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Friday, December 26, 2008

What Are The Chances That We Just Hit The Second Great Depression Out In Ukraine?

by Edward Hugh: Barcelona

Well, one good turn deserves another. So if, like Paul Krugman (and me, I think, though I hadn't gotten as far as thinking through all the implications of what was happening when I posted the original piece) you take the view the Ukraine industrial output chart I put up yesterday could be the smoking gun (or starter's pistol, or line judge flag, or whichever metaphor works for you) that tells us that the second great global depression in the history of modern industrial capitalism may now have begun, then here are some more of those tell-tale charts to put in you pipe and smoke - or if , like Huck Finn that is your preference, to chew on.

Of course, it is quite possible that Paul Krugman may only be saying that a Great Depression has broken out in Ukraine, and obviously only he can say what he really thinks, but as far as I am concerned, since one of the hallmarks of the original Great Depression was a sudden sharp drop in output, sustained over a number of years, and in a large group of countries, accompanied in several cases by outright price deflation, then I do think that what we now have on our hands is something that looks more like a depression than a recession (or slowdown) is what we now have on our hands, and what makes me more or less sure about that is looking not only at what is happening in Ukraine, but at neighbouring Russia, and China, and so on and so on. The point is that Ukraine is not an isolated case - if it were then we would simply be able to say that a large depression had broken out in Ukraine, and that would be that. But since part of the explanation for this sudden drop in output in Ukraine is a lack of working credit, and since this credit drought has now spread across most of Central and Eastern Europe (see Russia here, Poland here, and Romania here), and since the by-product of the Ukraine situation is likely to be a whole cycle of debt defaults, which will certainly spread well beyond Ukraine's frontiers, and since in the wake of those defaults banks will become even less enthusiastic to lend, well then it does seem to me that what is happening in Ukraine has some more general significance. I also certainly think all of this was not far from Krugman's mind when he made the post, since what he wasn't doing was simply (in true bloggie fashion) saying ha ha, look what's going on over there. What he was saying is "watch out, this can come back and give us all a kick" - which again is what he was doing with his Japan work in the late 1990s, and it did. My feeling, and it is only a feeling, is that what he wanted to do was move the debate on, and up a level. We can't address the kind of problems we are facing if we fail to recognise we are facing them, and one of our problems in responding to this crisis (and especially here in Europe), has been a consistent failure to recognise the importance of what was happening, and to take measures which were up to the challenge. What was it they used to say: Ninja mortgages, ha, ha, ha. I don't see these people laughing now.

Evidently, since history never exactly repeats itself, I am certainly not saying that the current crisis is going to last an entire decade, or end in a big war, or anything like that. What I am saying is that it has already made a place for itself in the history books, and already belongs to the class of large and unusual economic phenomena, and that we can learn a lot about how to handle our present problems by looking at the experience of 1930s. Of all of this I am absolutely convinced, and I have a pretty good idea that both Bernanke and Krugman are too, if you look at the constant references to those years in almost everything they say and do these days

Now Let's Look At Some Charts

Well, for those who missed it, here is the Ukraine chart that is causing all the fuss:

Japan industrial output isn't exactly falling at the same dramatic pace as Ukraine, but a 16.2% year on year fall isn't to be sniffed at either, and this is what they informed us today happened in November. Worse still, according to Japan's Economy Ministry output is expected to decrease by a further 8.0% between November and December, which, if accurate, will surely push the year on year decline in December over the 20% mark, not the great depression, but then again, not exactly enjoyable.

And exports, which drive the Japanese economy, were down by 26.7% in November. Even more to the point, deflation is baaack, or almost back, since "core" core prices hit zero (or 0.1% below current overnight BoJ interest rates) in November, and outright deflation surely isn't far behind.

You can find more detail on all today's Japan data over at the Japan Economy Watch Blog, and for those of you who want some more deflation background on Japan, well, Krugman has the goods here (extremely wonkish).

Moving nearer to home we have Germany. Here is the latest (flash) December manufacturing PMI for Germany, which is just about as point of the spear as you can get in terms of just in time data.

The slope of that line looks pretty telling doesn't it, especially if you are into depression economics. Then we have the November new orders chart, another shocker, and indicator of much worse to come, I think.

Now going back to this point:

“There is a burgeoning economic crisis in the European periphery,” Krugman said on the ABC network Dec. 14. “The money has dried up. That’s the new center, the center of this crisis has moved from the U.S. housing market to the European periphery.”

I think this is largely true, if we mean by the periphery the UK, Ireland, Eastern and Southern Europe, but the periphery in a very literal sense always ends up biting the hand that feeds it, since German industry depends on exports to that periphery perhaps more than to anywhere else, so it is not surprising that once the periphery folds, the shock wave moves on in towards the centre. I don't know if the blast which is about to hit Germany next year will count as a depression, but if it doesn't, it is going to be a damn close call. And the hard part for Germany is when you get to ask yourself where exactly the new demand will come from to drive the exports?

Moving off now towards the periphery, we have Spain to the south, where the money certainly has dried up, and with it internal demand for Spain's manufactured products. The November PMI showed Spanish industry contracting at an all time series maximum for any country.

Central Europe

The whole of central European manufacturing is now contracting rapidly. First off, the Czech Republic

Then Poland

And finally (for this little illustration) Hungary

Then There Is Russia

Moving on now to Russia, industrial output was down by 8.9% year on year in November, so it hasn't yet reached Ukraine levels, but at the rate of contraction they are experiencing I wouldn't be too confident that that state of affairs will last too long.

And Finally China

Where the November PMI also showed quite a strong contraction:

So where does that leave us? Well basically I'm not sure. We still need to see more data. (Do I sound horribly like Jean Claude Trichet at this point?). If we look at the chart for US industrial output which Krugman presents, the first thing which is pretty obvious is that the 1928-1930 boom-bust was a pretty rapid affair.

After that output dropped very sharply, going in the space of twelve months from a 20% expansion to a near 30% contraction, and the contraction continued at those levels until mid 1932, when the position started to improve - although all this year on year % contraction data is a bit misleading for non specialists, since to have a 30% contraction in mid 1932, following near 30% contraction in mid 1930 and (what) a 15% contraction in mid 1931 (taking into account base effects) then the drop is really massive, and I doubt even Ukraine (barring very worst case scenarios where the country simply disintegrates) will get this.

But where this current output slump (or call it what you will) in a number of key countries already does resemble the 1930s more than any other drop in activity since (remember, Japan's November fall in output is greater than anything that has happened in the entire lost decade-and-a-half - and the biggest since at least 1953) is in the sharpness of the drop, and in the sequencing of events. By sequencing I mean the fact that we have had a pretty dramatic financial crisis, which has lead to a generalised loss of confidence in the banking sector, and this in turn has produced a credit crunch, which is now working its way right through the real system. And nothing, but nothing, at this point, seems to be barring its pass. That is the worrying bit, and that is why I don't think we are going to see a generalised "turnaround" in activity in 2010, or even 2011, this show is going to run and run, at least in some of the worst affected countries. And we still don't know just how many icebergs there are lying out there for our convoy to hit. In particular, since we all just got the excess leveraging is bad, current account deficits are bad, exports are good religion, it isn't obvious at this point just who the customers are going to be to drive any new expansion when it does finally come. Life, as we know, is always full of surprises, and we should ever be ready for them, for good or for ill.

Thursday, December 25, 2008

As The Politicians Battle It Out Ukraine's Economy Tunnels South In Search Of Australia

By Edward Hugh: Barcelona

“In Ukraine, the evidence is still that policymakers do not quite understand the seriousness of the challenges they face,”. Timothy Ash, analyst at the Royal Bank of Scotland.

“There is a burgeoning economic crisis in the European periphery,” Krugman said on the ABC network Dec. 14. “The money has dried up. That’s the new center, the center of this crisis has moved from the U.S. housing market to the European periphery.”

Make no mistake about it. What is taking place right now in Ukraine is extraordinarily serious. The IMF have recently agreed a support loan to the country, but the politicians themselves still can't agree on whether or not they are actually going to abide by the conditions attached to it. Meantime, as we can all see on our TV screens, tensions with Russia continue to escalate, fuelled by the conflict-ridden negotiations over Ukraine's gas debt.

And just to add to the nighmare, Ukrain's economy made a dramatic entry into recession in Q4 2008. In fact, so severe has been the slowdown that nobody at this point can even muster enthusiasm for opening up one of those interminable discussions about whether or not what the country is going through really counts as a "technical recession" (in terms of two successive quarters of GDP contraction) or not, since the drop in national output has been enormous, and it it fairly obvious that isn't about to come bouncing back up again. At least not for the next several quarters it isn't, and - to give us an early glimpse of the terrain onto which we are now entering - the World Bank have just forecast a 4% contraction in GDP for 2009.

