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Tuesday, December 29, 2009

Hungary's Economic Correction Still Fails To Convince

by Edward Hugh: Camprodon

"Hungary’s potential economic growth should be 2 percentage points over the corresponding EU figure in order to ensure convergence".
Prime Minister Gordon Bajnai, speaking in London in October
Two contrasting pieces of news about Hungary's economic plight have caught my eye over the last week. In the first place, and in an evident sign of the times, retail sales reportedly fell at their fastest annual rate in over ten years in October, whilst secondly, and more surprisingly, I learnt that Hungary’s economic-sentiment index rose to its highest level since October last year, when the gale force wind sent by the fall of Lehman Brothers engulfed the country. How can this be, I thought? These two pieces of information would, at least on the surface, seem to be pretty contractictory, with the former suggesting the deepest recession in living memory is getting even worse, while the latter seems to add backing to government claims that the worst is now behind them.

Gloomy Days Ahead For Consumer Spending

Hungary’s retail sales dropped 0.6% month on month in October, just slightly more than they did in September (-0.5%). In fact Hungary’s retail sales have risen only twice in monthly terms over the past 12 months, and one of these months was June (+0.2%) when consumer anticipation of an impending 5% VAT hike drove large crowds into furniture and household electronics stores. Not unexpectedly this was followed by the July numbers, which saw the largest monthly drop in a decade (-2.3%).

But a glance at the chart below should also reveal that the decline in retail sales is now long term, and not just a product of the recent crisis. Sales peaked in mid 2006, and have since been falling steadily, and while the year-on-year drop was as large as 7.5% in October - another decade long negative record - in fact they are now down nearly 12% from the August 2006 peak, and there are no strong grounds for believing that this trend will now reverse. And the reasons are obvious, since in addition to shrinking personal income levels, and a tighter credit environment credit, Hungary's ageing and declining population is also increasingly acting as a damper on household consumption.

In fact the situation with vehicle and auto part sales (which are not included in Eurostat retail sales) is even worse than the above data indicate, since given that Hungary is in the midst of a fiscal crisis, there is no room for a cash for clunkers type programme, and sales volume fell an annual 40.1% in the ten months to October, with the decline in October alone being 50.5% (following a 52.3% annual drop in September).

And there is worse news to come for the car sector, since even though the government hiked both the excise tax on petrol and the rate of VAT to 25% from 20% in July, sending fuel prices up like never before, yet another excise tax increase is now on its way. The excise tax on fuel is set to go up as of 1 January 2010 driving the price of gasoline and diesel up by roughly HUF 11 and HUF 7 a litre, respectively. As VAT is levied also on the excise tax, the VAT burden will also increase even if the rate itself won't change.

Confidence Rises

On the other hand according to the GKI sentiment index, confidence is now back at its highest level since October last year, when the credit crisis engulfed the country. The rise follows widely publicised government forecasts that the economy is now heading out of its worst recession in 18 years. The GKI sentiment index rose to minus 25.4 in December from minus 27.5 in November and a record-low of minus 46.2 in April. Business confidence rose to minus 16.7 from minus 18.9 and consumer confidence increased to minus 50.1 from minus 51.9.

According to Finance Secretary of State Tamas Katona Hungary’s economic decline bottomed in the third quarter of 2009 and the rate of contraction should ease in the final three months of the year. Katona suggested the economy may shrink 5 percent in the fourth quarter after contracting 7.1 percent in July-September. The economy is likely to contract an annual 6.7 percent this year and 0.6 percent next year before a return to growth in 2011, according to government forecasts (the EU Commission forecast a 6.5% decline in 2009, and a 0.5% one in 2010, while the IMF are predicting a 6.7% drop this year followed by a 0.9% drop next year). In the short term therefore, all are agreed that the economy will keep contracting, even if the possibility of a quarter of positive growth (which would technically mean exiting recession as currently defined) is not excluded.

The real issue facing students of Hungarian economic growth is thus not 2009, but the extent of any rebound in 2010 and beyond. It is on this rebound, and the level of inflation associated with it, that the future Hungarian fiscal deficit numbers, and the even more critical debt to GDP numbers, sensitively depend. The EU Commission currently forecasts 3.1% growth in 2011, while the Hungarian Central Bank is forecasting 3.4% growth in 2011 (see chart below).

The question is, are these expectations for such a strong rebound in 2011 really realistic, and even more to the point, is there any evidence for Prime Minister Bajnai's claim that a large number of analysts share his governments view that Hungary’s long term GDP trend growth potential is around 4%. Or put another way is there evidence for support for such an optimistic view of Hungary's growth future beyond the limited circle of economists who promoted the reform manifestoes (like Oriens, CEMI etc) on which current government policy is based? Certainly I can say that this analyst doesn't share that view, and reading around I have difficulty identifying others who do. Even the reasonable and ever moderate Portfolio Hungary were moved to raise an eyebrow at this claim, saying they "read Bajnai’s statement with a measure of surprise, as GDP estimates for Hungary have been typically way below 4%". The most pessimistic forecast they had seen was below 2% (this would certainly be my view, possibly 1% trend growth would be realistic at this stage), and they stated they were unaware of any "serious estimates above the 3% mark".

What is so striking (and in my view so unrealistic) about the kind of rosy estimates which are being circulated (as illustrated in the Bank of Hungary forecast chart above), is that not only do the median estimates seem to assume a "V" shaped rebound, even the outer limit, worst case type scenarious are based on the idea of a fairly strong rebound, and almost no consideration is given to the possibility that this may not happen, and that the country may be stuck nearer to an "L" shaped non-rebound, where rates of contraction slow, and slow, but growth proves to be surprisingly elusive and hard to come by.

These issues are not new, and I have blogged about then before (in this post - Hungary's Trend Growth And Debt Sustainability - about the scenarios offered for debt repayment in a paper by Lajos Deli and Zsuzsa Mosolygó from the National Debt Agency). Despite protests to the contrary, and despite the IMF's argument that "In emerging market countries with debt overhangs, the “Keynesian” effect of fiscal adjustment is likely to be outweighed by “non-Keynesian” effects related to expectations and credibility" it is really all about growth, more growth, and only about growth.

Non-Keynesian effects have to do with the offsetting response of private saving to policy-related changes in public saving. In particular, if fiscal adjustment credibly signals improved public sector solvency, a fiscal contraction could turn out to be expansionary, as private consumption rises based on the view that future tax hikes will be smaller than previously envisaged.
IMF - Hungary, Request for Stand-By Arrangement, November 4, 2008
The simple issue is, if domestic demand is (for demographic reasons) not able to rebound as the IMF (and the signitaries of the very influential Oriens Report "Recovery, A Programme For Economic Revival In Hungary") imagine, then how is GDP growth going to be strong enough to reduce the weight of debt to GDP?

As everyone recognises, if domestic demand remains weak, growth will critically depend on exports, but the export potential of the economy will depend on the pace of recovery elswhere in the EU, and on relative prices as expressed through the value of the HUF, but almost no serious consideration is being given to the possibility that either the HUF is overvalued compared to the need to export or that EU growth may also be weaker and harder to come by than most median forecasts are assuming.

And indeed things are worse than they seem at first sight, since Hungary (and Hungarians) are, by and large, not in debt in their own currency, so allowing excess inflation does not sweat down the debt, since it only make export prices less competitive, unless you devalue to compensate, in which case the relative value of the debt is unchanged. But if you refuse to devalue, then, quite simply, you get hoisted on your own petard, which is basically where Hungary is right now.

So, the real question, as ever, is where the ingredients for growth are going to come from. Remember, Hungary's population is now declining steadily.

and ageing

and the working age population is also irredeemably falling.

