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Monday, April 28, 2008

Food Prices, Farmland, Global Rebalancing and Rural Labour Shortages

by Edward Hugh: Barcelona

Ukrainian President Viktor Yushchenko said last week that he had agreed to let Libya grow wheat on 100,000 hectares of land in the Ukraine. In exchange, Libya promised to include the former Soviet republic in construction and gas deals.
With so many interesting debates going on the Demography Matters blog at the present time I find it hard to pull myself away, but I couldn't help getting drawn into the implications of the points raised by this article in the Financial Times about how the global pressure on food supplies and the rapid increase in prices is now leading to an equally rapid increase in the price of farmland in one country after another. And then, thinking about a country like Ukraine - with a declining population, rapidly falling unemployment, and growing labour shortages - I couldn't help scratching my head and asking myself, but just where are they going to get the labour force from to work all this extra land they want to cultivate?

But lets get back to land prices for a moment. According to the Financial Times with prices of commercial and residential now property falling in many developed economies, investors are begining to find themselves faced by a rather tricky problem set: they can either stick all those millions (or bliions) which they no longer feel happy to place in first world property into a novel value store like food (and start for example hoarding rice, or buying soy futures) or they can turn their attention towards a more traditional and well established asset: farmland. Long seen as a declining sector, agriculture has just received an enormous fillip as global demand for food has skyrocketed. As a result, the value of agricultural holdings across the European Union has been rising to record levels.

In the UK prices have risen by 40 per cent over the last year alone, and there is apparently plenty of room for prices rises across the whole continent. In Lithuania - to take just one example - a hectare of agricultural land was estimated to cost €734 ($1,167) in 2006 compared to €164,340 in Luxembourg (which was Europe's most expensive country at the time). In Poland average prices for farmland are estimated to have risen by 60 per cent between 2003 and 2006. In neighbouring Ukraine – not an EU member – prices for the best land are forecast to double this year from the 2007 value of $3,500 per hectare as one investment fund after another piles in (you know, all those pensions people will be looking to receive later). Even Serbia, another non-EU country, has seen a steep increase. Real estate analysts estimate arable land prices in Serbia’s agriculturally rich northern region, Vojvodina, at roughly €7,000-€8,000 per hectare this year, up sharply from €5,000 last year.

Even in distant Afghanistan the rise in the value of conventional farming is being noted, since opium crop is forecast to shrink by as much as half this year after 2007’s record harvest, according to counter-narcotics officials in Kabul, as evidence grows that poppy farmers are switching to legal crops, attracted by the rising food prices.

All of this raises a number of very interesting questions, not least of them being why it is all happening now (number one), and where many of these countries who have surplus land to offer- but have had congenitally low fertility for longer than I now care to remember, and have been busying temselves over the last few tears exporting what scarce labour resources they have to Western Europe or Russia (Latvia, Lithuania, Ukraine, Poland, Slovakia, Romania, Bulgaria etc) are going to find the labour forcethey would need to work the extra land (number two).

Why The Price Rise Now?

Well on the first point, I really can't do better than direct your attention to another very interesting article in the Financial Times, this time one from Martin Wolf, entitled "A turning point in managing the world’s economy". Wolfe's main point for our present purposes is this one:

"As the latest World Economic Outlook from the International Monetary Fund remarks, “the world economy has entered new and precarious territory”. What are perhaps most remarkable are the contrasts between booming commodity prices and credit-market collapses and between buoyant growth in emerging economies and incipient recession in the US. So where are we? How did we get here? And what should we be doing?"
The point to notice here is that it is not just investment funds who are busy adapting their behaviour since we all have a rather novel problem set on our hands, as the credit crunch wends it way forward and property markets drift (at best) into stagnation in one OECD economy after another, commodity prices are rocketing, and the best bet at this point is that the developed world is heading towards a protracted bout of stagflation (where central banks are constrained to operate a tight monetary policy, keep credit on a tight rein and basically restrain growth to contain inflation), while emerging market economy after emerging market economy (of course it is not quite as simple as this) seems to be revving up on the development ramp prior to launching into "we got lift-off" mode.

The April 2008 IMF World Economic Outlook estimates that the US economy may shrink by 0.7 per cent between the fourth quarter of 2007 and the fourth quarter of 2008, and eurozone growth is expected to fall to some 0.9 per cent or so this year, yet while the most important high-income economies stumble (even where they do not actually fall), the picture in the majority of emerging economies is for only modestly diminished growth, with rates of 7.5 per cent being anticipated for emerging Asia ( with China on 9.3 per cent and India on 7.9 per cent); 6.3 per cent for Africa; and 4.4 per cent in the western hemisphere. These latter are certainly not growth rates to be sneezed at.

But what we have going on here is not only a growth rate differential, it is also a massive currency re-alignment. The consequential rapid and dramatic rise in dollar GDP values (produced by the combination of strong growth and the declining dollar) means that convergence in global living standards - at least in the cases of those economies who are experiencing the strongest acceleartion - is now happening much more quickly than anyone could have - even in their wildest moments - dreamed back in the 1990s. All of this is very well illustrated by the case of Turkey, as can be seen in the chart below.

According to Wolf:

Emerging economies have been the engines of growth over the past five years: China accounted for a quarter; Brazil, India and Russia for almost another quarter; and all emerging and developing countries together for about two-thirds (measured at PPP exchange rates) of world growth. Furthermore, notes the WEO, these economies “account for more than 90 per cent of the rise in consumption of oil products and metals and 80 per cent of the rise in consumption of grains since 2002” (with scandalously wasteful biofuels programmes contributing most of the remainder).

This situation can be observed quite clearly in the two charts which follow, which are based on calculations I made last autumn from data available in the IMF October 2007 World Economic Outlook database. Now, as can be seen in the first chart the weight of the US economy in the entire global economy has been declining since 2001 (and that of Japan since the early 1990s). At the same time - and again particularly since 2001 - the weight of the so- called BRIC economies (Brazil, Russia, China and India) has been rising steadily.

This is just one example - and a very basic one at that - of why Claus Vistesen and I consider that demographics is so important, since it is precisely the population volume of the BRIC (and other similar) countries and the fact that they start their development process from such a very low base ( ie there is such huge "catch-up" potential since they were allowed to become so comparatively poor, for whatever reason) that makes this transformation so significant.

Again, if we come to look at shares in world GDP growth we can see the steadily rising importance of these BRIC economies in recent years and the significantly weaker role of "home grown" US growth. In 1999 the US economy represented 30.91% of world GDP, and in 2007 this percentage will be down to 22.4% (on my calculations based on the forceast made by the IMF in October 2007). In 200 the US economy accounted for a staggering 40.71% of global growth, and by 2007 this share is expected to be down to 6.43%.

But most of the data I present above predate the financial market turmoil of August 2007. In fact what has been happening post August 2007 is really fascinating and actually quite unique, since following the breakdown we have seen in some of the world's leading wholesale money markets - and in particular in the securitised-mortgage-paper based ones - the credit system in all the G6 economies is steadily slowing - and all the world's major developed economies are gradually entering recession. All the major developed economies, but not, of course, the newly developing ones, as I am indicating.

This state of affairs may well now become a relatively drawn-out affair since the structural rise in food, energy and commodity prices that is being produced by such a dramatic rise in living standards in the world's most populous countries means that we are likely to have continuing high structurally driven inflation, and to this needs to be added a longer term relative downward drift in the value of G6 currencies vis a vis emerging economy ones (the euro has still to feel the force of this, since recently it has simply risen and risen, but I think it will come, while the dollar case is already clear enough) means that in the OECD world we are more than likely in for a protracted dose of stagflation, as central banks on the one hand are constrained from too much monetary easing by inflation concerns, while the credit crunch on the other seems to imply that cheap mortgage and personal finance is unlikely to become so widely and freely available as it was, whatever the base interest rates at the central banks.

Yet unlike previous recessionary occassions (arguably ALL such previous occasions in living memory) funds are not coming running home to the G6 economies for safe cover during this downturn. Instead they are in a kind of headlong flight towards the emerging ones: hence the steady fall in the dollar, and the rise in currencies like the Turkish lira, the Brazilian real or the Indian rupee. In these countries it is literally raining money (saving good old Ben the trouble of having to get his helicopter out). We could take the Indian case as a clear example here.India's foreign exchange reserves (which are a reasonably proxy for the rate of capital inflows) rose $2.7 billion to touch $311.9 billion during the week ended April 4, and this is a rise of some 50% on the level of $204 billion which existed in May 2007.

At the same time, and despite having fallen back somewhat recently, India's rupee is up substantially against the dollar, perhaps by 12% across 2007 as a whole.