In a year when you would think little would surprise us the sharp change in real Ukraine GDP dynamics has been astonsihingly swift, with the growth rate moving from the 11% year on year expansion registered in August to the 14% year on year contraction reported in November (according to data put together by the World Bank). GDP for the whole January-November period is now down to 3.6% when compared with the equivalent months in 2007, and this is reall a sharp drop, since the average over the first nine months of the year was a growth rate of 6.9%. For his part the office of Ukraine President Viktor Yushchenko is suggesting that gross domestic product may contract at an annual rate of between 7 percent and 10 percent in the first quarter of next year, and by 5 percent over the whole year, according to Oleksandr Shlapak, deputy chief of staff to the president.

The contraction has been led by sharp falls in manufacturing and construction, while the financial system has been in serious trouble since late September, and the loss of UAH deposits from the banking system has amounted to 14% during October and November. But the real problems Ukraine is facing in confronting this most serious economic crisis, lieas in the political sphere, and the complete lack of the kind of political consensus which is so necessary to see through the measures which can it to an end.

Political Chaos Adds To The Problems

Ukraine’s government - which is laways a chaotic process at the best of times - is once more having a serious identity crisis about who it is and what it wants to do, with one of the exectutive's two visible hydra's heads (Prime Minister Yulia Timoshenko) seeking to respond by manipulating the currency downwards, by boosting social expenditure to an extent which will push next year’s budget deficit up to 2.96 percent of gross domestic product (from an agreed 1.4%) and well beyond the IMF pact level, and by attempting to resolve the trade deficit problem by imposing an administrative tax on imports. The other head of the hydra (President Viktor Yushchenko) is busy opposing all these moves on the grounds that they may jeopardize the second tranche of a $16.4 billion loan from the International Monetary Fund, and obviously, were this to be the case, the country would basically find itself bankrupt, and at the mercy of whatever sentiments the global financial markets wish to express when it comes to Ukraine.

Of course regular readers of this blog will not be surprised to find that this politically split personality crisis goes right into the heart of the central bank (see my Monetary Chaos Breaks Out At the Ukraine Central Bank post) and no one will be really that surprised to find that the two key characters in this round of the saga are (yet one more time, read the linked post, its all explained there) National Bank of Ukraine Governor (and board chairman) Volodymyr Stelmakh’s and Petro Poroshenko head of the central bank council.

Well things are really hotting up at the moment, with Viktor Yushchenko this week threatening to fire some central bank employees (presumeably those who were not implementing the decision to allow the Hryvnia to float), while Yulia Timoshenko was busy demanding the dismissal of National Bank Volodymyr Stelmakh himself - presumeably because he was trying to stop further currency intervention. In an official statement the central bank council responded by accusing Timoshenko of stirring up “chaos” and undermining the nation’s banking system, while Timoshenko, for her part has now taken the matter to the Ukrainian parliament (the Verkhovna Rada - where she may well carry a majority) which will now hold a full debate the role of the central bank next week. It seems not to matter too much here that the bank council is simply trying trying to implement a set of policies which were agreed to (or everyone thought they were agreed to) as part of the IMF loan agreement.

“A hryvnia level above 9 per dollar is unacceptable, it threatens the economy and banking system,” Petro Poroshenko, the head of the central bank council said. “The situation with the hryvnia rate demands urgent measures.”

Volodymyr Stelmakh, Central Bank Governor, the Yulia Tymoshenko Bloc is proposing his immediate arrest.

(Interfax-Ukraine) - Yulia Tymoshenko Bloc has proposed that, based on results of a report by an ad hoc parliamentary commission scrutinizing the National Bank of Ukraine's activities, an address should be sent to the Prosecutor General's Office and that National Bank Chairman Volodymyr Stelmakh should be arrested. "I think that, based on the report's findings, there will surely be an address to the Prosecutor General's Office of Ukraine and other law enforcement agencies, which, by the way, are already conducting inquiries," Volodymyr Pylypenko of the Yulia Tymoshenko Bloc said in an interview with Interfax on Wednesday. "The best gift in this situation can only be an order on taking [National Bank of Ukraine Chairman Stelmakh] into custody for all wrongdoings the National Bank has committed in the past months," Pylypenko said.

President Yushchenko did express the hope last Tuesday that Ukraine's currency market might be moving rightside up, with the hryvnia trading at about 7.8-8.0 to the dollar and level of "stabilising" dollar purchases by the central bankdeclining, but Prime Minister Tymoshenko remained unconvinced that this was a desireable level, and demanded more concerted intervention to move the currency up to a much higher level - around the 6-6.5 to the $ mark. She gave Yushchenko a week-and-a-half apparently, since otherwise she stated the country would face increasing problems with inflation, and in the banking and other sectors. It is not clear (at least to me) why these problems (which are, and will continue to be, serious) should suddenly deteriorate within the time scale of ten days, but presumeably there was another, more political, message behind this choice of words.

Adding to the confusion, Ukraine's parliament, has decided to impose an additional 13% temporary duty on all imported goods - and this despite the fact that Ukraine only recently entered the WTO. A total of 269 MPs from the ruling coalition and the Communist Party voted for the relevant law which amended existing Ukranian lefislation - with, it was said, the aim of improving the state of Ukraine's balance of payments. "Duties have been increased on all imported goods, apart from a [so-called] 'critical' [list of goods]," the head of the parliament's committee for tax and customs policies, Serhiy Teriokhin, is quoted as saying.
"I'm alarmed by the report of my legal department on parliament's decision to impose an additional temporary duty on all imported goods. Parliament's decision puts Ukraine's presence in international programs in jeopardy," President Yushchenko said at a press conference yesterday. "Similar decisions by Russia and Europe might be made against us in three days,".

IMF Taking Large Political Risk

Last month, a point in time which now seems so distant it feels like eternity, Ukraine received approval for a two-year IMF loan intended to help support its banking system and cover the country’s widening current-account gap during what was always seen as being a difficult adjustment process. Under the terms of its agreement with the IMF, Ukraine is expected to have a balanced budget next year. If the Cabinet fails to meet the target, then the Fund may withhold the second tranche of the loan, according to press statements by Balazs Horvath, IMF representative in Kiev. Ukraine received the first installment of $4.5 billion last month, and is due to get the second tranche in February. Obviously the IMF is by now well accustomed to playing the part of the "bad boy" in this type of situation, but what if the country they are trying to deal with should simply "implode", right in its face, I'm not sure even the hardened hand of the IMF are ready for this. So let's just hope I'm exaggerating, and that it won't happen (fingers tightly crossed everyone, please).

Discrepant GDP Forecasts

So Ukraine faces a crisis on three fronts, financial, economic and political. On the real economy side, the Ukraine cabinet currently expects growth in the country’s economy to slow to 0.4 percent next year, compared with a final rate which turn out to be somewhere between 1.8 percent and 2.5 percent this year. As I say the World Bank now expects a 4% contraction in GDP next year, and thus a 0.4% expansion in the budget is potentially a very serious problem indeed for the deficit, if the economy underperforms, as it surely will.

“The draft budget, prepared by the Cabinet, is not realistic,” Yushchenko said today in a statement on his Web site. “The 2009 budget is a tragedy; it is the most irresponsible document worked out by the government. Professionals should plan a realistic budget, not optimistic.”
The government plans to cover the budget deficit by selling bonds in domestic and foreign markets, and is to receive a $500 million loan from the World Bank to cover the budget deficit. Under the terms of the IMF agreement with the Inernational Monetary Fund Ukraine has pledged to keep its 2009 budget deficit under 1 percent of gross domestic product, below the 2 percent initially planned by the government. In October, the government reduced its planned 2008 budget revenue from the sale of state assets to 401 million hryvnia ($59.4 million) from 8.6 billion hryvnia, citing the unfavourability of the moment for selling.

Pressure On The Hryvnia

The Hyrvnia has been falling for a number of weeks, but the rate of decline has really accelerated in the last ten days, and we are really now talking about one of those famous currency crises. The national currency has fallen 50 percent against the dollar since June, and according to Michael Ganske, head of emerging markets in London for Commerzbank, it may well drop another 24 percent in the next few weeks given market sentiment and that the International Monetary Fund package effectively limits central bank intervention to halt the slide. The terms of the IMF $16.4 billion bailout package, agreed to last month, require Ukraine to move toward a flexible exchange rate and place a maximum limit of 4 percent for any reserves reduction during the remainder of 2008 (from the base of around $32.8 billion). Thus while the agreement does allow intervention to stem “disorderly” swings, it places a tight limit on what this means. And this now is just the problem, although before we jump to our guns, we should bear in mind that what is provoking the fall is not the IMF and the bailout, but confidence in the ability of the political system to implement a workable recovery plan. Trying to run a currency corridor, and accepting the inflation that went with it, is how we got here in the first place.

