rate, the need to avoid a significant subsequent depreciation in the currency may well make it very difficult to bring this rate down again as the need to revive the domestic economy becomes more pressing. Yet another case of something which easily goes up, but has more difficulty in coming down.

In addition, low exports, rapidly growing euroized liabilities in the corporate sector, and other external vulnerabilities discussed above are closely linked to the financial sector. In these circumstances, even moderate disturbances may eventually lead to changes in the household sector’s balance sheets and could quickly spill over to the rest of the economy. These considerations suggest that on balance, the current rapid growth of household credit is making the country more vulnerable.

Similar conclusions about the enhanced vulnerability of Serbian households over and above those of regional neighbours can be derived from examining the Emerging Market Bonds Index (EMBI) for six Central and East European countries. As indicated by the chart below, the increase in EMBI spread is much higher for non-EU member states (except Bulgaria) than for the EU member countries. In addition, the increase in the spread is higher for countries running high inflation and balance of payments deficits, i.e. countries more vulnerable to external shocks. The largest increase in the EMBI spread from June 2007 to January 2008 was recorded for Kazakhstan and Bulgaria (140%), followed by Serbia (118%) and Ukraine (106%). Far lower increase was recorded for more developed Central European countries and EU member states - Poland (67%) and Hungary (49%).

Serbia's current account deficit hit an all-time high in Q4 2007, as did its share in GDP (18.9%). Relative to Q4 2006, it widened by 58.4% as a result of a rising deficit on trade in goods and services (51.9%). The shares of the current account deficit and the deficit on trade in goods and services in GDP rose by 3.4 and 3.3 structural points, respectively. The deficit on trade in goods and services widened as exports growth slackened and growth in imports picked up.

The decline in the year-on-year growth rate of exports which we have been seeing for some time continued into Q4 2007. This slowdown in post July 2007 export dynamics was partly the result of a drop in the export of cereals (due to the drought and a temporary ban on exports), and non-ferrous metals and iron and steel (due to the autumn overhaul in US-Steel). The value of exports of these products decreased from a record level of EUR 176 million in July to EUR 99 million in December.

If movements in these three sections of the Standard International Trade Classification (SITC) are excluded from calculations, the dynamics of export growth in the fouth quarter remained stable at around 30%, in euro terms. Commodity exports in dollar terms hit record highs (USD 2,515.8 million), but declined on a quarter on quarter basis in euro terms. This was the first time since 2002 that exports in Q4 did not rise on a quarter earlier.

The composition of exports also saw positive changes, as the share of machinery and transport equipment almost equalled that of food and live animals and miscellaneous manufactured articles, and seems set to become the second most significant section of exports in 2008 (after manufactured goods).

However, the year-on-year growth in imports, and consequently the trade deficit, was higher in the second half of 2007, as rising domestic aggregate demand spilled over into higher imports.

Migration and Remittances

Some indication of the extent of Serbian out-migration can be obtained from the remittances flows, which were estimated by the World Bank to be running at a rate of 17.7% of GDP in 2006. Now this is a very large share in GDP value, and has lead people to use the expression "labour export" driven development in the case of countries like Moldova and Serbia. But this view misses one important feature of the situation, and that is that - unlike high fertility socities like Pakistan or the Philippines - Serbia is not resource rich in labour, Serbia's current fertility is 1.4 and not three point something. Labour is a precious and potentially scarce resource in a low fertility society, and far from exporting, Serbia needs to hang onto what it has, and even attract back many of those who have left.

Back in 2002, according to the statistics office, there were roughly half a million Serbs working abroad, about 100,000 of those being in Germany. In that year there were 2 billion dollars worth of remittances coming back. In 2006 there were roughly 4.7 billion dollars coming in, so we could estimate that the number of those working abroad has more or less doubled to near the million mark over these years. In a country with a labour force in the 3 to 4 million region, this is a lot of people.

Slowdown or Hard Landing?

Returning now to the immediate short term dynamics of the Serbian economy, it is worth noting that the real growth rate of household demand was 3.8% year on year in Q4 2007. However the sharp quarterly decline over Q3 (10.7%) was the result of both a slowdown in the nominal growth rate (from 18% in Q3 to 13% in Q4) and the strong surge in inflation. As can be seen in the chart the transformation is remarkable. GDP gowth is no longer being driven by household demand, and the dangers of a very rapid slowdown (Baltic style) are now evident. Given the added financial vulnerability which exists in the Serbian case, and the ongoing political uncertainty this situation is certainly a cause for concern.

Higher wages have been increasing both consumption and imports, and thus fuelling the increase in the current account deficit. They have also contributed to the increase in inflation in the non tradable sector and have made the job of the National Bank much more difficult.

Looked at in this way Serbia seems to be caught in some kind of trap, one where out-migration has been producing substantial remittances and an increase in consumer and foreign exchange loan demand, and this increase in demand has been fueling a wage price spiral which seemed at one point to be hurtling out of control (remember that euro denominated loans carry a much lower rate of interest than dinar denominated ones, and they have thus effectively been circumventing the central banks monetary tightening), but which now appears to be in danger of imploding in on istelf, especially as the global credit crunch steadily bites and makes it more and more difficult to keep expanding the credit. And all of this has been taking place while unemployment - according to official data - has been running at over 20%. So what happens next? This is very hard to say, since no-one really has ever been here before, but it does appear that a vice is tightening around Serbian, and this time it is an economic and not a political encirclement that is taking place. The Bank of Serbia will certainly now find it hard to loosen monetary policy without provoking a rout for the dinar, and meantime the Serbian economy effectively looks set to all but wilt on the vine.

And meantime no one in any position of responsibility mentions even in the faintest of whispers that most dreaded of of all the dreaded words: fertility.

Some further explanation of the theorectical logic that lies behind the argument advanced in this post can be found in:

Inflation in Russia: Too Much Money Chasing Too Few People?


Catch Up Growth and Demographics - Evidence from Eastern Europe