What this really means to me is that the damn has finally burst - and that the huge accumulation of population at one pole of the planet and of wealth at the other is now in the process of unwinding itself - and really there is no turning back. Country after country is now hitting the development high road and this will not only have an impact on the rate of global population growth (slowing it markedly), global fertility (ditto) and global ageing (in this case we are likely to see an acceleration, as improving health increases life expectancy, while declining fertility reduces the size of the younger cohorts), it will also put enormous short term pressure on the supply of global resources, and it is on this issue that I really want to focus here.

The picture is that not only is population growing rapidly in some developing countries (foreseen), but both population and per capita living standards are growing (not foreseen) - and indeed these living standards are rising so fast that the gap between some of the leading countries and the developed economies is closing rapidly. This latter - unforeseen- effect is the principal reason we are seeing such acute pressure on the global supply of agricultural products.

One of the obvious reasons for such a sharp rise in demand for agricultural products is that food consumption forms a much greater part of the extra income earned in a poor country than it does in a rich one. As a rough and ready rule, the poorer the country the greater the share of every extra dollar earned which will be spent on food.

To take the example of Russia, Russia's very rapid economic growth since the turn of the century is producing an equally rapid rise in incomes and living standards. According to the Russian Statistics Office Rosstat, average real wage and disposable income increased by 16.2 and 12.9 percent, respectively during the first nine months of last year, and increases of this order, when coupled with currency changes, produce a very sharp rise in purchasing power, as can be seen in the chart below.

The consequence of rapid growth in a tightly constrained labour market like the Russian one isn't hard to predict: rampant inflation. In fact Russian consumer price inflation accelerated in March to hit an annual rate of 13.4% (Bank of Russia data), up from 12.7% in February, and led by bread, vegetables and other food costs. Prices rose 1.2 percent from February. Russian prices have already risen by an icredibly 4.8 percent in the first three months of this year alone (January to March).

And if we come to look for a moment at the components of Russian inflation (see charts below) we will find two of our old friends out there in the forefront - food and construction. In fact in the first 10 months of 2007 the rate of increase in construction costs was some 15% (as compared to only 9% during the equivalent period of 2006). And if we look at the chart for Russian CPI weightings (see below, - and note by way of comarison that in China and Turkey, food related products also constitute around 25% of the CPI basket).

And again here Russia is a nice example of the extent of this problem, since Russia's manpower shortages (see this post) mean that supply in the agriculture sector is now pretty constrained, while technological improvement if investment totals are anything to go by is not notably accelerating. Investment in transport and communication constituted 23.31% of total investment in Russia the first half of 2007, investment in real estate constituted 12%, and investment in agriculture constituted only 4.7% of the investment total.

In terms of FDI the situation seems to be even worse, since FDI in Russian agriculture only constituted 0.7% of total FDI during the same period (World bank data). As a result of all this neglect it should come as no surprise to find that labour productivity in Russian agriculture only grew by 4.4% per annum over the 1999 - 2004 period (the lowest by a long way for any sector, World Bank calculations), and thus starved of its workforce, and lacking the necessary capital investment to compensate, Russian agriculture is bound to struggle to meet the needs of an ever more affluent urban population. The result of course is that Russian inflation is now spiralling upwards almost out of control.

Rice As An Example of What is a Global Problem

Thailand's benchmark 100 percent B grade white rice was quoted at a record high of more than $1,000 per tonne last Thursday as a result of constrained supply and rising demand as governments in one rice producing country after another consider taking steps to restrain exports. The price was up from around $950 per tonne a week earlier and $383 per tonne in January. Thailand is the world's number one rice exporter and exports almost twice as much rice as India, its nearest rival.

In fact Thailand produces about 22 million tons of milled rice annually and exports about 10 million tons. The sharp spike in prices was produced by a report from a World Bank official earlier in the week, and prices did subsequently fall back again after Finance Minister Surapong Suebwonglee siad reassuring words to the effect that Thailand has no plans to limit rice exports.

``If a key exporter like this limits foreign sales, it would be very much like Saudi Arabia reducing oil exports,'' said James Adams, vice president of the bank's East Asia and Pacific department.

Several of the world's food producers - including Egypt, Vietnam, China and India - have recently placed restrictions and limits on food exports in an attempt to contain domestic prices and to reduce protests from urban consumers. Brazil - which this year should harvest an 11.9 million ton rice crop, up from 11.3 million last season - was busy backtracking at the end of last week on an earlier decision to restrict exports. Brazil's Agriculture Minister Reinhold Stephanes followed the example of his Thai counterpart and stated that Brazil would not, in the end, curb exports. Pakistan is also stepping up to the plate in what has virtually become a global emergency and has stressed it has plans to export 2.5 million metric tons this year, according to farm minister Chaudhry Nisar Ali last week.

Vietnam, however, which is the world's third-biggest rice exporter (after Thailand and India), is going to go ahead and reduce rice shipments by 11 percent this year to 4 million tons to ensure supplies and attempt to curb inflation that is its highest in more than a decade (see more on Vietnam in this post). In doing this Vietnam is following in the footsteps of the world's number two rice exporter - India - whol last month put significant restrictions on the export of rice.

Indonesia, which is the world's third-largest rice producer (as opposed to exporter), also intends to hold back surplus rice from export this year in order to bolster domestic stockpiles, according to President Susilo Bambang Yudhoyono speaking on April 18. Export restrictions are particularly threatening to the large rice importers whose populations ofetn depend of the staple for their basic food supply. The Philippines was the world's largest largest importer last year, followed by Nigeria. The Philippines received offers for only two-thirds of the grain it sought to buy on April 17.

Rice is in fact the second largest produced cereal in the world. At the beginning of the 1990s, annual production was around 350 million tons and by the end of the century it had reached 410 million tons. World production totaled 395 million tons of milled rice in 2003, compared with 387 million tons in 2002. This reduction in total output which occured around the turn of the century is largely explained by the strong pressure which have been placed on land and water resources, which led to a decrease of seeded areas in some Western and Eastern Asian countries.

Production is geographically concentrated in Western and Easter Asia which account for more than 90 percent of world output. China and India, between them host over a third of the global population supply over half of the world's rice. Brazil is the most important non-Asian producer, followed by the United States. Italy ranks first in Europe.

Growth has however been far from linear. Historically, production in ex-Japan Asia has increased steadily but at the end of the 1990s Asian output started to stagnate and in particular in China where rice areas have declined as a consequence of water scarcity and competition from more profitable (oleaginous) crops.

The international trade in rice is estimated between 25 and 27 million tons per year, which is only a very small part (5-6 percent) of total world production., and this makes the international rice market one of the smallest in the world when compared with other grain markets such as wheat (113 million tons) and corn (80 million tons). It also means that the price level is very sensitive to comparatively small changes in some key exporters.

Besides the traditional main exporters (Thailand, Vietnam, India and Pakistan), a relatively important but still limited part of the rice which is traded worldwide now comes from developed countries in Mediterranean Europe and the United States. There are two major forces behind this: new food habits in developed countries and new market niches in developing countries.

(please click over image for better viewing)

As we have seen, rapid eceonomic growth across Asia is now putting enormous pressure on food prices. Consumer prices in China, the world's fastest-growing major economy, soared 8.7 percent in February, the fastest pace in 11 years. In Thailand, inflation is running at 5.3% (March) but this is still enough to worry the government, while in Vietnam, inflation jumped to 19.4 percent this month, the fastest pace since July 1995. Vietnamese food prices jumped 30.6 percent from a year ago, with the component including rice leaping 30.1 percent from March 2007 and 10.5 percent from February 2008.

The Food and Agriculture Organization said in February that 36 nations including China face food emergencies this year. World rice stockpiles may total 72.1 million metric tons by end of July, the lowest since 1984, the U.S. Department of Agriculture said.

Prices of agricultural commodities are also being driven by investors looking for alternatives as the dollar and stocks drop. Global investments in commodities rose almost 33 percent to $175 billion last year, according to Barclays Capital. The UBS Bloomberg Constant Maturity Commodity Index of 26 raw materials climbed to a record on Feb. 29 and is up 16 percent so far this year.

But not everyone wants to restrain exports. Rubens Silveira commercial director of Rio Grande do Sul state's Rice Institute said the state - Brazil's No.1 rice grower - should export about 10 percent of this years crop at current prices, and argued that these exports will both help support domestic prices and provide incentives to producers to invest in improving output. Mainstream economists tend to agree with him:

``Limiting exports is pure politics and bad economics since export controls destroy the incentive of farmers to plant more rice,'' Nobel laureate Gary Becker, an economist at the University of Chicago, said in an interview. ``But governments tend to favor the urban workers over the farmers, since urban groups are more politically active.''

