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Saturday, May 31, 2008

Currency Dilemmas in Eastern Europe

by Claus Vistesen: Copenhagen

We are certainly getting a fair share of the market action in Eastern Europe at the moment. Of course, such a perspective will depend on the bias of the observer but I definitely think that recent events within the Eastern European economic edifice suggest that the economic climate is beginning to steer towards downside risks as well as markets in some spheres are decidedly jittery. Moreover, the market focus and discourse has also turned from a focus on the down side economic effects from the credit crisis to a focus on the risks of lingering and increasing inflation.
This is natural I think but the main tendency remains not least in the context of Eastern Europe. In short, we are now moving into a period where the global economy, in key areas, will be dominated by stagflation.

Not too long ago we learned that the Baltic countries with all probability have entered a recession going out of Q4 2007. Now, economies move up and down as we know but the situation in the Baltics is still quite remarkable since with a real economy grinding to a screeching halt you would not exactly expect wage growth in the double digit territory. Yet, this is exactly what we are observing across the Baltics and indeed in the rest of the Eastern European edifice; the recent alarming numbers from Estonian Q1 wage cost being a case in point. A hard landing it is then as Bloomberg also tries to define as follows:


An economic ``hard landing'' is when fast growth spurs inflation, which in turn erodes consumers' buying power and quickly leads to a recession.


This not quite true I am afraid since what we have on our hands in the Baltics and what we are likely to see across many other Eastern European countries is stagflation. And note that this is an entirely different kind of stagflation than the Disney World variety keeping central bankers in Washington and Frankfurt awake at night. No no, this is a regular Alfred Hitchcock specimen. We are consequently talking about a major correction here which may likely turn into deflation at some point. The problem, as I have outlined before, is that these countries are now effectively out of labour which means that there is simply no slack in the economy to fall back on, hence the lingering inflation even in the context of a rapid de-acceleration of growth. Obviously, this cannot go on. Just as well as the unemployment rate cannot drop to 0 the price level will have to correct but the process will most likely be very inelastic and especially so in a context of fast paced global headline inflation pressures.

If this represents the dire economic prospects of many Eastern European countries what might they do to steer clear of the worst casualties?

This question coupled with a renewed focus on the risks of persistent inflation shores up at a major dilemma with respect to management of the currency not least for countries currently pegging to the Euro. The Baltics fall in this category. On the one hand, the rampant inflation levels suggest that the exchange rate be loosened to allow appreciation and thus pour water on the roaring inflation bonfire. On the other hand however the Baltics, as well as many other CEE countries, are saddled with extensive external deficits financed by consumer and business credit denominated in Euros. It is not difficult to see that this represents a regular vice from which it will be very difficult to escape since as long as the peg remains deflation seems the only painful alternative as a mean of correcting. But at this point nobody knows quite how long such a process should undergo as well as whether it would be politically viable. If the peg is abandoned though, two important reservations should be made. First of all I am not at all sure that the exchange alone can quell the inflationary pressures and secondly it is not certain that the currencies will appreciate at all once de-pegged since the current account deficits may well weigh so much as to move the currencies in the other direction. Of course, initially they will but you can easily imagine a situation in which interest rates would have to be kept in recession provoking territories in order to ensure that the inflows are obtained.


Looking beyond the Baltics, the dilemma of letting the exchange rate appreciate to combat inflation versus the risk of a prolonged slump as it proves impossible to restore competitiveness can hardly be better illustrated at the moment than by the flurry surrounding the chain of commands at the Ukrainian central bank and the currency over which it presides. Obviously, the spectacle in Ukraine has the added flavor that it has essentially thrown the central bank into limbo as internal authorities wrestle for the final say. Edward has an excellent and quite amusing overview of the debacle here.


Basically, it has been recognised for a while now that with inflation running at some 30% on an annual level the central bank has been under considerable pressure to allow the Hryvnia to trade more freely against (e.g.) the USD. A week ago we thus learned that the Hryvnia was already beginning to nudge upwards agains the USD in the interbank markets, climbing as far as to 4.74, because traders speculated that the central bank had quietly abandoned the daily market operations to keep the Hryvnia within the official rate of 5.05 to the USD (with a band at 4.25-5.05). At this point deputy governor Oleksandr Savchenko cautioned as per reference to the dilemma cited above that the Hryvnia would only be allowed to appreciate if it coincided with an amelioration of the external deficit. Little could it be known that the topic, which at the time seemed highly speculative, was to race to the forefront of the agenda last week as the Ukrainian central bank has scrambled to agree with itself on what actually to do.

As such, internal differences of opinion within the central bank were made embarrassingly obvious as the board vetoed a decision by Governor Volodymyr Stelmakh to restate the official USD/HRY rate to 4.85 in an attempt to put a lid on inflation. Once again the dilemma of how to combat inflation while harboring a large current account deficit hovered the debacle as Petro Poroshenko, head of the central bank council noted that such an appreciation would be out of tact with realities of the Ukraine's external balance. Thus the rate of the USD/HRY was restated to the original 5.05. This value looks increasingly unrealistic however as the Hryvnia is trading persistently out of the band. This means that in due time we will probably see an attempt, by the central bank authorities, to lift the trading band.

The trials faced by Ukraine are not without an immediate precedent since only two months ago Hungary moved in to scrap the trading band keeping the Forint in the relatively wide band at 240.01-324.71 to the Euro. As with the debate on in Ukraine the decision by Hungary was taken in a similar light. When the decision was made the Forint was trading much closer to the 240 mark which indicates that the Forint was allowed to trade freely in the anticipation that the Forint would move in a direction which could help quell inflation. As with Ukraine who is visibly in a state of confusion about what exactly to do the decision in Hungary cannot be said to have been an easy one. At the time I stated the following which I feel is still a relevant point.


By letting the Forint flow freely they are consequently hoping that the ensuing appreciation will help the central bank in its uphill struggle to bring back inflation within target. I put emphasis on hoping here since it is far from certain I think that the Forint can be expected to stay elevated vis-à-vis the Euro. So far though the markets seem to be indulging the central bank in its move. After having been the emerging market whipping boy of this year the Forint saw a hefty appreciation on the back of the move. Yet, as noted, this may not last. Moreover, the scrapping of the trading band has also effectively opened up the door to all those unhedged liabilities which the households and cooperations and households have taken up.

(...)

Having said all this however, I do think that this move was the only reasonable way that Hungary can begin, ever so slowly, to wriggle herself out of the wrench in which she is now situated. The problem is that the scrapping of the band in order to do something about inflation as well as to stay credible in the face of increasing market pressure may not work out as expected in the longer term. This is not an argument for not doing it though but inflation is not Hungary's own problem and what we thus need to realize is that Hungary effectively is the first economy to really have entered the malice of stagflation.
So far the move by Hungary seem to have paid off in so far at the Forint has not weakened materially as it is currently trading at around the 245 mark to the Euro. In fact, if we look at the three months in which the Forint has traded freely it has strengthened from around 263 to its current value of 245ish.

So, given the recent battle of wills at the Ukrainian central bank the apparent successful comparative strategy in Hungary should the Eastern European economies (including of course Russia here) steadily let their currencies climb to take up the fight against inflation? Well, if we leave aside the obvious question that allowing for free trading of your currency does not exactly mean that you get it what can we say about the viability of this strategy?

Be careful what you wish for

Basically, the discussion about exchange rate regimes in Eastern Europe can be expanded into a much wider debate about emerging markets resisting nominal appreciation of their currencies vis-à-vis the US dollar and the Euro. Recently, the Economist had a large piece on global inflation which ties in with this discussion as well as Morgan Stanley's Stephen Jen recently noted how exchange rate appreciation might in fact be inflationary. It is thus important to understand that it is far from certain that letting the currency appreciate will have any material effect on inflation. In fact, in an Eastern European context this will only increase the purchasing power of the consumers thus fuelling already overheating economies. Another point which is specifically tied to Eastern Europe is that if domestic nominal interest rate increase to keep up with inflation rates it will have a strong substitution effects towards Euro denominated loans. This can become a dangerous cocktail should the tide turn against the currencies.

