German GFK Consumer Confidence, The Euro and the Future of Eurozone Growth

by Edward Hugh: Barcelona

German market research group GfK's forward-looking consumer climate index was unchanged at 4.5 points in March 2008 from February. Since the forward index is unchanged at a rather low level this is not especially positive news.




And since the constant reading is the by-product of a number of significant shifts in the sub-components, it is perhaps worth looking at these in detail. Firstly economic expectations:

The slight improvement in economic expectations apparent in January has not been sustained for long. After rising by a good 5 points at the start of the year, the indicator dropped considerably in February and fell 14.1 points to stand at 14.6. A decline of this order of magnitude has not been since the end of 2006.

The evolution in this index does not look at all positive, to say the least. Then we have the propensity to buy.

After two consecutive rises in a row, consumer propensity to buy in Germany dropped back significantly in February and the indicator fell from minus 8.8 points in January to minus 15 points.

This index is now well bogged down in negative territory, which is entirely consistent with the contraction in domestic consumption seen in Q4 2007. Finally income expectations.

After a slight dip in January, income expectations rose again this month, with the indicator climbing 4.2 points to its current level of minus 0.5 points. After two slight falls in a row, consumers’ expectations regarding their own financial situation are therefore once again at the level recorded in November 2007.

As we can see, this has stabilised and even improved very slightly in the last couple of months. Unfortunately, this is likely to be the most carefully watched indicator over at the ECB, and this sudden revival in income expectations is just what they don't want to see. Basically the distribution of the sub components would seem to be the worst of all combinations from the point of view of macro economic policy making, although not - it is worth noting - from the perspective of euro/dollar market participants, and it is not surprising that the combination of yesterday's news about the IFO reading and this GFK one has finally sent the euro through the 1:50 barrier.

The Munich-based Ifo institute said yesterday that its business climate index, based on a survey of 7,000 executives, increased to 104.1 from 103.4 in January. But as we can see in the chart below this rise was only a very moderate improvement, and the change was largely in the current conditions component, without much significant change in the longer term outlook.



The dollar in fact went up as far as $1.5047 per euro, the lowest since the European single currency was introduced in 1999, before trading at $1.5017 as of 6:47 a.m. in London from $1.4974 in late New York yesterday. The euro reached a six-week high against the yen as traders continued to bet the ECB will keep its 4 percent rate unchanged in coming months, with euro falling back to 160.56 yen after reaching 161.39.


Obviously what now gets to happen next would seem to be anyone's guess, since we are well past the point were previous experience could be considered a sure guide. Clearly one possibility is that this euro "rally" will rune out of steam (but would we be right at this point in treating this simply as a rally, may it not be more a structural by-product of something or other, see below). For one thing, for the euro to receive a substantial downward correction one has to assume that the US treasury would simply sit back and let it happen. But the US is itself in the midst of its own hard fought "dollar correction" which is seen as being essential to correct the current account imbalance, so at the present point the US Treasury are far from being unhappy with the current state of Euro-USD, and they could resist anything which smelt of a sharp upward correction in the dollar, maybe even by selling dollars.

I am sure they would accept a moderate downward adjustment, say - guessing for illustration purposes - to 1.40. But I am not sure they are ready willing and able for a major upward hike in the dollar. Nor are very many people in the financial markets anticipating this outcome, even though the macro economic data we are seeing would be much more in harmony with such a view.

Again, neither the Japanese and nor the Chinese would be especially happy about the advent of a "cheaper euro" since they have been tending to regard the European markets as a convenient fall-back position in the face of a weakened export market in the United States (and it might be interesting for someone or other to explore what the Russians and the Gulf-peggars would be looking for at this stage). Basically there are some pretty hefty players at the central bank level out there pushing their own interests, and many of these will not coincide with the forward looking macro concerns at the ECB, so we need to try think about and monitor how they respond at each given stage.

Basically, as I have been arguing, there are two opposite tendencies at work here. A short term one for the dollar to fall vis a vis the euro, and a longer run one whereby both of them have fall against an as yet unspecified basket of currencies. The basket may be unspecified, but my guess is that the rupee and the real will be in it. Possibly the Turkish lira. In fact how all this might pan out is that those who are left in the basket of emerging market currencies tracked by Bloomberg after the coming correction is over (ie, for example, after Eastern Europe has been forcefully stripped out) might well go to form the emerging nucleus here. So market realities rather than G7 policy may well be the final determinant here, which I suppose, given the zeitgeist of the times, would only be appropriate.

What I am trying to work out as all this moves forward is what weighting (in that mental topological map we all carry round in our heads I mean) to give to each of the processes - the short one and the long term on I mean. Up to the end of last year I was always expecting a euro crash against the dollar (since the underlying longer term macro seemed to suggest this), but then so many things have happened that neither I nor anyone else was expecting (I WASN'T expecting so many immigrants to arrive in Spain over the last 5 years, for example, and I wasn't expecting the Japanese housewives loss of home bias, nor the way in which local central banks could lose control of monetary policy etc etc) that I think the only thing to beware of at the moment are the "we've seen all this before" type of arguments".

So now I am not so sure at all what gets to happen next, and I am would be simply arguing for keeping a semi-open mind, and following closely what actually happens as it happens. This is also the case since there is no easy and obvious solution that suits everyone here, and that is always a problematic factor.

Meanwhile, the German economy is visibly slowing. The detailed GDP data were out earlier in the week, and quarter on quarter growth is slowing steadily and inexorably.



The rate of increase in monthly exports is also falling raidly (to zero in December)




while houshold consumption has suffered a complete slump since the heady days of the pre VAT hike in Q4 2006.




And it is not simply the German economy that is slowing, none of the "big four" could be argued to be in perfect shape. Italy may already be in recession. ISTAT haven't even had the stomach to release the Q4 2007 numbers yet, although everyone who will have seen the provisional version of them has been busily revising down the 2008 outlook considerably.

Almost all the macro data we have seen coming out of Spain over the last three months (retail sales, industrial output, services activity, consumer confidence) has been unequivocally bad. Strangely the only vaguely positive reading was Q4 2007 preliminary GDP data, and we are still waiting for details to try and understand why this should be the case. Spain seems to have had a bank loan sudden dead stop in December, and according to the latest Eurostat release construction activity is now falling heavily (down 9.5% year on year in December). So we now seem to face the very preoccupying possibility of a credit crunch and systemic banking crisis feeding into a naturally slowing real economy.

The only vaguely positive outlook among the big four would seem to be in France, where performance is holding up rather better than the rest, but how long this will prove to be sustainable if the rest continue to head south is a very moot point indeed.


Germany continues to constitute the major puzzle for many observers. Job growth continues, but at the same time consumption slides. Evidently with so many older workers being sucked into employment the bang per buck in jobs for consumption terms seems low, and many of the jobs being created may have a very low real economic content. On the other hand, despite some slowdown of late Germany is apparently exporting and investing like hell, but what the question we need to ask ourselves is just how vulnerable that may be to any problems which boil over in Eastern Europe.