And it isn't only rice that is under pressure. Wheat prices are also rising fast. Wheat for July delivery was trading at around $8.1750 a bushel on the Chicago Board of Trade last week, down from the February peak, but still up 62 percent in the past year. Global wheat production is expected to rise 6.8 percent in the 2008-09 season as record prices spur farmers to sow more, the International Grains Council said last week. Wheat output is expected to climb to 645 million tons from 604 million tons this season, according to the London-based council. Inventories are forecast to gain 12 percent to 128 million tons, led by an increase in the U.S.

Global wheat production will advance approximately 6 percent in 2008 over 2007 - to an all-time high of 640 million metric tons - as record prices spur farmers to grow more according to Rabobank estimates. That is 37 million metric tons up on output in 2007 . Plantings will also gain 5 percent and global stockpiles will rise 9 percent they suggest. But then we might like to note that even with a 6% growth rate in output (which is no mean rate of increase) prices have still risen by 62 percent. This gives us some measure of the scale of the problem.

The prices of wheat, corn, rice and soybeans have all risen to record levels this year on shrinking global stockpiles and rising demand from the food, feed and biofuel industries. The rally has meant higher costs for everything from Italian pasta to Japanese noodles, and spurred street protests from Haiti to Ivory Coast.

``We have been neglecting our basic rice production infrastructure and research and development for 15 years,'' said Robert Zeigler, director-general of the International Rice Research Institute in the Philippines. ``

India's output is increasing rapidly, but so is demand there, as high rates of economic growth boost incomes. Indian wheat output may climb to 76.8 million tons this year, according to India's agriculture secretary PK Mishra. That's up on the 74.8 million tons estimated in February and up from 75.8 million tons last year. Indian rice output is also expected to rise to a record 95.7 million tons, from the 94.1 million tons estimated on Feb. 7. That's 2.5 percent more than the 93.6 million tons produced a year earlier, but still far from enough to stabilise Indian wholesale prices which are now running at the fastest pace in nearly three years.

Labour Supply

"Thailand has even gone the extra mile to explore additional land for rice production," James Adams, the bank's Vice President for East Asia Pacific, said in a statement.

But with countries as far apart as Ukraine and Thailand (where fertility in each case is already well below replacement level, see here for Ukraine, and here for Thailand) moving to open up more land for agricultural production, we may well want to ask ourselves just where the anticipated manpower is going to come from. Ukraine is already suffering from severe labour shortages as most of its immediate neighbours (and in particular Russia) have sought to resolve their own labour shortage problems by importing Ukrainian migrants. Now the labour shortages back home are producing yet another a massive inflation bonfire:

Since this post is already inordinately long, I am continuing the labour shortage part of this study, in a separate post focusing on Vietnam (which can be found here).


So what is the point - at the end of this very long and tortuous post - that I am actually trying to make here.

Well I think my points would be several.

1/ Firstly and most obviously that the current increase in global commodity prices is NOT simply a monetary phenomenon. Of course it IS a monetary phenomenon, since without he money, as the economic "smart-aleks" likie to point out you can't have the inflation, but it is not SIMPLY a monetary phenomenon, since it is underpinned by profound structural changes in the real economy, structural changes which are taking place on a global scale. Under such circumstances traditional monetary policy is in fact rather limited in its ability to substantially change the situation. Basically the central banks are not as powerful, or as influential, as many seem to think they are, and in particular when globalised money markets mean that traders can leverage funds from one country which is forced to reduce interest rates to meet domestic growth needs (the United States) to supply credit to another where the central bank is busily trying to tighten (India) and where the bottom line in the so-called "carry trade" is set by a Bank of Japan which even during the longest expansion in the country's recent history has proved unable to raise its base interest rate above 0.5% (with few really taking the trouble to ask themselves why this is).

2/. Some of the global imbalances which have been built up over the last half century are now unwinding. In particular some countries which became very poor and very populous in the second half of the 20th century, having now entered their demographic transitions (and see this excellent recent post from Claus for a much fuller exploration of what this really means) are well on the high road to economic development. But due to the specific structure of short term demand as income rises (ie that the marginal propensity of populations in these countries to spend extra income on food) we are seeing important structural changes in some relative prices globally, and the consequences of these changes are quite far reaching.

3/. Almost all countries globally are passing through the Demographic Transition, but countries are at different stages in the process, and in particular some countries have already seen fertility fall sharply below replacement while still remaining economically relatively poor (Eastern Europe and parts of Asia - in particular China, Vietnam and Thailand). This situation really presents us with quite new and complex issues in the context of the rapid rise in the demand for food which the rising living standards which are occuring in these countries is producing. Unlike previous experience in the traditional "demographic dividend" countries, low rural fertility in the above countries means that as young people leave to enter the rapidly growing urban labour market insufficient are left to increase agricultural output at a fast enough rate. Part of the solution to this problem is technological, with increased investment taking place in agriculture, but only part, since as we have seen in developed economies like Spain and the United States which have recently increased their agricultural output, a constant supply of relatively cheap migrant labour has also been necessary. A second solution comes from increasing the relative wages of rural labour (which in its turn of course stimulates technological investment), but then there is no getting away from it, food is going to become relatively more expensive, and this situation is not going to change.

Global Demographics - (Almost) Uncharted Waters

by Claus Vistesen: Copenhagen

This post is something of a departure from our normal practice here at Global Economy Matters, since most of the posts on this blog deal with the explicitly economic aspects of global demographic changes, while we normally post more demographically oriented posts on our companion (sister) blog Demography Matters. In this case, however I am going to make an exception, owing to the interest of the paper I am reviewing here for economists generally, and also since it provides a nice companion piece to Edward's post on global food prices.

The topic is consequently global demographics, what we know about them, and even more importantly what we don't know. Such questions cannot be adequately answered in even the most ambitious blog post. However, if we want some sort of basic orientation then we could do a lot worse than visit a recent paper by David S. Reher entitled Towards Long-Term Population Decline: A Discussion of Relevant Issues. The paper is as per usual walled for non-subscribers of a university server but you can get a long most adequate survey of the paper here at Edward's Demography Resources.

Let us begin with the abstract which contains two crucial points that are very important to take away.

This paper contains thoughts on the process of imminent population decline under way in much of the developed world and quite possibly in other world regions as well. We are witnessing the beginnings of a vast trend change which promises to bring to a close a period of population growth that has lasted for several centuries. It can be shown that this great change is a byproduct of the demographic transition that unleashed a number of the forces leading to where we are today. The extent to which much of the developing world will follow the reproductive trends of the developed world, with their social and economic implications, is discussed. The decades ahead for much of the world will lead us into mostly uncharted territory that bears few similarities with past periods of population decline. The purpose of this paper is to stimulate reflection and debate on a subject that looms as perhaps the key social issue of the twenty-first century.

As many of you may know from rudimentary knowledge of demographic processes the original idea of the demographic transition always encompassed the idea that fertility would stabilize at replacement levels once the final stages had been dispensed with. This is then to say that the original idea of the DT envisioned a notable degree of balance (homeostasis) in the level of population with the obvious exception that an ever marginal decline in mortality coupled with a rise in longevity would steadily translate into ageing of the world's population. We know now that this idea of a balanced steady state (and no, this choice of word is NOT coincidental) in fertility must be seriously doubted and for all intent and purposes discarded as a valid theoretical explanation. Consequently, it is only very few developed countries today that can boast a fertility rate at replacement levels and indeed if we pull out the ruler none of the developed economies save perhaps the US qualifies for the strict definition of replacement fertility. This must then be the first important thing to take away at this point. The demographic transition or more specifically the evolution of fertility and rising life expectancy is not over and at this point there does not appear to be a theoretical governing mechanism to provide a balance. On the contrary and most worryingly we are now observing that the rapid decline in fertility which has occurred across a wide batch of developed economies is now being repeated, and more importantly fast forwarded, in the context of many emerging and transition economies. Notable examples here would be Eastern Europe, large parts of Asia, as well as Northern Africa. Conclusively this leaves us with two intertwined points which are absolutely crucial to be aware of. Firstly, and as I have argued before the demographic transition is not over and following from this is, as mr. Reher puts, the fact that we are moving into uncharted territory.