In light of the comments made above I think that the following points are important to take away.

There has been decisive change in market discourse from a focus on growth to a focus on inflation. This has lead to expectations by investors that emerging economies will allow their currencies to appreciate more swiftly against the G3 currencies. Apart from the usual suspects in the context of the petro exporters and China this has also lead to investors punting on revaluations (essentially decisions to let the currency float) in the context of Eastern Europe as well as in Russia.

In an Eastern European context I believe that such expectations may be unfounded or at least that they do not adequately take into account the downside risks. Obviously, the market's reaction to the recent debacle in Ukraine is mixed. As such, S&P moved in noting how inflation was likely driven by non-monetary factors and that the move, given the market's initial reaction, would almost definitely worsen the external position. Ironically, all this is based on an ex-ante assumption that the Hryvnia will actually now appreciate steadily as per function of market movements. This is far from certain I feel.

Demographics may be able to help us here. Basically, the global economy is characterised by a process where money goes for top line yield. In this context rising interest rates and nominal currency appreciation act as a very strong magnet for inflows of funds. In such a situation it takes a strong and essentially balanced demographic profile to be able to carry the load without running into a spiral of overheating. Brazil may indeed have an adequately strong demographic edifice but Eastern Europe and Russia decidedly have not.

In fact, what we are missing at the moment is indeed economies with the adequate capacity to suck up the excess liquidity; especially as the US has dropped the baton of the global consumer of last resort. This is why I feel that encouraging a process of steady currency appreciation in an Eastern European and Russian context may ultimately lead to a severe pro-cyclical effect and thus even more overheating. The risk is that when the backdrop comes it will be all the more grim.


Stephen Jen may actually be right when he says that currency appreciation is inflationary in a world where excess liquidity goes for yield. As I have said before I don't think that any of this warrants complacency vis-à-vis inflation but currency appreciation driven by either higher nominal interest rates and inflows will, in many cases, lead to overheating. No where is this more true I feel than in Eastern Europe. To peg or de-peg and to fix or let float? These two questions seem to be high on the agenda for many Eastern European central banks. In many ways, this is understandable. Strong headwinds from global inflation as well as an increased focus on this in the market discourse may eventually be what forces many countries to loosen the reigns on their currency. After Hungary and now Ukraine the Baltics, with their pegged currencies, seem set to enter the spolight. If we apply the prevailing market logic there is certainly enough inflation to go around even for a sharp currency appreciation. However, as I try to point it is not certain that you get what you want in the context of de-pegging and actually you may end up getting more than you bargained for. One thing is thus certain. If liquidity moves in favor of Eastern Europe at this time in the cycle the only viable way for these economies to correct will be through a prolonged period of deflation. The thing is that given their demographic structures nobody knows how far such a process would be and whether politicians can see it out, this latter point being particularly important in Hungary and Ukraine.

Wednesday, May 28, 2008

Polish Central Bank Leaves Interest Rates Unchanged in May

by Edward Hugh: Barcelona

Poland's Monetary Policy Council left interest rates unchanged in May for a second consecutive month as it awaits more data on inflation and economic growth before making any further increases. Rate setters kept the seven-day reference rate at 5.75percent at their meeting this morning.



The central bank has raised rates seven times in the past year to curb inflation as rising salaries and record-high employment spur consumer demand.

Poland's inflation rate unexpectedly fell back in April, a factor which has also evidently influenced today's decision. The rate slipped to 4 percent from 4.1 percent in March. Consumer prices gained 0.4 percent in the month.




Unemployment has been falling steadily, and using the EU harmonised methodology there were 1.313 million Poles unemployed in March (the latest month for which we have such data) and the seasonally adjusted unemployment rate was 7.7%.



Polish retail sales continued to grow at a healthy clip in April, if rather more slowly than in March, a factor which may well have influenced the central bank policy decision. Retail sales rose 17.6 percent from a year earlier and 2.9 percent from March.



On the other hand Polish industrial output growth accelerated in April, although this whole situation is clouded somewhat by the timing of easter this year, and the fact that April thus had more working days than March. Production rose an annual 14.9 percent, compared from 1 percent in March. Month on month, production was up 4 percent over March.





The zloty has gained 5.6 percent against the euro and 12.7 percent vis a vis the dollar this year, driven by strong economic growth, the prospect of euro adoption and rising yield differentials as the central bank has steadily raised rates.

The Polish government now forecasts that growth will slow to 5.5 percent this year from the decade-high 6.5 percent in 2007.



Central bankers are concerned that slowing growth won't prevent higher wages and employment from speeding up inflation. Average corporate wages rose an annual 12.6 percent in April, while employment increased 5.6 percent from a year ago. It remains to be seen whether the current policy rate will be sufficient to continue to hold back inflation given the vigour of the current expansion and the steadily dwindling pool of appropriately trained and educated workers.

Friday, May 23, 2008

Monetary Chaos Breaks Out at the Ukraine Central Bank

by Edward Hugh: Barcelona

Does anyone happen to know offhand the "official" dollar rate of the Ukrainian currency, the Hryvnia? I am asking this question since clearly over at the central bank they are having difficulty deciding at the moment, since - like the legendary character Hydra - they seem to be speaking with two "heads" at the same time, and the only question I can ask is: would the real representative of the Ukraine central bank please stand up!

This issue unfortunately is neither a small nor a comic one, since Ukraine is currently running a 30% plus annual inflation rate, and letting the currency rise against the dollar is one of the few serious anti inflation policies anyone has on the table at the present time.

Essentially the story to date is that the Ukraine central bank had been keeping the "official rate" for the national currency - the Hryvnia - at 5.05 to the dollar (within a broader target band of 4.95-5.25) since August 2005 - although traders have generally been saying that the bank effectively stopped intervening around February-March. However during the last 24 hours the "official rate" has become a highly contested issue, with one part of the bank's monetary policy structure suggesting that the official rate has now been revalued to 4.85 to the dollar, while another part is denying this and maintains the rate is still 5.05. Basically one part of the structure is challenging the right of another to take decisions.

Of course the reaction of the financial markets to this state of affairs is not that hard to predict (at least in the immediate term), and Ukraine's hryvnia fell the most against the dollar in a single day in over eight years yesterday, falling 4.01 percent on the day to trade as low as 4.7875 per dollar by 6:04 p.m. in Kiev, down from 4.5550 late Wednesday, making it the worst performer among the 178 global currencies being tracked by Bloomberg yesterday.

The fall at this point may, however, be more part of the internal tussle which is taking place in the bank itself than any knee-jerk financial markets reaction (although that could well be to come as central bank credibility at this point must be tending towards zero), and a according to Agata Urbanska, an emerging-markets currency strategist in London at ING Bank "They (the central bank, or part of it) are back in the market................This is all about the central bank weakening the currency.''


The latest incident is only one more episode in a long term tug-of-war which has been going on inside the central bank (and of course, inside the Ulraine parliament itself, since, it will be remembered, President Viktor Yushchenko was recently physically prevented from giving his state-of-the-nation address before parliament by legislators loyal to Prime Minister Yulia Tymoshenko who blocked access to the speaker's chair). The immediate problem started on Wednesday when Ukraine`s central bank board (note here the key term board) announced that it had decided to strengthen the official rate of the hryvnia to 4.85 to the dollar from the previous level of 5.05.

This move was not entirely unexpected since the bank has been under constant pressure to revalue or liberalise the hryvnia since inflation began rising dramatically in the autumn of last year, and Central Bank Governor Volodymyr Stelmakh had announced back in late April that there would soon be a "move" on the exchange rate front. However in a statement which now assumes rather more significance than it did at the time, the bank`s council (yes, note the COUNCIL - not the board - since the council is the other main player in this game) explicitly repudiated Stelmakh and rejected the idea of broadening the band on the very same day. From that moment on it should have been clear that monetary policy at the Ukraine National Bank was in for a bumpy ride, and so it has been.