Basically German export growth is highly interlocked with growth in the EU10, and to a lesser degree Russia, Ukraine, Serbia, Croatia etc. Some of these economies are still accelerating very rapidly - Poland, Slovakia, the Czech Republic, Romania Ukraine, Russia etc - and obviously Germany is getting a lot of very positive spin off from this. But much of this frenetic growth this isn't going to last very long. The strong uptick in inflation across the whole region suggests that one economy after another is now overheating, and some who have already blown out after the over-heat are now steadily "cooling" - Latvia, Lithuania, Estonia, Hungary, possibly Bulgaria. So how far are we away from all this overheating producing a sudden bout of "cooling" in a wider group of East European economies. Months at the most I would say. And if this view is right, and Germany can no longer continue to boost sales in Eastern Europe to get growth, what does that tell us about the ability of its export dependent economy to stand the pressure of a very high euro-dollar as we move forward? This I think is the key question we should all be asking ourselves at this point.

Estonia, Between Wage Driven Inflation and a Growing Credit Squeeze

By Edward Hugh: Barcelona

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

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

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

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




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

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



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




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




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

Strong Growth Slowdown

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




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



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

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

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

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

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

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

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

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

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

Cooling Down in Eastern Europe?

By Claus Vistesen Copenhagen

Just as we are nearing the transition from Winter to Spring here in Europe which traditionally promises to bring more pleasant and mild weather it seems as if Eastern Europe might just be getting a much welcome dose of cold air to quell its many overheated economies. This fresh breeze of cold air was inevitably coming in helped along from the breath of the illusive credit crunch and essentially it is also, in this respect, much welcome. Yet, the issue which now confronts Eastern Europe and many of her economies is not so much the confusing sequence of seasonality but rather how not to freeze over completely and tumble into a hard landing. Here at Alpha.Sources and elsewhere I have been adamant in my description of the issues in Eastern Europe and how I think the situation may turn out worse than many observers think. None of us know of course; we can merely asses the facts as they are presented for us and follow closely the incoming data. Two recent very worthwhile contributions to the debate on Eastern Europe and more specifically the Baltics are presented to us in the context of RGE's Euromonitor where Christoph Rosenberg and Karsten Staehr posts separately on the topic at hand. Christoph and Karsten seems to more or less agree with respect to the main thrust of their arguments. Both authors write in the context of a recent conference organized by the IMF and Eesti Pank where the Baltic situation was discussed. Karsten also refers to his recent article in the monetary review from the Danish Central Bank. Both the authors in question field arguments which are somewhat different from my own and my colleague Edward's and in this light I think it would be most interesting to go through some of the points and see whether we cannot learn something from each other?

Let us commence with the question of whether the Baltics will experience a hard or a soft landing? At this point in time it is very difficult to see. It is certain that we are now seeing signs of significant slowdowns not only in the Baltics but across the whole Eastern European edifice. The tricky question we all want to answer is the extent to which this slowdown will turn into a rout and a possible economic crisis of some sorts. In this entry I will focus on the Baltics as I try to scrutinize this question although I need to emphasise the need, in this context, to keep a weary eye on Hungary and Romania where especially the former is beginning to look increasingly shaky by the day. Regarding the Baltics Christoph makes the following important point ...

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

The dynamics here represent a very important point to take aboard. The past years' expansion and subsequent build-up of large negative external positions in the Baltics have mainly been driven by consumer and mortgage credit supplied by foreign (most notably Scandinavian) banks and credit institutions. In this way, the Baltic economies are very dependent on this link not only to keep the external position from not correcting too quickly which would happen if the foreign banks suddenly closed shop and retreated their fangs but also in order to keep and restore confidence in their economies and most importantly the currency boards tying their currencies to the Euro. Quite simply, the Baltics need these banks to now follow them down into whatever the current slowdown will bring. Will the banks be ready for this? So far, there has been no obvious signs of distress from the banks operating in the Baltics apart from words of warning from the rating agencies directed towards Hansa Bank and its operations in the Baltics. Some would even point to an upside in all of this. The recent 4th quarter results by two of Scandinavia's biggest banks Nordea and Danske Bank suggest, that they, contrary to their continental and transatlantic peers, have been dodging the incoming bullets from the credit market turmoil to such an extent that even Neo from the Matrix should be nodding approvingly. But the global credit market environment is only now waking up to the hangover from the past 5 years' exuberant credit expansion and we have already seen how the credit crunch has affected anything from regional cajas in Spain to indebted Hungarian households. In this light I remain less sanguine but concur that each day passing without further signs of distress is a good one. It remains certain then that a lot of importance can be hinged on the extent to which the foreign banks are willing to continue their operations in the Baltics as well as the extent to which they are willing to let the credit taps stay open. Karsten seems to be rather optimistic in the face of the credit market turmoil

The positive side effect of this [the subprime crisis] is that indebted borrowers in Estonia, Latvia and Lithuania will not face larger debt servicing payments, which again may reduce the likelihood of widespread bankruptcies. The global financial setback may thus have led to exactly the form of financial restraint that the overheating Baltic countries need.

This is kind of reverse causality relative to the way I have traditionally narrated the credit crunch in the context of the Baltics and Eastern Europe. However, this does not mean that Karsten is not right in the main. My main gripe would be that the slowdown was bound to come anyway as the labour market tightening and subsequent credit fuelled wage growth was bound to finish at some point entirely because of reasons endogenous to the Baltic situation. In this light, the credit crunch hardly comes at a convenient time since it may lead to the credit and financing of the external balance being pulled too quickly.

The second point I want to discuss is relates to the whole situation surrounding the currency pegs in the Baltics. Many commentators, including yours truly, have emphasised the risk of a run on one of the Baltic currencies which would take the form of a Asian crisis style test of the currency boards and thus ultimately by derivative the ECB's willingness to provide assurance. Christoph however seems to be lees convinced ...

These pegs have proven to be remarkably resilient, surviving the Russian crisis as well as recent attempts by outside market players to take positions. Speculators have not found a chink in the armor because the spot market is tiny and a forward market non-existent (contrary to the impression generated by those quotes on Bloomberg screens). From the Baltic governments’ point of view, abandoning the euro pegs, even in the face of mounting external pressures, would likely create more problems than it solves, given that many households and enterprises have borrowed in euros.

The illiquidity, or in the case of the forward market non-existence, of the FX market in the realm of the Baltic currencies is an important case in point. It is unlikely that the Baltics will be the first in line in connection with a potential currency run in the context of Eastern Europe. That dubious honor seems to have landed at the front step of Hungary and Romania. However, the fixed exchange rate regime represents another mounting problem for the Baltics in the current situation. How are they going to correct? This brings us into the heart of the predicament in my opinion and thus how the Baltics are in a bit of a bind. Consequently and as Christoph himself points out fiscal stimulus can not be used to counter the current downturn since in the end we are talking about a deficiency of external and not internal demand. Yet, this is also a textbook case of the ever recurrent trilemma often cited in the context of international economics. With free capital movement and a fixed exchange regime monetary policy is out as well as is de-valuation. Moreover and as noted, since fiscal policy also seems to be out of the question (some are even talking about a contraction) we are basically letting the reigns go hoping that the chariot won't fly off the cliff. Those of you with Austrian inclinations would undoubtedly be cheering away at this point emphasising out that this is the one and only way that these economies can correct. This is a discussion for a separate post but suffice to say that there is a distinct possibility that all this will end in deflation since absent the adjustment mechanisms cited above this is the only conceivable way to break the vice. It is important to note that there is nothing deterministic about this scenario but it may in fact happen. And once we allow ourselves to consider the possibility we need to ask whether it wouldn't really be better to devalue in order to restore external competitiveness? However, this can hardly be seen as an ideal outcome either since as Christoph notes in a faint sentence, and as I have analysed extensively, Baltic enterprises and households would be severely exposed as a large part of the outstanding stock of loans are denominated in Euros. This brings us back to the question of deflation and whether the foreign banks would stay put in such an execrable macro environment and ever so important how such an environment would affect the tendency of net outward migration. I cannot say that the chain of events will play out as I am suggesting. But there is a risk. In the concrete context of Karsten and Christoph they both seem to end their analyses on a somewhat open note with a tendency to lean towards the soft landing scenario.