In general, I would say that Reher's small article is a good starting place if you want to understand some of the issues at work and also if you want to understand what the historical background of the demographic transition is. Reher frames his discussion around the issue of population decline and how world is now moving into a new regime of steady to declining population dynamics. Obviously and since mortality rates have declined much faster than fertility rates it will take some time before the global population actually start falling in numbers even if of course notable asymmetries are present. For example Russia's population is already declining and so is Japan's and unless aggregate European fertility rates rise to an almost unimaginable number the population will begin to decline slowly here too in a few years (also it has to be said with important asymmetries). Even though this perspective is important I am not a big fan of narrating the demographic changes in the context of population decline. There are two main reasons for this. First of all I think that population decline on a global scale need not be a detrimental development for the human race. In fact, a considerable amount of evidence supports this. Secondly, because I am convinced that the main economic effects from demographic changes need not be found in the context of declining populations in absolute numbers but rather in the form of the rapid and relentless process of ageing which is sweeping the planet in these years. Reher of course also notes this and mentions several times the potential impact of ageing. However, I like to take it even further. Another way to look at the demographic transition is consequently to look at it as a transition in age structure of a society. I am thus very much in tune with the original work on this conceptualization by the Swedish demographer Bo Malmberg. In this way and from a macroeconomic point of view the focus on ageing and changing age composition of a society opens up an important unattended flank in the realms of macroeconomic theories of growth and capital flows. In this context I feel that the following issues are very important to keep in mind ...

  • The implied notion of an economic steady state runs into severe calibration issues in the context of the ongoing demographic transition. Growth theorists, of course, were always from the beginning aware of the potential effects of a skewed relationship between old and young people in a society. A whole battery of research consequently exists under the common notion of OLG (overlapping generations framework) which deploys standard life cycle assumptions to derive steady states in a modeling context of a rudimentary age structure of society. However, the theory runs into distinct problems when trying to formulate a steady state framework for countries that do not appear to exhibit a steady level of output growth over the long run. In this way, the steady state becomes a proverbial moving target. In addition there is evidence to suggest that the demographic transition is not a deterministic process but rather path dependent and thus endogenous to the growth process itself. Given the fact that we don't how this process ends it makes the potential modeling endeavor extremely difficult.
  • Economies today are not closed but highly interdependent. If we couple this with the fact that the process of ageing occurs in radically different tempi across the batch of global economies I believe a number of important externalities can be identified in the context of the global economy. What does it for example mean that Japan is running a near 0% interest rate policy because it has found it impossible, after more than a decade, to effectively escape deflation? What does it mean for global capital flows that some economies are now, not only prone as the original theory predicts, but rather dependent on external demand to grow? And what happens as all the global economies steadily age thus all becoming ever reliant on external demand to grow?*
  • Growth is above and beyond driven by the availability and quality of human capital; both on a macroeconomic and microeconomic level. Institutional set-up matters in the sense that they can make or break an economic edifice depending on their efficiency but without human capital the economic engine does not work. Institutions can be a powerful catalyst for the quality of human capital but on the other hand modern institutional arrangements also seem to be at the very heart of the dramatic decline in human capital formation (fertility) we have observed and indeed are observing. Moreover, there is evidence to suggest that a negative feedback mechanism is at work with respect to the quantity and quality of human capital. And as Edward likes to frame it, a society has a maximum capacity for growth when its age structure is at a specific golden level (i.e. when the most productive cohorts (say 25-45) are at their maximum size relative to the whole population). Yet, as the demographic transition ripples through this median moves steadily upwards and in this context the extra productivity extracted does not carry the same weight as it did before. In fact, and going back to the idea of a steady state it seems a very sound theoretical assumption to state that in order to observe a steady state of economic growth we need to have a balance by which the size of the most productive cohorts is fairly stable (the US would seem to be almost the only empirical precedent here).

These are but some of the questions which arise in the context of the global demographic changes and their impact on the economic environment.

If we return to Reher's piece I think that a couple of noteworthy rather random points can be extracted.

As I have relentlessly been arguing in the context of the topic at hand one of the most preoccupying concerns is that the observed and lingering trend in the developed world now seems to be repeating itself in the context of the world's emerging economies. In fact, as we have seen a wide array of transition countries are now finding themselves with severely damaged population dynamics. Reher is very specific on this topic which he uses essentially to argue that the world is now, for better or worse, entering a completely new and unknown demographic regime. Also he latches on to the idea that the demographic transition is indeed a path dependant process and not one which occurs automatically in the context of a pre-scheduled process of catch-up growth from the point of view of transition economies ...

Throughout the developing world, aging and its attendant economic and social challenges will become an acute social issue relatively soon after it becomes a central concern for societies in the developed world (Demeny & McNicoll, 2006b, 257–259). The intensity of change will leave these nations with but a brief window of the opportunity for modernization within which to take full advantage of the ‘‘demographic dividend’’ derived from their own transitions (Bloom et al., 2003).

What drove (and drives) this rapid demographic transition in the first place? This is perhaps where Reher is most elaborate. He consequently engages in a large and detailed discussion of the social change that occurred along side the demographic transition. Specifically, Reher devotes a large section to the changing role of women in our society and what effect this has had on childrearing. As far as I can see especially an elaborate account of the quantum effect of fertility emerges (curiously without a reference to the original work by Becker and Barro). Reher especially devotes attention to the process of family planning and completed family size. This is then an entrance point to the tempo effect (postponement of births) of fertility decline. As such, at any given point in time couples (or women) have a desired family size but the steady process of birth postponement may exert a notable influence on the final fertility level (i.e. cohort fertility). Moreover, Reher also refers to studies by the Austrian demographer Wolfgang Lutz who has devoted a lot research to the idea of a convergence towards a common very low level of fertility in Europe. An even more interesting side issue here is to actually develop a theory to explain these developments in desired family size potential convergence towards a one-child ideal. A considerable amount of debate has been made in the context of European sociological studies and specifically in relation to studies which have shown how many women in Europe's low fertility regions do not want to have children at all. A couple of months back Edward had a very elaborate piece on Demography Matters on this topic. Ultimately of course the idea that all this in the main can be pinned on the emancipation of women in terms of labour force participation and the social changes which accompanied it remains a rather dubious theory. Edward shows us as much in a recent very detailed analysis of Italy's demographics.

Finally, Reher manages to hit the proverbial nail on the head with his comments on international migration and the potential for ageing societies to mitigate their demographic travails through importing labour.

Labor shortages will be one aspect of the issue of aging. In some countries, this shortage of working age population is easy to predict because numbers of births have already been declining for several years. We believe that it is only a matter of time (perhaps 2–3 decades) before they begin to affect many or most societies in the developing world. The availability of surplus labor (potential migrants) to compensate the dearth of labor in the developed world may eventually be called into question, as the sending countries begin to suffer labor strictures of their own.


International migration itself, the focus of much current attention and concern, is unlikely to represent more than a temporary and rather inadequate solution for skewed age structures and population decline for two reasons. (1) Fertility among migrants, while initially higher than among the native populations, very quickly tends to decline to levels holding in the host society. (2) More important, perhaps, is the fact that many sending regions will be experiencing labor shortages of their own within two or three decades. It is unquestionable that these countries currently have abundant supplies of surplus labor that can be funneled fairly directly to receiving countries, normally developed ones, suffering from labor shortages. This situation, however, cannot be sustained indefinitely because of the dramatic fertility decline
taking place among those sending countries.

The only problem here with Reher's account is his time frame. 2-3 decades is way too optimistic. These issues are here today and very soon, if they are not already, they will come on the political agenda most prominently in Eastern Europe where for example the EU is still spinning the inter-relationship where CEE and Baltic migrants travel to the West as a positive one. The fact is that it is not and if the EU does not wake up to this they may end up with a lot dissatisfied new member countries.

In Conclusion

Reher's piece is well worth more than a scant glance. What I particular like was already emphasised in the beginning of this review. The demographic transition is not over but remains an ongoing process and this means that the global economy or society is moving into uncharted waters. At this point we already know a lot about the effects of demographic change but since we don't know the extent and/or the end of the changes themselves we are faced with a rather peculiar scientific problem. Personally, I tend to, unlike Reher, focus mainly on the dramatic force of ageing which is sweeping across the global economies. Especially, I like in this context how Reher emphasises the fact that the demographic transition seems to be moving much more rapidly in emerging and transition economies. This is a very important empirical fact to take away. In this respect I also think that Reher manages to pinpoint very accurately the issues which pertain to global trends of migration from the point of view of the sending countries rather than the traditional spin that this is a win-win situation for all parties involved.

A lot of literature is out there on this topic of the general trend in global demographics but I do think that Reher's piece is one of the better specimen.

* In more technical economic terms we are speaking of the fact that the global economies, as a result of ageing, will tend to have the same time-preference for consumption over saving thus leading to the optimal policy choice of many countries becoming the nurturing of a perpetual external surplus vs. the rest of the world. The formal theoretical impetus for this argument can be found in the notion of the inter temporal approach to the current account (see also here).