Not to be upstaged by the decisions of the Board, Ukraine's central bank council itself met yesterday and formally rejected the hryvnia revaluation which had been decided on by the bank's board only one day earlier, and issued a press release stating that the official rate still stood at 5.05 to the dollar. This was the first example of one body vetoing another since the bank was founded when Ukraine became independent in 1991.

The bank council has 14 members, including the governor, parliamentary speaker Arseniy Yatsenyuk, and a number of parliamentary deputies. Stelmakh himself abstained at yesterday's vote while the other members all backed the veto of the board's decision.


"Today, the action of the board of raising the official rate to 4.85 was rescinded. Therefore, the official rate stands at 5.05/$," Petro Poroshenko, the council's head, told a news conference after a council meeting. He also advised the bank's board to re-examine the issue on Friday and suggested the board could only overturn the council's decision with a two-thirds majority.


Now for those of you who are - like me - a little bit confused by this somewhat Byzantine institutional structure, perhaps I should make plain that the board is effectively the bank's executive, while the council is a body created to formulate a framework for ongoing monetary policy. But now we find the board hold that the hryvnia is valued at 4.85 to the dollar, while the council maintain that the "official" value is still 5.05. So which is it? Well at this point your guess is as good as mine - and this is certainly "pluralist" monetary policy in action - but the board do seem to want to insist that they are going to have the last word, since late last night Reuters reported that the board had decided to overturn the councils veto and had issued a statement saying the hryvnia's rate on Friday would stand at 4.85 to the dollar -- unchanged from the rate it had set for Thursday, revalued from 5.05, before the council imposed its veto.

The Ukraine parliament - the Verkhovna Rada - have however voted to summon central bank of head Volodymyr Stelmakh to give an explanation of his actions (by 382 votes out of a possible total of 447) following a proposal put forward by the parliamentary groups of the Party of Regions, the Block of Lytvyn, BYuT, and CPU.


Anyway, I do know how many of you are able to follow all of this? Personally my head is already whirling. And the whole situation became even more bizarre late last night when central bank officials declined to comment on whether the board had in fact overturned the earlier council veto decision, effectively sidestepping the problem posed by head of the council Petro Poroshenko earlier in the day when he stated only a two-thirds vote on the board could do this.


Basically the background to all of this is that until recently, the central bank had been intervening regularly, buying and selling currency to maintain the hryvnia within a prescribed tight-corridor of 5.0-5.06. As a rseult the hryvnia had been hovering around 4.7-4.8 since the central bank stopped intervening in February-March, but in recent days it had begun to soar, touching at one point 4.6 to the dollar, following comments from various central bank officials indicating a revaluation was coming soon, and pressure from credit ratings agencies and multilateral bodies like the IMF to allow the currency to rise in an attempt to soak up some of the globally imported inflation.

Earlier this week a rapid (and possibly speculative) surge in demand took the market rate to 4.6 leaving a gap of about nine percent between the interbank and the official rates, leading the bank`s deputy chairman, Oleksander Savchenko, to state on Monday that decisions would be taken "in the next few days" to tackle the hryvnia`s "highly volatile rate". Effectively it was the developing gap between the official and the interbank rates which precipitated the move on the part of the bank BOARD.


So the problem here is inflation and what to do about it. Ukraine's inflation rate was once more up sharply in April - passing the threshold of the 30% annual rate - as the bickering continued between Prime Minister Yulia Tymoshenko's government and the office of President Viktor Yushchenko over economic policy and how to handle the problem. Inflation was up 3.1 percent month on month (running at an incredible 37.2 annualised rate), and although this was lower than the 3.8 percent monthly increase registered in March (which was a 9-year record) it was still far higher than most analysts were expecting.

Annually, inflation reached a huge 30.2 percent - aided by an almost 50 percent jump in food prices - and the cumulative price rise for the first four months of this year was 13.1 percent, a 'mere' 3.5 percentage points above the government's whole year 2008 target of 9.6% which the government has yet to revise.





The Ukraine central bank has been trying to soak up hryvnia liquidity since the start of the year, twice raising the refinancing rate (which is now at 12 percent, up from 8 percent at the end of last year) and issuing a large amount of depository certificates.

The bank has also repeatedly said that it sees a strengthening of the hryvnia as a means to combat inflation. And of course the bank has been under continuing pressure to revalue or liberalise the hryvnia after inflation began to accelerate in the middle of last year.

When the decision to change the official rate was announced by the board on Wednesday the ratings agency Standard and Poor`s immediately called the move a step towards curbing price rises.


"Liberalising the exchange rate regime should help to curb inflation of tradeables, and in particular commodities such as gas and food, which are priced in dollars," the agency said in a statement. It has currently a rating of BB- for Ukraine.


However ones the smoke finally clears on all this we will be left with a number of outstanding questions. Not least of these is whether in the mid term the hryvnia is not more likely to move DOWN than up. Certaily Ukraine's economic problems are now substantial ones. This was explicitly recognised by Standard and Poor's in its comments following the decision by the bank`s move board, and they painted a bleak picture for Ukraine, saying inflation was boosted by non-monetary factors and that a stronger hryvnia would ultimately harm exporters, raising the current account deficit.

"In the first quarter of 2008, nominal government expenditures increased just under 50 percent, pushing up public sector wages and sending a highly inflationary signal to the private sector," it said. "Loose income policy continues to affect goods prices via second-round effects."


The agency also lambasted the government of Prime Minister Yulia Tymoshenko in January, calling its fiscal policies "populist" after it began paying compensation to people who`s Soviet-era savings were wiped out by hyperinflation during the 1990s.

Tymoshenko has repeatedly promised that the government would be able to bring inflation under control in just a few months, and some officials had even predicted deflation during the summer months due to bumper food harvests (which are more than possible, the harvests, not the deflation, and this may mean in the short term that economic growth and inflation only accelerate).

Meantime Ukraine is currently running a current-account deficit, a deficit which has widened to $4 billion since the beginning of the year, and many analysts estimate it may exceed $15 billion by year-end. In fact the IMF estimate that it will reach 7.6% of GDP this year.




Conclusion

By way of conclusion I would like to make three simple points about this strange affair. The first of these is that the situation in the Ukraine to some extent parallels the situation in Russia, since both countries are facing a major inflation problem, and both are under pressure to allow the currency to rise to soak up some of the inflation. The political battle in Ukraine also mirrors the one in Russia in this sense, since the Putin/Medvedev group have been making it quite clear that they favour going for growth over the need to tackle inflation, and thus will resist currency revaluation pressures, even though the inflation itself will at some point almost inevitably undo all this solid growth performance due to the instability which will eventually follow, as I attempt to explain in this post.

The second point would be that the ability of simple currency appreciation alone to handle the kind of overheating Ukraine is experiencing is in fact rather questionable. Basically letting the currency appreciate can soak up some of the global dimension in Ukraine inflation, but it will not in and of itself resolve the internal overheating dimension. Ukraine, like Russia, has a declining population and a declining working age population. Unlike Russia Ukraine has out-migration and not inward migration. This means that the labour shortage issue in Ukraine is expecially acute when growth is in the 5 to 7% pa range. Basically Ukraine does not have the human capital resources to grow this quickly, and having a steady stream of remittances from those working abroad fueling consumption and construction only adds to (and does nothing to help resolve) these underlying problems.

Lastly, it is clear that Ukraine is now locked in to some sort of "boom-bust" cycle, but the bust may well not be imminent: that is to say we may well go up further before we finally fall back to earth. The reason for this is the current high in wheat prices, and the fact that Ukraine may well have a bumper harvest this year.

