Is Estonia Now Definitely Heading for a Hard Landing?

by Edward Hugh: Barcelona

The only really big question about the EU10 economies as we enter 2008 is - among the more vulnerable ones (the Baltics, Bulgaria, Romania, and Hungary) - who will be the first to go.

One obvious candidate is Estonia, although it is far from occupying poll position at this point, as Romania is teetering more and more by the day, and foreign investors look for the door in Hungary as the economy geers up to enter recession.

But today we are focusing on Estonia, which Danske Bank A/S senior analyst Violeta Klyviene - echoing the words of ECB board members Jurgen Stark and Lorenzo Bini Smaghi - recently described as going from "boom to bust". Looking at some of the data I am presenting here, it seems hard to disagree.

Basically we have two sets of curves to look at. One set go up, and they basically refer to prices. The other set go down, and they refer to levels of domestic economic activity and consumer and producer confidence. First inflation.

Estonia inflation December 2007

Estonia's inflation rate rose in December to a nine-year high, led by food and housing costs, raising concern that price growth will destabilize the currency regime by making exports increasingly uncompetitive at the same time as domestic demand plummets. Estonia's inflation rate jumped to 9.6 percent, the highest since August 1998, from 9.1 percent in November, the statistics office said in Tallinn today. Prices rose a monthly 0.7 percent.



And there is no sign of a slowdown in price increases in the near future. Finance Minister Ivari Padar recently forecast inflation in Estonia would be at least 10 percent in the first half of 2008 because of tax increases on alcohol, tobacco and fuel.


Reail Sales


Estonian retail sales growth slowed in November to the lowest level in more than four years as consumer confidence weakened. Retail sales increased an annual 6 percent, compared with an unrevised 9 percent in October, according to data from the Tallinn-based statistics office last week. It was the lowest growth since September 2003, according to statistics office data.



The statistics office describe the 5% month on month decline in sales as "characteristic of the period prior to Christmas marketing in December". This may well be, but the slope of the downward line in the above chart is remarkably constant. Still, we will soon know when we get the December data.


Banks such as Citigroup and Goldman Sachs have been increasingly saying the Baltic countries, and especially Latvia, face increased risk of a ``hard landing'' because of accelerating inflation and widening current-account deficits, and this has lead to increased speculation about a possible devaluation of the Latvian lats and the Estonian kroon. Finance Minister Ivari Padar forecast last month that inflation, which accelerated to the fastest pace in nine years last month, will be at least 10 percent in the first half of 2008 because of higher taxes on alcohol, tobacco and fuel.

Consumer Confidence

Consumer confidence fell in December to its lowest level in more than 2 1/2 years on worsening expectations for personal and state finances, according to the Estonian Economic Research Institute.



The consumer confidence index fell to minus 10 this month from minus 7 in November, the Tallinn-based Institute of Economic Research said at the end of December. In December 2006, the index was at 7 points.

Consumer spending has weakened in the past months due to rising interest rates and stricter lending terms set by banks, slowing the Baltic country's economic expansion in the third quarter to a four-year low of 6.4 percent. Rising inflation, at a nine-year high of 9.1 percent in November, has also worsened consumer's expectations.

The latest release of the EU Commission Economic Sentiment Indicator for Estonia (published yesterday) gives us a very similar picture.



Copmparing the three charts, and observing how they mark such a very similar line, I would say the position now is very clear indeed.

Industrial Output

Estonia's annual rate of industrial production growth slowed significantly in November, with production falling in areas as diverse as dairy products and wood production fell. Output, adjusted for working days, rose an annual 4.4 percent, compared with a 5.9 percent rate in October. Production fell a monthly 0.7 percent on a seasonally adjusted basis, compared with a 1.3 percent increase in October. The economy is evidently slowing, although it would be hard to draw any definitive conclusion about how rapidly from this data.





Industrial output growth was hampered by a slowdown in manufacturing as companies faced increasing labor shortages with unemployment at a 16-year low while domestic demand has evidently started to cool.




Trade Deficit


Estonia's trade deficit shrank to the lowest level in eight months in October as machinery imports fell from a year earlier. This is not a good sign, as it more than likely reflects a slowdown in investment. The October deficit fell to 3.6 billion krooni ($333 million) from a revised 4.6 billion krooni in October of last year and a revised 4.2 billion krooni in September, the Tallinn-based statistics agency said in an e-mail today.

Basically the big picture is that import growth has stalled entering 2008 as Estonians spent less on cars, clothes and household goods due to rising interest costs and the weakening consumer sentiment. Export growth has also slowed as companies struggle with rising wage costs, which were up 20 percent in the third quarter.






Conclusion

So what happens next? Well obviously all of this is completely unsustainable, especially as most of the EU10 and Eurozone countries (not to mention the UK) are all now themselves likely to slow significantly. So now, to answer my own question a hard, hard landing seem unavoidable. How will this manifest itself? well basically we should expect to see increasing pressure on the Kroon currency peg with the euro, a pressure which, in the short term at least, the Estonian authorities will try and resist.