Wednesday, April 23, 2008

The French Economy - Acting As The Eurozone Buffer?

by Edward Hugh: Barcelona

What really strikes me about the slowdown we are currently seeing in the eurozone economies is not so much what we are seeing, but how we are seeing (or if you like interpreting) it. The core of the issue is to be found - as is ever the case - in the details. And first and foremost among these details is the way in which inflation is so obviously crimping any attempt on the part of the ECB to use conventional monetary policy (namely lowering interest rates) to help the ailing Spanish (see here) and Italian (see here) economies. As a result the Sabre rattling continues in Frankfurt and the euro continues to move onwards and upwards, touching an all time high of $1.6019 yesterday (for a fuller exploration of some of the issues which arise here, see Claus Vistesen's recent The ECB - One Play-Book, One Page, One Purpose post).

It also doesn't seem to me to be without some significance that what sent the euro off upwards again yesterday was a comment from French Central Bank Governor Christian Noyer.

“Our big problem is to ensure that inflation returns below 2 per cent next year,” Christian Noyer told French radio. “If needed, we will move interest rates.”
What Noyer seems to be saying is that the French economy is weathering the storm, not only were exports up in February, but unemployment continues to fall, and industrial output continues to surprise on the upside, while the French services sector remained the one bright spot on an otherwise darkening eurozone horizon, at least according to the March reading of the Royal Bank of Scotland purchasing managers index. So it is the underlying strength of the French economy at the present time which is the real news behind the headlines of the record euro level we saw yesterday.

In fact the substantial appreciation in the value of the euro (which should have some kind of disinflationary pass-through impact) may well make an actual rise in ECB interest rates unlikely in the near future, but it is interesting to note that - in a significant turnround - the financial markets have started to price-in the slight possibility of an increase in ECB rates later this year. The ECB meanwhile mainatins the posture that the economic uncertainty surrounding the current outlook makes the direction of its next interest rate move unclear.

What really caught my eye this morning, however, was the following comment in the Financial Times:
France’s economic outlook could play an important role in the ECB’s thinking. Spain is facing a sharp housing market correction, while German economic growth is thought to have been surprisingly strong at the start of the year. “The fact that France is holding up in the middle is probably preventing eurozone [economic] numbers from moving significantly to the downside. It is a bit of a buffer,” said Jacques Cailloux at Royal Bank of Scotland.

France may be a bellwether for the eurozone because its relative resilience lies in the absence, so far, of a credit crunch or sharp slowdown in consumption.

Basically what is strange about all this is how it is precisely the French economy (in terms of the durability of its domestic consumption) that is really holoding things together in the eurozone right now (along with German exports - but NOT German consumption - of course). What is most striking from where I am sitting is how little thought all those big-name widely-quoted economists seem to be giving to the implications of what is happening. Claus Vistesen and I would argue - naturally - that the apparent resilience of the French consumer (how can I keep my head, when all around me are losing their's) has someting to do with France's comparatively favourable demographics. But perhaps others who do not share this view would also like to offer some sort of explanation - for reasons of intellectual self-respect if for no other reason.

Basically I find it hard to see - if I follow the standard explanations - how it is that an economy that everyone has spent the last five years or so trashing - for its labour market inefficiencies, its profligate government spending and its high level of state intervention - turns out to be doing just fine (or nearly so), while all around are starting to visibly wilt.

Obviously there is more to this story than simple demographics. The French banking system didn't invent its own version of the Spanish "cedulas hipotecarias", and wasn't offering such a huge percentage of variable mortgages, and wasn't offering so many 100% (or 110%) Loan to Value mortgages. That is the French banking system seems to have been more (or better) regulated (and that used to be a dirty word), and as a result isn't facing any imminent danger of fiancial meltdown since - desite having the same nominal interest rate as Spain - French householders were not sent of on a "buy one, and buy a second what while you're at it" housing spree of anything like the proportions which we have seen in Spain and Ireland. But again most commentators don't even seem to be even picking up on this part.

The roots of this recent renaissance of the French economy in economics discourse in fact go back to the autumn of last year, when the Financial Times ran a rather interesting story (see my original blog post here) which pointed out that:

"The size of the British economy has slipped below that of France for the first time since 1999 thanks to the slide in the value of the pound. Sterling’s rapid fall to 11-year lows against European currencies has also pushed Britain into sixth place in the world. The US, Japan, Germany, China and France all had larger economies than the UK in the third quarter of 2007."

Basically the facts behind the story are that in 2006 French GDP was worth €1,792bn compared with £1,304bn for the UK. With sterling worth €1.47 on average in 2006, this put the UK economy comfortably 6.7 per cent ahead of the French one. But with sterling on the slide - it has fallen by more than 10 per cent against the euro in the past six months (to the current €1.32 to the pound), the UK economy entering 2008 is now 4 per cent smaller than France's.

And again there is a bigger picture story behind the headlines here, one that has to do with the fact (as Claus Vistesen tried to sketch out here) that France, far from being the "sick man of Europe" in economic terms, and as a result of some very important underlying macroeconomic structural features, is now enjoying a new lease of life.

This view must surprise some people, since it is obviously a long way away from a lot of conventional wisdom which is being written on the matter. Basically, if you follow the institutional reforms discourse, then the UK should be streaking ahead of France following the latters failure to grasp the nettle and "reform" itself (something, please note, that the present author considers highly desireable in and of itself). But such reforms only focus on micro level phenomena, and do not take into account certain key macro economic trends, and in particular they seem almost never to take into account important macro level phenomena like comparative demographic shifts. What this means quite simply is that something here isn't being measured as it should be, and the outcome is bad results and bad forecasts.

This use of bad arguments (or at best partial ones) also makes it very difficult to persuade some people - in this case French voters - to do something that they are evidently very reluctant to do, and that is support the reform process. When your key argument is flawed, and you can't point to the benefits you would like to point to (even if in fact many of the reforms being proposed are quite necessary, especially in terms of the long term sustainability of the health and pensions systems). This peculiar situation was also recently highlighted by the move of those eternal "bette noires" of the international financial institutions - Argentina and Thailand - when they complained only last year to the world bank that since the normal "competitiveness" indexes were giving them very bad ratings, while at the same time their economies were putting in strong performances, then there must be something wrong with the indexes. I imagine they are still waiting for a coherent reply.

Basically the whole "institutional reforms" story is wrong, not because such micro level competitiveness-oriented reforms are unnecessary (they normally are), but because they are only part of the picture, and thus offer a very misleading perspective. A classic example of what I am talking about was also offered by the Financial Times's recommendations to Spain on how to solve the economic mess which the Spanish economy is now headed towards (incidentally, I would point out here that I have nothing against the Financial Times, and I am simply quoting their correspondents since they form part of what I consider to be a much more general problem..

Spain has been content to enjoy the benefits of cheap credit and strong European demand for its goods and services. Unlike France, it has not embarked on the structural reforms needed for longer lasting prosperity.

Mr Zapatero pretends these are not needed. But, if re-elected, he should rethink. Generous tax cuts should be avoided in order to maintain a mildly restrictive fiscal stance. Measures to foster competitiveness are essential. These should include dismantling barriers to competition in retailing, transport and energy. He should ditch a preference for national champions.

Persistent weakness in productivity growth must be addressed too. Recent steps to expand Spain’s small technology base, promote entrepreneurship and bolster its ossified education system are positive. But universities need more independence. Allowing companies to opt out of collective wage deals would make the labour market more flexible. This is far from a comprehensive manifesto. But it is the least Spain must do if it is to remain one of Europe’s pacesetters

Now I think we could pass quietly over the little detail that France is now being cited as a country which is benefiting from structural reform. What is notable about the kind of "rescue package" being proposed for Spain is that it is largely ignores the substantial underlying macro economic questions which are in play - like the health of the banking system, some evaluation of the impact of "financial efficiencies", interest rate policy at the ECB, the value of the euro, the presence of five million immigrants (who have largely arrived over the last 6 or 7 years at just the same time as the current account deficit - which the FT does mention -has balooned), the role of the eurosystem and covered bonds in making cheap interest loans available at what were effectively negative real interest rates, etc, etc, etc.

Evidentaly non of this is directly Mr Zapatero's fault, any more than it was Mr Aznar's fault. This is not the moment to attempt a fuller analysis of Spain's current problems - you can find a first attempt at getting to grips with these here. Rather my objective is to point out that basing yourself on micro economic analysis alone you will never get to the heart of major economic issues which face us. And this is what the current mainstream economic discourse seems to do, spilling in the process an excessive amount of ink about shop opening hours, flexible labour contracts, and privatisation of "national champions" (all of which, please note, may well be a good idea, but I can tell you now, none of these are going to get Spain out of the problem which is about to arrive, nor, for that matter, will they prevent the inflation bonfire from currently roaring away in Eastern Europe which I was drawing attention to in my Slovakia post yesterday).