Economic analysts (and CEE specialists) 4Cast are predicting a significant recovery in agricultural performance across the entire East European region this year, driven by a massive rise in crop yields and farming output. They say weather conditions seem favourable in many countries in the region. Gábor Ambrus, analyst at 4Cast in London. believes the effect will be most visible where the share of farming is high, i.e.: Ukraine and Romania, while Poland, for example, may not benefit especially as it was spared from much of the regional draught in 2007.

Ambrus sees Romania and Ukraine as particularly likely to benefit from an agricurally driven boost to headline GDP effect. (The share of Romanian agriculture in GDP is 7-8%, so even a 30% increase in farming output may boost GDP by 2pp above expectations.) The effect on Ukraine is even larger with agriculture having something like a 17-18% share in GDP. The crop estimates being offered by UkrAgroConsult indicate a 35% increase in crops, and this could boost GDP by as much as 6pp over 2008, offsetting much of the slowdown coming from other sources, Ambrus argues. Of course this estimate may well be on the high side, but nonetheless Ukraine should get a substantial GDP boost, which means we should watch out, since this train may well now be about to accelerate before coming to what looks like it will inevitably be a "sudden stop".

Anyone interested in a rather fuller explanation of the underlying human capital resource problem could do worse than read this post I wrote some months ago on the topic.

Update

Well it is less than an hour since I put the post up, and already I am updating. I suspect this may happen more than once in the coming days. The latest news is that - unsurprisingly - Ukraine`s central bank chairman Volodymyr Stelmakh publicly confirmed this morning the bank's change in the official hryvnia rate to 4.85 per dollar from 5.05. The show goes on.



“The bank’s board made decision to confirm the change of the rate. We are confident that we do everything right, and we will defend our position”, V.Stelmakh said. According to him, the bank`s council had no right to decide on economic or legal issues and he saw the bank`s change of the official rate as merely eliminating imbalances in the market, and based on economic factors, rather than a "revaluation".

Tuesday, May 20, 2008

Brazil's Economy - Not Emerging Anymore?

By Claus Vistesen: Copenhagen

Brazil is interesting; not only because of its fabulous nature, its rhythmic and musical heritage, and its (alleged) repository of beautiful women but also because of the position it commands in the global economy, the latter topic being the focus of this note. Consequently, Brazil's economy represents an excellent point of departure for the evaluation of many highly strung discourses in the context of the global economy and her financial markets. These discourses include the debate on de-coupling/re-coupling, global inflation, Bretton Woods II/global imbalances, and global liquidity/SWFs just to name a few. In what follows, I will try to present an argument to explain why it is that I am so very constructive on the upside potential for Brazil's economy, while at the same time trying to untangle (as I have tried so many times before) some of the above mentioned areas of discussion and debate in the context of the global economy and Brazil.

Perhaps the most telling sign of Brazil's increasing status as a global force to be reckoned with was the recent announcement by Brazil's National Petroleum Agency (ANP) of the discovery of a new oil field (Carioca) which potentially holds as much as 33 billion barrels of oil - enough to supply every refinery in the U.S. for six years - making it the third-largest oil field ever discovered (only Saudi Arabia's Ghawar and Kuwait's Burgan fields are bigger - Ghawar reputedly holds as much as 83 billion barrels of crude, while Burgan is claimed to have up to 72 billion). Coupled with the discovery last year of the Tupi field - which has an estimated reservoir of between 5 and 8 billion barrels of oil, and could itself produce output at the not to be sneezed at rate of a million barrels a day - this is very likely to fast forward Brazil rapidly up through the ranks of global oil producing nations. This new found oil prowess even prompted the president Lula da Silva recently to suggest that Brazil enter OPEC.

Such oil discoveries come at a near-perfect time for Brazil who thus seems set not only to enjoy the upward march of commodities such as sugar, rice, beef, soya, oranges, iron ore etc but now also the black gold. Of course, the set up of a proper supply chain in the context of oil production takes time and it will take at least one year before we see the first barrels rolling in from Tupi not to speak of Carioca. However, Petrobras (Petroleo Brasileiro SA) is not sitting idle and the effects of Brazil's oil discoveries are already rippling through the market. Extraordinary evidence of this was delivered in the context of Petrobras' demand for the world's deepest-drilling offshore rigs to put action behind the recent discoveries. Petrobras is rumored to be hawking as much as 80% of global capacity as a function of the company's demand for deep drilling rigs and given the fact that these things don't exactly come off the shelf with the same ease as flat screens it will take some time for supply to respond to the increased demand thus pushing up rent for these vessels.

In many ways, as Edward also hints in a recent article the oil discoveries mentioned above represent a good initial image of Brazil's growing role in the global economy. Petrobras thus projects investments to the tune of 112 billion USD between 2008 and 2012 which, if realized, are sure to calm down even the most careful treasurer in the Brazilian finance ministry.

Thus assured of Brazil's current economic potential we should take a few steps back and have a look at the historical economic performance of Brazil, how it got to where it is today and where it is likely to go in the future? First, why not take a glance at some charts?

It does not take much of a macroeconomist to see how the stories above tell a story of rapid economic development. Obviously, it is difficult to make solid conclusions solely on the basis of growth figures but as can readily be observed Brazil is moving up in the world. Especially, the figures for PPP adjusted GDP are interesting since they show how Brazil is steadily and unrelentlessly creating an ever larger share of global GDP. The inflation figure also shows that almost a decade's worth of rampant inflation has now receded to much more comfortable levels. As for the allure of Brazilian asset markets the last figure just about sums it up. Over the three year period a US investor investing 1 mill USD the 16th of May 2005 would have been able to walk away with just shy of 4.5 mill USD the corresponding date 2008 (note that the exchange rate is with our US friend here too). Of course, such examples are not kosher as we are not looking at risk (e.g. standard deviation or global beta) but the rate of expansion in the main stock index is still quite remarkable, even border lining on a bubble if you look at the growth rate alone. This performance is, of course, to some extent shared by the other usual suspects who make up the notorious BRIC group, as originally coined by Goldman Sachs. I would not want to take anything away from GS here but simply note that the BRIC narrative is not exactly fitting for what is happening in the global economy. It is indeed true that the four economies are amongst the fastest growing economies of the world but they are very difficult in terms of structural setup which tends to blur the analysis. Specifically, I would distinguish between Brazil, India, and China on one side and Russia on the other. Soon in fact China may join Russia's side of the fence if the inflation bonfire currently experienced proves inextinguishable.


Brazil's rise not only in terms of GDP at constant prices but also in PPP terms cuts right across the whole debate on de-coupling which at times has developed into a rather badly played football match between the US and Europe. In this way, I never really was a fan of the original idea of de-coupling whereby the Eurozone ascended to take over from the US as the new global economic power train (and reserve currency repository). I simply think that this debate was principally flawed in its foundation. As such, it was never about whether the Dollar should fall or not, but given that it was always going to adjust downwards, against who and against what was it going to adjust? What we are currently observing in the global economy is then a process of recoupling of unprecedented proportions. Basically, the big economies of Latam and Asia not only want to be rich on population but also on economic wealth and what we are observing across the global economic edifice is the unwinding of the post WWII imbalances in which one half of the world got economic growth whereas the other got population growth. Brazil's rise in terms of purchasing power is a clear sign of this and in this light, the rise of big economies such as China, India, Brazil, and Turkey will change the tectonic plates of the global economy. Ultimately this process may be a difficult transition for the global economy and in particular for those countries yielding their ranks but it should not be lamented.

Too Much of a Good Thing?

Alas, this global process of re-coupling is not a linear and steady one, and it is getting clouded by the Bretton Woods II edifice in which Asian economies alongside petro exporters maintain a fixed exchange rate policy to the US accumulating vast reserves in the process. Brazil finds itself right smack in the middle on an unprecedented global hunt for nominal yield as excess liquidity, wide global interest rate differentials, and key fixed exchange rate regimes determine the global flow of funds. Especially, as the US economy falters, the shift of capital flow to snub the return to negative real yields in the US is piling the pressure on asset markets in countries who maintain open capital and financial accounts. This has prompted many analysts to lament the inflation targeting policy of the central bank as it serves to keep nominal interest rates too high thus sucking in too much capital for the economy’s own good.