So, if this was the immediate cyclical perspective how might the longer term structural perspective aid us in the answer of whether in fact this will be a soft or hard landing. Following a graph of quarterly growth rates (y-o-y) in the Baltics Karsten makes the following noteworthy point ...

The figure clearly shows the very high trend growth in the Baltic countries, only interrupted by the downturn in 1999 as fallout from the Russian crisis. Given the low initial income levels, part of the impressive growth performance can probably be explained by ‘catch up’, where import of technology and organisational knowledge speed up growth. In 2006, the purchasing power adjusted GDP per capita in the Baltic countries still amount to approximately 50-60% of the EU27 average.

The important point here is the idea of catch-up growth and more specifically how catch up growth is related to the demographic profile of almost all Eastern European countries. You see, the very impressive growth spurt we have observed since the Baltics' accession into EU has not come without a cost. Two stylised facts are important to tune into here. Firstly, there is the steady trickle of labour out of the CEE and Baltic economies into Western Europe. All these 'Polish plumbers' which has become the catch-all phrase for the east-west migration have undoubtedly aided in amending supply side issues in the receiving countries and in some cases even boosted trend growth (e.g. in the UK). However, it has also intensified the pressure on wages and thus inflation in Eastern Europe not only because of their physical numerical absence but also because of the human capital component as many of these workers are those in the highest end of the value chain (i.e. most productive) relative to the countries they are leaving. The second point we need to remember is quite simply the point that the Baltics and their Eastern European peers have moved through the demographic transition far more quickly than economic development has had time to really sink in. Notable and important differences clearly exist between the Baltics and many Eastern European countries but the stylised facts remain. So, this is, in fact, not a question of being right or wrong in terms of calling the immediate cyclical outcome of the slowdown but about a deeply structural problem. In this specific light it would be most severe if the Baltics and/or Eastern European countries tumble into deflation since this would potentially intensify the emigration as well as make it much harder to accomplish that much allured catch up growth. In essence, I agree then with Christoph when he concludes ...

The lesson for the governments and citizens in the Baltics is that they should lower their expectations, be it with respect to income growth, large-scale public investment projects or speedy euro adoption. Modesty and prudence are the best insurance against falling into the Portuguese slow growth trap—or experiencing a sudden Asian-style output contraction.

This is indeed the case but take note. The lowering of these expectations may be much more permanent and enduring than you might imagine and as such it is rather important that the tumble is not too rough. I guess that my main addition to Christoph's list of solutions as he presents them is quite simply that we take a look at the demographic edifice of the region and individual country since if we don't, the situation is not likely to improve much in the long run.

In Summary

In this note I have reviewed a number of arguments recently made on the Baltics from Karsten Staerh and Christoph Rosenberg over at RGE's Euromonitor. I think the two authors' analyses are very solid but I do have a few objections and niggles when it comes to the main conclusions. I concur that the extent to which the Baltics or one of three will experience a hard landing is a difficult question to answer at present. It is clear that Q4 2007 marked the beginning of a notable slowdown across most parts of the Baltics and Eastern Europe and now we will see how 'bad' it turns out. Above, I have highlighted reasons as to why I tend to lean towards the pessimist narrative but also realise that both Christoph and Karsten field arguments to the contrary. There are three main reasons why I am on the pessimistic side of the median ...

• The risk of contagion. Events in Hungary and Romania point to a deterioration of economic fundamentals by the day. The laws of economics do not as such prescribe that this need to affect the Baltics but since the underlying issues are much the same I do think that the risk of contagion is there. The most important potential transmission channel of such contagion would be the extent to which a debt crisis and subsequent withdrawal of foreign credit in one country could lead to similar events in another country.

• The lack of adjustment mechanism due to a fixed exchange regime and translation risk due to unhedged cross-currency liabilities of households and corporations. The main risk as I see it is that one or more of the Baltic countries will slip into deflation on the back of the current slowdown. The alternative which would be to un-shackle from the Euro hardly seems positive for two overall reasons. Firstly, the ensuing debt burden levied on economic agents in possession of Euro denominated loans would be quite severe and secondly there would be political issues as the prospect of future entry into the EMU would be seriously dimmed.

• Finally, I tend to assign a rather strong weight to demographics as a variable in this whole situation. In my opinion a large part of debacle many Eastern European countries now find themselves in is due to their unique demographic situation. Focus is needed here I believe and especially we need focus on attempts to raise fertility and to keep people from leaving. As a Dane I see how those Polish plumbers have been a most welcome addition to an overheated Danish construction industry and I can also see how Ireland and the UK have benefited from Eastern European labour. But, we need a more balanced focal point on this and one which also takes into account the impact on the sending country. Remittances are fine indeed and so are claims that migration is temporary but this is also part of the whole edifice. In this way, the degree to which Eastern Europeans choose to stay in their current country of residence seems to be somewhat proportional to the potential severity of the current slowdown.

The Spanish Banks' Growing War Chest

by Edward Hugh: Barcelona

Leslie Crawford had another very useful article in the Financial Times last week (a handy addition to this earlier one).

According to Crawford the Spanish banks are accumulating a “war chest” of assets to be used later as collateral to access European Central Bank credit in the event their liquidity needs rise even while wholesale money markets in asset backed paper continue to remain closed to them.

It is important to remember here that the huge expansion in mortgage credit in the country in recent years has been largely fed by the banking sector’s widespread use of mortgage-backed bonds to fund lending growth (the so called Cedulas Hipotecarias, see my post on this here), and that the Spanish banks have been second only to the UK in Europe in this respect.

In recent months, and with the Cedula market effectively shut, Spanish banks have been steadily increasing their use of funding from weekly liquidity auctions conducted by the ECB, which has long accepted mortgage-backed bonds as collateral.