Tuesday, April 22, 2008

Slovakia's Euro Membership Bid

by Edward Hugh: Barcelona

Slovakia has recently taken some important "baby steps" on its path towards future euro membership. In particular the government in Bratislava has now officially asked the European Central Bank and European Commission to assess whether or not it is now ready to adopt the currency on 1 January 2009.

The response of the European Commission to the application will likely be made known on 7th May (with the European Parliament taking a decision shortly after in the event of a favourable decision).

On the surface it is easy to get the impression that what is now involved is a mere formality, with the ECB and the EU Commission coming under considerable political pressure to say yes after their recent cold-shouldering of Latvia and Lithuania, and given all the economic problems now being encountered in Hungary following the application of the Lisbon agenda inspired "austerity programme" isn't someone somewhere badly in need of some sort of success story to inspire the others? This indeed is how most analysts and much of the popular economic press are treating the situation - almost as if what we were now looking at was already some sort of "done deal".

Slovakia has applied to join the eurozone next January, dismissing the concerns of some European central bankers and economists that its economy is not ready for the rigours of membership. If the application at the weekend is successful, Slovakia will become the sixteenth of the European Union’s 27 countries to adopt the euro. It will also be the second former communist country to do so, following Slovenia, which joined last year.
Financial Times
But are we? In recent days doubts have begun to surface. The most recent example perhaps took place last week when Pervenche Beres, chairwoman of the European Parliament's committee for Economic and Monetary affairs, who was leading a "fact finding" delegation to Bratislava rather noticeably dropped-into her on the record press remarks the emphatic observation that the debate about Slovakia's euro membership has now moved on from whether or not the country's economy met the formal euro inflation criteria to the issue of the "sustainability" of Slovakia's current inflation rate. That is to say the EU institutional structure is likely to look well beyond whether or not Slovakia's inflation level as registered during the 12 months to April 2008 meets a set of rather formal criteria to the much more thorn-ridden issue of what might subsequently happen to the inflation rate if Slovakia is given the "go ahead" on May 7.

That Commissioner Beres point was not simply incidental was underlined by the fact that the very same point was re-iterated by the Economy and Finance Commission representative during questions at last week's press briefing on the EU's March inflation numbers. Indeed, despite the fact that Slovakia has for some time now been within the Maastricht inflation criteria, the EU Commission has repeatedly expressed concerns over the sustainability of the current state of affairs, and in doing this not furthest from their minds will be the rate of inflation which is currently to be found in neighbouring Slovenia (Slovenia it will be remembered was admitted to the eurozone in January 2007). In March 2008 Slovenia's annual inflation rate was running at 6.6% - the highest in the eurozone - and rising. Indeed Slovenia's inflation rate has now more than doubled in the year and a quarter since she adopted the euro.

Thus - and quoting Pervenche Beres - the discussion has now moved on from the nominal compliance with the Maastricht criteria - to issues associated with the ongoing sustainability of Slovakia's present economic path, and these concerns about sustainability - taking their cue from what has happened in Slovenia - take us into a much larger arena, one which goes to the very heart of this problems of applicability for a one size fits all monetary policy to economies having the sort of structural characteristics which are currently being exhibited by the Eastern European EU accession members. Surely it is not mere accident, or so the argument goes, that inflation in Latvia is currently running at 16%, in Bulgaria at 13.2% , in Lithuania at 11.4%, in Estonia at 11.2%, in Romania at 8.7%, and in Hungary at 6.7%. Even in Poland and the Czech Republic - the two economies which (not entirely coincidentally) have historically allowed their currencies to float freely against the euro - inflation is raunning at 7.1% and 4.4% respectively and rising (and this despite very sizeable upward movements in both their currencies).

Economic memories may be short, but they are not that short, and most of the policy makers responsible for the current decision will remember only too well that a Slovenia which not so long ago appeared to meet the euro yardstick without difficulty, now faces a preoccupyingly high inflation level, a level which only feeds concerns that the absence of "homegrown" monetary policy may make it impossible to target emerging asset price bubbles (and there is an increasing consensus among central bankers about the need to at least try and do this) in a way which means that one East European economy after another (where they to follow an early euro adopion course) could be sent off down the boom bust path recently followed by Spain and Ireland. In economics, as in other areas, you live and learn.

And that's why EU institutions at various levels are now busily investigating whether a similar situation could also emerge in Slovakia. If the experts from the ECB and EU commission came to a conclusion that what just happened in Spain and Ireland could also happen in Slovakia, then the country will most likely not get the invitation to join the euro zone.

Due Process

The main document that will offer us the European Commission’s current view of Slovakia’s preparedness for Euro adoption will be the Convergence Report, due out on May 7. On the basis of this report, the EC will either propose Slovakia’s membership of the Eurozone or remain silent. Should the Commission recommend membership – and such a decision requires there be a consensus on desireability among all 27 Commissioners – Slovakia’s bid would then need to be approved i) by the European Council, ii) by the European Parliament, and iii) by ECOFIN on July 3. This latter body is the council of EU Finance Ministers, should the application move forward - it is at the ECOFIN meeting that will the final conversion rate for the Slovak Koruna will be decided.

However, as I am indicating, evidence is now accumulating that Slovakia's application - at least for this year - may well not get past the initial Convergence Report hurdle. The most recent piece of evidence suggesting this outcome was offered by a report in Bloomberg this weekend about the existence of a draft version of the ECB document which will accompany the Convergence Report - a document of which Bloomberg reporters seem to have had sight. According to the Bloomberg story (citing two people described as "familiar" with the document)the draft expresses "serious concern" about the outlook for Slovak inflation. The draft, which is effectively a progress report on Slovakia was circulated earlier this month to EU central banks for comments before the final version is approved by the ECB General Council. When approached by Bloomberg ECB spokesman Wiktor Krzyzanowski declined to comment on the content of the draft report, but implicitly accepting its existence. All I can do, he said, is "confirm that we are in the process of preparing a convergence report for all countries with derogations".

The next piece of evidence we will have of EU Commission and ECB thinking on Slovakia's application is likely to come on April 28, when the EC publishes its latest forecasts for all the EU economies - including the Slovakian one. This forecast should help to shed light on many of the key issues surrounding Slovakia’s bid, and in particular the sustainability of low inflation, since the Commission itself will need to offer its own inflation forecast.

Lying at the heart of the present debate is the recent trajectory of Slovakia's EU harmonized inflation rate, which is the index the EU uses to assess euro requirements. Inflation on this measure rose for a seventh consecutive month in March to 3.6 percent, a 15 month high. As can be seen from the chart below, and if you look at the recent trend inflation line, everything now hangs on what you expact to happen next.

Formally, to adopt the euro, applicants must have 12-month average inflation within 1.5 percentage points of the average of the three EU countries with the slowest price growth. The EU target in March was 3.2 percent and Slovakia's 12-month average rate was 2.2 percent, well inside the limit. Slovakia also already meets the other principal euro-adoption requirements including those relating to the size of the budget deficit and level of accumulated government debt.

Consumer-price growth in Slovakia has accelerated from a record low of 1.2 percent achieved last August. The central bank on January 29 forecast a rate of 2.8 percent for the end of 2008 and 2.9 percent for a year later. Coincidentally the Slovak central bank is due to release new forecasts on April 29. I say coincidentally, since with the Commission publishing separate forecasts the day before, in the event that the two forecasts differ the debate is going to be well served.

And in fact differences are already apparent, since while thinking at the Commission and the ECB inclines towards the idea that the rising inflation in Slovakia is a result of demand pressures, the Slovak central bank does not agree, and argues that structural supply side factors like oil and food prices are to blame. Of course, both demand pull and supply push elements are at work, the real issue is in what proportions. Putting his cards straight down on the table is Slovak central bank governor Ivan Sramko, who recently stated that the risks to the forcecast mentioned in the Bank's inflation report are "well known", but not demand driven. He accepted that the Slovak central bank and the EU commission have differing views on whether the current pace of economic growth in Slovakia is inflationary and as well as on the extent of the koruna strengthening effect on inflation.

"Our view is not quite the same as the commission's" he said "We think that the effect of koruna's strengthening isn't as big as presented." ..... the pickup in inflation isn't driven by domestic demand and the economy "isn't overheating".

GDP Growth Surge

One of the reasons for the Commission's unease is the sudden growth spurt that took place in Slovakia at the end of 2007, with the economy expanding by a record 14.3 percent in the fourth quarter, the fastest pace anywhere in the European Union. This was higher than the preliminary estimate of 14.1 percent reported by the Slovak Statistical Office on February 14, and compares with a 9.4 percent annual rate in the third quarter.