The recent lingering backdrop of the external balance into deficit (see below) is among other things used as ammunition. Current interest rates are at a hefty 11.75% and it does not take much financial literacy to spot the carry trading (see appendix) plays available. Recently, Antonio Carlos Lemgruber voiced a similar critique in the context of RGE's Latin America monitor. Mr. Lemgruber's main argument is pinned on one of the most illusive of economic concepts in the form of the output gap which measures the divergence between the potential output and actual output. According to him Brazilian monetary authorities are too pessimistic on behalf of the economy's capacity to grow. Currently the interest rate is set on the basis of a potential growth rate of 3-4% while Lemgruber believes it to more like 7%. This would require a lower nominal interest rate to keep the economy growing without stoking 'inflationary pressures.' In terms of the actual numbers for potential output I tend to side with Lemgruber but we need to realize, I feel, that the measure of capacity in an economy such as Brazil's is tremendously difficult. The reason for this is simple and relates to the process known as the demographic dividend.

This note shall not dwell extensively by the pace of the demographic transition in Brazil but simply note that Brazil quite like almost all of the other socalled emerging economies is closing the demographic gap with the rest of the OECD quite rapidly. The figure below shows this process quite neatly even though we should be very careful about extrapolating on general population momentum on the basis of fertility numbers.

As can be observed there is some uncertainty as regards to the pace of fertility decline going into the 21st century. What can see however is that Brazil is steadily nearing the sub-replacement level and based on expectations we should expect her to continue. In fact, according to the US Census Bureau database Brazil's TFR is already below replacement levels at this point (1.86) although a more detailed analysis is needed to tell for sure. This means that the demographic dividend by which falling fertility provides a period in which the non-working age dependency ratio of the economy declines is now occurring in the context of Brazil. However, we also know that there are no free lunches and the favorable environment provided by the DD is also followed by a less favorable environment as the age dependency steadily rises as well as the productive profile of the country shifts as the age structure effects ripple through. In this light, the DD becomes an opportunity to lock-in the highest possible growth path and this is exactly what Brazil now needs.
It is in this specific context that I see the difficulties in estimating capacity in Brazil since no one really knows at this point. We know however, that capacity is growing in Brazil and that at the present time it is probably somewhat larger than the 3-4% currently fielded by the central bank. The debate thus shores up in a somewhat circular reasoning exercise. There is no doubt that the increasing purchasing power of Brazil's currency (more about that below) is warranted (see Macro Man for a semi-empirical account of this). But in a world where yield is the name of the game inflation targeting policies become virtual magnets for funds at the same time as the policy itself brings little relief in terms of inflation which springs from external headline pressures.
Lowering interest rates could help here but it would hardly stem the flow of carry trades and at the moment inflationary tendencies does not seem to warrant such moves. The crucial question is simply whether Brazil's fundamental growth path and inherent ability to create investment opportunities merit a base return of 11.75% (or similar)? In reality of course this is the same discussion as with the output gap as well as it is a discussion of what the base nominal rate actually consists of in terms of a measure of domestic investment capacity (i.e. a demand perspective) and/or foreign investors view on business risk (supply side perspective). We should also remember that the PPP model is an equilibrium model which predicts parity driven by inflation differentials. This is very difficult to discern in the context of Brazil though if we accept the premises that the economy itself is in a transition. More importantly, how well does the PPP fit the actual realities of the global economy? As recent as yesterday Stephen Jen wrote a neat piece in which he argued that currency appreciation might actually be inflationary in the current context of the global yield hunt. Through such a lens PPP hardly seems to be the right measure to gauge the ‘true’ value of the currency. Yet, as we turn to the next subject we shall see that the real issue here is not so much whether to be optimistic or pessimistic on Brazil's future economic prowess but rather whether Brazil should submit itself to rules of the game which would entail a transition towards a growth path by which internal investment exceeds internal savings, on a flow basis, ... in short, how much of a negative external balance can and should Brazil run?


As I will sketch out below I believe that Brazil can now, in broad terms, go two ways and it is in the distinct interest for Brazil herself and the global economy that Brazil is encouraged on to one road rather the other.


Letting the Capital Flow?

Consequently as we home in on the issues of global imbalances, Bretton Woods II, excess liquidity Brazil becomes an important litmus test for the choices many big countries with comparatively young populations face. Let us begin with the visual inspection to get us off the mark.

As can be observed the appreciation of the Real and the subsequent increase in purchasing power has resulted in a deterioration of Brazil's external balance although as I have argued before endogeous life cycle effects which spring from demographics may be equally as important. The trade balance in goods is not yet in the red most likely due to the push from commodities; if Brazil is now set to enjoy an oil windfall the trade balance in goods can perhaps be kept in the plus. The current account however is now firmly in negative on the back of deficit in services trade and the income balance. The latter subcomponent is not without interest here since a negative income balance is exactly what we would expect in the context of a country such as Brazil with a comparatively young population. If we look at the financing of the deficit we can see that the inflow of FDI has been steadily positive for a number of years which provides initial support for a solid base of financing. Portfolio investments have been somewhat more volatile which is quite as expected but the recent years seem to have seen a sustained and increasing inflow. After all, if I can make a graph of Bovespa such as the one above, so can others. The recent retrenchment of inflows seems to have come as a result of the jitter in credit markets. In this light what we have now is an important test case in terms of just how much capital that will leave Brazil in the context of global turmoil in credit markets. Conventional wisdom would hold that Brazil should suffer an exodus of capital but I am not so sure. In fact, given the amount of liquidity bouncing around I don’t see where portfolio managers would put their money even though, of course, the recent surge of commodities can in some ways be seen as a flight from traditional risky assets.


In terms of the amount of carry trade which seems to worry many an observer I have to note upfront that this is really difficult to read out of macroeconomic data. The real juicy data series here would be high frequency FX data on retail and institutional positions in the spot market. Having said that loans have indeed recently been an increasing part of the financing of the Brazilian external deficit which may hint to carry trading positions. If we further consult the subcomponents in the form of short term loans and currency deposits there seems to be an increasing volatility which may hint to a lot of activity on the short end of the maturity curve. This could be akin to carry trading activity. The big spike which shows a large repatriation of funds could be indication of unwinding of short positions in the money market as the realities of the credit turmoil became apparent. The main quibble with this carry trade analysis is that carry trade usually is carried out in the spot market where, in periods of low volatility, highly leveraged positions earn a hefty daily roll (or so I would imagine). In fact, I would imagine that such strategies frequently form a part of many beta (market) portfolios since when volatility is low and it is clear that the uncovered interest rate parity does not hold carry trading profits are too good not to be had. Obviously, since the credit turmoil washed in on the shores of financial markets I imagine that investors and hedge funds are becoming more careful.

If these are the realities of the current external position of Brazil is there something to be worried about? Should we fret a Brazil with an external deficit due to boom/bust effects from volatile capital flows?

A crucial first step to make here is to pin down the position in which Brazil finds itself with respect to the ability to issue debt since it forms an important part of the overall picture in terms of investor confidence. My feeling here is that a lot of the worry on behalf of Brazil is rooted in history and thus a once bitten twice shy mantle. In this way, many emerging economies can be said to suffer from the so-called original sin which alludes to their creditors’ demand that loans be repaid in foreign currency from the point of view of the issuing economy. Of course, this can quickly turn into a self-fulfilling prophecy since with a large stock of loans denominated in foreign currency a rapid deterioration of the fundamentals of the domestic currency may sharply increase the costs of servicing the debt. Nowhere is this more important than in the context of Latin America in general. On the back of the global recession in 1981-1983 and Volcker’s interest rate hikes the debt burden increased sharply for Latin American countries. Coupled with foreign investors’ flight to safety this pushed Latin America into the so-called debt crisis whose aftermath, among other things, included the subordination to IMF’s and the World Bank’s policy decisions (known as the Washington consensus) since these were the institutions coming to the aid of many the Latin American countries.