The banks have done this by securitising pools of mortgage debt, which they keep on their balance sheets rather selling, and these are pledged to the ECB in exchange for funding. Now I am macro economist, rather than a banking specialist, and it is not immediately clear to me what the banks who are doing this hope to achieve in this way, since if they are themselves effectively having to buy their own bonds using cash, and cash is at the end of the day even more liquid than bonds, where is the benefit? One answer could be that they are issuing new mortgages backed by these bonds, and then using the bonds as collateral for the ECB loans, in which case they are effectively swopping cash - which earns of course no yield - in their reserves for securities which do pay yield, since indirectly this yield is paid by those who pay the mortagages which are being used as backing (and are of course themselves "illiquid"). The recent widely publicised offer by Banco Santander to take-over mortgages (and customers) from other banks, always providing that these mortgages originated prior to 2002, could be an indication that this is in fact the objective. But again all of this only makes sense if the banks in question are increasing their reserves as a "war chest" against anticipated future losses on the mortgage side of their business, and what we need to think about from a macro economic point of view are the implications of this increase in the cash reserve ratio (ignoring for the moment the fact that they may be doing this via the "eating their own" bonds technique, which may reduce the damege to bank profitability, but does little to offset the money supply contraction implied as far as I can see). Certainly this would seem to imply yet another channel of indirect credit tightening.

And of course none of this tells us very much about two crucial questions: what the rate of new mortgage issue is going to be moving forward (since the banks are offering a maximum loan to value ratio of 80% in an environment where few people have savings), and what the position of the smaller - regional cajas - banks is here, since they are evidently the most exposed to the whole problem. The cedula-backed bonds have been largely issued on a 10 year renewable basis, and start coming-up for rollover in substantial quantities after 2010. Basically some 300 billion euros need to be "rolled over" during 7 years, and since the existing holders are likely to cash in, it isn't at all clear where the regional cajas are going to find the resources needed to do this. So could the Spanish government be faced with an inevitable "Northern Rock" type solution here? This is doubly the case, since noone at this point has any realistic idea of the actual forward path of Spanish property values over the 2010 to 2017 horizon, and this is basically the reason why the asset back securities market is closed to Spanish products - and unlikely to open any time soon - and basically why the cedulas are so different from the German Pfandebriefe (with which they are so often compared) since the latter where sold on the market AFTER the correction in property prices following the end of the 1995 boom, and were thus pretty resistant to further downward movement, and in any event in the German case the bonds were ultimately backed by government guarantees to the deposit holders in issuing banks, and so in this sense the investment grade rating had a certain logic to it.

So we only have questions here as we move forward.

Nonetheless recent Spanish banking data does make interesting reading. According to data released by Spain's central bank, Spanish banks doubled their share of the ECB’s weekly funding auctions in the final quarter of last year, taking their borrowing up to €44bn in December from a running average of about €20bn over the previous 15 months. This extra lending from the ECB of almost €24bn outstrips the quarterly amounts raised previously by Spanish banks from securitisation markets, which is an important comparison because the banks have increasingly used mainly mortgage-backed securities as collateral with the ECB. This jump has increased its share of Europe-wide borrowing from 5 per cent of the ECB’s total to 10 per cent, a number which more or less proportional to the weight of Spain in the eurozone economy, but what is so striking is the rapid rate of expansion. Before this money wasn't needed, and now it is.

Jean-Claude Trichet, the ECB president, who in fact came on a vistit to Spain only last week, went out of his way to stress that in no way was the Spanish or any other eurozone banking system being bailed out. “We have not changed our rules [in order to accept mortgage backed bonds],” he is quoted as saying.


Another noteworthy detail about this sudden "eat your own bonds" expansion, is that larger amounts of securitised bonds are being created appears to be being used. Santander, Spain’s largest bank, said it has €30bn in loan-backed securities on its books that it could use as collateral, while BBVA, Spain’s second- biggest lender, has €60bn in such bonds available.

Popular, a mid-sized bank that relied on wholesale markets for 42 per cent of its funding before the credit crisis, says it has €11.4bn in bonds that could be used in ECB auctions, but says it has to date not resorted to raising funds via the ECB.

So the bottom line here is that the European Central Bank has effectively been indirectly responsible for funding new lending in Spain in recent months, replacing banks’ traditional use of wholesale capital markets, since these have been effectively strangled by the global credit crunch. And so there is one last point to think about. Spain has been running a substantial external deficit, one which it needs a constant inward flow of funds to underpin.



During the last seven years, external funding into the cedulas (which ammounted to some 60% of the total) essentially offset the deficit. But now these flows have stopped, so how is Spain going to finance its deficit? Another way of thinking about this would be to say that private borrowers were effectively attracting the funds into spain which then paid the current account deficit. Or if you prefer, (on a sort of back of the envelope basis) not a single barrel of oil consumed in Spain since 2000 has to date been paid for. It has all been supplied on tick. So the problem now is that not only does Spain actually have to start paying for its oil, it also has to pay back all the oil which was consumed between 2000 and 2007 (as it will discover when "rollover time" on the cedulas arrives). Or is the ECB also going to reinvent itself here, becoming payer of the last resort on the individual national external deficits?

The Czech Republic, A Classic Case Of Bad Timing?

by Edward Hugh: Barcelona

The Czech Republic's economy unexpectedly expanded accelerated in the last quarter of 2007, graowing at the fastest pace in two years, fueled by investment, solid exports and rising employment. Gross domestic product grew at a 7.0 percent annual rate on a seasonally and working day adjusted basis (preliminary data), compared with a revised 6.4 percent in the third quarter, the Czech Statistical Office said today. The Office also announced that the economy grew 6.6 percent in 2007.

The quarterly rate of expansion accelerated from the 1.4% achieved in the third quarter to a full 1.9% in Q4.However it should be noted that the statistics office single out expenditure by health insurance companies, which are classified as part of the general government sector, as contributing to the GDP increase by approximately 0.5 percentage points (ie a good part, if not all, of the acceleration). They suggest that this is probably due to higher demand for health services which remained free till the end of the year and in anticipation of the introduction of medical fees for certain services in 2008. So much of this may well be "one off".



Following the news the koruna had its biggest weekly gain in 5 1/2 years - rising for a fourth succesive week - and at one point was up by as much as 0.7 percent on the day (at 25.080, its highest level ever against the euro), before closing at 25.193 by 4 p.m. in Prague. In the last week it has advanced by 2.4 percent, the fastest rate since June 2002. So far this year the koruna has been the best-performing of the nine European emerging-market currencies, gaining 5.5 percent against the euro.



Household consumption has bolstered the Czech economy's expansion for almost two years now, and is driven by accelerating wage growth, a 30% y-o-y rate of increase in lending and a decade-low jobless rate. The very low number of people now remaining unemployed has given rise to concerns that if the economy should continue to grow as quickly as it is doing currently, then wage-cost driven inflation may get the economy in its grip in the way it has done in other EU10 economies. The average nominal hourly wage in industry rose by 11.3% in December 2007 over December 2006, while the average monthly nominal wage in industry rose by 7.4% in 2007 when compared with 2006.



The extra growth is certainly creating employment, and there were 1.9 percent more people working in the economy during the last quarter of 2007 than there were one year earlier. Still, the statistics office (although it gave no details, for thpse we will have to wait till March) stated that household spending growth slowed in the fourth quarter (retail sales, for which we do now have December figures, rose only at an annual rate of 4.3%), dropping back from the 5.6 percent rate of increase of the previous three months, discouraged perhaps by the 4.4 percent inflation rate experienced over the period.