Part of the reason for the acceleration was that cigarette producers stockpiled products to avoid a January increase in a tobacco excise tax - according to the Bratislava-based office - but still, if this was the only factor it would mean one hell of a lot of cigarettes going into inventories. Not that the economy hasn't been expanding rapidly in recent times, and in fact it expanded by expanded by 10.4% in 2007, but this suden surge has all the hallmarks of an "overheating burst", and in particular when it is lined up against rising retail sales and falling unemployment.

Retail Sales

Another circumstantial piece of evidence for the overheating hypothesis comes from the retail sales data. Slovakia's retail sales grew at a record annual rate 16.6 percent in February as wages rose steadily.

Sales picked up from a 15.6 percent annual rate in the previous January. At the same time average industrial wages increased by 5.6 percent in February, the fastest in a year, and up from a 4.1 annual rate in January.

One indicator of this newly unleashed consumer purchasing power can be found in the fact that Slovak new-car sales rose 15 percent in February from a year earlier, according to the Slovak Car Industry Association said. Dealers sold 7,375 new passenger cars and light trucks in February, up from 6,421 a year earlier accoring to the association. They also reported that in the first two months of 2008 14,237 new vehicles were registered in Slovakia, up 27 percent from the same period last year.

Employment and Unemployment

Further evidence for the idea that the Slovak economy may be running above its capacity level can be found in the relations between levels of job creation and unemployment, since the unemployment rate fell to a record low of 7.6 percent in March (down from 7.8 percent in February). The number of unemployed available for work in the country (which has a population of around 5.4 million) was down to 198,011 from 204,574 in February.

Thus the unemployment rate has been halved over the past four years as foreign investors such as carmaker set up factories, creating new jobs and driving economic growth. But the decline in unemployment has raised concerns that grwoing labor shortages may begin to push up awages and inflation and hold back economic growth in ways which we are now becoming accustomed to all across Central and Eastern Europe. In fact the numbers of unemployed dropped by 33,000 (or 14%) between March 2007 and March 2008, and with Slovakia's low fertility background meaning that less and less young people arrive on the labour market looking for work questions arise about the sustainability of this process.

If we look at employment growth, this has also been rising steadily, with total employment up about 10% (or 200,000 - from 2.17 million to 2.4 million) between the start of 2005 and the end of 2007.

There is, however, considerable evidence that Slovakia - and some other CEE countries - have a kind of dual economy, with some export oriented sectors receiving strong FDI flows and achieving high productivity and employment growth, while others remain almost stagnant in total employment and productivity growth terms. For example, the production of transport equipment was up by 42% in November 2007 when compared with January 2007, machinery and equipment by 26% and electrical and optical equipment 37%. Meantime output growth in the resource sector and in labour-intensive industries was virtually unchanged – textiles were up by 1%, leather declined 4% and the wood industry by 2%. Moreover, the stronger industries – machinery and equipment and electrical and optical equipment – have tripled their output since 2000.

One good example here are Slovakia's new carmakers, who currently expect to produce some 675,000 vehicles in 2008, up from 572,586 in 2007, and 295,373 in 2006, according to representatives of Volkswagen Slovakia, the Slovak units of Kia Motors and PSA Peugeot Citroen in a joint statement during the AutoSlovakia08 conference held recently in Bratislava. The companies have all recently set up plants in Slovakia for a variety of reasons, including the fact that wages in the country are generally lower than in western Europe and that the strategic location in central Europe makes it easy to deliver cars throughout the continent. Although wages have risen, these increases are still not enough to deter the companies involved. But clearly this can change if the increases continue.

There have been consistent warnings about the growing labor shortages which are accumulating - especially among the relatively more scarce younger workers - and this may start to create a problem for other investors, including the auto-parts companies that are intending to follow the carmakers.

Slovakia's unemployment rate was at 8.1 percent in January 2008, compared with 14.47percent in May 2004, when Slovakia joined the European Union. The average monthly gross wage has risen 39 percent during the same period and now stands at 22,224 koruna ($1,010). The Slovak Economy Ministry expects the number of people employed in the car industry to reach 100,000 in 2010 from some 67,000 in 2007.

Indications that foreign companies now arriving in Slovakia are having difficulty finding employees are now widespread, and local newspaper Hospodarske Noviny daily recently ran a feature story on the issue where the general tenor was a steady flow of complaints that those who could and wanted to work are no longer available, while those who are available are mainly long-term unemployed (50% of the unemployed have now been unemployed for more than a year) with little education. While the situation seems to have been quite different only a year or so ago, companies now increasingly feel have little choice, and are obliged to employ workers who haven't even completed a basic education.

Labour-market experts say that while attention was paid to attracting new investors to less developed areas, hardly anyone bothered to research the local education structure. At the same time, the low salaries on offer are dissuading some people from taking simple manual jobs, while those who do accept are often forced to work overtime and weekends simply so that their companies can meet deadlines.

One of the aggravating factors here has obviously been out migration, although the Poles and citizens from the Baltics have evidently attracted a lot more media attention than the Slovaks. The vast majority of the 765,630 East Eupean migrants working in the UK in 1976 were Poles (505,300 Poles), but these were then followed in importance by 77,000 each from Lithuania and Slovakia. Much smaller numbers in fact came from the Czech Republic, Hungary, Latvia, Estonia and Slovenia. Even in the neighbouring Czech Republic the largest group of foreign migrants with rights to work comes from Slovakia, and at the end of last year 101,233 Slovakians were legally working in there. However even the Czechs are now noticing that labour supply in Slovakia is no longer what it was, since their badly understaffed health service can no longer rely on nurses recruited in Slovakia.

But looking a little beyond the immediate problems caused by out-migration, at the end of the day the reason that Slovakia can't grow for any great length of time at 6 or 7% without sending inflation spiralling up out of control is the age structure of its population, and this age structure is a product of long term below replacement fertility, and a substantial decrease in the annual number of births which produces much smaller "entry level" cohorts and means that the labour market "supply side" component is very tightly restricted. Annual births in Slovakia reached an all time high of around 100,000 a year in the late 1970s. By the late 1980s the number had dropped to around 80,000, and reached a low of around 50,000 in 2000 (or a 50% fall from the peak) where they have stubbornly more or less remained ever since.

This decline in births is reflected in a decline in the total fertility rate, which fell to an all time low of 1.2 TFR (or roughly half population) rate in 2004 before "rebounding" slightly to 1.25 in 2006.

Fiscal Deficit

One of the other criteria for euro membership relates to the fiscal deficit, and the size of the accumulated government debt to GDP ration. On the former count Slovakia has no worries at all, since Slovak government debt was well below the stipulated 60% of GDP level, at 30.7% in 2006 and falling. On the annual fiscal deficit side the situation is rather more complex, since the country has often run what would be considered "excess deficits" (ie over 3% of GDP) in the past, and indeed the EU Commission did open an excess deficits procedure against Slovakia, although in 2007 the deficit was down to 2.2 percent of GDP, 0.7 percentage point less than the original 2.9% target.

Evidently a number of issues raise themselves at this point. The first of these would be the sustainability question. It is one thing to run a deficit below the 3% during the candidate year for euro membership, and quite another thing to hold it there, as we have already seen in a number of rather infamous cases.

Slovakia's government revised has in fact recently revised its budget-deficit targets for 2008 and 2009 to meet EU Commission demands for further spending cuts and the original 2008 deficit target of 2.3 percent of gross domestic product has now been cut to 2 percent of GDP. The 2009 target has also been trimmed to 1.7 percent of GDP from an earlier 1.8%. As I say Slovakia in fact has been subject to the EC’s Excessive Deficit Procedure since 2004, and needs to have this procedure withdrawn before the EC can recommend it for Eurozone membership. This withdrawal seems very likely, but will only be confirmed after the forecasts are published on April 27th.

But there is an additional issue here, and that concerns the possibility that the Slovak economy may be overheating. Given that the Slovak central bank if gradually reducing control over monetary policy, with its key policy rate being now held at only 0.25% over the ECBs refi rate, and the koruna exchange rate being increasingly alinged with the central parity rate being set for euro membership, fiscal policy is basically the only demand management tool which is open to the Slovak authorities, and the European Union has consistently urged Slovakia to cut the shortfall more as the economy has grown at a faster and faster pace. Basically the EU Commission hold that the Slovak government should use tighter fiscal policy to counter inflation pressures, which are set to rise when price growth will no longer be tamed by a strengthening currency. My own personal feeling is that if the Commission and the ECB want a "get-out clause" for postponing Slovak membership this issue will give them the lever they need, since at the present time Slovak still targets a deficit of 0.8% of GDP in 2010 and is only contemplating achieving balance by 2011. Given what happend to GDP growth in Q4 2007, and the present spurt in inflation, there seems little justification for this position.