The only real remedy Ukraine’s central bank has at its disposal at this point is to raise its base refinancing rate, and this it duly did last week, taking it up from 18 percent to 22 percent in an attempt to arrest the hryvnia’s decline To give us some idea where we are at this point, at the start of 2008 the dollar bought 5.04 hryvnia, while right now it can purchase around 8.25 hryvnia.

The central bank is currently offering to sell dollars at 8.0 hryvnias and to buy them at 7.8788 on the interbank market. Yushchenko told a news conference last week that the central bank had bought $270 million on Monday and Tuesday, but had been required to sell only $30 million on Tuesday. He informed the assembled journalists, however, that complete stabilisation would need to wait until after the debts for Russian gas and other expenditures had been paid (you should be able to start to smell just how complicated all this is by this point, just who exactly is batting for who here?). "Until debts are paid for gas, and settling the debts of (the national road network) Ukravtodor, it would be madness to talk about steps aimed at a fundamental, professional stabilisation". "Everything is earmarked", he claimed, "$3 billion (for intervention from reserves), more than $2 billion set aside for gas arrears, $1 billion for repayment of a loan to Ukravtodorom, $200 million to (rocket maker) Yuzhmazh, leaves only an additional $400 million to defend the hryvnia."

As a result of the $7.5 billion the Ukraine central bank spent supporting the hryvnia in October and November foreign reserves fell to $32.7 billion as of Nov. 30. At the same time the hryvnia has declined 21 percent against the dollar over the last month alone . Under the terms of the agreement with the IMF, the reserves should not fall below $31.4 billion by the end of this year, so we are talking about a very close call on this front too.

Equities Down And Credit Default Swaps Up

Ukraine’s stocks have also been falling, and the benchmark PFTS stock index is down 74 percent this year, the third-steepest decline among the 22 so-called frontier markets tracked by MSCI Barra. Mariupolsky Metallurgical Plant, Ukraine’s largest steel company by revenue, has fallen 92 percent on the Kiev stock market. On the other hand the extra yield investors demand to own Ukrainian government bonds instead of U.S. Treasuries has increased more than nine times this year to 25.86 percentage points, according to JPMorgan Chase’s EMBI+ indexes, which compares with an average three-fold increase in the main emerging-market index to 7.09 percentage points.

Loan Defaults Coming

And as the currency slides, so too does the ability of the average Ukrainian to pay his or her debts. Another Yushchenko aide, Roman Zhukovskyi, recently estimated that up to 60 percent of foreign-currency loans and mortgages could default given the extent of the decline. Ukraine, which has around $105 billion in corporate and state debt, has the fourth-highest credit risk worldwide, according to credit-default swap data. The cost of insuring Ukraine bonds against default is up more than thirteenfold this year, to an astonishing 31 percent of the amount of debt protected. This puts the country behind only Ecuador, which defaulted last week (59 percent), Argentina, which defaulted on $95 billion in bonds in 2001 (46 percent), and Venezuala ( 33) percent, according to the data from CMA Datavision.

Ukrainian companies need to repay as much as $4.1 billion this month while lenders refuse to refinance debt, according to Dmitry Gourov, an economist at UniCredit in Vienna (oh, no, not Unicredit again, see this post). Dollar denominated loans made up 53 percent of credit issued by Ukrainian banks as of 30 September, according to central bank data.

Thus, with just over half of all bank loans denominated in US dollars, they obviously become vastly more expensive for borrowers who are paid in the national currency.

Aggressive lending by banks that borrowed heavily from abroad has obviously contributed to Ukraine’s ballooning private sector external debt (currently estimated at $85 billion). Official figures indicate that only some 2.5 percent of loans are currently problematic, but this situation is obviously about to worsen considerably next year as the currency is down and the economy contracting.

Earlier this month, Finance Minister Victor Pynzenyk called on banks to refinance loans amid a weakening hryvnia and rising interest rates. Some banks in recent days said they would seek compromises with clients, rather than hike interest rates further. Pynzenyk’s proposal called on the NBU to amend its rules to allow borrowers either partially or in whole to pay back loans in the national currency at the exchange rate which was operative when the loan agreement was signed. The banks, in turn, would be allowed to lower their capital/asset ratios and write off their losses, thus paying lower taxes, which would also require amendments to the tax legislation. Obviously some such solution will need to be found for this problem. (There has already been some move in this direction in Hungary, another of the countries which is strongly affected by the forex loans problem).

Other measures under consideration at the present time include extending loan periods, and the temporary reductions in loan payment installments. If the hryvnia-dollar exchange rate further widens, mass loan defaults are inevitable, according to Yuriy Belinsky, head analyst at Astrum Investment Management. At the current Hr 8 to the $1 rate, “40 percent won’t be able to pay their loans,” Belinsky told Korrespondent, a Russian-language Ukraine newspaper.

And the situation is deteriorating fast, a quick visit to the foreclosure sections on the websites of banks like Finance and Credit Bank or Alfa will turn up plenty of property and cars already listed for sale or soon to be auctioned. But given the slump in the real estate market and falling house prices it isn't clear that banks will find it any too easy unloading any property they do repossess. We are back to the "you owe them a little money and you have a problem, and you owe them a lot of money and they have a problem" situation. Last weekend, the NBU also recommended that banks lower interest rates on foreign-currency denominated loans, but the problem is going to be, as ever, who is actually going to fund these measures?

Industrial Output Plummets

Meantime in the world of the real economy things simply get worse and worse. Industrial production shrank by a record 28.6 percent in November as steel, machine building and oil refining slumped, after a 19.8 percent decline in October.

And as output falls, prices come tumbling behind. Steel production dropped 48.8 percent in November, while the price of the benckmark European hot rolled coil has fallen 47 percent since August and is now at around $425 a metric ton, according to data from U.K. industry publication Metal Bulletin.

World Bank Forecast

The World Bank have predicted a sharp recession for Ukraine in 2009, with GDP being expected to fall by some 4.0 percent. This compares with their July forecast of 4.5 percent growth. The Bank also cut back its forecast for 2008 growth to 2.3 percent from a previously forecast 6.0 percent. It raised its inflation forecast for this year to 22.8 percent from 21.5 percent previously predicted, up from 16.6 percent in 2007. It cut its forecast for inflation next year to 13.6 percent from 15.3 percent.

(please click on image for better viewing)

The Bank take the view that the Ukraine government - in agreeing to the terms of the IMF loan package - have initiated an important programme of macroeconomic adjustment measures, but (with a wary eye on what is actually going on in the Parliament) stress that consistent implementation is essential to avoid a further erosion of market confidence. In their latest report the Bank highlight the shift towards a flexible exchange rate policy, financial sector stabilisation measures , and a more conservative fiscal policy, but as we have seen, these are just the measures which seem to be being challenged by some of the political participants .

So What Does The Future Look Like?

Obviously Ukraine is heading into a major recession in 2009 fuelled by the nasty cocktail of a credit crunch, a terms of trade deterioration, and a consequent massive slowdown in both internal and export demand. Given the damage to competitiveness caused by two years of double digit inflation, macroeconomic stabilization will require a very large and significant correction, and this will mean a significant tightening of aggregate demand and a shift in its composition away from domestic consumption and towards net exports. The government debt stock is currently low at 10 percent of GDP, and will undoubtedly remain sustainable throughout and after the adjustment, even allowing for the potential costs of bank recapitalization. But the ability of the Ukraine administration to carry out the necessary adjustment hinges critically on the willingness of external creditors to refinance the banking and corporate sector debts, and this willingness in its turn depends on the perception those creditors have of the level of political coherence and stability the country has. And as we are seeing such perceptions must be reasonably near an all time low at the present time.

But even with the best political system in the world, the economic correction facing Ukraine is going to be large and the stresses enormous. The World Bank more or less spell this out in the paragraph I extract below. A 200% contraction in real imports (ie not due to cheaper energy prices or something) is massive, and we are talking about a basically balanced budget (ie very little fiscal stimulus) and monetary policy where interest rates are at the current giddy heights of 22%.