This change in the structure of Czech GDP growth, with consumer demand accounting for a smaller portion of expansion, and exports and capital investment accounting for more, is fueling central bank optimism that the inflation rate can gradually be clawed back to the mid-point 3 percent target by next year, from the whopping 7.5 percent registered in January.



The bank predicts GDP will grow 4.1 percent this year after an estimated 6.1 percent in 2007, thus being a touch more skeptical than the Finance Ministry who are currently advancing a 4.7 percent growth outlook for this year.



Long Term Structural Problems On The Fiscal Side


There is however still plenty of room for concern about the medium term evolution of the Czech economy. Only last week the European Union reiterated its call for the Czech government to address underlying fiscal pressures linked to the pace of population ageing in the Republic, and stressed that the administration needed to do more to prevent the creation of excessive budget surpluses. The call was made as part of the EU Commission periodic assessment of individual country convergence programmes.

The Czech Republic is by no means the oldest of the EU10 societies, indeed at around 40 the Czech median age is not especially high at this point (even by EU10 standards) - and Slovenia and Bulgaria have higher median ages.

(please click over image for better viewing)



But life expectancy in the Czech Republic is significantly higher than the rest of the group (coming second in this respect only to Slovenia) and hence the weight of pensions expenditure is likely to be greater than in many other states in the region.



As a result of this higher than average EU10 life expectancy, and many years of lowest-low fertility, the Czech population median age is set to rise very rapidly - to around 44 in 2020 - which means that the Czech Republic will soon be older than several West European societies (where there has been higher fertility and more substantial immigration) like France or the UK. And this despite the fact that the Czech Republic has been one of the few EU10 societies to be really proactive on the immigration front in recent years.




The Czech Republic's budget deficit is now within the EU 3 percent of GDP limit, but this is not the Commission's real concern in this report. Rather what are being raised are longer term structural and sustainability questions. The Czech government should "exploit the likely better-than- expected 2007 budgetary outcome to bring the 2008 deficit below the 3 percent of GDP reference value by a larger margin" the EU said in the report since "The Czech Republic remains at high risk with respect to the sustainability of public finances".

Essentially the EU is criticising the Czech Republic for failing to take advantage of the record economic growth to cut spending, overhaul the pension and health-care systems and reduce the deficit so it may be used as a stabilising cushion in the event of an economic slowdown. The Czech Cabinet has responded to the ongoing criticism from the Commission by amending the tax code, cutting welfare spending and imposing health-care fees. But the Commission is far from satisfied, and in particular they have said the following:

The Czech Republic appears to be at high risk with regard to the sustainability of public finances. The initial budgetary position in the programme is not sufficiently high to stabilize the debt ratio over the long-term. The long-term budgetary impact of ageing is well above the EU average, influenced notably by a substantial increase in pension expenditure as a share of GDP as well as a significant increase in health care expenditure. Implementation of structural reform measures notably in the field of pensions and health care aimed at containing the significant increase in age-related expenditures would contribute to reducing risks to the sustainability of public finances. While initial steps have been made to reform the health care system, reform of the pension system still lacks implementation against a definite timetable.

To date the Czech Cabinet has pledged to trim the public deficit to 2.6 percent of GDP in 2009 and to 2.3 percent in 2010, but given the rate of GDP increase, and the rapid rise in the koruna, a strong move in the direction of a budget surplus would seem to be called for.

The Czech administration, which in 2006 abandoned 2010 as the country's euro-adoption date, has pledged to overhaul the welfare, pension and health-care systems in an attempt to ensure that country is in a position to fulfill the EU fiscal rules after it accepts the common currency. One of the problems being faced is that the ruling coalition lacks a sound majority in the Czech Parliament, and has to rely on two former opposition deputies, which makes progress on serious reform an uphill struggle.

But if it remains substantially unamended, the current pensions system will weigh heavily on state finance during the coming years due to the rapidly increasing number of retired people and the shrinking number of potential contributors. The working age population - 15 to 64 - is set to shrink from around 7.25 million now to around 6.4 million in 2025.



While the elderly dependent population - defined as being over 65 - is set to rise from around 1.5 million currently, to around 2.25 million in 2025.



Now the numbers involved here are not excessively large, and the situation can to some extent be eased by immigration, raising participation rates, and raising the retiremnt age beyond 65. But it is important to note that all the countries in the region are facing - to a greater or a lesser extent - the same problem, so it isn't clear where the migrants are to come from, and if they ultimately will arrive from another continent, then this has implications for the cultural model on which these societies have been based to date. Which is not to say that such an outcome is unattainable, but simply that it is not going to be as easy in practice as it perhaps appears to be on paper.

On the pensions side the current problems are threefold: i) the excessive reliance on a PAYGO system, ii) the high level of contrubutions, iii) the low level of the retirement ages. Pension contributions currently total around 30% of employee earnings, of which 7.5 percentage points are paid by employees and 22.5 points by employers. These contribution levels are among the highest in the OECD, and only Hungary, Italy and Slovakia have higher contribution rates.

Following an earlier reform, the retirement age is gradually being increased from 60 to 63 years for men and from a range between 53-57 years to one between 59-63 for women (with the retirement age depending on the number of children they have had) between now and 2013. But such age increases are clearly far from sufficient. As a result the Czech cabinet agreed last Monday to raise the retirement age and lay the basis for wider pension reforms to secure the system's long-term financial stability.

The cabinet sent a bill to parliament which envisages a gradual increase in the retirement age to 65 by 2030 and an extension of the required length of employment. A further proposed step will follow later which involves moving from the current pay-as-you-go scheme to a partially fund-based system where people save for their own pensions. Czech pension payments are expected to reach 306 billion crowns ($17.34 billion) this year, taking up nearly 30 percent of the national budget, and will grow rapidly as the population ages if nothing is done.


Basically the big problem with moving from PAYGO to partially funded schemes is maintaining the payments from the PAYGO system during the transition. As a way of trying to get round this problem the government proposes to set up a fund fed by income from privatisations, with the idea being that the shortfall caused in the old system by the payment diversion into would be made up from the reserve fund. Many Czechs already have private pensions savings, which are supported by government subsidies and tax breaks, but the volume is too low to support them in retirement. The average Czech state pension is 9,111 crowns ($515.9) per month, about 42 percent of the average salary.


Bad Timing or Bad Decisions?

So much for the longer term issues, but the real danger facing the Czech economy at the present time is that a number of faulty short-term decisions, and a certain tardiness in reform coupled with an unhelpful external environment, may well cost the Czech Republic dear in the longer term.

In the first place the recent decision to raise administered prices in January has produced a sharp 2% hike in the annual inflation rate (from 5.4% in December to 7.5%in January). In particular the government raised value-added tax on basic items such as food to 9 percent (up from 5 percent), and introduced a 30 koruna ($1.71) fee for doctor's visits. In total the health service increases added 0.5% to the annual inflation rate. The price of electricity also went up 9.5 percent and natural gas 7.8 percent. State-controlled rents jumped 18.9 percent from their December level.