As I said about the retail sales data above, these have now been falling since mid 2006, so it is hard to believe that we are going to see any significant resurgence (taking retail sales as a proxy for private consumer demand), especially as it seems Hungarian's are not now borrowing to anything like the extent they were two or three years ago (see below), and that (for age related reasons it is unlikely the earlier pattern will return. So I will correct myself: it isn't all only about growth, it is all about how to get the exports which can produce the growth. Anyone not recognising that is living, quite simply, in cloud cuckoo land, and after 40 odd years of Stalinist surrealism one would have thought that Hungarians in general had had enough of all this. But perhaps not. Look at the confidence index, and at how many people are prepared to accept Bajnai's assertion that Hungarian trend growth is 4% per annum.

Where Is The Growth Going To Come From?

"Looking at the structure of the Hungarian economy I frankly have difficulty seeing where the growth is going to come from. Without a major devaluation (and even then given international circumstances) Hungary will have problems attracting FDI in even the reduced quanities it has been doing over the last five years. The domestically owned private sector has enormous problems and is tied closely to the level of state spending. The financial sector and business services suffers from international problems and it isn't as if Hungary's largest bank - OTP - doesn't have some fairly serious problems of its own tied up in Ukraine, Bulgaria etc. Agriculture and food processing? Well, perhaps - but that isn't in that great a state either."

"It is worth pointing out that except for a brief period at the end of the 1990s when privatization receipts and above trend economic growth eased the situation Hungary has had a long term problem with its external debt going back to 1978 that it has never really escaped from. Successive Hungarian governments have prioritised the precise payment of the debt and have refused to seek rescheduling or restructuring on the grounds that this would damage business confidence. One can actually read the history of economic policy prior to 2000 as being about securing Hungary's public financing needs given this policy choice, to the detriment of the needs of the real economy. I read the relaxation of budgetary discipline after 2000 (and especially post-2002) as being about the interaction of mounting frustration at low living standards among the population with the dynamic of party competition."

"That having been said, if one looks at the long view it is difficult to believe seriously that Hungary's debt burden will ever be paid off. Given that servicing these debts will depress the level of economic growth, I think it really is time that the EU, IMF and the authorities in Budapest swallowed hard and accepted reality - a realistic debt consolidation/restructure that takes in both the public and private sector debt is a fundamental condition of stablizing the situation. This is what no-one wants to recognise."
Mark Pittaway, Senior Lecturer in European Studies, UK Open University

Hungary’s third-quarter GDP contracted by 7.1% year on year in the July-September period compared to the 7.5% fall in Q2 .Quarter on quarter the economy contracted by1.8%, the sixth quarter in a row that the economy has shown negative growth.

Quarter on quarter Hungary's export-driven economy shrank 1.8 percent following a revised 1.9 percent contraction in the second quarter. This was the sixth quarter in a row that GDP growth was negative. The rate of contraction is down considerably on the 2.6% rate of fall seen in the first quarter, but the velocity of contraction is still alarmingly high.

In fact domestic demand fell by 13.3% year on year in the third quarter (see chart below), so the fall in GDP would have been much larger if it had not been for the impact of net trade.

As can be seen in the above chart, since the last quarter of 2008 Hungary's net trade impact has been possitive, and imports have fallen dramatically faster than exports. And the effect continues, since the export-import gap rose again in October, to 9 percentage points from 5.9ppts in September, following the high of 13.5 ppts in July, by far the largest seen in recent years.

This impact is not, of course, based on a strong recovery in exports, but rather by the fact that imports fall even more than exports (on an annual basis). Basically, when there is a movement in the net trade balance caused by a drop in imports GDP falls more slowly (following a pattern we have already seen in Spain, Greece etc). In fact, for statistical reasons a fall in imports appears as an INCREASE in GDP because the net trade position improves. But unless this drop in imports is accompanied by a significant improvement in the competitiveness of domestic industry (and hence a trade surplus driven by exports) then all you have is economic stagnation and falling living standards, since, for example, house prices will continue to fall, and everyone will feel worse off. Unemployment will obviously also rise, as those involved in the retail sector selling the imports will lose their jobs. People working in the ports for domestic directed external trade trade ditto.

This is the whole argument for devaluation in these kind of circumstances (Greece, Spain, Latvia, Hungary etc), since the devaluation not only helps export industries, it also helps the domestic sector by making imports more expensive. Thus, if demand was there, then a fall in imports would be compensated by a rise in domestic supply, and your interpretation of the equation would not hold.

The whole problem, however, in the cases of the former current account deficit countries is that the internal demand is now longer there, since it was based on unsustainable borrowing in the first place, borrowing that appeared to be supported by rising property values or state guarantees (in the case of fiscal deficits) as collateral. The property prices are now falling, and the deficits are now being slashed back, and neither are going to rise back again anytime soon and therefore the kind of borrowing we saw before isn’t coming back again anytime soon. So the bottom line is there is a sharp fall in consumption, whatever the headline GDP number says.

In fact the causal mechanism is that the absence of capital inflows leads to a drop in consumption, which in turn means there are less imports. But my big point is that the accounting mechanism used to generate the GDP number (making Net Exports a positive input convention) masks to some extent the actual drop in living standards, since Net Exports was previously negative (and hence a drag on GDP), and the drop in domestic consumption and imports simply makes it less negative.

Of course, there are two ways to make imports less attractive, one is devaluation and the other is structural reform to make the domestic sector more competitive, and that is the Oriens/Bajnai approach, and there is little objection at all to much of what they propose, except that, as we are seeing in one country after another this procedure doesn't act quickly enough to undo the severe distortions that had been produced earlier, but then I doubt, from what they say, that the Oriens signitaries would accept that these distortions were as severe as I argue they are - just look, for example, at the drop in domestic consumtion - 13% - and this after three years of near economic stagnation. Hope against hope.

This having been said, exports, and the current account balance have been improving in recent months, although not by a long way fast enough to push the economy back up towards growth. Hungary posted another huge foreign trade surplus of EUR 471 million in October, according to the latest revised numbers released by the Central Statistics Office. October marks the ninth month in a row when Hungary posted a trade surplus in the EUR 320-550 million range.

Despite this significant improvement in the trade balance the Current Account only just managed to sneak into surplus in the second quarter, largely as a result of the very strong negative balance in the income account, which is a product of the very negative net investment position of the Hungarian economy (ie non Hungarians own a long more of Hungary than Hungarian's own of the rest of the world, and this creates a huge imbalance, and as Mark Pittaway says the bullet will have to be bitten - one way or another - about what to do about this at some point.

In October, exports dropped 11.8% year on year (on a euro basis), while imports plunged by 20.8% year on year.

This gradual improvement in Hungarian exports has also lead to a modest recovery in the industrial sector, mainly due to stimulus-programme-induced stronger demand in western Europe. Industrial output fell 15.6 percent in the third quarter, down from a fall of 20.5 percent in the previous three months, while recent data showed output grew month on month for the second time in a row in October.

Against this background, weak exports, and domestic demand in full retreat it is not surprising that investment has been falling, and dropped 6.8% year on year in the third quarter.

What these continuing declines in investment mean is that the level of investment is now at much lower levels than it once was - below the 2005 level according to the rough and ready index I prepared for the chart below.

Construction activity is also well down, and has been for some long time now, following the sharp drop between summer 2006 and summer 2007 on the back of the first austerity programme (see chart).

Government consumption is also contracting due to the pressure to reduce the fiscal deficit.

All in all, the third quarter GDP data indicate that Hungary's domestic economy is not showing any signs of recovery whatsoever, nor should we expect it to do so. The hike in VAT in July hurt private consumption while capital spending has been continually cut back given the failure of export demand to rebound as strongly as hoped. The need to maintain a restrictive fiscal policy stance will also indirectly weigh on consumer and corporate spending, with the consequence that in my view GDP will decrease by nearly 7% in 2009 and then by around 1.5% in 2010.

Monetary Policy Tangle

Hungary's central bank (NBH) last week cut its base rate by 25 basis points to 6.25%. The move which suprised the market participants (the consensus had been for a 50-bp reduction in surveys conducted by both Portfolio.hu and Reuters) now means the benchmark rate has been cut by 3.25% since July. Not everyone was surprised however, since in an interview on 10 December, Centrak Bank MPC member Péter Bihari had said it would be wise to calm rate cut expectations. "Any overshoot in (rate cut) expectations can backfire later. We (the central bank) need to stay sober, and we also need to communicate this sobriety outside," he said.