The basic macroeconomic parameters in our forecast are broadly consistent with those of the IMF program. Balance of payments pressures will lead the economy to adjust the composition of growth through 2009. As a result, the current account deficit is expected to improve from over 6 percent of GDP in 2008 to 1-2 percent of GDP in 2009-11. To achieve this adjustment, an over 20 percent real import contraction will be needed in 2009 in order to counter the 7 percent forecast terms of trade deterioration. Real wages and employment are forecast to decline in 2009 to restore price competitiveness of Ukrainian exports in the wake of declining export prices and to support the adjustment in aggregate demand. With this current account adjustment and with the support of the IMF Stand-By, the external financing gap would be closed under our baseline assumptions. Declining commodity prices, tightening liquidity and the forecast decline in domestic demand will contribute to disinflation. However, offsetting this, the exchange rate correction and the adjustment of energy and utilities tariffs will make disinflation a more prolonged process. We assume that the government will maintain a balanced budget in 2009 (not accounting for bank recapitalization costs) and have a small deficit thereafter.

So I think we need to be very clear at this point. The Ukraine position is very difficult, and everything is very delicate. The danger of total financial meltdown (which would be in this case in the private banking sector, not sovereign debt) is real and significant. The economic downturn has only just started and further downside risks are large and depend critically on the size of external shocks and the limitations imposed by inadequate policy responses.

Any further deterioration in the terms of trade (unlikely at this point given how far steel prices have already fallen, but these prices may stay lower for longer than many in the sector can sustain) or further decline in export demand would certainly put almost unsustainable pressure on the real sector. Banking sector vulnerabilities may be further exacerbated by further overshooting of the exchange rate and external debt refinancing difficulties as corporate balance sheets weaken further and household incomes come under strain from rising debt service costs.

Prudent fiscal, monetary, and financial policies (many of them anchored in the program supported by the IMF), accompanied with renewed efforts to deepen structural reforms, can help Ukraine to stabilize its situation and move the economy towards recovery. Conversely, a continuation of the current disorderly response and poor implementation of the agrred policies may easily trigger further financial chaos leading to an even shaper downturn and a postponement of any recovery off into the distant sunset.

But Beyond The Recovery, What About The Demography?

One of the reasons why I think the IMF and the World Bank are taking such a big risk with their credibility in Eastern Europe at the moment, is that I don't think they are getting through to the heart of the problem. One way of thinking about this is to take Paul Krugman's favourite Keynes quote - "we've got magneto trouble" - and ask ourselves whether all we have before us in the CEE countires right now are magneto problems, or whether, to continue with the metaphor, we may not have issues with the cylinder head gasket. And it gets worse, because the cylinder head gasket does seem to have blown (and it will keep blowing) because we have leakage problems in the sump, and the main oil pump isn't working - and who knows, maybe the crankshaft even needs replacing. As they always tell you when you take the car into a garage for "fixing", we won't know till we take the thing apart. What do I mean?

Well take a look at the chart showing the relative size of annual births and deaths in Ukraine over the last twenty years.

I mean to the normal and untrained eye stands the problem stands out a mile, population dynamics went underwater in the Ukraine in the early 1990s, and they aren't coming back to the surface again (not now, not in thirty years, not...... well maybe never is too much of a long time, but certainly not over a time horizon which is going to make any essential difference to anyone who is already alive today.)

And this is without taking any outward labour migration into account, so just think about the negative labour market dynamics that this implies, and already has implied. Can anyone really be surprised that Ukraine has been suffering from acute inflation as its number one problem?

To some extent it is worth stressing here that what really matters is the actual numbers of annual live births, rather than any more complex measure of fertility. In 1989 for example there were nearly 700,000 children born in Ukraine. By 1998 this number was near to 400,000 (ie there was a drop of 40% or so in a decade). In practical terms (and if we take 18 as an average age for labour market entry in a country like Ukraine) next year there are potentially 650,000 people to enter the labour force, but by 2016 this number will be only 400,000. So it isn't simply a question of pushing the fertility rate up towards the replacement rate (a difficult, but not impossible task), we also need to think about what economists term the "base effect" here, that is that with each passing year and cohort you have less and less women in the childbearing ages, so even if those women replace themselves, the base of the pyramid is still much narrower than the top, and it is the people at the top who need caring for and financing.

And even if some of this loss can be offset at the workforce level by increasing labour force participation at the older ages, we would still be talking about a very sharp rise in the average age of the workforce. And productivity improvement alone cannot possibly hope to compensate for the kind of labour force contraction we should reasonably expect, at least not over such a short period of time it can't. So this is just one more reason why, against all expectation, fertility really does matter.

While many continue to believe that falling populations don't actually have any tangible impact on economic performance, it is very striking to notice that when it comes to ageing and declining populations we really lack ANY evidence to substantiate that claim in the affirmative. On the other hand we do have plenty of evidence from countries where the population is either falling or gathering negative momentum to suggest that these countries face some very special kinds of economic problems. The example of Eastern Europe is clear enough I would have thought, but people really do need to take a closer look at what has been happening in recent years in countries like Japan, Germany, Italy and Portugal. And if falling population does produce its own kind of economic problems, well then we should be expecting to see plenty of them in Ukraine, since as we can see in the chart below Ukraine's population peaked in 1993, and has been in some sort of free-fall ever since.

Evidently there are a number of factors which lie behind this dramatic decline in the Ukrainian population, fertility is just one of these (with poor health and net emigration being the others). Ukraine fertility is currently in the 1.1 to 1.2 Tfr range, and, as we can see in the chart below, it actually dropped below the 2.1 replacement level back in the 1980s.

Another major influence on demographic dynamics is health, and one good measure of this is the level of life expectancy, which in the Ukraine case has shown a most preoccupying evolution, since it has been falling rather than rising. The chart below shows life expectancy at birth for both men and women, the male life expectancy is evidently significantly below the combined figure.

This life expectancy situation is, as well as being preoccupying, highly unusual (it is however paralleled to some extent in Russia itself, and some other CIS countries). Apart from the obvious, the deteriorating health outlook which this data reflect places considerable constraints on the ability of a society like Ukraine to increase labour force participation rates in the older age groups, and this is a big problem since this is normally though to be one of the princple ways of compensating for a shortage of people in the younger age groups.

So what about the future? Well, two issues are really starting to worry me at present, the first of these is the short term fertility shock Ukraine will undoubtedly receive on the back of the current crisis. If young people were already rather reluctant to have children, then then will now almost certainly be much more so, given the downward pressure on living standards we are about to see.

The second worry concerns the future of the country itself. A recent study carried out jointly by the Kiev based Democratic Initiatives Foundation and Nova Doba History and Social Sciences Teachers Association found that while more than 93 percent of the Ukrainian seventeen year olds they inteviewed considered themselves Ukraine citizens, only 45 percent said they planned to live and work only in Ukraine, citing Western Europe, Russia and the United States as possible future destinations. When 55% of your potential future labour force are thinking of working elsewhere you have a problem, and one which needs a solution. Simply putting a strip of band-aid over a festering wound won't work, I'm afraid, however much the Ukrainian people may struggle and sacrifice. With or without Keynes, we've got more than magneto problems on our hands here.


A much fuller analysis of the problems presented by Ukraine's long term population implosion (including the issue of out-migration patterns and trends) can be found in this post here.

Wednesday, December 24, 2008

What Is The Level Of Deflation Risk In Germany?

by Edward Hugh: Barlecona

Only one thing is really clear about the Germany economy at the present time, and that is that it is shrinking rapidly. In fact it contracted far more than most analysts and observers expected in the third quarter (although I, for one, was not especially surprised), entering what now appears to be its worst recession in at least 12 years as both exports and domestic spending continue to fall. German gross domestic product in Q3 dropped by a seasonally adjusted 0.5 percent from the second quarter, when it fell by a quarterly 0.4 percent, according to revised data from the Federal Statistics Office. The Germany economy last had a two quarter contraction of this magnitude back in 1996.

And all the signs are that the fourth quarter will be worse than the third one, so the situation may even surpass the 1996 recession.

What's more the 2009 outlook promises to be even worse. The International Monetary Fund are now forecasting outright GDP contractions for the U.S., Japan and the eurozone next year, with Germany's economy expected to shrink by at least 0.8 percent (this as we will see is one of the most optimistic forecasts currently on the table for German GDP next year). The European Commission declared the 15-nation eurozone to be in recession in November, and just over 40 percent of the exports from this highly export dependent economy go to other eurozone nations.

The only positive elements in the Q3 GDP data are to be found in the slight increases in both final household consumption and government expenditure. On a seasonal and calendar-adjusted basis, household consumption expenditure rose by a quarterly 0.3%, while government final consumption expenditure rose 0.8%. Gross fixed capital formation rose slightly (0.1%) due laregly to a sharp uptick in construction over the second quarter (+0.3%, following –3.4% in the second quarter and +5.5% in the first).