However, that was back in the 1980s. Today the global capital markets look decisively different. Not only do IMF’s reserves resemble little more than a minor Asian nation’s war chest but Brazil itself has changed strikingly. Recently, we got Brazil’s upgrade to investment grade by Standard and Poor and if you look at the debt to GDP ratio it does not come off as particularly alarming and has even fallen in the recent years. The ever careful analysts over at RGE’s Latin America Monitor do not seem too convinced however. Thomas Trebat consequently questions the soundness of S&P’s decision to grand Brazil the IG batch. Trebat’s principal worry is that the upgrade comes at a time when Brazil has all the cyclical winds blowing her way and consequently voices caution as to what may happen if Brazil suddenly sees less vibrant times. One example here could be a fall in commodity prices which would widen the external position even more as well as it could bring into question foreign capital’s willingness to buy Brazilian debt. Some part of Trebat’s analysis is no doubt perfectly valid and the investment grade feather should not be seen as an excuse to increase public spending without keeping the balance between receipts and expenses in check. Ultimately, it is also a question of what importance we ascribe to this investment grade edifice. Personally, I feel that the whole global sovereign debt structure may soon move into limbo since if you extrapolate the debt position of countries such as Italy, Japan, and Germany you end up in la-la land as it is clear that at some point, due to their rapid demographic decline, they simply won’t be able to pay. In such a perspective I certainly don’t see why Brazil should not, at least, enjoy the same categorical debt rating. Another theme which Trebat latches onto relates to Brazil’s growing foreign reserves which still cannot match the likes of the USD peggers but still amount to a good cushion. Trebat on the other hand sees it differently as he points to the rather technical point that the reserves, in terms of import coverage, represent a low and highly cyclical factor. I can see the mechanics here but I disagree with the point inferred from them. Basically, Brazil’s ability to sustain an external deficit must, at least in part, depend on the economy’s ability to generate positive NPV projects that can attract foreign capital. Also and perhaps equally as important demand in Brazil for imports must be seen in the context of other nations’ propensity to export and not within a rather arbitrary reference frame of the FX reserves’ import coverage.

In many ways, the mentioning of Brazil’s foreign exchange reserves brings us to the pinnacle of this discussion and Brazil’s role in the global economic edifice of macroeconomic imbalances, excess liquidity, and Bretton Woods II. In this way, the description above could seem to vindicate the idea that Brazil is now submitting itself fully to the global flow of funds. This is not quite true however.

As we can see there is a clear structural break in the pace of accumulation and if we home in on 2007 and 2008 in terms of monthly data this becomes clearer. The recent step-up in reserve accumulation clearly has something to do with the Real’s flight upwards against the USD and on several occasions have heard about Brazil’s plight in trying to stem the flow of capital inflows. We know in this context that the Central Bank on occasions have been dipping its toe engaging in countervailing market operations to put a leash on the Real. A year ago Brad Setser put words on Brazil’s possibilities as he asked …

I wonder when Brazil will start to contemplate an investment fund. Brazil's reserves are mostly in depreciating dollars and it too will soon have more than it really needs.

Now, this proposition is in itself very interesting since it latches on to the whole flurry about state backed investment vehicles known as sovereign wealth funds and where those bulging coffins of FX reserves should actually go. In Brazil’s concrete case the potential deployment of the reserves no doubt links in with the charts shown above of the external balance. As such, it does indeed seem tempting to try to reign in that deteriorating income balance through the placement of some 200 billion worth of reserves. Moreover, as Brad Setser points out most of the reserves is in USD which has not exactly been a fun asset to be stocking as of late.

In the grand scheme of things Brazil’s decision on this is intimately tied in with the discourse on global capital flows. At the moment Brazil is then a net importer of capacity through its negative external balance. If commodity prices suddenly take a dip this role is certain to be intensified. Is this necessarily a bad thing or perhaps more timely should we expect it to be otherwise? After all a negative external balance is not only about an endogenous process of over consumption and under saving but also about the country’s consumption profile as per function of its demographic profile which translate into distinct lifecycle dynamics. I, at least, tend to believe this to be the case. Also, if we accept this view we must also recognize that other countries will have a propensity to export as per function of their age structure. As I have argued many times before this perspective on global imbalances and how demographics affect capital flows is important to slot in alongside the more traditional narrative on Bretton Woods II and USD peggers.

With these points in mind we could return to my original question of what in fact Brazil should or can do. There are two options. One is to accept the rules of the game and let the capital flow freely in turn making sure to keep the domestic books in order. Another would be to ramp up intervention in the currency markets and to start deploying a state backed investment vehicle to scour the global asset markets for yield. Obviously, this is not entirely a choice to be made at this point but Brazil can still choose to look in either direction I feel. The road taken, be it forced or chosen, will matter a lot however. First of all it will matter for the global economy since the last thing we need at this point is for a country with so favorable growth conditions as Brazil to revert into a growth path driven by excess savings. If Brazil is currently passing through its demographic dividend and even striking oil in the process it also means that the country has a golden opportunity on its hands. One obvious policy proposal I have voiced in the context of other countries is to make sure that fertility does not plunge too far. If the US Census Bureau's estimate is valid and we are already at a TFR at 1.88 it indicates that the process is moving fast indeed. In terms of more plain vanilla economic reforms I would like to reiterate that institutions do in fact matter and now would thus be the time that Brazil enacted those much hailed liberalization reforms and developed efficient markets. In this context the growing size of the public sector as a result of commodity windfall should be watched I feel.

Keep Drilling; when an Ugly Duckling turns into a Swan?

As you can see above I am rather bullish on Brazil from a structural point of view. When I look at Brazil and its underlying economic fundamentals I think that the outlook looks remarkably well. Obviously, there is no automaton here and Brazil may soon enough be struck by a wayward lighting in the context of the global credit turmoil. Yet, current market events are also a test in this case since it will indeed be interesting to see just how much turmoil Brazil will feel if the sh*t does decide to hit the proverbial fan again. How much will the Real really fall and how much of those incoming funds will really leave? Pessimists tend to argue that nothing material has changed in Brazil’s context and that moving into the current patch of slow growth with a widening external deficit presents a large peril. I don’t see it like this at all.

As can be observed however in the references above not everybody agree. One important narrative here is that Brazil has enjoyed a remarkable stint of growth on the back of favorable global conditions which is now set to come to an end. Morgan Stanley’s Marcelo Carvalho recently voiced such an opinion in a slew of notes where he points out that Brazil, although better shielded than before, is far from immune from global financial headwinds. Far be it from me to disagree with a general note of caution. Things may indeed turn for the worse as we progress into the real economic effects of the financial crisis. However, the global economy is now in a position where it needs a Brazil with an external deficit much more than it needs a Brazil with a pegging exchange rate amassing and investing reserves.

I don’t think that Brazil was ever an ugly duckling and while we should not dismiss the voices of caution out there I remain positive on behalf of Brazil. It won’t be easy for Brazil to submit to rules of the global economy where money goes for top line yield. The potential skewness in terms of capital inflows may turn out to be quite large with all the downside risk it brings. However, I don’t quite see how it can be any other way given the economic fundamentals.


Appendix – So what the hell is a carry trade?


Carry trading links in to the principle in the UIP (uncovered interest rate parity) and essentially how this does not hold. The UIP states that the expected change in the spot rate must reflect the interest differential between the two currencies. More specifically the theory predicts that in the context of interest rate differentials the country with the high interest rate will see its currency depreciate (i.e. as it is assumed ex ante that the higher interest rate is a compensation for this depreciation). In formal terms:

If the UIP does not hold we can attempt a carry trade which essentially exploits the interest rate differential between the two countries. Note that in the example below our domestic investor (Ms Watanabe) lose money as the funding currency (the Yen) appreciates.