Although Hungary’s inflation outlook might have justified a 50-bp cut, the recent weakening in the forint (the HUF hit a 6-week low vs. the EUR last week) and the rise in the 5-yr CDS spread to a 3-month may well have signalled the need for a more cautious move, since following events in Dubai and Greece questions are rising about how long the relatively favourable global investor mood can last. Also, the imminence of elections, and the dangers of fiscal loosening (either before or after the election) urge prudence, especially in the light of what we have just seen in Greece.

The smaller than expected move also suggests that easing will be cautious in the first months of next year, and that the bank will be sensitive to any signs of worsening market conditions (especially ahead of next spring’s elections). Weaknesses in the real economy still argue for lower rates, and without moving towards closing down the interest rate gap forint loans will never become competitive with Euro or CHF ones"

Despite this afternoon’s decision by the National Bank of Hungary (NBH) to cut interest rates by a smaller than expected 25bps to 6.25%, there is a good case for further monetary easing over the coming months. We continue to think that the profile for interest rates priced into the market is too high."

"Both we and the consensus had expected a larger 50bps cut today, although the fact that one member of the Council voted for a smaller 25bp reduction in November did suggest that a slowdown in the pace of easing was possible. The forint gained 0.25% against the euro immediately after the decision."

"Nonetheless, while policymakers may now move in smaller steps than we had previously thought, the case for further monetary easing remains strong. The decision to cut by just 25bps today is likely to have been motivated in part by signs that output in some sectors (notably industry) has started to pick up. But while the prospects for some parts of the economy have undoubtedly improved in recent months, the overall pace of recovery will remain subdued."

"In particular, domestic demand will remain a significant drag on growth. A combination of a fragile banking sector, a high proportion of fx-denominated debt and the continued rise in non-performing loans, means that the overall availability of credit remains constrained."

"And although the bulk of the tightening measures have now been implemented, a public sector wage freeze, and private sector wage restraint needed to offset the recent sharp rise in unit labour costs, means that the pain will linger into 2010 and 2011."
Neil Shearing, Capital Economics

Inflation Overshoots Expectations In November

Hungary’s consumer prices rose 5.2% year on year in November, an acceleration from the previous month (4.7%). Month on month prices were up 0.3% . This was an upside surprise since analysts forecasts had been for a rise of 5.0%.

The main reason for the increase was an increase in the prices of unprocessed food (especially fruits and vegetables), energy and fuel. Disinflation is slowing in tradable goods, driven mainly by the durable goods sector (especially new and used vehicles and televisions), while market services disinflation came to a halt (most service prices increased except for tourism and books).

The impression is that the underlying disinflation process has started to slow and there are risks to the medium term inflation outlook. The seasonally adjusted core inflation has been stagnant at around 5% since July, while the CPI adjusted for tax changes started to accelerate in November (it moderated from 3.7% YoY in June to 0.9% in October and picked up to 1.4% in November).

Which means the NBH’s inflation forecast of 1.9% for 2011 may come under pressure. Inflation may well accelerate to 5.6% in December and peak at around 5.8% in January and can then fall to below 3% by the end of 2010. As Neil Shearing says "Despite the uptick in inflation to 5.2% in November (from 4.7% in October), we support the Central Bank’s view that it will "significantly undershoot" the 3±1% target when July’s VAT hike drops out of the annual comparison." Still maintaining this sort of price range with the present Forint value is simply going to prolong and prolong the economic downturn.

Employment Falling As Unemployment Rises

Unsurprisingly, against this background unemployment is rising and rising, hitting 9.9% of the labour force in October, according to Eurostat seasonally adjusted data.

Total employment has been on a downward trend since the middle of 2006.

But one of the impacts of the economic crisis has been that employment in the public sector, after falling under the austerity programme has risen sharply since the spring (due to a number of employment schemes designed to keep unemployment down, especially in the regions), and is now back up above its earlier level.

Real ex-bonus wages (the central banks targeted measure of wage inflation) has been in negative territory (by around 1%) since the summer.

Bank Credit Turning Negative

As is well known a very high proportion of mortgages in Hungary are non-forint denominated (over 85%, mainly in Swiss Francs), but the HUF value of these mortgages has been falling for over a year now.

As has the total value of outsanding mortgages in any currency.

Although the stock of mortgages had not been high by some West European standards (around 50% of GDP), they had been growing at a rate of around 20% per annum over the last several years (see chart) but the crisis brought this to an end, and the year on year increase was down to only 2% by October, and will more than likely be negative by the end of the year. Which means, credit expansion and new house construction will NOT be driving any coming Hungarian recovery.

In the current climate, with unemployment rising, and wages falling, and an economy contracting at nearly 7% a year, it isn't hard to understand why not that much new bank lending is going on. Those who are creditworthy are trying hard to save, while those who need to borrow normally aren't that creditworthy, so pleading to the banks to lend more is rather like asking them to subsidise new bad debts, and that is really not something you can do. What kicked the whole current process off in Hungary was a short sharp credit crunch, but now it is the contraction in the real economy which is following its own dynamic, till someone finds a way to put a stop to it. It is the drop in output that is preventing banks from lending, and not banks being unwilling to lend that is causing the contraction to continue.

Election Chaos Looming

Having seen the shennanikins which have recently taken place in Greece, it was obvious that the run in to the coming election was always going to be complicated, with accusation and counter-accusation being thrown from one party to another. The big problem is that neither party has exactly clean hands in this context, but one thing seems sure, that the 2010 budget is liable to slippage, whether because of the current ruling party moving invoices from 2009 to 2010 (on the assumption that they are going to lose the election, so what the hell), or because the incoming party is going to make promises which will lead to an overspend which they will then blame on their predecessors.

A group of economists close to opposition party Fidesz now claim next year’s budget "is full of tricks", including unrealistic macroeconomic assumptions that will lead to a deficit far larger than the cabinet’s projection. The current Finance Ministry Péter Oszkó played down the criticism as politicking ahead of the coming elections, and this may well be, but some of the points they make to not, for all that, lack validity.

The 29 economists, who promoted a 'no’ vote on the 2010 budget bill in November, include Zsigmond Járai (Finance Minister of the Fidesz government and former Governor of the central bank), Ákos Péter Bod (Ministry of the Industry in the MDF cabinet and former Governor of the NBH), György Szapáry (former Deputy Governor of the NBH, currently responsible for international relations in Fidesz), Tamás Mellár (head of the statistics office (KSH) during the Fidesz government) and Károly Szász (head of financial markets watchdog (PSZÁF) in the Fidesz era).

Zsigmond Járai argues that, on the one hand the 2010 budget is based on unrealistic macroeconomic assumptions - e.g. only a 0.6% economic contraction while GDP may well shrink by considerably more, possibly by as much as 1.5%, while on the other planned austerity measures, like reduced subsidies, will also worsen the balance. Among his list of "overestimation tricks" the former central bank head mentioned VAT and corporate tax revenues. The economists claim that the underestimation of the GDP contraction will result in something like HUF 200 bn less budget revenues, adding that another HUF 200 bn shortfall due to smaller-than-expected revenues from taxes and contributions.

The current official estimate for the general government deficit in 2010 is 3.8% of GDP, a target which is considered to be realistic by both the IMF and the European Commission. The Fidesz economists claim the gap - without supplementary bufget changes - could be as high as 7-8% of GDP. György Matolcsy, a leading Fidesz economic spokesman stressed that such a large deficit would be unacceptable for Fidesz as well, and made clear that they are not saying such a massive budget overrun should be tolerated.

Matolcsy said the 2010 budget included no reforms or system overhauls to jumpstart growth in the second half of 2010 as the cabinet expects, and that in his opinion a sustainable growth path is unlikely to be reached before 2013.