In addition there was a large increase in inventories, and inventories contributed a whopping 0.9 percentage points to Q3 growth (see chart below), and without this build-up the contraction would have been much sharper - so watch out since this inventory increase which will more than likely be unwound in the fourth quarter, with considerable downside impact. Imports were up significantly (largely due to the rise in oil prices - oil peaked around $147 a barrel in July), while exports dropped, as a consquence movements in the net trade balance had a negative impact on final GDP.

Capital formation in machinery and equipment (ie investment) was down sharply (–0.5%), after increasing for seven quarters in a row. Thus the entire positive impact of domestic consumption and increased inventories was more than offset by a very rapid and sharp deterioration in the net export position. Between July and September exports were down by 0.4% over the previous quarter, whereas imports were up 3.8%. This meant that net exports contributed a whopping minus 1.7 percentage points to q-o-q GDP, and headline German GDP is extraordinarily sensitive to changes in the net trade position (see chart below).

Deteriorating Short Term Outlook

Looking forward into Q4, the signs, as I said, are for deterioration, as can be seen from the fact that (according to the latest flash PMI) German services contracted for the third consecutive month in December, even if the rate of contraction was slightly less than that in November.

Worse still, the contraction in manufacturing accelerated, and sharply so, clocking up its fifth consecutive month of contraction according to the flash estimate. The data released by Markit Economics showed German manufacturing registering its lowest reading for manufacturing since the survey was started in April 1996, with the indicator falling to 33.5, down 2.2 points from the November result and significantly exceeding the 1.3 point decline expected by the analysts. If we break the figures down we find that output tumbled all the way to 29.9 (from 32.3 in November), while new orders slipped 3.3 points to a record low of 25.8. Meanwhile, the employment component reached its worse level in the history of the index, coming in at 40.9 for the month from November's 43.6.

October Industrial Output Down

The PMI data are obviously only survey-based forward-looking estimates, but when we come to the actual data we find they are normally pretty near to the mark, since German industrial output fell strongly in October - dropping a seasonally adjusted 2.1 percent from September - according to the latest data from the Economy Ministry. Year on year working day adjusted output fell 3.8 percent. And November’s drop was led by a 3.1 percent month-on-month slump in the demand for investment goods, which means that companies are anticipating a serious slowdown in final manufactured goods further on down the line.

And the PMI is Confirmed By New Orders Data

I think nothing gives us a clearer illustration the dramatic nature of the industrial slowdown the Germans are now experiencing than the chart reproduced below which shows changes in monthly orders (both domestic and for exports) for German manufacturing industry over the last decade. As you will see (to use one of my choice phrases of late) we just went careering off a cliff.

New manufacturing orders dropped 6.1% in October from September, and in September they fell 8.3% from August. The quarter on quarter drop is huge - in the order of 40%.

Export orders are falling faster than domestic ones in the longer term during Sepetmber even domestic orders started to contract sharply as well - a 6.1% drop as compared to 6.2% for exports. What this suggests that the "second round effects" on domestic consumption from the drop in export sales are now hitting domestic manufacturing order books.

Exports Up Only 1.4% In October

Now it is, I think, generally accepted that German domestic demand is lacklustre, and has been for some years, and the German economy lives (or dies) from exports, so it is not without importance that according to the most recent provisional data from the Federal Statistical Office, October German exports were worth up only 1.4% (non price adjusted) and imports up 5.4% from their respective October 2007 levels. After calendar and seasonal adjustment, exports in fact decreased by 0.5% (and imports by 3.5%) month on month when compared with September.

The foreign trade surplus was 16.4 billion euros in October 2008, down from the October 2007 surplus of 18.9 billion euros.

Growth Outlook

It is very hard to put precise numbers on where the German economy is likely to go from here. Certainly GDP growth next year is going to be a shocker on the downside - with or without those notorious calendar adjustments. The Essen-based RWI economic institute are forecasting what now seems to be a "low end" prediction of a 2 percent contraction for next year, but even this would already be the biggest annual contraction since World War II. The have been joined by the IFO institute, who foresee a contraction of 2.2%. At the present time everyone is moving on the downside and accepting the reality of what is happening, with the Berlin-based DIW economic institute also cutting its forecast for the final quarter of 2008 to a contraction of 0.3 percent - down from previously anticipated growth of 0.2 percent (citing in justification the declines in industrial output and construction). The Kiel-based IfW suggested this week that the German economy will shrink 2.7 percent next year - the most pessimistic assessment by any leading research institute. Worse they are suggesting that equipment investment will drop 7.4 percent in 2009 (following a 4.9 percent this year) and that exports will decline 9 percent, (compared with an estimated gain of 5.1 percent in 2008). If these last two guess-timates are anywhere near right, then the German 2009 contraction will be very significant indeed, since exports are the key to the functioning of the German economy.

According to a report in the Frankfurter Allgemeine Zeitung earlier this month the Germann Economy Ministry currently estimate that the economy may shrink by as much as 3 percent next year.

Even further along the scale there is Deutsche Bank, who are forecasting a contraction of as much as 4 percent next year. Deutsche Bank chief economist Norbert Walter makes his forecast based on the deteriorating economic situation in Russia and in the Middle East, countries which have been vital in sustaining demand for German exports in recent months. As a fair weather pessimist on the German front, I feel that Walter may be near the mark than most, and my reasoning would be based on the severity of the downturn both in Russian and Eastern Europe, as well as the slump in Southern Europe, lead by Spain's sharp and resonant housing crash. Since these regions collectively are customers for a very sizeable part of German exports, I expect a pretty horrendous H1 for German GDP in 2009 - and the bad news could go on a good deal longer, since I am sure the East and Southern European agonies are going to drag on at least int0 2010.

Business Confidence Plummets

Certainly the omens for Q4 2008 are now clear enough. German business confidence has been falling sharply since the summer, and dropped to its lowest level in more than of a quarter century in December. The Ifo institute business climate index, which is based on a survey of 7,000 executives, fell to 82.6 from 85.8 in November, giving the main index lowest reading since November 1982. The drop was largely a product of a significant fall in the current economic situation component - which fell to 88.8 from 94.9 in December. Expectations remained largely unchanged at a very low level.

The main sub components all remained very low in December,but what is most striking is the rapidity of the deterioration we have been seeing in the manufacturing sector.

German consumer confidence has held up rather better (possibly a function of the resilience of the labour market, and the drop in inflation) and has remained largely unchanged following a fairly sharp deterioration in August. In December growing pessimism about the short term economic outlook was offset by a stronger willingness to buy, and GfK AG’s forward looking index for January, based on a survey of about 2,000 people, held steady at 2.1.

Employment Resists The Downturn

German unemployment continued to drop in November, despite the scale of the recession that just hit the country, and employers continue to retain and even recruit staff while orders slump. The number of people out of work, adjusted for seasonal variations, dropped a further 10,000 in November to reach 3.15 million, following a 26,000 fall in October, according to data from the Federal Labor Agency. The seasonally adjusted unemployment rate held steady at 7.5 percent, a 16- year low.

Meanwhile separate data from the Federal Statistical Office show that in October 2008 there were 40.84 million Germans in employment, an increase of 538,000 (or 1.3%) over October 2007 . In facr this was the highest number of Germans employed ever. Month on month the number of those employed was up by 219,000 on an uncorrected basis, which was equivalent to an increase of 39,000 ( or 0.1%) on a seasonally adjusted basis. So the great German jobs machine is still working.

The big question which is puzzling many economists however is why this increase in employment does not feed though to private consumption. My own personal feeling is that you need to look at the age profile of the German workforce, and the low value added content of much of the new employment. Some reflection of this can be found in the fact that (on aggregate) labour productivity (price-adjusted gross domestic product per person in employment) in the third quarter of 2008 was down by 0.1% year-on-year in Q3 2008. When measured on a per hour worked basis labour productivity was down by 0.2%.

So jobs are created, but household consumption expenditure hardly moves, and in fact it decreased by 0.3% year on year in Q3, despite the 0.3% increase quarter-on-quarter. So as unemployment has fallen German households have been spending less, especially on food, beverages and tobacco (–1.5%) and on transport and communications (–3.1%). The big factor in the latter decline was the marked decrease in private car purchases and the sharp drop in petrol consumption. As can be seen in the chart below, following the pre- VAT rise spike in Q4 2006, household consumption has remained decidedly lacklustre, despite the economy have had one of its most substantial expansions in over a decade.

If we look at the seasonally adjusted monthly retail sales chart (see below) we will see that these have been dropping steadily (stripping out the December 2006 spike) since mid 2006, and the decline continues.

Price Inflation Falls Dramatically

So to get back to the question I ask in the title to this post, we know that the German economy is going to contract sharply next year - by anything between 2 and 4 percentage points - so given the severity of this shock just what are the dangers that the sudden negative energy shock can push core inflation over into deflation mode?