So the danger is that the application of such measures in an environment where growth is strong, and possibly even above capacity, and the labour market is extremely tight, may simply lead to an ongoing process of second round effects, where wage rises to compenate for inflation (or over and above the inflation rate) simply add more fuel to the underlying inflation dynamic. In order to try and avoid this outcome the central bank will undoubtedly continue raising interest rates. The bank has already raise rates five times since last June - at quarter point intervals (with the last raise being on the 8 February - and the current rate is at 3.75%. The prospect of the bank doing just this, coupled with the comparatively high rate of GDP growth, is already pushing - as we have seen above - the koruna ever onward and upward. If, as now seems likely, the Czech base interest rate should pass an ECB refi rate which was on the way down as the eurozone economy slows, then this upward pressure on the koruna might well accelerate, and the central banks attempts to restrain inflation with conventional monetary policy might well prove thwarted.



Added to this problem of inflation and a rising koruna, is the associated one of the evolution of the Czech trade balance. While the Czech Republic has so far enjoyed a fairly healthy goods trade surplus, this does not come by divine fiat, and changes in relative prices can erode the situation quite rapidly. Exports in December were up 5.2 percent year on year down down substantially from the 20 percent rate in November and the smallest figure in the whole of 2007. For the time being this is simply a seasonal blip, but the whole Czech external trade situation will now need monitoring carefully, and in particular given that the German economy now seems to be slowing, and the Czech economy is inter-locked with Germany (31% of the CRs exports went to Germany in 2007) to a very high degree.



In this context the position of the fiscal deficit of the Czech administration takes on even more importance. As indicated above, the Czech Republic's budget deficit is certainly likely to fall with the EU limit of 3 percent of gross domestic product this year, although the deficit may in fact widen to 2.95 percent of GDP from an estimated 1.9 percent in 2007. The original goal for 2007 was 4 percent of GDP, so the outcome is, in terms of the EU convergence process, not especially bad. But in terms of the current short and medium term macro environment, the projected level of deficit is certainly fraught with risk. Ideally the objective for 2008 should be a budget surplus. This would act as a brake on excessive growth as the koruna rises (since capital funds into the CR in search of yield will definitely increase in the short term) and both the surplus and the newly higher interest rates would provide something of a cushion should further deterioration in the external environment (and especially in Germany) lead the Czech economy to start to slow too rapidly. However, as noted above, the extent of the danger does not seem to be appreciated, and we are still looking at a deficit in the 2 to 3% range. The risk that this may provoke excess inflation which will be hard to eradicate later is real and present, and hence the evolution of the Czech CPI will need to be monitored closely, especially given that January's large base effect is now built in for the whole of 2008. We can only realistically expect inflation to start to come seriously down as we get towards the autumn, and only then if.......

Turning The Screw on Hungary; Three Possible Tipping Points

by Edward Hugh: Barcelona

Hungary's forint firmed slightly today after standing up to several waves of pressure, settling around what still amounts to a one-week low against the euro. The mildly favourable retail sales data that came out in the US during the afternoon eased some of the pressures on emerging market economies and in the collective upswing the forint managed to get back below the 262 to the euro level. Just enough to knock out stop-loss levels, but hardly anything to get excited about. The forint had been as far down as 266 to the euro earlier last week - amid a spate of rumours which included the idea that the prime minister was about to resign, and that the central bank was about to announce an emergency rate cut (or was that increase, I never was sure which possibility was most in people's minds at that point). Indeed it was clear that a general downturn in global risk appetite which struck all across emerging market instruments was hitting Hungary's long-unsteady markets the hardest.

Hungary's economy has slumped to decade-low in growth following a government belt-tightening campaign aimed at straightening out its public finances.







Danske Bank Analysis


Portfolio Hungary reports this morning on the view of Danske Bank analyst Lars Christensen. Christensen's argument is that it is only a matter of time before the forint follows the leu, the kronur and the rand in weakening significantly. In particular he argued that the forint is not sufficiently protected by adequately high interest rates.

Since the outbreak of the global credit crunch in August 2007 many currencies in the EMEA countries which have been running large current account deficits and/or have accumulated large ratios of foreign debt have been under significant selling pressures. According to Christiansen:

“Most notable has been the weakening of the Romanian leu, Icelandic kronur and the South African rand, which have all weakened around 15% since the beginning of August. The lira has more or less been flat against the euro since early August and the forint has “only" weakened around 5%".


“While we clearly see a risk that these currencies can weaken significantly more, there is also a risk that this weakening will spread to other EMEA economies with similar problems. In particular, the Turkish lira and the Hungarian forint stand out,"

“While high interest rates in Turkey give some protection, it is hard to use the same argument for the forint and hence we believe that it is only a matter of time before the forint follows the leu, the kronur and the rand and weakens significantly."

(The base rate is currently 13.75% in Iceland, 11.00% in South Africa, 9.00% in Romania, 15.75% in Turkey and 7.50% in Hungary.)

As he points out, imbalances have been reduced in the Hungarian economy on the back of last year's tightening of fiscal policy, but the markets have also 'rewarded' the Hungarian government for this by not selling the forint as much as the continued large imbalances and large foreign debt could 'dictate'.

Also, as the global credit crisis drags on there is an “increasing risk that we will have a repeat of the forint 'crisis' of 2006", where the HUF fell sharply from around 250 against the euro to 285 in a comparatively short space of time. And the global financial environment at that time was significantly more benign than is the case at the moment. So a forint at 280 or below to the euro hardly seems an unlikely level at this point in time, and indeed Lucy Bethell from RBS was arguing exactly this earlier in the week.

In particular, Christiansen stressed that any “slippage" on fiscal policy in Hungary would hit investor confidence hard and this would also “likely lead to downgrades of Hungary's credit ratings". And this is just why tomorrows Q4 2007 preliminary GDP data will be so important, since if the figure slips to any great extent on the downside this is bound to place strong question marks around Hungary's 2008 budget targets which are - let us remember - based on government estimates of GDP growth in the 2.8 to 3% range.

And before we leave Christiansen's analysis, I would like to draw attention to one point: the comparison with Turkey. Back in August 2007, just after the credit market crunch started to close its grip, I wrote a long post (and an even longer analysis) of Turkey, where I tried to argue that even though Turkey's economy would come under pressure just like those of its East European neighbours, the underlying soundness of Turkey's demography, and hence the element of homeostatic regulation which it would enjoy following from any significant downward correction, meant that it could well emerge with a lot less medium term damage from the coming global storm than the rest of Eastern Europe. This view is now about to be tested, as indeed is the whole thesis that demography and fertility don't matter to economics. As I wrote at the time:

There are good theoretical reasons - at least if you take demography seriously there are - for imagining that the Turkish economy might well prove to be more robust than some of the Eastern European ones will under the strains the various economies are under and about to receive. These latter economies, despite their apparent vibrance are actually much more fragile under the surface, and it is for this very reason that the observed response differences bear examination day by day.

I Suppose That's The Hill Sergeant, and I Guess You Are Going To Make Me Climb It.


The most probable scenario we now face is for the forint to experience a succession of waves of attack, and a systematic attempt to knock it of the perch on which it is so delicately poised. All free-market economists of course believe in the workings of financial markets as a regulatory mechanism, but we don't have to believe they are fair, kind or forgiving.