The document has not been slow to attract criticism, and apart from Finance Minister Ozskó, Lajos Bokros, Hungary’s former Finance Minister and PM candidate from the minor opposition party MDF, lashed out at the group saying their argument was "ridiculous".

In an interview with public television MTV, Bokros said that "the only alternative to sovereign default was to cut budget spending, take away welfare contributions, e.g. the 13th-month pension and 13th-month wage in the public sector that spun the economy into catastrophe and that led to (government) debt to surge sky high." "How do you create growth from these (measures)? Only via reforms," he stressed.

A large part of the issue seems to revolve around what to do with the bulging debts of quasi governmental institutions like hospitals, the state-owned railway company MÁV and the Budapest Transport Company (BKV) . Fidesz seems to assume that these debts will need to be swallowed. Bokros does not agree: "If a budget were about consolidating the debts of every (state-owned) companies automatically and without restraint the next year, it would be but a rejection of any reform," he said. "Reforming" according to Bokros means not covering the debt of "inefficiently operating public institutions", because these liabilities had probably been accumulated due to their profligacy."So, what do you have to do then? [You need to implement] reforms and a create a competitive situation that will have inferior companies go bust and good-quality institutions double in size."

While sympathising with Bokros in the spirit, it is not clear to me that things are going to be so easy as he imagines in the letter. One thing is however clear, he is right that if solutions are not found for these issues, especially in the problematic pensions and health sectors, Hungary will go bankrupt.

One thing is clear though, life is not going to be easy in post election Hungary. If Fidesz is voted back to power it will create a new budget, a new tax regime and a new labour policy for as early as July, according to György Matolcsy, and the new government should also sign a new Stand-By Arrangement with the IMF. Matolcsy reiterated that Fidesz has three scenarios for the tax system: one proposing a radical reduction of personal income tax with a flat family rate; another which would decrease rates on the entire spectrum of taxes; and a third which would cut social-security and health-insurance contributions for employers and employees alike. The only thing which doesn't seem clear is how he expects to pay for all these, especially since he doesn't anticipate a serious return to growth before 2013.

Matolcsy also claims that the budget deficit will be 3-4 percentage points higher than the targeted 3.8% of GDP, citing central bank staff projections in their Inflation Report that the gap is likely to be 4.3% of GDP. Fidesz expects the gap to come in at 4.5% and foresees that state-owned enterprises such as the railway company would need debt consolidation amounting to 3% of GDP. Matolcsy also pointed out that there may be other downside risks to next year’s budget beyond the 7.5% deficit he claims it already incorporates, including a larger-than-expected contraction in consumption, unemployment and a fall in lending to households that could lead to smaller tax revenues. All of these points are not without some validity. Further the ongoing drop in investment will continue to eat into tax revenues and lower-than-forecast inflation could decrease budget income next year, he added.

Fidesz The Likely Winners, But By How Much?

The gap between Hungary’s two main political parties has narrowed slightly of late, according to the latest opinion survey by Medián. While an increasing number of voters reported a lack of strong party affiliation, Fidesz has witnessed some decrease in its supporter base. Support for Fidesz within eligible voters has been gradually melting away in recent months, and is now down to 40% in December from 43% in November and 47% in July. The Hungarian Socialist Party meanwhile saw a only a minor and not statistically significant increase in support. But this change in percentage support is more due to an increase in undecided voters than anything else, since 66 per cent of respondents — all decided voters — would vote for Fidesz in the next legislative election, up one point since October.

The ruling Hungarian Socialist Party (MSZP) remains a distant second with only 19 per cent, followed by the Movement for a Better Hungary (Jobbik) with 10 per cent. Support is much lower for the Hungarian Democratic Forum (MDF), Politics Can Be Different (LMP), and the Alliance of Free Democrats (SZDSZ).

We should not forget that although Bajnai is portraying himself as being the head of a technocratic government, he is in reality the head of a government which is supported by MSZP. It is clear that the 2010 elections are lost. The game is already for 2014 elections. The government now have apparently stabilised the forint, slowed down the shrinking of the economy, and restored some kind of order and feeling of leadership. The price is high, but it seems that the population by and large accepted the situation as it is. The slight increase of popularity of MSZP and Bajnai himself may support this statement. Now, compromises have been made for a short time with major public service sector agents to accept the restrictions. But, somewhere around next August everyone will be up in arms for new financial support. The latest move of the government, to finally accept the long term and symbolic demand of FIDESZ to cut the VAT on the gas-price to 5% is already, I think, a mine for FIDESZ laid down to explode next year. All the messages of the members of the government are now portraying the government as a similar "responsible" stabilisation force as the 1995 Bokros package was, which would propel again Hungary into a "sustained" high growth as was experienced between 1997-2005 (of course now we all see better the price of this decade of growth). So what we are seeing here is a creation of a "new development" discourse, which it is expected will be destroyed by the "incompetence" etc of the Orban government. - Andras Toth, Sociologist

Huge Structural Reforms Gamble

Well, I think I have said more than enough already in this post, so I think I will leave your with the thoughts Gábor Egry (a Hungarian political scientist) expressed in an e-mail interview with me. Basically it seems to me that Gábor is right, the 4% growth target has no scientific basis behind it at all, and is just a hope that has been repeated so many time people now think it has become a reality. What is going on in Hungary now is a huge gamble, a leap into the dark almost, based on the idea that a shift in the tax structure, and a fiscal discipline to reassure would be investors can bring a growth surge, a growth surge which I argue is structurally impossible without doing something about the level fo the forint, the problem of the forex debt, and without getting domestic monetary policy firmly back in the hands of the NBH.

Gábor Egry - Research Fellow, Poltikatörténeti Intézet (Institute for Political

Maybe it is worth taking a look at the history of this idea of 4% trend growth. As far as I can recall it - apart from the constant remarks of politicians that Hungary needs a growth 2 points higher than the EU core states and this was somehow always expected to be 4% - both before and after the last elections a group of economists started putting forward ideas for the renewal of sustainable growth in Hungary and they elaborated a series of - let's put it this way - Slovak-type measures would very soon result in 4% trend growth. As the then government chose another type of policy mix for their budget consodilation, these critics never failed to emphasize that with this Slovak-type set of measures not only would the slow growth period after the budget (austerity, 2006) restrictions have been avoidable, but that these Slovak measures were the only possible way to elevate the trend growth to 4%. Usually it was the same guys coming with the same proposals, just branded differently. (CEMI, Oriens etc). Then, when in 2008 the Reform Aliiance was formed, they recycled these ideas. And even though the Bajnai government is an MSZP supported one at least initially it was the result of Gyurcsány's attempt to compell the party to accept the Reform Alliance program. From this persepctive Bajnai's statement is quite logical: they are implementing measures that were proposed by experts with the promise that they would lead to a 4% trend growth. Anyway, the idea that such measures will restore a higher and sutainable trend growth is deeply anchored in the Hungarian economist's thinking, and most of them - among others Bajnai, who was the loyal but critical supporter of these ideas in the Gyurcsány government - will adhere to it as it was the main component of their criticism of earlier policy and as such it is a core component of their common identity.

Beyond the historical anecdotes I see some serious faults and gaps in the reasoning behind the approach, especially as their reasoning is really causal, but rather based on the use of analogies. The main thrust of the approach is not simply to make production in Hungary wage-competitive by cutting the so called tax wedge, but also through making labor cheaper for local companies and attracting FDI, thus raising the employment rate. So, they work with both a direct causal relationship between tax rates and the employment rate and with an indirect one, but they then connect this second one causally to the tax rates again. I would argue, that such soft factors, as labour mobility have had at least as as important impact in the Hungarian case. According to Oriens, the FDI sector in Hungary is said to be overcapitalized, but I'm not sure whether this is because of the relatvely high labor costs or is a result of the immobility of the workforce. It is really important to observe how unemployment is geographically distributed in Hungary, and how this geographical distribution has not changed in the last two decades, despite efforts to change this situation with methods in principle similiar to the present ones, i.e. giving incentives indirectly through economic policy to market forces.