Basically, if we get the kind of very hard landing I am now anticipating, then we should expect to see inflation gradually ease, since there will be no demand pressure to push up prices. Possibly we will even see the reverse side of the coin, namely price deflation as we get into the second half of 2008, everything here depends on the pace of the "bust".

The first indicator then should be a turnround in the upward movement in consumer prices, and the second should be an end to those famous labour shortages, as the long run trend in declining unemployment turns round, and unemployment starts to rise. We can already see that producer prices (lead by export producer prices which have been falling since the summer) have started to ease in October and November. This could be read as a firts indicator for what is to come.



Wages and salaries have been rising rapidly, and we should expect to see this rate of increase decelerate, and probably quite sharply:




Estonian economic growth eased to 6.4 percent in the third quarter from 11.2 percent in 2006, and we should expact to see this rate of deceleration increase.



And finally, and perhaps most importantly, unemployment. This has been trending steadily downwards, and should really expect the trend to reverse itself. This will mean, basically, that the days when Estonia urgently needed to import migrant workers to try and avoid this huge spike in wages and prices is now largely passed. This does not mean that in terms of longer term stability Estonia does not need to focus on raising fertility and attracting new citizens from elsewhere to compensate for those who have simply not been born, but all of this will now take rather a back seat as the short term dynamics increasingly take over. One measure of the difficult situation Estonia will probably find itself in is that the policy priority will now need to switch from attracting migrants to retaining the young workers it already has and avoiding an uptick in out migration. It all depends on the level of distress which Estonia's citizen are faced with at the end of the day, and this depends on exactly how hard this hard landing turns out to be.

The Eurozone Economies Entering 2008

by Edward Hugh: Barcelona

Evidence of a growing slowdown in the Eurozone economies continues to show up across the board. German retail sales, for example, fell for the third consecutive month in December according to the Bloomberg purchasing managers retail sales index released at the end of December. The index came in at a seasonally adjusted value of 44, compared with 43.6 in November. A reading below 50 indicates contraction. Retail sales as measured by the PMI also fell across the entire 13 nations euro bloc in December, with sales falling in France for a third consecutive month (the December index came in at 49.1), while a Italian sales dropped to 44.7 from 45.3.

This general impression is confirmed by the latest release today from Eurostat, which shows European retail sales fell the most in at least 10 years in November (the latest month for which they have released data) as rising food and energy continue to hit the consumer's wallet. Retail sales declined 1.4 percent from a year earlier, and this is the biggest drop since at least 1997. Sales also fell 0.5 percent from November, which was the third decline in four months.

The purchasing managers index for the euro zone manufacturing sector also eased up in December to a give a final reading of 52.6, down slightly from 52.8 in November. The December figure was revised up slightly from the earlier flash reading of 52.5. The manufacturing PMI for the whole zone managed to remain above the October low of 51.5, but the December reading is nonetheless the second weakest figure since Aug 2005.

EU Commission Confidence Index Down All Round.

The general picture of an economic slowdown in the eurozone is once more highlighted by yesterday's realease of the December data for the EU Commission Eurozone Economic Sentiment Index.

The Commission’s economic sentiment indicator is on a clear downward path. At 104.7 in December, down from 104.8 in November, the index was at its lowest since March 2006.





But perhaps more important than the steady downward drift in the general indicator are the individual country differences.



As can be seen, the all important German economy is slowing steadily, although not as fast as some. Part of the reason for this may be the unusual performance of the German labour market. This is a pretty complex matter, and I feel that simplistic interpretations may be sending some analysts straight up the garden path here. I have a long (beware, I mean very long) post studying this problem here, and I will publish some summary results on this blog in due course.

Italy, as I have outlined in greater depth here, has been steadily drifting off towards its next recession since the middle of 2007, but the big news of the moment is what is happening in Spain and Ireland, since as is well known they were the two countries in the eurozone to be most affected by the "housing fever" boom, and if you look at the chart above the correction in these countries since September is striking in its velocity. As the FT comments:

Spain is demonstrating that prospects could vary significantly across the eurozone. Since September, confidence in the Spanish construction sector has tumbled, and the Commission’s survey results showed sentiment deteriorated in December in Spanish industry, retailing and among consumers as well.

I have two very extensive posts on the Spanish situation on my Spain blog (here and here) and I will post a summary here in due course.

But not everything in the Eurozone is bad news at the moment. Take France, for example.



And Yet France Resists!




As the above chart illustrates, France is slowing, but it is not slowing as fast as the rest of the group, and so we may hope that it is the French economy which can do some of the heavy lifting to sustain the eurozone economies in future quarters, since this downturn is going to be an especially difficult one given that the normally boyant Spanish economy will be in the sick ward along with the customary Italian and German patients. This view may surprise some readers, since it is not normal to speak postively about France at the same time as mentioning Germany as a downside element, but then facts are facts and not mere opinion, and this is a moment when all the narratives about how things actually work are going to be well and truly tested, and I fear that "goldilocks" opinions like those currently being advanced by Morgan Stanley's Elga Bartsch are going to be found severely wanting (especially her German powerhouse argument, presented in her xmas "Pulling a Slow Train" post which you can find here. In that post she actually says - and I quote directly - "Germany could well be on the way to becoming the new growth locomotive in Europe. The phase of underperformance in terms of GDP growth, which has plagued Europe’s largest economy for years, is clearly over." As I say, I think this is to misunderstand what ha sbeen happening in Germany, and what the macro issues which present themselves there really are, but in any event we are all going to get to see soon enough).