Well, if we look at German producer prices - which can reasonably be considered a forward looking indicator for future prices, we find that they dropped sharply in November - in fact by the most since records began in 1949. This was of course a reflection pf the fact that the cost of oil declined drastically, but it is also an indicator of growing excess capacity as the global economic slowdown curbs demand. Producer prices fell 1.5 percent month on month, while the year on year rate fell back 5.3 percent. But if we look at the index itself (see chart) we will see that prices peaked in July (when oil prices were at a record), and have been falling steadily since.

And if we take a look at German consumer and producer price inflation together (see chart below), we will see that the energy price shock went in two waves. When the first wave petered out, consumer prices also fell, but they soon steadied, as the force of the expansionary momentum helped prices find a floor. But look what is happening after the second wave, producer prices are in virtual freefall, and these are dragging consumer prices along behind them, and when we think of the scale of contraction which we may well see in 2009, then it seems to me that the danger of opening up a deflationary dynamic behind the shock is a real and credible one.

In fact German consumer price growth slowed to 1.4 percent in Novermber according to the EU harmonized measure, down from 2.5 percent in October, falling significantly below the ECB’s price stability threshold of around two percent, and the lowest level in two years. Again this was the biggest decline since the federal statistics office started calculating German inflation using the HICP methodology in 1996. From a month earlier, prices were down 0.6 percent.

Again if we look at the index itself, we can see that prices have been falling since the summer, but if we dig a bit deeper, and take a look at the core index (that's the one to watch really, without energy, food, alchohol and tobacco, see chart below) then we will find that even on this measure prices have been stationary, and what we now need to watch out for is that the shock from the credit crunch driven GDP contraction addeded to the negative energy shock doesn't simply drive the core index into negative territory. It is impossible to say at the present time whether this will actually happen, but obviously the risk is real, and those over at the ECB would do well to remember this.

Fiscal Stimulus And Rising Deficit Pressure

Reactions to a problem of this magnitute will need to be on two fronts. The ECB obviously need to bring interest rates down rapidly and dramatically, and probably need to be thinking about how they can operate Japan and US style quantitative easing within a Eurosystem framework. On the other hand a fiscal response is essential, and Angela Merkel is reputedly considering a new package of measures in the early new year in addition to the stimulus package (estimated to have a net worth of about 31 billion euros in 2009) already announced.

The German Premier met the leaders of Germany's 16 states last Thursday to discuss additional measures, but no details of the package under discussionhave yet been announced. Angel Merkel did, however, suggest on Friday that the emphasis will be on infrastructure projects such as schools and roads - but since the areas of the Germany economy which are currently suffering most are the exports and capital goods sectors it isn't clear how much value this will really be.

But all of this has a downside, since it is now estimated that Germany will need to sell more debt next year than at any time since the end of World War II to finance the vaious measures being taken. Gross federal bond sales are set to expand by nearly 50 percent - to 323 billion euros ($471 billion) from 220 billion euros this year - according to the emissions calendar of the Federal Finance Agency. The 2009 issuance will be made up of 149 billion euros in bonds with a maturity of one year or more and 174 billion euros in shorter-dated money market securities.

The bond sales calendar is based on a budget that assumes economic growth of 0.2 percent next year, but as we have seen above this forecast is way out of line with what leading economic forecasters anticipate, thus the level of financing will likely be considerably greater at the end of the day, even without any additional stimulus packages.

Thus, following a 2008 budget which was basically balanced following a longer term strategy, Angela Merkel will now need to cope with a federal deficit which is certainly going to expand significantly as tax growth dwindles and spending rises. And bank rescue costs will come on top of the above, pushing the credit requirement up even further. Germany created a 480 billion-euro bank rescue fund in October comprising 400 billion euros in guarantees and as much as 80 billion euros in recapitalization steps, both of which will need to be financed in some form or other through the bond market. It is thought that around 200 billion euros will be approved in guarantees by the end of January and about 20 billion euros in capital measures. It seems however that bonds sold to boost banks’ capital reserves will be reported off budget, and thus not figure in accounts reported to the European Union's Eurostat office.
Germany plans to finance part of its 500 billion euro ($636 billion) bank rescue package by issuing bonds to banks in exchange for new preferred stock, according to Finance Agency head Carl Heinz Daube. ``The banks will not be allowed to sell the injected government bonds,'' Daube said in an interview in Tokyo today. ``So far there's obviously not a huge demand for any rescue measures, but this might change in the coming weeks.'' Germany's rescue plan, approved by lawmakers on Oct. 17, amounts to about 20 percent of the gross domestic product of Europe's biggest economy. Chancellor Angela Merkel's administration pledged 80 billion euros to recapitalize distressed banks, with the rest allocated to cover loan guarantees and losses.

Despite the changed dynamic in public finance, however, the German government is unlikely to experience any real difficulties selling its debt, and the country continues to enjoy a "stable'' outlook from Moody's Investors Service on its Aaa government bond ratings according to a report published earlier this month.

"Germany's public debt payment capacity is strong and Moody's anticipates no problems with regard to affordability or adverse debt dynamics, even with the impact of the economic slowdown likely to be felt on both sides of the government balance sheet,'' said Moody's analyst Alexander Kockerbeck.

It is not clear, however that things are going to remain quite so cut and dry in the future, as the government continues to expand net borrowing on the one hand while slower economic growth even after the recession, on the other, will continue to restrain revenue growth. And as Germany's population ages, health and pension costs are set to mount, and to some extent all this fiscal strain is going to undo a lot of the impact of the "good housekeeping" measures taken in earlier years, making another set of painful reforms more or less inevitable as and when the recovery comes. Angela Merkel is undoubtedly well aware of this harsh reality, and this is surely part of the explanation for why she has tried to keep debt growth under control as possible - much to the chagrin of her EU counterparts in London and Paris, where the demographic dynamics are, of course, much more favourable - even as her budget expands to pay for the emergency fiscal programs.

"A balanced budget remains our target because the demographic changes in Germany will increasingly have an effect from the middle of the coming decade. We must not overburden the younger ones," Merkel said.

Monday, December 22, 2008

Why The IMF's Decision To Agree A Lavian Bailout Programme Without Devaluation Is A Mistake

by Edward Hugh: Barceloan

The IMF finally announced it's Latvia "bailout" plan on Friday. The plan involves lending about €1.7 billion ($2.4 billion) to Latvia to stabilise the currency and financial support while the government implements its economic adjustment plan. The loan, which will be in the form of a 27-month stand-by arrangement, is still subject to final approval by the IMF's Executive Board but is likely to be discussed before the end of this year under the Fund's fast-track emergency financing procedures, and it is not anticipated that there will be any last minute hitches (although I do imagine some eyebrow raising over the decision to support the continuation of the Lat peg). The Latvian government admits that some of the IMF economists involved in the negotiations advocated a devaluation of the lat as a way of ammeliorating the intense economic pain involved in the now inevitable economic adjustment. But the government in Riga stuck to its guns (supported by the Nordic banks who evidently had a lot to lose in the event of devaluation), arguing that the peg was a major credibility issue, and the cornerstone of their plan to adopt the euro in 2012.

"It (the programme) is centered on the authorities' objective of maintaining the current exchange rate peg, recognizing that this calls for extraordinarily strong domestic policies, with the support of a broad political and social consensus," said IMF Managing Director Dominique Strauss-Kahn.
In return for the loan the IMF have agreed a "strong package of policy measures" with the Latvian government and these will involve sharp cuts in public sector salaries, and a tight control on Latvian fiscal policy. The IMF have insisted on a substantial tightening of fiscal policy: the government is aiming for a headline fiscal deficit of less that 5 percent of GDP in 2009 (compared with a anticipated deficit of 12 percent of GDP in the absence of new measures) - to be reduced to 3% in 2010 (thus the Latvian economy will face not only tight effective monetary policy in 2010 - via the peg - but also a less accommodating fiscal environment, frankly it is hard to see where the stimulus to economic activity is going to come from here) . Structural reforms and wage reductions will also be implemented, led by the public sector, and VAT will be increased, all with the longer term objective of further strengthening Latvian competitiveness and facilitating the external adjustment. The problem is really how the Latvian population are going to eke it out in the shorter term.

"These strong policies justify the exceptional level of access to Fund resources—equivalent to around 1,200 percent of Latvia's quota in the IMF—and deserve the support of the international community," Strauss-Kahn said.
The loan from the IMF will be supplemented by financing from the European Union, the World Bank and several Nordic countries. The EU will provide a loan of €3.1 billion ($4.3 billion), the World Bank €400 million ($557.6 million), and several bilateral creditors [including Denmark, Estonia, Norway, and Sweden] will contribute as well, for a total package of €7.5 billion ($10.5 billion).