There really are areas where even near-starvation was not capable of moving people out of their villages and making them go look for employment elsewhere. I know that there are counter-examples in the sense that in huge areas a lot of people remained deliberately unemployed as they have found easier ways of making money in the grey or black economy, for example, near the Ukrainain border. Such people, instead of being moved by the modern dynamic of the market economy, resorted to - let's put it vaguely - pre-capitalist methods of work organization and resource redistribution. I don't really see how any kind of tax cuts will move them out from these places and as they have no significant taxable or taxed income it won't generate surplus demand for local companies either. Otherwise, I wouldn't neglect the fact that the fall of unemployment and the rise of employment in many Eastern countries coincided not only with lower taxes, but with EU accession, making it much easier for people to seek work in the West. And in fact millions did it. (For example at least 10% of the Slovak workforce worked abroad before the crisis.) But this is mobility is more or less lacking in Hungary, and Hungarians by and large never left for the West seeking work.

On the question of the deficit, it wouldn't surprise me if there was some accountancy massaging going on behind the scenes. The government may well have put a part of this years deficit on last year's one, raising that from 3,2 or 3,4% to 3,8 and they try to convince the state railways not to reclaim their VAT this year etc. Oszkó conveys self-assurance but he is paid for that. I wouldn't be surprised to find out at the end that this year deficit will be higher than forcast, but I don't see too much room for the IMF to protest, either.

They let Latvia raise its deficit a number of times, Romania is not only doing the same but may even finance the deficit (or in a more populist tone, this year's pensions) from IMF money and - at least as far as I can see - even accept political arguments regarding government incapability to implement unpoular measures before specific elections as arguments to support non compliance. Maybe Hungary will overshoot the deficit, but at least on the surface - in terms of measures implemeted - it is adhering to the terms. The government can simply tell them, ok, guys we did what you proposed, a slightly higher deficit was the result, accept it. Moreover, with the animal spirits currently prevailing around the world I really don't think the news of a 4,1% deficit will do any harm as long as markets are in love with recovery, while even a surplus can not prevent a collapse if their mood changes fundamentally...

Monday, December 28, 2009

Quantifying Eurozone Imbalances and the Internal Devaluation of Greece and Spain

By Claus Vistesen: Copenhagen

Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.

Churchill 1942


  • The extent, so far, of the internal devaluation process depends on the time period used for analysis. Using Q3-2007 as the beginning of the economic crisis suggest that Greece and Spain have not corrected relative to Germany as a benchmark. However, if we look entirely at the world in a post-Lehmann context the picture is different with Greece and Spain having observed excess deflation relative to Germany to the tune of -1.7% and -4.5% respectively for unit labour costs and -5.4% and -1.7% respectively for the PPI.
  • The correction observed in the context of unit labour costs appears technical as German unit labour costs have increased sharply since Q4-2008 due to a large reduction in working hours and an increase in short time work. In comparison, the relative correction in the PPI looks more solid.
  • The internal devaluation has not yet trickled down into the overall price level represented by the CPI. Both using the period Q3-07 to Q3-09 and Q4-08 to Q3-09 as the relevant time horizon reveals that there has been no meaningful internal devaluation in Greece and Spain measured on the CPI.
  • While the analysis presented here may go some way to quantify the intra-Eurozone imbalances and the course of the internal devaluation so far it is impossible to say precisely how far (and for how long) Greece and Spain (and indeed Latvia, Hungary etc) have to go here. More importantly, it is impossible to say exactly which measures that must be taken albeit that they have to be severe in the context of reigning in public spending and, ultimately, the public debt and ongoing deficit. Likewise, it is difficult to quantity just how high unemployment should drift and for how long it should stay there in order to grind down past excess.

As 2009 is fast approaching an end it is worth asking whether this also means an end to the financial and economic crisis. Even if 2009 will be a year thoroughly marked by a global recession it could still seem as if the worst is behind us. Most of the advanced world swung into positive growth rates in H02 2009, risky assets have rallied, volatility has declined to pre-crisis levels, and interest rates and fiscal stimulus have been adeptly deployed to avert catastrophe. However and precisely because the last part has been a crucial prerequisite for the first three and as policy makers are now adamant that emergency measures must be scaled back or abandoned either because of necessity or a balanced assessment, it appears as if Churchill's well known paraphrase is an adequate portrait of the situation at hand. In this way, what is really left in the way of global growth once we subtract the boost from fiscal and monetary stimuli and what is the underlying trend growth absent the crutches of extraordinary policy measures?

This question is likely to be a key theme for 2010.

Nowhere is this more relevant than in Greece and Spain who, together with Eastern Europe, have slowly but decisively taken center stage as focal points of the economic crisis. With this change of focus a whole new set of issues have emerged in the context of just how efficiently (or not) the institutional setup of the Eurozone and EU will transmit and indeed endure the crisis.

I won't go into detail on this here mainly because I would simply be playing second fiddle to what Edward has already said again (and again) in the context of his ongoing analysis of the Spanish and Greek economy to which I can subscribe without reservations. It will consequently suffice to reiterate two overall points in the context of Spain and Greece.

Firstly, the main source of these economies' difficulties, while certainly very much present in the here and now, essentially has its roots in population ageing and a period, too long, of below replacement fertility that has now put their respective economic models to the wall. It is interesting here to note that while it is intuitively easy to explain why economic growth and dynamism should decline as economies experience ongoing population ageing, it is through the interaction with public spending and debt that the issue becomes a real problem for the modern market economy. Contributions are plentiful here but Deckle (2002) on Japan and Börsh-Supan and Wilke (2004) on Germany are good examples of how simple forward extrapolation of public debt in light of unchanged social and institutional structures clearly indicate how something, at some point, has to give. Whether Spain and Greece have indeed reached an inflection point is difficult to say for certain. However, as Edward rightfully has pointed out, this situation is first and foremost about a broken economic model than merely a question of staging a correction on the back of a crisis.

Secondly and although it could seem as stating the obvious, Greece and Spain are members of the Eurozone and while this has certainly engendered positive economic (side)effects, it has also allowed them to build up massive external imbalances without no clear mechanism of correction. Thus, as the demographic situation has simply continued to deteriorate so have these two economies reached the end of the road. In this way, being a member of the EU and the Eurozone clearly means that you may expect to enjoy protection if faced with difficulty, but it also means that the measures needed to regain lost competitiveness and economic dynamism can be very tough. Specially and while no-one with but the faintest of economic intuition would disagree that the growth path taken by Greece and Spain during the past decade should have led to intense pressure on their domestic currencies, it is exactly this which the institutional setup of the Eurozone has prevented. I have long been critical of this exact mismatch between the potential to build internal imbalances and the inability to correct them, but we are beyond this discussion I think. Especially, we can safely assume that the economists roaming the corridors in Frankfurt and Brussels are not stupid and that they have known full well what kind of path Greece and Spain (and Italy) invariably were moving towards.

Essentially, what Greece and Spain now face (alongside Ireland, Hungary, Latvia etc) is an internal devaluation which has to serve as the only means of adjustment since, as is evidently clearly, the nominal exchange rate is bound by the gravitional laws of the Eurozone. Now, I am not making an argument about the virtues of devaluation versus a domestic structural correction since it will often be a combination of the two (i.e. as in Hungary). What I am trying to emphasize is simply two things; firstly, the danger of imposing internal devaluations in economies whose demographic structure resemble that of Greece and Spain and secondly, whether it can actually be done within the confines of the current political and economic setup in the Eurozone.