Assume:

USD/JPY: 120 (indirect quote)

USD/JPY: 115 (indirect quote) - after one month

Monthly USD rate: 0,6%

Monthly JPY rate: 0,012%

We progress in the following steps (amount invested 100 USD)

1. Borrow amount equal to 100 USD (i.e. 12000 yen) in domestic money market and convert spot to invest in the US (i.e. invest 100 USD in US money market)

2. After one month you will have earned 100USD*(1+0,06) which equals 100,6 USD.

3. Convert this amount back to Yen at the prevailing spot rate which in period two is 115. Thus, you convert back to get 100,6*115 which equals 11596 Yen.

4. Use the proceeds for the carry trade to pay back domestic loan. You will have to pay back 12000*(1+0,012) which equals 12014,4 Yen.

In this case we consequently lose as Japanese investors. The percentage lost can be calculated as follows. [(result from carry-payback on domestic loan)/result from carry]*100

i.e. [(11596-12014,4)/11596]*100 = -3,61%.

Note here that the main risk is for an appreciation in the funding currency/low rate currency. In essence there is an almost linear relationship between the % change in the spot rate and the % interest differential spread. I.e. the % deviation from the theoretical prediction of the uncovered interest rate parity. Let us demonstrate.

Over the period in question we observe an appreciation of the Yen to the tune of (115/120)-1 which equals 4,167%. The interest rate differentials earned amounts to 0,588% (0,6-0,012). Now, if we subtract 0,588 from the percentage change in the spot rate we get approximately the loss calculated above (i.e. 3.57%). As such the main risk is (and this is almost always the case) that when volatility is high the spot rate will change much more than can be compensated by the interest rate differential thus resulting in a large potential loss.

Digging deeper into the theory what would be the future spot rate implied by this information given an assumption that the UIP holds? Well, given the fact that the interest rate differential is in favor of the US we should expect the USD to depreciate against the Yen in order to negate the interest spread which could have otherwise been earned. This was what was built into the model but by how much should the USD depreciate as implied by the UIP? As a very rough and ready approximation we can say that the expected change in the exchange rate (E)ΔS is equal to the interest differential; in this case (0.6-0.012) which is equal to 0.588%. A depreciation of the USD of 0,588% would imply a USD/JPY rate of 120*(1-0.00588) which is equal to 119.304.

Thursday, May 15, 2008

Q1-08 Eurozone GDP - A Last Salute from Germany?

By Claus Vistesen Copenhagen

The preliminary and 'non-broken up' GDP figures for the Eurozone economy are now out for the first quarter of 2008. In many ways, I have been in a bit of GDP mode this week as I both made a sneak peek to the Eurozone release as well as I concluded that the Baltics have now entered a recession (a post which even made it to the front page of Moneyweek.com; thanks for that plug.) From a market perspective such ardent attention is surely not warranted. I hardly think markets moved more than a few digits on today's news most likely because the result was already priced in albeit not the 1.5% from Germany I imagine. Yet, what did we get from today's Eurozone GDP release? Well, let us visualize the figures.

As can be immediately confirmed today's release is all about Germany which posted an unprecedented expansion of 1.5% q-o-q. Also interesting was Spain's obvious slowdown and Italy's continuing absence from the data (we are supposed to get figures from the stats offices the 23rd of May). However, let us have a look at what happended in Germany and where that hefty 1.5% reading comes from. As Edward detailed back in March the first two months of January and February were very strong in Germany before momentum levelled off considerably in March and now as well in April and quite possibly May. So far we don't have a detailed break up of the figures but it is safe to say that the expansion in Germany was driven primarily by corporate capex and specifically construction. Moreover, this strong showing of corporate investment is also a derivative of strong external demand which is also sure to have contributed favorably to today's figure. This is not to say that domestic demand and consumption were not significant but given the level of the figure I am very confident when I say that the main driver was not consumption expenditures. Having said that 1.5% still seems to be an almost extreme number. I have been busy talking with my colleagues about this and one of the reasons we have settled is the seasonal factor.

Basically, the mild weather which is widely cited means that a lot of work would have been advanced. Also, my colleagues made the point that the y-o-y figure at 2.6%, albeit strong, was not strong enough to merit 1.5% q-o-q. So, this is merely to say that before you go out talking about annualised figures of 6% you would be wise to consider the underlying momentum.

Turning to the other big four Eurozone countries we observed, as expected, a significant slowdown in Spain where the global credit turmoil has now decisively spilled over into a slump in construction and housing hitherto the hallmarks of the Spanish growth spurt. A contraction in domestic demand is consequently cited as the main culprit in Spain's case. Germany should of course be looking more than careful here since Spain is one of the 10 biggest customers of German exporters. In many ways, the sub-par Spanish showing is also historical since it marks the first time in a considerable number of years that Spain is trailing the Eurozone average. Based on the correction which now seems to be materialising this could very well mark a structural break as Spain is now set to position itself on a lower growth plateau.

In France, GDP continued to muddle along quite nicely at 0.6% and in many ways France seems to have taken its newly found label (branded her here among other places) as the Eurozone's Mme Average. Undoubtedly, France will slow too but I don't think we will see an actual contraction here. A relatively buoyant domestic consumption factor will prevent this as Edward tries to explain here. The last economy amongst the big four is Italy which again opted not to release its figure. Presumably we are going to get figures for both Q4 07 and Q1 08 later this month as noted above. Meanwhile we are left guessing. Most economists agree that Italy may have already tumbled into a recession in Q4 2007. As for the current figure it is difficult to say. Clearly, Spain's lacklustre performance cannot in itself have dragged down Germany's 1.5% to 0.7% as was the aggregate figure.

If we look across the rest of the Eurozone edifice the result was mixed which indicates that a marked slowdown here is not the explanation either. This pretty much leaves Italy (and Ireland from whom we did not get figures either) to explain why Germany's impressive showing did not push the aggregate figure into the +1% territory. Back of the envelope calculations suggest (see below) that Italy was probably very close to flat in Q1 assuming that the 0.7% figure includes any implied Italian weight at all. At this point it is very difficult to say but can be inferred with some certainty is that Italy was the first Eurozone economy, together with Ireland and Spain of course, to be tussled into the ropes and very likely onto the canvass as a result of the global slowdown. As I have explained again and again this is no coincidence and Italy's situation can consequently be explained through a mixture of unfavorable demographics and institutions where I tend to look more closely at the former than the latter. If we peer across the rest of the Eurozone edifice a couple of things should be noted. Most prominently the Netherlands, who after all account for some 6% of the aggregate economy, slowed considerably posting 0.2% q-o-q. Greece continued to expand at 1.1% while Portugal contracted -0.2%.

So, where does it go from here?

To answer this question we could do a lot worse than visit the recent monthly ECB bulletin out today. In words and graphs it paints a picture of a slowing economy across the board noting in passing the factors such as mild weather and strong external demand in the context of Germany which provided to deliver the impressive Q1 figure. In particular, industrial production as well a the leading indicators in the form of new orders are mentioned to have contributed strongly. The ECB's researchers also emphasise that the construction rebound is likely to be short lived. In Spain and Ireland in particular we have seen a sharp correction but also construction confidence indicators have fallen throughout the beginning of 2008. More worryingly in terms of the general economic outlook business activity and leading PMI indicators in the context of the service industries show a decisive downward trend. Services as we know account for just shy of two thirds of the Eurozone economy.