The stabilization program forecasts that the economy will contract 5 percent next year, the Finance Ministry said in a statement yesterday. Revenue is expected to fall by 912 million lati ($1.7 billion) next year and spending will be reduced by 420 million lati.

Strangely the IMF statement was not very explicit the key topic - the currency peg - in the sense that it was a little short on argumentation as to why it considered - despite its well known waryness about such approaches, and having got its fingers very badly burnt in Argentian in 2000 - that it would be best to continue this arrangement in the Latvian case, despite the Fund's strong emphasis on the need to current the large external balances which exist (see Current Account deficit in the chart below).

All we really know about the background to this decision is contained in the statement the IMF posted on its website on December 7:

Mr. Christoph Rosenberg, International Monetary Fund (IMF) Mission Chief, issued the following statement today in Riga :

"Following the IMF's statement on Latvia on November 21, 2008, good progress has been made towards a possible Fund-supported program for the country.In cooperation with the European Commission, some individual European governments, and regional and other multilateral institutions, we are working with the authorities on the design of a program that maintains Latvia's current exchange rate parity and band. This will require agreement on exceptionally strong domestic adjustment policies and sizeable external financing, as well as broad political consensus in Latvia In this context we welcome the commitment made today by the Latvian authorities. All participants are working to bring these program discussions to a rapid conclusion."

So there seems to have been a trade-off here, between the IMF agreeing (reluctantly I think, but this is pure conjecture since there is little real evidence either way) to accept the peg, and the Latvian government agreeing to exceptionally strong adjustment policies. But the question is: was this agreement a good one, and will the bailout work as planned? I think not, and below I will present my argumentation. But before I do, I think it important to point out that the kind of internal deflation process the Latvian government has just accepted is normally very difficult to implement, which is why economists tend to favour the devaluation approach.

Just how large the competitiveness issue is in Latvia's case can be guaged by looking at one common measure of competitiveness, what is known as the country's real effective exchange rate. The REER (or Relative price and cost indicators) aim to assess a country's price or cost competitiveness relative to its principal competitors in international markets. Changes in cost and price competitiveness depend not only on exchange rate movements but also on cost and price trends. The specific REER prepared by Eurostat for its Sustainable Development Indicators is deflated by nominal unit labour costs (total economy) against a panel of 36 countries (= EU27 + 9 other industrial countries: Australia, Canada, United States, Japan, Norway, New Zealand, Mexico, Switzerland, and Turkey). Double export weights are used to calculate the REERs, reflecting not only competition in the home markets of the various competitors, but also competition in export markets elsewhere. A rise in the index means a loss of competitiveness, and as we can see, Latvia has suffered a huge loss of competitiveness since 2005. There is a lot of "correcting" to do here.

The problems of loss of external competitiveness Latvia faces are not new, nor are they unique. Russia may be a lot larger than Latvia, and Russia may also have oil, but Russia's internal industrial core has become uncompetitive, and there is really only one sensible way of attacking this problem, and that is through devaluation, as Standard & Poor's Director of European Sovereign Ratings argues in the extract I cite below. One of the unfortunate side effects of the fact that currency policy has become almost a matter of national strategic importance in Latvia has been that the necessary open-minded discussion of the pros and cons of the situation has not been possible.
Accompanied by generous government spending, the credit boom also fueled inflation, which weighed on the competitiveness of Russia's noncommodity sector. As wage growth averaged nearly 30 percent over the last two years and the ruble-denominated cost of production rose, domestic manufacturers found it very difficult to compete with cheap high-quality imports. As a consequence, entrepreneurs logically avoided manufacturing and, instead, invested in much more profitable and more import-intensive sectors, such as banking, retail and construction.

The resulting structural imbalances were well camouflaged by the extraordinary growth in energy and other commodity prices. For six straight years, the earnings from Russian oil and commodity exports on world markets have increased much faster than the cost of imports, offsetting the less flattering volume effects. From 2003 through this year, the cumulative difference between export and import price inflation in Russia was a fairly remarkable 74 percent. This put upward pressure on the ruble, encouraging borrowers to take loans in dollars or euros at negative real interest rates, under the assumption that the ruble would appreciate indefinitely. But it also provided an important source of financing.
Frank Gill, director of European sovereign ratings at Standard & Poor's in London, writing in the Moscow Times

So the Latvian competitiveness problem has become evident to everyone, and perhaps the best indication of the severity of the problem is the way that people almost laugh at the suggestion that Latvia must now live from exports (exports, what exports?, they say). However it is clear, and especially given the force of the agreed internal adjustment, that domestic demand is now dead as far forward as the eye can see as an effective driver of GDP growth, and, as can be seen in the chart below, exports are going to have a hard time of it, even after growth in other European countries picks up in 2010 (or whenever).

The competitiveness problem can be seen quite clearly in the above chart, as Latvian wage rises became detached from productivity improvements in the second half of 2005 and the rate of increase in exports shrank rapidly, while imports began to enter at a much faster rate. This process eventually itself in the first half of 2007, with import growth at first increasing rapidly, only to subsequently decline, giving in the process some positive increment to GDP from the net trade effect - as exports once more began to accelerate (creative destruction impact) even while imports fell through the floor. However as the external trade environment has darkened, even this expansion in exports has petered out, and inflation adjusted exports are currently hardly growing, and may even turn negative in the coming quarters. 2009 promises in any event to be a very hard year, but without a truly massive correction in relative prices there will be no recovery in 2010 either, and probably not in 2011. Remember, wages are now about to start falling, unemployment is about to start rising, and government expenditure is about to get pruned, so the only possible area for growth is external trade, and any inbound FDI that can be attracted to build productive capacity for exports. On top of which the correction in the current account deficit means that Latvians collectively - government, companies and households - are going to have to start saving, and a rise in net aggregate savings is basically tantamount to a brake on internal demand. So whichever way you look at it, exports are now the name of the game.

Why Keep The Peg?

Given all the problems that having the peg are likely to create, what then are the arguments for maintaining it? Well frankly, such arguments are hard to find at this point, in the sense that there are relatively few people, at least in the English language, who are willing to stick their neck out and try to justify what, in my humble opinion, is virtually the unjustifiable, and the implicit consensus among thinking economists would seem to be that this is a bad idea. The decision does, however, have its advocates, and Anders Aslund of the Peterson Institute has been bold enough to have a try, so, in the interests of balance and try and get some purchase on what the arguments might be, I am reproducing his argument in its entirety.
Why Latvia Should Not Devalue
by Anders Aslund December 9th, 2008

Latvia has a severe financial crisis, the preconditions for which have long been evident. A fixed exchange rate to the euro led to an excessive speculative influx of capital, boosting Latvia’s private foreign debt to 100 percent of GDP. Inflation soared to 16 percent, and the current account this year to 15 percent of GDP. Latvia’s budget has traditionally been almost in balance.

For most countries, devaluation would appear inevitable, and some argue that Latvia has to devalue its currency, the lat. But Latvia’s circumstances are peculiar, making the standard cure not only inappropriate but harmful. A severe wage and social expenditure freeze would be a better prescription, along the lines of a preliminary agreement on macroeconomic stabilization reached on December 8 among the Latvian government, the European Commission, the International Monetary Fund (IMF), and the Swedish government.

Now the questions are how much financing Latvia needs, who will give it, and on what conditions? The key outstanding issue has been whether Latvia should devalue or not. But given that Latvia—and Estonia—are experiencing high inflation with close to balanced budgets, devaluation is neither necessary nor desirable. A freeze of wages and social transfers would be preferable for both economic and political reasons.

First of all, thanks to Latvia’s limited GDP, $27 billion in 2007, sufficient international financing can be mobilized. The combination of IMF, EU, and Nordic funding should be sufficient.

Second, devaluation is likely to aggravate inflation and it could start a snowball effect of higher inflation and repeated devaluations. A devaluation would not be less than 20 percent and it would cause greater social and economic disruption.

Third, the great number of mortgages held in euros would force a massive blow-up of bad debt and mortgage defaults, which in turn would seriously harm the population, the housing sector, and the banking sector and thus the economy as a whole. Such a banking crisis is not necessary. One of the three big banks, Parex Bank, has already gone under, but the other two, the Swedish banks Swedbank and SEB, are strong enough to hold, if no devaluation occurs.

Fourth, Latvia’s main macroeconomic problem is inflation. Devaluation would initially aggravate inflation, while a wage and social expenditure freeze would sharply reduce inflation. High inflation has led to the excessive current account deficit. Latvia does not suffer from any structural terms of trade shock

Fifth, a freeze on wages and public expenditures would strengthen the budget, while devaluation is likely to lead to severe budget strains.