On the last question I personally adamant that it has to since failure would mean the end of the Eurozone as we know it but this is also why I am quite worried, and intrigued as an economist, on the first question. Specifically and as Edward and myself have been at pains to point out (and to test and verify) this medicine while certainly viable in theory has three principal problems. Firstly, it takes time and may thus amount to too little too late in the face of an immediate threat of economic collapse. Secondly, an ageing population spiralling into deflation may have great problems escaping its claws, and thirdly, because of the pains associated with the medicine the patient may be very reluctant to acccept the treatment. Especially, the last point is very important to note from a policy perspective and was made abundantly clear recently in the context of Latvia where The Constitutional Court ruled that the very reforms demanded in the context of the IMF program to reign in costs through cutting pensions would violate the Latvian constitution. And as Edward further points out, the situation is the same in Hungary where voters recently (and quite understandably one could say) decided to reject a set of health charges that were exactly proposed as part of a reform program designed to reign in public spending. We are about to see just how willing Spain and Greece are in the context of accepting the austerity measures that must come, but similar dynamics are not alltogther impossible.

Consequently, and while I agree with Edward as he turns his focus on the inadequacy of the political system in Spain and Greece to realize the severity of the mess; it remains an inbuilt feature of imposition of internal devaluations through sharp expenditure cuts that they are very difficult to sustain given the political dynamics. This is then a question of a careful calibration of the stick and carrot where the former especially in the initial phases of an internal devaluation process is wielded with great force.

Internal Devaluation, What is it All About Then?

If the technical aspects of an internal devaluation have so far escaped you it is actually quite simple Absent, a nominal exchange depreciation to help restore competitiveness the entire burden of adjustment must now fall on the real effective exchange rate and thus the domestic economy. The only way that this can happen is through price deflation and, going back to my point above, the only way this can meaningfully happen is through a sharp correction in public expenditure accompanied with painful reforms to dismantle or change some of the most expensive social security schemes. This is naturally all the more presicient and controversial as both Spain and Greece are stoking large budget deficits to help combat the very crisis from which they must now try to escape. Positive productivity shocks here à la Solow's mana that fall from the sky may indeed help , but in the middle of the worst crisis since the 1930s it is difficult to see where this should come from. Moreover, with a rapidly ageing population it becomes more difficult to foster such productivity shocks through what we could call "endogenous" growth (or so at least I would argue).

With this point in mind, let us look at some empirical evidence for the process of internal devaluation so far.

In order to establish some kind of reference point for analysis I am going to compare Greece and Spain with Germany. This is not because Germany, in any sense of the words, stands out as an example of solid economic performance as the burden of demographics is clearly visible here too. However, for Spain and Greece to recover they must claw back some of the lost ground on competitiveness relative to Germany. This highlights another and very important part of the internal devaluation process. Spain, Greece etc will not only be fighting their own imbalances; they will also fight a moving target since they may not be the only economies who face deflation or near zero inflation as we move forward.

Beginning with the simple overall inflation rate measured by the CPI we see that the level of prices (100=2005) has risen much faster in Greece and Spain than in Germany. Compared to 2005 the price level in Germany stood 7.1% higher in Q3-09 which compares to corresponding figures for Spain and Greece at 11.5% and 10.3% respectively. However, this does not tell the whole story about the build up of imbalances since the inception of the Eurozone. Consequently, since Q1-00 the price index has increased some 15% in Germany whereas it has increased a healthy 29.3% and 27.2% in Greece and Spain respectively.

Turning to the bottom chart which plots the annual quarterly inflation rate a similar picture reveals itself with a high degree of cross-correlation between the yearly CPI prints, but where the German inflation rate has been persistently lower than that of Greece and Spain. The average inflation rate in Germany from Q1-1997 to Q3-2009 was 1.6% and 3.5% and 2.8% for Greece and Spain respectively. It is important to understand the cumulative nature of the consistent divergence in inflation rate since it is exactly this feature that contributes to the build-up of the external debt imbalance. From 2000-2009(Q3) the accumulated annual increases in the CPI was 57% for Germany versus 109.4% and 104% for Greece and Spain respectively. Assuming that Germany remains on its historic path of annual CPI readings (which is highly dubious in fact), this gives a very clear image of the kind of correction Greece and Spain needs to undertake in order to move the net external borrowing back on a sustainable path which in this case means that these two economies are now effectively dependent on exports to grow.

If the divergence in Eurozone CPI represents a general measure of the built-up of external imbalances and the need for an internal devaluation through price deflation two other measures provide more direct proxies. These two are unit labour costs and the producer price index (PPI) which are both key determinants for the competitiveness of domestic companies on international markets. Intuitively one would expect unit labour costs as an important input cost to drive the PPI which measures the price companies receive for their output. Yet this is only going to be the case if the companies in question have market power on the domestic market. Consequently, if you regress the quarterly change of the PPI on the quarterly change on unit labour costs you get a negative coefficient in Germany and a positive coefficient in Greece and Spain (highly significant for Spain and not so for Greece). This is exactly what one would expect since German companies are highly exposed to the external environment (where they enjoy no market power) and thus has to suffer any increase in the cost of labour input through a decline in their output price. Conversely in Spain, the connection between an increase in unit labour costs and the PPI is strongly positive which suggest that Spanish companies has enjoyed considerable market power due to a vibrant domestic economy [1]. It is exactly this that must now change.

If we look at unit labour costs and abstract for a minute from the increase in German unit labour costs from Q2-08 to Q2-09 in Germany [2], both Greece and Spain have seen their labour cost surge relative to Germany since the inception of the Eurozone. Since Q1-00 the accumulated change in the German index has consequently been 15.2% which compares to 97.7% and 105.6% for Greece and Spain respectively. More demonstratively however is the fact that since the second half of 2006 the labour cost index of Spain and Greece have been above the Germany relative to 2005 which is the base year. Consider consequently that the labour cost index in Greece and Spain was 13.3% and 16.4% below the German ditto in Q1-2000 and now (even with the recent surge in German labour costs), the Greek and Spanish labour cost index stands 7.2% and 5.2% above the German index.

Turning finally to producer prices the similarity between the three countries in question are somewhat restored which goes some way to support the notion of persistent lower labour cost growth relative to fellow Eurozone members as the main source of the build-up of Germany's "competitive advantage" and in some way the build-up of intra Eurozone imbalances.

Essentially, and while definitely noticeable the divergence between Greece/Spain and German on the PPI is less wide than in the context of unit labour costs and the CPI. Consequently, and if we look at the index, the divergence which saw Spanish and Greek producer prices increase beyond those of Germany came very late in the end of 2007. Moreover, the correction so far has been quite sharp in both Greece and Spain relative to Germany with the PPI falling 14.8%, 5.7% and 2.8% (yoy) in Q2-09 and Q3-09 in Greece, Spain and Germany. The accumulated increase however, in the PPI, from 2000 to Q3-09 has been 85% in Germany and 136% and 101.7% in the Greece and Spain respectively.

If the numbers above indicates the extent to which intra Eurozone imbalances have manifested themselves in divergent price levels and rates of inflation, the concept of internal devaluation concerns the net effect on the prices in Greece and Spain relative to, in this case, Germany. On this account, and if we put the beginning of the financial crisis as Q3-07 (i.e. when BNP Paribas posted sub-prime related losses) the butcher's bill look as follows.

From Q3-07 to Q3-09 and in relation to the CPI the average quarterly inflation rate in Greece in Spain has been 1% and 0.66% higher than in Germany. The accumulated excess inflation rate over the German inflation has been 8% in Greece and 5.29% in Spain. Only in the context of Spain do we observe some indication of the initial phases of a relative internal devaluation as Spain has seen an accumulated inflation rate lower than that of Germany to the tune of 1.28%.

Turning to unit labour costs the picture changes quite a lot depending on the time horizon. Using the same period as above, the average quarterly excess increase in unit labour costs of Greece and Spain relative to Germany has been 1.75% and 0.3% in Greece and Spain respectively. The accumulated increase in unit labour costs has consequently been a full 14% and 2.8% higher in Greece and Spain relative to Germany. However, if we focus the attention on the period from Q4-08 to Q2-09 and due to the fact that labour hours in Germany have gone down further than in Greece and Spain, labour costs have corrected sharply in Greece and Spain relative to in Germany to the tune of -5.2% and 13.7% (accumulated) and -1.7% and -4.6% respectively. The fact that German producers have so far cut down sharply on labour hours could mean that Germany should claw back some of the lost ground vis-a-vis Greece and Spain if and when these two economies follow suit.