In the most recent print edition, which I imagine is going through the printer as I type, the Economist is furthermore duly cautious in terms of extrapolating on the basis of today's figure. The failure of domestic demand to take over in a situation where corporate investment loses strength is one of the important points. Of course as the Economist also points out, the reluctance of the ECB to provide stimulans on the interest rate front has straddled up government officials to knit together fiscal stimulus packages. The first of these to be brought into effect will be in Spain where the budget is still - just - fielding a surplus. In Italy and Germany where fiscal balances are much more tight plans are also in the smelter. This however is going to result in more attention from the EU in the context of those Maastricht convergence criteria; especially I imagine in the context of Italy who is already running a rather gung-ho fiscal policy.

In order to summarize on the outlook the Q1 2008 expansion is not likely to last. I am especially looking for a marked slowdown in Germany after the extreme 1.5% reading this quarter. In my opinion Germany may thus very well see a contraction in Q2 on a q-o-q basis. I also think that Spain will continue to trail the sub 0.5% figures and possibly even a contraction in q2 and q3 depending on how far and severe the correction in construction and housing is. This points to considerably lower aggregate figures for the rest of 2008 and possibly even negative numbers at some point. In this light, Italy also needs ardent watching. Evidence suggests that Italy not only may already be in a recession but also that the downturn may be lasting and inelastic. In short, after what can only be seen as a swan song in Q1 2008 the risk and direction is now entirely to the downside. Once Germany slows down which it almost certainly will in Q2 we will see the real effect in the Eurozone.

In this light an important question is whether the ECB will react to today's release. Certainly, reduction of interest rates can hardly be justified on the back of this figure. However, given the backdrop which is certain to come in Q2 as well as the much welcome sign that the increase in annual inflation rates are easing you cannot but think that the ECB's bias is about to change. It is not however going to change swiftly. Inflation is still way above the comfort level and even though news of lower global food prices in April rolled in over the wire today I hardly think we are out of the inflation woods yet. The underlying tendencies are too strong I think. For more on this Macro Man's recent invocation of the three axioms of globalization is an excellent place to go. Consequently, I don't quite see the ECB moving its bias in public yet even though the cycle is now certainly turning.

Appendix

The flat growth rate for Italy is found relatively simple but obviously assumes that the 0.7% figure includes Italy at all. As such, if we take the 2007 GDP in current market prices we are able to assign the following weigths ...

Germany - 27.3%

France - 21%

Italy - 17.3 %

Spain - 11%

The Netherlands - 6.3 %

Belgium - 3.7%

Austria - 3.1%

Greece - 2.5%

Portugal - 1.84%

As can be confirmed this amounts to 94% of the entire Eurozone. If we further calculate the weighted average of these countries' growth in Q1 (excluding Italy) we get a growth rate of .644% already for 76% of the Eurozone's countries ex Italy and Ireland. This leaves us with this simple equation where G is the implied growth rate of Italy, Ireland, Slovenia and the rest of the small Eurozone countries.

G = (0.7-0.644)/(1-0.76) = 0.23%.

Now, we know that Slovenia grew smartly which leaves us with Ireland and Italy to share something like 0.15% which is basically flat. Of course, if one of these countries saw a sharp contraction then it means the other must have grown. Especially since Italy accounts for the largest weight by far it cannot have expanded much. I am not sure my method is valid though. In fact, if we include Slovenia it seems as if you hit 0.7% without including Ireland or Italy which may be the way the numbers have been calculated.

Sunday, May 11, 2008

A turn to the West in Serbia? Pro-EU parties handily defeat ultra-nationalists

by Manuel Alvarez-Rivera, Puerto Rico

Sunday's general election in Serbia, which had been widely anticipated to be a tight race between the ultra-nationalist Serbian Radical Party (SRS) and For European Serbia - a coalition of moderate, pro-European Union parties headed by the Democratic Party (DS) - had a completely unexpected outcome, with the pro-EU parties easily prevailing over SRS, according to both estimates published by the Centre for Free Election and Democracy (CeSID) and preliminary results issued by Serbia's Republic Electoral Commission.

The results contradicted findings from opinion polls that suggested the Radicals would top the poll, largely by playing on widespread anger in Serbia over Western backing of the former province of Kosovo's unilateral declaration of independence last February 17. However, the EU's offer of closer ties with Serbia - which included a pre-membership agreement and offers of free visas to Serbs by seventeen European countries - clearly helped the pro-European parties, which repeatedly warned a Radical victory would lead to Serbia's renewed isolation.

The election also dealt a blow to the conservative Democratic Party of Serbia-New Serbia (DSS-NS) alliance of outgoing Prime Minister Vojislav Kostunica, which continued to lose ground and came in a poor third place. Kostunica's center-right coalition government with DS and the right-liberal G-17 (now part of the pro-EU coalition) came apart last March over the issue of suspending ties with the EU in the aftermath of Kosovo's independence, triggering Sunday's parliamentary poll - Serbia's third nationwide vote in fifteen months - three years ahead of schedule. All three ruling parties were (and remain) staunchly opposed to Kosovo's independence, but DSS-NS - along with the opposition SRS - advocated a hard-line stand against Europe over the issue.

While the leftist Socialist Party of Serbia (SPS; originally the party of the late strongman Slobodan Milosevic) and its allies scored significant gains in the election, at the time of writing it remained unclear if the left-of-center Liberal Democratic Party (LDP) - the only party that has accepted the independence of Kosovo - would retain its parliamentary representation by securing at least five percent of the vote. CeSID's projection has the party narrowly crossing the threshold, but LDP stood just below five percent in preliminary election results issued on election night (subsequent official results placed the party above the threshold, as noted under Update).

Irrespective of the LDP result, the pro-EU parties will almost certainly finish well short of an absolute majority in the new National Assembly (Parliament) - whose 250 seats are allocated by proportional representation on a nationwide basis - and SPS could end up holding the balance of power. It was originally expected the party would join forces with SRS and DSS-NS, but according to CeSID's estimate the three groups would have an overall majority of just four seats in the event LDP actually secured parliamentary representation, and the Socialists have not ruled out reaching an agreement with the pro-European parties to form a stronger coalition government.

Update

Serbia's Republic Electoral Commission reports that final results of the May 11, 2008 parliamentary elections were as follows:

For European Serbia - 1,590,200 votes (38.4%), 102 seats
Serbian Radical Party (SRS) - 1,219,436 votes (29.4%), 78 seats
Democratic Party of Serbia-New Serbia (DSS-NS) - 480,987 votes (11.6%), 30 seats
Socialist Party of Serbia-Associated Pensioners Party-United Serbia (SPS-PUPS-JS) - 313,896 votes (7.6%), 20 seats
Liberal Democratic Party (LDP) - 216,902 votes (5.2%), 13 seats
Hungarian Coalition - 74,874 votes (1.8%), 4 seats
Bosniak List for the European Sandzak - 38,148 (0.9%), 2 seats
Coalition of the Presevo Valley Albanians - 16,801 votes (0.4%), 1 seat
Others - 99,992 votes (2.4%), no seats

In addition, there were 88,148 invalid ballots, or 2.1% of the total number of votes cast. The election had a 61.4% voter turnout, slightly up from 60.6% in 2007, and nearly identical to the turnout figure for the first round of voting in last January's presidential election.

Following the election, SRS, DSS and SPS, which together commanded an overall parliamentary majority of six seats, announced they had reached an agreement "in principle" over the future administration. However, United Serbia (JS) - one of the Socialists' junior partners - subsequently called for the suspension of talks with SRS and DSS, due to conflicting views over the Stabilization and Association Agreement (SAA) with the European Union. In due course, the Socialists did an about-face and reached an agreement with the pro-EU parties, paving the way for the formation of an eleven-party coalition government headed by outgoing Finance Minister Mirko Cvetkovic, with Socialist leader Ivica Dacic as First Deputy Prime Minister and Minister of the Interior. In July 2008, the new government - which also includes several small ethnic minority parties - narrowly won a vote of confidence in the National Assembly.

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?

and

Catch Up Growth and Demographics - Evidence from Eastern Europe