Basically there are strong demographic grounds for imagining that France (just like the United States) is not in as bad a shape economically as some imagine (as Claus spelt out in this post back in early 2007, where he explains why France is not, in economic terms, "the sick man of Europe") despite having severe institutional deficiencies and a very poorly functioning labour market. Some call all of this an example of my demographic "tunnel vision", but the nice thing about economics is that theories are testable - if you accept the judgement of the data - so I would simply ask the skeptics to bear the argument in mind and follow the data as we move forward.


In fact French Gross Domestic Product grew by 0.8% , in the third quarter of 2007according to revised estimates from the French statistics office Insee published last week. One of points which stood out in this data was the strong performance of domestic consumption -a d here France differs considerably from both Germany and Italy - with household expenditure rising by 0.8% ( following 0.6% growth in the second quarter of 2007). This surge in domestic consumption contributed 0.4 percentage points to quarterly GDP growth. General government expenditure slowed from a 0.5% y-o-y rate in Q2 to 0.4% and thus only contributed 0.1 percentage point to Q3 GDP growth.

Total Gross Fixed Capital Formation (GFCF) grew at an annual 0.6% rate (0.4% in the previous quarter). The GFCF of households grew by 0.6%. In total GFCF contributed 0.2percentage points to GDP growth. Exports growth also increased (1.5% following 0.7% in the previous quarter), while imports grew more slowly, by 1.0% (after 1.8% growth in Q2), so that changes in net foreign trade contributed +0.1 point to GDP growth (after being a -0.3 points drag in Q2). Inventory changes did not contribute to GDP growth (after +0.1 point in the preceding quarter).



A glance at the long term annual growth chart for the French economy gives some indication of why I am so confident that France will weather the storm better.




Despite the fact that France - just like everyone else - gets recessions, there is much more soliditity and regularity in the growth, and the trend is much higher than that to be seen in Italy, for example.

And when we come to Germany, even though the line is not as negative as it is in Italy, a clear downward movement in trend growth can be observed. But please observe the bounce-back after 2002, and especially the sharp upspike after the begining of 2006. That is what all the debate is about. Is this trend sustainable? Demographics says it isn't. Conventional analysts like Elga Bartsch say it is. Now we are going to see who is right, and hopefully modify and calibrate our models accordingly.


Strong Points and Weak Points in France Looking Forward

Euro zone purchasing managers surveys for the manufacturing sector also tend to confirm the idea that the economy of most eurozone member states has been slowing in the fourth quarter despite what seem to be pockets of resistance in some countries.

The purchasing managers index for the euro zone manufacturing sector eased to a final 52.6 in December from 52.8 in November. The December figure was revised up slightly from the provisional reading of 52.5. The manufacturing PMI for the whole zone has managed to remain above the October low of 51.5, but the December reading is still the second weakest figure since Aug 2005.

As suggested above, country level PMI surveys are giving the impression that national growth disparities within the euro area may be widening. France, for example, continues to resist the general downward trend in manufacturing with the French manufacturing PMI staging a small rally and climbing to 53.8 in December from 52.5 in November.







Nonetheless Q4 may not be so positive as the third quarter was. As already noted, retail sales dropped in France in Novermber for the third month in succession according to the PMI, with the December index coming in at 49.1,




However French consumer confidence in unexpectedly dropped to a 19-month low in December. Consumer sentiment fell to minus 29 from minus 28 in November,according to Insee, the Paris-based national statistics office. The December reading is the lowest since May 2006.

So nothing is perfect. France will note the slowdown. My argument is simply that it will note it much less than some of the others. As far as I acn see at present, Spain and Ireland may well be the first ones formally into recession, closely followed by Italy, with Germany holding out just a little bit longer, and only really dropping in the wake of events in Eastern Europe, on which her exports are heavily dependent. Basically, to orient yourself here, it is important to understand that the eurozone countries are enetering the present recession with all the key policy indicators acting as headwinds (the precise opposite of the situation in the US. The ECB are stubbornly sticking to "inflation vigilance" (while the Fed is giving greater emphasis to providing a platform under the economy and easing), inflation is biting into consumer purchasing power (ditto the US in this case), the euro is at very high levels which presents problems for exports and sucks in imports (both of which are negative for GDP, and the US dollar is of course falling, making exports more competitive and acting as a brake on imports), and at the same time the 3 month euro libor, despite some recent reduction, remains stubbornly high, making it more difficult for banks to sustain liquidity and hence more reluctant to lend (again, the Fed has been somewhat more successful in easing 3 month interbank rates. So there it is I'm afraid, downwards we go with a big push from the available policy instruments.