Finally, in relation to producer prices the picture is very much the same as in the context of unit labour costs with the notable qualifier that the relative excess deflation observed in Greece and Spain from Q4-08 and onwards is likely to be less "technical" and thus more "real" than in the case of labour costs. In this way the period Q3-07 to Q3-09 saw the excess rate of produce price inflation reach 14.8% and 6.8% (accumulated) and 1.8% and 0.8% (quarterly average) in Greece and Spain respectively. However, if we focus the attention on Q4-08 to Q3-09 the picture reverses and reveals a substantial degree of excess deflation over the Germany PPI in Greece and Spain to the tune of 16.1% and 5.2% (accumulated) and 5.4% and 1.7% (quarterly average) for Greece and Spain respectively.

The End of the Beginning

As we exit 2009 it is quite unlikely that we will also be able to leave behind the effects of the economic and financial crisis and this is not about me being persistently negative or even a perma-bear. Things have definitely improve and much of this improvement owes itself to rapid, bold, and efficient policy measures. However, some economies are in a tighter spot than others and this most decisively goes for Spain and Greece who now have to correct to the fundamentals of their economies with rapidly ageing populations.

As this correction largely has to come in the form of an internal devaluation the following conclusions are possible going into 2010.

  • The extent, so far, of the internal devaluation process depends on the time period used for analysis. Using Q3-2007 as the beginning of the economic crisis suggest that Greece and Spain have not corrected relative to Germany as a benchmark. However, if we look entirely at the worldin a post-Lehmann context the picture is different with Greece and Spain having observed excess deflation relative to Germany to the tune of -1.7% and -4.5% respectively for unit labour costs and -5.4% and -1.7% respectively for the PPI.
  • The correction observed in the context of unit labour costs appears technical as German unit labour costs have increased sharply since Q4-2008 due to a large reduction in working hours and an increase in short time work. In comparison, the relative correction in the PPI looks more solid.
  • The internal devaluation has not yet trickled down into the overall price level represented by the CPI. Both using the period Q3-07 to Q3-09 and Q4-08 to Q3-09 as the relevant time horizon reveals that there has been no meaningful internal devaluation in Greece and Spain measured on the CPI.
  • While the analysis presented here may go some way to quantify the intra-Eurozone imbalances and the course of the internal devaluation so far it is impossible to say precisely how far (and for how long) Greece and Spain (and indeed Latvia, Hungary etc) have to go here. More importantly, it is impossible to say exactly which measures that must be taken albeit that they have to be severe in the context of reigning in public spending and, ultimately, the public debt and ongoing deficit. Likewise, it is difficult to quantity just how high unemployment should drift and for how long it should stay there in order to grind down past excess.

In this sense, 2009 will not go down as the end in any sense of the word, but more likely as the end of the beginning.


[1] - Naturally, this argument assumes non-sticky prices and thus a 1-to-1 relationship in time between a change in input costs and output prices of companies. Since contractual arrangements are likely to make both sticky in the short run and likely with divergent time paths too, the quantitative results are not robust. The results for Germany are significant at 10% whereas those for Spain are significant at 1%. Mail me for the estimated equations if you really want to see the results.

[2] - The index rose 7.8% over the course of the year ending Q2-2009 which is way above 3 standard deviations of the "normal" annual change in the index from 1997 to 2009. The explanation is really quite simple and relates to the fact that German manufactures (in particular) has sharply cut overtime work and short time work has been rapidly extended (see e.g. this from Q2-09) which is obviously not the case in Greece and Spain. The fact that German producers have so far cut down sharply on labour hours means that Germany should claw back some of the lost ground vis-a-vis Greece and Spain if and when these two economies follow suit.

Friday, December 25, 2009

Marching Separately But Striking Together Over At the ECB

by Edward Hugh: Campdevanol

Well first of all, a very Happy Xmas to any of you foolish enough to be reading tiresome posts like this one on such a special day as this - a tiresome post which simply starts by going into some nitpicking follow-up detail to my earlier post on ECB liquidity and monetary policy separation - That Which The ECB Hath Separated, Let No Man Join Together Again! - but then starts to explore the rather more torrid topic of what exactly Latvia's Regional development minister Edgars Zalāns might have had in mind when he told the Delfi news portal that the Latvian agreement with the IMF and other lenders could "easily be amended given its shaky legal grounds" (there, that made you hiccup-back-up some of your xmas-pud, now didn't it?) or what Prime Minister Valdis Dombrovskis might have been getting at when he warned that “We will just go bankrupt if we observe all legal norms.”

But first some really tiresome (but important) details on the ECB, since the bank effectively wound up its anti-crisis program of extraordinarily long-term lending to banks last week with a final one year funding operation that is likely to keep short-term euro interest rates ultra-low at least for another six months. The general opinion is that the tender outcome suggested that much of the banking system can now live without the ECB's life-support mechanism, although a number of banks are still highly dependent on it.

The ECB injected 96.937 billion euros into the banking system in the third and last of its 12-month lending operations. As in the previous two 12-month tenders, the ECB gave banks all the money they asked for. However, in contrast to earlier tenders, it said the effective interest rate wouldn't be a fixed 1%, but rather would be tied to the average rate at the main one-week refinancing operations over the next year.

The general opinion is that last week's allotment - which will increase the total amount of ECB money in the market by around 14% - will keep the Euro Overnight Index Average, or EONIA (the key rate for interbank overnight money), around its recent level of 0.30%-0.35%. Actual overnight rates have barely moved from this level since the ECB's first 12-month tender - the whopping 442.24 billion euros allocated in June - created a structural surplus of money in the market (this was obviously the intention) and reduced the cost of borrowing well below the ECB's own targeted refi rate of 1%. And it is here that that tiresome little detail comes into play, since while the EONIA rate is unlikely to move from its present levels in the short term, once the funds from this first 12-month tender mature next June (thus removing much of the excess liquidity currently in circulation), the EONIA rate will in all probability start to move back towards the level of the refi target rate, which is where it normally stands.

So, I want to qualify a point I made in my previous post, since this upward movement in EONIA which will be provoked by the ending of the one year funding programme will constitute some form of monetary tightening, albeit a rather marginal and insignificant one.

At the same time, the recent decisions do not mean a complete termination of ECB lending operations to banks in the Eurosystem, since while the six-month tender due in March will also be the last, the three-month tenders the ECB had offered since its inception in 1999 will still continue, although it is not clear at this point whether these will have ceilings or not. Basically all these move form part of the bank's plans to end its non-standard policy measures over the course of 2010, even if it is unlikely to intentionally do anything to make matters worse for the troubled banks, provided that is, their national governments play ball with the structural reform programmes being advocated by the EU Commission.

Fewer Banks Borrowing More Money - And No Prizes For Guessing the Culprits

The number of banks bidding (224) was down by more than 60% on the 589 who participated in the previous 12-month operation in September, indicating that fewer banks now need such help. The banks that do remain dependent on the ECB, however, appear to be even more dependent than they were three months ago, since the average bid rose from 128 million euros to 433 million. While the ECB refuses to comment on which banks participated in the tender, it seems pretty clear that they were concentrated in countries on Europe's periphery (Greece, Spain, Ireland, possibly Austria), and indeed last month, the Greek central bank specifically urged Greek commercial banks to show restraint in the coming tender, and not increase their dependence on ECB funding.