Sixth, the Latvian population seems politically committed to the fixed exchange rate, and it seems prepared to take a freeze of incomes and public expenditures, and if necessary even cuts. Therefore, devaluation could lead to undesirable and unwarranted political convulsions.

Finally, devaluation in Latvia would inevitably drag down Estonia as well, and all the effects would be doubled, while Estonia might hold its own without Latvian devaluation. Lithuania, which does not really have any serious financial problems, could also be harmed. I would have recommended that the Baltics abandon their fixed exchange rates a few years ago, but this is the wrong time to do so.

The argument I am making applies only to very small economies with basically sound economic policies. Russia and Ukraine are in a very different situation. Both suffer from major structural changes in terms of trade because of slumping commodity prices, and they should let their exchange rates float downward with their terms of trade.

The main arguments in favour of the peg would thus seem to be as follows:

1/ Latvia's situation is exceptional (is that also true of Bulgaria, Estonia and Lithuania?). It is hard to know what to make of this. Certainly the comparison with Ukraine and Russia does not seem appropriate, since these are ultimately competitor countries as far as manufacturing industry goes, and they are devaluing not because of their raw material exports (agriculture and energy) are too high, but because the price of the products from their manufacturing industries are too high due to all the earlier internal inflation, and the attempts to maintain the currency value via the controlled "corridor".

2/ A severe wage and social expenditure freeze would be a better prescription than devaluation. Well they would be a good prescription, but they simply are not possible, since simply freezing things where we are won't work, the imbalances are too large, so we are talking about sharp reductions in wages and public spending (as nominal GDP goes sharply down, then even a 5% fiscal deficit will mean spending has to contract - by 420 million lati according to the budget forecast - although the IMF has agreed to a policy of protecting social expenditure as much as possible).

3/ Then there is the forex mortgage situation. This I agree is a major problem, as devaluation implies default, and an oncost for Sacndinavian banks. But if we are sending the entire Latvian population through all this simply to attempt to avoid defaults on mortgages we are making a mistake, since obviously the sharp rise in unemployment we can expect and the sharp fall in wages can have a similar impact. I mean, one way or another the REER (see above) is going back to the 2005 level, so the mortgages will be just as unaffordable, and in my view the best solution to this would be for the Scandinavian (and Italian - Unicredit) banks to take a haircut, and receive compensation via their domestic bank bailout programmes. This would be a much more equitable sharing of the costs of the forex lending programme having gone wrong. To take another example, Spain is not devaluing from the euro, yet a hefty round of mortgage defaults (and builder bankruptcies) is now expected. So it is really a case of default through one door, or default through the other one. Which way would you like to go, sir?

4/. That devaluation would provoke inflation. Well this is just the point, devaluation would only provoke significant inflation IF Latvia still didn't have an independent monetary policy (to restrain domestic demand), but since part of the reason for devaluation is precisely to recover control over monetary policy again, this argument seems to me not to be completely valid, and it seems to be forgetting the other problem, deflation, which is much more likely to become Latvia's real problem over the next two or three years. Trying to run some form of Quantitative Easing (which is the new "in" term for how best to handle monetary policy in the midst of a liquidity trap, which may well be where Latvia and several other CEE economies are now headed) without independent monetary policy is quite frankly, completely impossible. If we look at the chart for the producer price index I reproduce below, we will see that the PPI (which is normally regarded as an indicator of coming inflation) is no longer climbing, and seems set to start to come down., and this could easily be an early warning signal for forthcoming deflation.

5/. The Latvian population seems politically committed to the fixed exchange rate, and appears prepared to take a freeze of incomes and public expenditures. This may well be true, and is an impression I get when I look at some of the comments on my blog. Many Latvians (and citizens of other Baltic states) have accepted the peg as some indication of "post-independence" indication of national "seriousness", and that any stepping-back from it would be seen as some kind of defeat. I understand this view, but I think it is a mistake, since sometimes it is better to accept defeat in order to live to fight again another day. I think Latvian politicians are to some extent reacting to this kind of pressure, to some extent thinking about their own invested social capital, and to some extent under pressure from Nordic banks. In any event all three of these seem to have more influence than the rational arguments about the advisability of the peg. There is no doubt in my mind that the coming recession will be longer and deeper if the peg is maintained. Indeed I am almost certain that the attempt to sustain it will fail (and that we will see some kind of rerun of Argentina 2000 - in all three Baltic countries and Bulgaria) and really the sooner the population become aware of this the better. Basically what we witnessed in Argentia in 2000 was basically a process of growing battle fatigue and war weariness, as the population were asked to make one sacrifice after another in support of a policy which couldn't work, and only lasted as long as it could. The end product is that when the peg finally breaks the local population will be severely disillusioned, and the politicians will totally lack credibility, which is a sure recipe for chaos, as we saw in Argentina in 2001.

Indeed, if anything the position is arguably worse in Latvia at the present time, since the optimum conditions for a free and open debate about the alternatives aren't exactly in place at the moment it seems very hard to know what the population at large would decide if they had complete access to all the arguments.

6/. Finally, devaluation in Latvia would inevitably drag down Estonia as well. This is undoubtedly a consideration in the mind of the IMF (and Lithuania, and Bulgaria) but really all of this will have to be faced by all four countries sooner or later, especially since the only way out of their recession will be, as I am saying, through exports, and most of the other competitor countries (look even what is happening to the Polish zloty and the Czech Koruna as I write) will see the partities of their respective currencies well down on the euro as we enter the recovery.

Where Is Growth Now Going To Come From?

Basically the key argument for devaluation is that it is easier to manage an economy with a low level of inflation (please note I am saying low, very low, certainly below 2%, ask Ben Bernanke or the Japanese is you don't believe me) than it is to manage an economy which is in deflation freefall. The big danger in Latvia is not only that there can be a real (ie price adjusted) contraction in the economy of 5% in 2009 (or more, the economy is down 4.9% year on year in Q3 2008, and things are certainly going to get worse), but that this contraction may be accompanied by price deflation (ie actually falling wages and prices) which means nominal (current price) GDP would decrease by the size of the real contraction plus the fall in prices. Thus we could see a very large drop in nominal GDP in 2009 and 2010. If realised this would be a very difficult situation to handle, and I doubt the people currently taking policy decisions in Latvia are fully aware of the implications (although the IMF economists should know better). In particular the deflationary debt dynamics would be very hard to control, and again, especially without independent monetary policy.

It is important to remember that these loans which have been agreed to are simply that, loans, to guaranteee the external financial stability of the country during the forthcoming correction, but they do not, in and of themselves solve any of the real economy problems. And they will need to be repaid if they are used, and will nominal Latvian GDP heading down, the cost of repaying them effectively goes up in terms of real Lat earnings. This is what debt deflation means.

The International Monetary Fund on Friday said it now expects a net income of
about $11 million in fiscal year 2009, and not a shortfall of $294 million as
previously forecast, as more countries turn to it for rescue loans in a
deepening financial crisis. "The improved income outlook reflects new lending
activity that is estimated to generate additional fund income of about $247
million, assuming all disbursements under the recently approved arrangements are
made as scheduled," the IMF said. Since early November, the IMF has approved
rescue packages for Hungary, Iceland, Ukraine and Latvia as the global crisis
spreads to more emerging economies.

I am citing the above Reuters report, not as a criticism of the IMF - they are simply doing their job as best they can, and under very difficult circumstances - but to remind people that the IMF is effectively a bank, and these are loans, and interest is paid, and there are no "freebees" here, and definitely no "free lunches" - not even in the newly established Latvian soup kitchens.

So we should ask ourselves where growth is going to come from - the growth that will now be needed to repay the capital and interest on these loans. Certainly not from household consumption if we look at the chart below, or from government consumption given the restraint on public spending. The private consumption position can only deteriorate as wages fall and unemployment rises.

Not from manufacturing industry in the short term (until prices correct, and the external recovery starts), and again look at the chart.

And finally don't expect an investment driven recovery (again see chart) until the demand for Latvian exports picks up, and it becomes attractive to start expansing capacity.

Basically I feel the biggest condemnation which can be made of the package which has been announced is that it doesn't seem to contain one single policy for stimulating the economy, and stimulation and a return to growth is what Latvia badly needs by now.

And the worst case scenario outcome of the way all this is being handled (and the issue that actually concerns me the most) is the possibility that young people decide to start migrating out of the country again, in order seek a new future and to start sending money home to help their families confront the difficult circumstances. Since Latvia's population is already declining this would be the cruelest cut of all, and one would have to then ask just what kind of future really awaits this unfortunate country?