The Koruna

An additional problem which is likely to influence EU Commission thinking on Slovakia's application is the timing of any possible revaluation of the Koruna, since the Commission feel that a further revaluation of the Crown would complicate the assessment of whether the exchange rate has been stable enough to qualify for Euro adoption, or whether in fact the exchange rate regime was closer to what might best be described as a crawling peg one. This is really the principal reason that the National Bank of Slovakia has been marking time on what virtually all participants now consider to be a virtually inevitable future revaluation. On the other hand this issue is hardly likely in and of itself be a major obstacle to entry - although it could be added to the list of excuses for saying no if Damocles sword does, at the end of the day, fall to that side - since the exchange rate criterion is itself seen as rather obsolete given that it was shaped in the aftermath of a spate of devaluations in the late 1980s and early 1990s and is not really relevant as envisioned to the present circumstances of the catch-up growth countries.

However the koruna issue is relevant to the whole overheating debate, since the disinflation process which occurred in Slovakia during 2007 reflects both currency appreciation and slower price deregulation compared with the previous period. The impact of the exchange rate on inflation is measured by using the exchange rate pass-through coefficient, and it is just here that another thorny issue raises its head since the Slovak Ministry of Finance of Slovakia argues that the coefficient is close to 0.1 (a 10% appreciation reduces inflation by 1 percentage point) while the National Bank of Slovakia (NBS) sees the coefficient as lying somewhere between 0.1 and 0.2. The European Commission view on pass-through coefficient seem to be closer to the NBS estimate. What this effectively means is that the Commission take the view that Slovak inflation has been more restrained by currency appreciation than the government are willing to admit (and hence the underlying inflation rate which would be encountered once the currency can no longer rise after fushion with the euro is accordingly higher). Thus the Commission see the pass-through coefficient as yet more evidence for ongoing overheating, and the justification for the immediate application of a budget surplus as even stronger.

Under the assumption that Slovakia's membership is finally accepted (an eventuality that, as I write this article, seems to me to be getting less and less likely by the paragraph) then the consensus seems to be that there is a reasonable chance of a final revaluation of the central parity (currently 35.4424) to between 32.5 and 33.5 before July, in order to ensure that the conversion rate doesn’t represent devaluation from market levels - and indeed Finance Minister Jan Pociatek said on April 5 he "cannot rule out" revaluation. Any such de-facto “devaluation” associated with EMU convergence (ie if the koruna were not to be revalued, and remained at the current - below market value - central parity) would obviously become a further inflationary factor in 2008 and 2009, simply because the Koruna had been trading around 33.6 to the euro (5.2% higher than the current central parity) since March last year, and in recent weeks it has risen even higher, up towards the 32.30 - 32.40 range.

( Explanatory note: under criteria Slovakia must meet before it can adopt the euro, the koruna is allowed to trade 15 percent above or below the pegged value. This target is one of the five conditions for aspiring members of the euro region must comply with in order to test the stability of their exchange rates for at least a two-year period. There is no formal requirement that the conversion rate should coincide with the peg but it should be near the equilibrium value of the exchange rate to prevent tensions.

The koruna has gained 2.8 percent in the past year, and this has fuelled the speculation that the government will revise the planned conversion rate for the second time in 10 months. Slovakia last raised the central parity rate by 8.5 percent to its current level of 35.442 per euro in March 2007, from 38.455.)

So Will She Won't She?

This I suppose is the bottom line here. I think at the end of the day this decision is a very close one to call, and certainly much closer than most analysts are currently suggesting. My feeling is that the door may well not be opened to Slovakia this spring, and the clinching factor for me would not be the March inflation number, but rather the Q4 2007 GDP growth one and the recent trajectory of wages and retail sales in the early months of this year. In addition the apparent intransigence of the Slovak government on the need to run a budget surplus in an attempt to drain liquidity from the system would worry me, in the light of what might happen in the future. One year out of an excess deficit procedure really wouldn't be sufficient proof of intent from where I am sitting, even if you could argue that this is to make poor Slovakia pay the broken plates occasioned by the earlier behaviour of some larger, and arguably economically more important, existing members. So I would argue that prudence here urges caution, and caution suggests not saying yes, or at least not saying yes right now. But then I am not the one taking decisions, and have no special insight into how their thinking might work at this point.

But if they do say no, then this does leave us with all sorts of very awkward questions about just where the decision will leave those who are still sitting it out in the waiting room. Clearly some East European economies are now hanging on a very narrow thread, a thread which spans the chasm which lies between having a nice orderly slowdown and having a very disorderly "hard landing". It is hard not to imagine that the decision on Slovakia's membership won't have some bearing on which of the possible outcomes we may see here. We might also spare a moment to think that this whole situation may well never have arisen if euro membership hadn't been insisted on by the EU as a membership condition for these countries, but having taken the trouble to have the thought we might then go on to think that equally there is no point in closing the farm door once the horse has bolted. But what we might also like to ask ourselves while we are at it is what exactly the risks are going to be if we do decide to close the farm door even before all the horses wanting to enter the barn are snugly tucked-up inside.


Well since writing this post Bloomberg have come in with yet another "scoop" here, since they have gotten their hands on a copy of a research paper prepared by the IMF for the Slovak government. In the paper the IMF apparently evaluate the exchange rate pass-through coefficient as lying in the 0.2 to 0.25 range (meaning that a 10% appreciation in the currency reduces inflation by 2 to 2.5 percentage points). Bloomberg interpret this as meaning that the IMF is siding with the Slovak government, but this is far too simplistic a way of looking at things. As I note in the post, the Slovak government hold the pass-through coefficient to be near to 0.1(meaning a 10% rise in the currency shaves only 1% off inflation), while the EU Commission and the National Bank of Slovakia hold this coefficient to be nearer to 0.2 (or at least in the 0.1 to 0.2 range). The IMF estimate - which may well be the most accurate one - seems to be even higher, but as such is nearer to the EC and NBS estimate than it is to the Slovak government one.

The point the IMF are probably making - but that the Bloomberg correspondent possibly doesn't understand, and I myself cannot be sure without seeing the report - is that since the koruna has only risen slightly over the last 12 months (about 2.8%, although it did rise around 10% in the year to March 2007, at which time Slovakia was allowed by the EU to raise the central parity of the koruna by 8.5% from the rate which was first set when Slovakia entered ERM-II in November 2005), then this rise cannot possibly carry the burden of explanation as to the earlier reduction in Slovakia's annual inflation - and in this sense the IMF seem to be saying that monetary policy and the reduction in the fiscal deficit must offer a much larger part of the explanation.

Slovakia's inflation rate fell to an all-time low of 1.2 percent in August, according to EU methodology, before global increases in food and energy prices pushed it back to 3.6 percent by March, a 15-month high. The drop in inflation in the 12-month period ending in August corresponded to a 12 percent strengthening of the koruna against the euro.

The IMF did however that Slovak inflation wasn't artificially manipulated by the regulation of utility prices - although I'm not sure that anyone has been suggesting it was.

``Regulated prices do not appear to have been artificially suppressed when benchmarked against unregulated prices of similar goods and services, against price levels and developments in the EU, and against underlying price pressures from commodity prices,'' the IMF said in the note

At the same time Slovak Prime Minister Robert Fico is out there and fighting:

Slovakia has met all the euro entry criteria and only a political decision by the European authorities could prevent it from joining the euro zone next year, Prime Minister Robert Fico said on Monday.

"In terms of the numbers Slovakia has met everything it was supposed to meet," Fico told a news conference. He said debate was still going on about inflation sustainability, but added Slovakia should not be disqualified as inflation is rising in all of Europe. "If somebody is thinking that Slovakia should not have the euro, it would have to be political consideration not an economic one," Fico also rejected arguments that inflation was kept artificially low by government pressure on energy prices.

Be all this as it may, the "revaluation" and "pass through" issue is - as I have been arguing - only a small part of the problem here, since in some senses this debate is now backward looking and what matters is the sustainability issue. The sustainability of Slovakia's fiscal deficit position (with ageing population issues looming) and the sustainability of the inflation rate as the labour market tightens and wages march onwards and upwards. I notice that with all the research going backward and forwards virtually no one is commissioning any research to get a NAIRU (non-inflationary natural unemployment rate)type triangulation on any of these economies at this point. The silence on this front is getting to be absolutely deafening. The whole situation would be laughable if it weren't so sad. I mean we are by and large talking about the wrong issues here (like currency revaluation) while in country after country (Ukraine and Russia too if you want to look) the inflation bonfire burns brighter and brighter on the back of structural problems on the labour supply side, problems which - to boot - have no simply and easy labour market reform "bandaid" fix.