Credibility Under Strain

Which brings us all the way round to Latvia. It is hard to assess the likely impact of the Latvian constitutional court decision that pension cuts included in the recent IMF-EU package are not legal, but personally I find the decision rather significant (for a discussion of the background see my post of yesterday - Latvia Is Back In The News, And Expect More To Come) since pension reform lies at the heart of the whole structural reform programme currently being demanded of "risky" EU states by the IMF, the EU Commission and the Credit Rating Agencies. Indeed the whole credibility of the EU's ability to manage it's own affairs could be called into question here. As Angela Merkel recently said:

"If, for example, there are problems with the Stability and Growth Pact in one country and it can only be solved by having social reforms carried out in this country, then of course the question arises, what influence does Europe have on national parliaments to see to it that Europe is not stopped.....This is going to be a very difficult task because of course national parliaments certainly don't wish to be told what to do. We must be aware of such problems in the next few years."

Well, I am sure some of our leaders must be becoming more and more aware of the problems presented with every passing day. Prime Minister Valdis Dombrovskis seems to understand the gravity of the situation “We will just go bankrupt if we observe all legal norms.”

My considered opinion is that it is the political pressures inside those countries (whether inside or outside the Eurozone) forced down the road of internal devaluation which can ultimately cause the agreements they enter into to fall apart, ultimately leading - in the Latvian case, and as Dombrovskis recognises - to sovereign default, bringing others (in the Latvian case, Estonia and Lithuania, or in the Greek one Spain) crashing down behind them.

As Baltic reports rightly put it:
The Constitutional Court’s ruling Monday that the decision by Latvia’s government earlier this year to lower pensions had violated the Satversme will, at the very least, force a new round of talks with international lenders and could trigger a new wave of political instability.

And as we should also note, the Constitutional Court also ruled that the government’s agreement with international lenders was also unconstitutional in that it hadn’t been approved by parliament, which takes us back to Merkel's point, and the absence of institutional mechanisms for the EU - under defined circumstances - to over-ride the sovereignty of national parliaments (what a hot potato that one).

Not Simply A Latvian Issue

And the issue isn't simply confined to Latvia, since we should not forget that Hungarian voters held their own referendum in March last year, where they effectively threw out a set of health charges introduced by the government as part of an "austerity programme" designed to bring Hungary's surging public deficit under control. And the long term financing of Hungary's health system has still not found a satisfactory solution.

I would also draw attention to this paragraph from my last review of the situation in Greece:
"We should also not fail to notice that Greece also had to raise 2 billion euros in debt via a private placement with banks last week, against a backdrop of credit downgrades and steadily rising spreads. The ECB undoubtedly agreed to this given the degree of policy coordination which must exist behind the scenes, since they are the ones who are financing the Greek banks, but it does highlight just how things have moved on in recent months, since only last year it was imagined that the Eurozone in and of itself gave protection from this kind of financing crisis, which was why only eurozone non-members, like Latvia and Hungary, were sent to the IMF. Now it is clear that while the ECB could keep protecting Greece from trouble till the cows come home, they cannot simply keep financing unsustainable external deficits and retain credibility. In this sense the financial crisis has now “leaked” into the Eurozone. And this has implications I would have thought, for countries like Estonia, who see eurozone membership as a “save all”. And obviously, the EU authorities badly need to plug this hole in their armour, or the entire concept of the eurosystem can be placed at risk, which is why I think we won’t see an explicit slackening in the minimum acceptable rating criteria."
So a very large credibility issue is now looming, and one which is leaving a gaping hole waiting to be plugged in the outer defences of the Eurozone.

Where Ireland Fearlessly Treads, Spain Fears To Wander

One of the policies which will undoubtedly be applied by the EU authorities in an attempt to bring this situation under control will be one of being seen to favour the "good students" against the flunkers. By good students here we may think in terms of countries like Estonia and Ireland. Estonia is clearly going to be "rewarded" in some way or other for its "solid performance" in the face of the crisis (if that is, it isn't inadvertently dragged kicking and screaming off that same cliff from which Latvia seems destined to fall), while Ireland, will receive all the protection the ECB is able to offer, and that, as I am stressing, is plenty. M Trichet's strident insistence that EU countries were like US states would end up being rather hollow if the eurosystem were to prove incapable of offering aid to one of its members who was following instructions and struggling for survival.

As in the case of Spain, a large part of the Irish debt is owed to foreign banks and bondholders who, rather than domestic Irish depositors, were responsible for funding the property boom. And, as the FT's John Murray Brown points out, the net indebtedness of Irish banks to the rest of the world rose sharply, from 10 per cent of GDP in 2003 to 60 per cent by early 2008.

But while the very survival of both Irish banks and Spanish Cajas has been increasingly questioned, the Irish government has stepped in to shore up their asset side by agreeing to take over the worst of the sector’s property loans, via the creation of the new National Asset Management Agency (NAMA), in way which contrasts strongly with the Spanish authorities who have simply limited themselves to denying there was any real problem.

Despite all the jitters about Irish sovereign debt in the light of the forthcoming annual fiscal deficits, what debt investors are really concerned about is the state’s huge contingent liability following the decision in October last year to guarantee all deposits and most debt of the five biggest banks. Analysts calculate that if there were a run on the Irish banks, the state would not realistically be able to find the 400 billion euros – an amount twice the size of Irish gross domestic product – the might need to meet their potential obligations under the guarantee. But this nervousness is to miss the central role the ECB would play in just this situation (should it arise, which it probably won't due to the credibility of the ECB guarantee). If the ECB were not able to shore-up Irish finances in times of crisis, then I think the Eurosystem would already be history.

But Spain is a very different problem, and a much bigger threat, not only because of its size, and the size of the debts, but also because Spain, unlike Ireland, is turning a deaf ear to European Council "advice". The banks have accumulated large quantities of houses and land on their balance sheet, and no one knows their actual value. And there is a stock of around one and a half million unsold new properties awaiting buyers who may never arrive. And with the continuing inaction, the nervousness only grows. As Bloomberg's Charles Penty points out in an excellent review article, the “skeletons” on the balance sheets of Spain’s banks are making many fund managers averse to the acquisition of stocks with a strong dependence on the Spanish internal market . He cites the case Alvaro Guzman, Managing Partner with Bestinver Asset Management, whose funds have been the best Spanish performers over the past decade.

“We are very pessimistic on Spain because we think there are still skeletons to come out of the cupboards -- basically marking to market the true value of real estate on the balance sheets of the banks,” Guzman says, “It’s not just the banks we’re out of but anything that has a Spanish cyclical component.”
Among Bestinver's concerns is the fact that the crash of the Spanish real estate market, which caught banks with 324 billion euros in loans to developers, will limit economic growth and tax revenues (an echo here of S&P), perhaps forcing the need for an eventual bailout by Germany (or France). And, of course, Bestinver's view is far from an isolated one. Penty produces another telling quote, this time from Jim O'Neill, Chief Global Economist with Goldman Sachs, who told Bloomberg radio that it was going to be important to see whether further damage to Greece’s credit ratings sparks a “cascading game” where the “market just starts going after Spain or Portugal." You bet it is going to be important!

Testing Days Ahead

Evidently Europe's institutional structure is in for a very testing time, and new and imaginative initiatives are going to be needed. Sovereign risk has now spread from non-Eurozone countries like Latvia and Hungary, straight into the heart of the monetary union in cases like Greece and Spain. Mistakes have been made. As I argued in my Let The East Into The Eurozone Now! piece back in February 2009, the decision to let the Latvian authorities go ahead with their internal devaluation programme never made sense, and the three Baltic countries and Bulgaria should have been forced to devalue - the writedowns swallowed whole - and admitted into the Eurozone as part of the emergency crisis measures. This situation has simply been allowed to fester, and in addition the much needed change in the EU institutional structure - to allow Angela Merkel the power she is asking for to intervene in Parliaments like the Latvian, Hungarian, Greek and Spanish ones, as and when the need arises - has not been advanced, with the result that we are increasingly in danger of putting the whole future of monetary union at risk. It is never to late to act, but time is, inexorably running out. As the old English saying goes he (or she) who dithers in such situations is irrevocably lost.