There seem to be three critical tests facing the forint in the short term. The first is the GDP and inflation data coming tomorrow. Starting with the Q4 2007 GDP data, my opinion is that this will surprise on the downside, and possibly give every indication of just how unrealistic most of the 2008 GDP forecasts for Hungary currently are. The second is the inflation data, and here the Hungarian central bank is now almost certainly in a heads I lose, tails I lose situation. If the CPI - Hungarian inflation was running at an annual rate of 7.4% in December - surprises on the downside this may encourage currency dealers to feel that the central bank will bow to political pressures and reduce interest rates - a move which the collapse in Hungarian internal demand suggests is badly needed.







But the reduction in yield differential would make forint denominated assets less attractive, suggesting that the foring would face a more testing toime and that an acceleration in capital exit would probably occur. If, on the other hand, the data surprises on the upside - which after today's December agricultural PPI data (38.1% y-o-y) seems more likely, then this may lead people to feel that the central bank will have no alternative but to increase rates. Indeed many market analysts have now reached the conclusion that such rate rises are more or less inevtiable. The latest of these has been Gillian Edgeworth of Deutsche Bank, who today projected a total of 100-bp rate hikes in the next six months (over the course of the next six policy meetings.), and in this she has joined a fine galaxy of observers including Goldman Sachs and Citigroup - who are projecting a 50-bp hike at the 25 February policy meeting, while Citibank analyst Eszter Gárgyán is on record as saying she does not believe that even a 50-bp hike could be enough to stop the weakening of the forint. I am not sure how much of the macro-economics of what is involved in all this these forecasters understand, but I am quite happy to say that the sort of monetary tightening that Gillian Edgeworth is contemplating is just not posible at this point in the game, since, apart from the fact that it would send Hungary off into one whopping and unholy recession (especially if it was accompanied - as it would have to be - by a continuing tightening of the loan conditions on Swiss Franc mortgages, due to the hightened currency risk default issues), the political dynamics would not accept it. You can only ask people to accept so much belt tightening before they rebel, and we are already over 18 months into this round, so tolerance must be wearing thin, and another year of monetary tightening is most definitely out at this point. If you have any doubt whatsoever on this, look at what has happened in other countries in other epochs.

So, given that not all market analysts are competely devoid of foresight, any move to press the tightening trigger can alos lead to a similar conclusion to a rate cut about the desireability ditching Hungarian assets, since more monetary tightening would only close even further the noose which is currently extending its grip over the internal economy. Such are the difficulties when you back yourself so tightly into a monetary and fiscal corner.

The second hurdle, or critical point, the forint will have to get over - assuming it survives tomorrow - will them be the meeting of the central bank itself on the 25 February, and again rate policy decisions either way can have unpredictable effects, and once more it is likely that an attack will be mounted, regardless of the decision taken, given (as I argue above) there are sufficient reasons for doubting that either policy option is a good one. What all this amounts to is that the Hungarian central bank has now run out of policy options, and it is just a question of time before we get to see what the financial market participants decide to do about the situation.

Finally, and assuming that the currency passes muster relatively unscathed in the first two initial skirmishes, the cherry is most decidedly and firmly likely to be planted on the top of the cake if the proposed referendum on some of the more controversial measures in Hungary's adjustment programme actually gets to be held on March 9th. Since a vote to abandon the contested education and health service charges - which seems on the face of it to be the most probable outcome - would virtually present a frontal challenge to the whole "adjustment" process, it is hard to see how the Gyurcsany government could continue under the circumstances (even if there would be no formal obligation to resign). This kind of situation is, of course, "more power to my elbow material" for those market participants with an acquired taste for warm, freshly-spilled blood, and really if we got through to this point, without anyone having the presence of mind to take the bull by the horns first (by which I mean making a virtue out of a necessity, and openly accepting that policy is now in a no-exit bind, and that a significant drop in the value of the forint is both inevitable and desireable, depite the fact that there will be a lot of renegotiating and cleaning up to do in the aftermath), then the outcome may well not be a pleasant sight to watch.

Review and Preview on Japan

(Cross-post from Alpha.Sources)

I realize that I am moving in a bit late with this but the data I use to input in my analysis only recently came out for December 2007. More generally, this post is going to be quite big since I have a lot of things I want to get off my chest this time around. I have two main areas of focus I want to cover.

• Firstly I want to finalise my analysis of Japan in 2007 with the December data for consumption expenditures and prices.

• Secondly, I want to continue with a general assessment of two of the main market points in Japan at the moment. The Yen and the BOJ rate policy faced with an incoming slowdown and potential recession.

As for the general situation in Japan I am sure it has not escaped your attention that Japan now seems set to enter a recession. The only question will be the extent and more importantly the length of the slump. In Morgan Stanley's GEF (edition 8th of February) Takehiro Sato points towards industrial production trends as well as US GDP readings and tantamount to the forecast that Japan is heading more meager times ...

The risk of dual recession is mounting. Our US economics team is already calling for capex-induced negative GDP growth in successive quarters (Jan-Mar, Apr-Jun), for a technical minor recession in the first half of the year by definition. We are forecasting that Japan will cling on to a modicum of growth in the Oct-Dec 2007 quarter, boosted by external demand, but there is a possibility that, like the US, that quarter will mark the peak and the economy will retreat in Jan-Mar. Future data for industrial production will tell us if this is the case.

This note will not focus on figures for industrial production or US GDP stats but rather I will initially move in with my traditional focus on the internal demand dynamics in Japan. As ever, the Japan Economy Watch contains the latest cyclical indicators fresh in off the wire in order to bring you up to speed. Here at Alpha.Sources I made a note recently which also sums up the most recent trends and pieces of data. For now, let us turn to the updated charts which usually form the main edifice of my analysis of Japan ...

If we begin with prices we see that inflation, at a first glance, seems to have returned to the shores of Japan even to such an extent that I will soon need to adjust the y-axis of my graph (and yes, this is an apology for a sloppy excel graph). Yet, the most important point to take away from this is, as I have been at pains to hammer home before, the disconnect between the inflation indices. Core inflation as measured by inflation ex food and energy prices is still in negative territory whereas the general index is shooting up thanks to headline inflation. This disconnect suggests that the inflation we are seeing in Japan is not driven by demand factors (demand pull) but rather by supply factors (cost push) and thus this does not signal an impending Japanese recovery. Quite the contrary in fact as the spurt of inflation at this particular point in time will only further pinch an already troubled Japanese consumer. Edward also moves in with a much worth while analysis of the inflation issues in Japan. A key point here will be the extent to which future inflation readings will have a bearing on the BOJ's decision to actually move in with a cut in the already low interest rate of 0.5% in order to accommodate a slumping economy. I don't think Fukui will cut rates before his term ends this spring and given the debacle which may arise in the context of finding a new governor it seems that economic fundamentals should not be the only thing to watch in order to make a call. What seems obvious however is that if inflation pressures suddenly show signs on abating the door will be open for a cut.

If we turn to the indicators for domestic demand proxied by various measures of consumption expenditures we can also close the book on my forecasts for 2007. As such, I dared to venture that growth in consumption expenditures would not increase by more than 1% on a y-o-y basis. Let us look at what we have.

Let us start by the forecast first. As can be observed the Japanese consumers put in a strong showing in December on a y-o-y basis with a 2.2% increase. I have to say that this figure represents something of a fluke for me since if you look at the underlying indicators such as income, retail sales and department store sales they all clocked in with declines. Ken Worsley also ponders the 2.2% increase and provides a detailed break-down which shows how spending on culture and recreation as well as furniture and household utensils accounted for a substantial part of the increase. I have to agree with Worsley though when it comes to January and beyond where the rise in energy prices, declining income, and a general slumping confidence will be sure to slow spending considerably. As for the forecast, the December reading almost had my forecast shattered or, if you will, assured that I was very close to the mark. Consequently, the mean value of the increase in consumption expenditures was a 0.95% monthly y-o-y growth rate. The two remaining charts are merely there for differentiation. The average value for the m-o-m chart was 0.217% in 2007 and together with the y-o-y figure it shows the momentum and level of growth rates we can expect from Japanese internal demand in a given economic environment. The long term index anchors my analysis in the sense that it supports the general hypothesis that domestic demand is on a structural decline in Japan and that this might very well be due to the demographic profile of Japan, this last point of course being a hypothesis of mine. In terms of forecasts for 2008 I have no trouble extending my forecast of an increase of <1%>

Firstly, I think that the Yen demands some attention. Recently, I noted how the Yen was driven by anything but macroeconomic fundamentals. This clearly still seems to be the case. However, the main question is when this will end? At the moment and if you look at the FX price action in the beginning of 2008 almost all Yen crosses have been correlated with the stock market and thus by derivative the general sentiment of risk aversion in the market. This is nothing new in the sense that since the subprime market hit the global economy in the middle of August 2007 the Yen has been the main canary in the coalmine when it comes to the risk sentiment in the market. Yet, the Yen is not only driven by cyclical factors. As such, the decline in home bias of Japanese investors as well as the general yield disadvantage of Japan suggests that all those talks about an undervalued Yen aren't clued in to what is really going on in the sense that what is really the fair Yen value at this point? We need to think about the fact that the whole global economy seems to be undergoing the initial phases of a much more structural correction (recoupling) and in this context it is difficult to see how the Yen can stand its ground. It might not happen today or tomorrow but I have difficulties seeing how the risk aversion dynamic can hold the ground for the more wider and structural trend. Turning to more immediate drivers of the Yen the potential that Japan would intervene in currency markets to cushion the Yen's depreciation has reared its head with regular intervals. Back in early November I asked the question putting the limit at 105 for the USD/YEN which. Various other estimates have been around. Morgan Stanley's Stephen Jen puts it at 100 which is just the same as Macro Man. Recently, currency strategist at Dailyfx Boris Schlossberg kept the speculations alive suggesting, as me, that 105 just might be the threshold for Japan. Currently the Yen is hovering in the region of 106-107 and in this light Boris' conclusion seems to be a sound one, if a bit noncommittal, to take with you in the trenches of FX trading.

While there is certainly no guarantee that the BOJ will intervene at the 105-100 area, economic factors and positioning data suggest that Governor Fukui and company may indeed opt for that solution. Given that possibility the above mentioned strategies should hopefully minimize risk and optimize return for both momentum and carry traders. At the very least traders should pay particular attention to the price action if USDJPY slides down to the 105 level in the near future.

From a macroeconomic point of view this makes sense. Japan is largely dependant on exports to fuel growth as well as need to remember that an appreciating currency is deflationary and Japan has not escaped those fangs just yet. As for the Yen all evidence seems to point towards a continuation of current trends for the immediate future with the Yen acting as a global parameter of risk and investors' risk aversion. In this light, the risk of intervention needs to be weighed in as a potential market mover as we move forward.

The second topic I want to cover has already been mentioned above and essentially also cuts across the whole discussion on the Yen. In short, what will we see from the BOJ? Perhaps the most important thing to note here is that before we get to the discussion of what exactly the policy rate will be as we move forward into 2008 the BOJ will need a new governor. As I noted in my long end-of-2007 note this may well turn out to be quite a messy affair. Whether the shift of guards at the BOJ will turn into the political gridlock many observers have indicated is difficult to see from my desk here in Europe. However, there are some clear risks. As I have argued before a situation of political stalemate in which the Democratic Party of Japan (DPJ) will use their majority in the upper house to stall the nomination of a new governor will, all things equal, bring the MOF closer to monetary policy making. Basic logic would, in such a situation, call for a freeze of the nominal interest rate until the new BOJ leadership is set to assume their seats. However, if this current slowdown turns for the worse it may provoke measures which at this point in time might seem unrealistic. One risk is thus that Japan re-enters ZIRP over the course of 2008 and that this happens sooner rather than later. Before this materializes however, I am quite happy moving in behind the Morgan Stanley team in forecasting a cut in the main refi rate for Q2 2008.

In Conclusion

A lot of ground has already been covered in this piece and as such I think it is time to move in with some summarising remarks. I had two main objectives in this note. Firstly, I finalised my monthly analysis of consumption expenditures (domestic demand) and prices for 2007. Even though 2007 most likely will go down as a rather strong year in relative terms the failure of the overall consumption expenditure gauge to break the 1% threshold YoY tentatively suggests that domestic demand cannot become a driver of growth in Japan in any given sense. This point was underpinned by the monthly and long terms indicators of consumption. In connection to prices, we observed how inflation seems to be coming back to Japan. Yet, if we strip out energy and food Japan is still stuck in deflation and even though the core-of-core index might also nudge up towards positive territory the transmission mechanism from headline inflation to core inflation does not suggest that the inflation pressures we are seeing are driven by buoyant domestic demand. This does not warrant complacency against inflation but tells a story which needs to be told I feel if you really want to understand what is going on in Japan.

I also had a brief look at the Yen and more specifically the driver of the currency. I concluded that while risk sentiment seems to be the main trend explaining the current movements more general structural forces should not be neglected. The key issue here is timing and thus the dynamic relationship between the immediate environment and the more long term structural trends. Moreover, I also reviewed the latest speculation that we will observe intervention in the FX market by MOF and the BOJ. At this point, we have no clear indication that this will occur but I think the possbility should be entertained that the MOF will dip its toe at some point. In terms of the the BOJ and a subsequent call on the rate policy in Japan I moved in behind Morgan Stanley noting that Q2 2008 will see a cut to 0.25%. Another factor which I discussed was the extent to which the departure of governor Fukui will result in a policy gridlock. The risk is definitely there I would argue and it is a possibility which should be taken into account. I think that such a gridlock would (and should) result in a an effective standstill of rate movements but if the slump turns for the worse new dynamics may come into play where the MOF moves in to 'politically' steer down interest rates. Whether 2008 will see ZIRP is still an open question I think. I believe the probability is fairly high not least because I think that the recession we are now seeing on the horizon may very well be more severe than many expect. The main question however is not centered on the slowdown in Japan per se. This is the nature of economic cycles in the sense that they go up and down; yet, what remains the most compelling question in Japan's case is just how far and how long it will be this time.