Russia's Contraction Eases But Knife-edge Risks Remain For 2010

by Edward Hugh: Barcelona


The Russian ruble strengthened the most in more than three months against the dollar yesterday (gaining 1.7 percent to 32.2247 per dollar at one point) as oil rebounded above $60 a barrel and OAO Sberbank reported better-than-expected earnings. Sberbank shares jumped 5.1 percent after first-quarter net income turned out to be above analyst estimates. But the rise was also helped by the fact that Russia’s central bank spent approximately $2 billion from reserves to try to stop the ruble from falling yesterday, taking central bank reserve spending over the two working days since they lowered interest rates half a percantage point on Friday to around $4 billion, according to reports in the newspaper Kommersant.

Russia’s central bank cut its main interest rates for the fourth time in less than three months at the end of last week after the government estimated the economy contracted an annual 10.2 percent in the January-May period. Bank Rossii lowered the refinancing rate to 11 percent from 11.5 percent following on initial reduction on April 24 and two further cuts on May 13 and June 5.

But the striking thing here is that today's ruble surge followed seven consecutive days when it fell - including yesterday when it dropped 0.5 percent against the euro and 0.1 percent against the dollar to hit the lowest close against the central bank's currency basket since May 4. Indeed only last week the ruble posted its steepest slide against the euro and dollar since January as oil prices fell and Russia's budget deficit contined towiden. And to top it all, as I say, the central bank reduced interest rates for the fourth time in less than three months.

Indeed just after the rate cut Alfa Bank’s Chief Economist Natalia Orlova commented that she was seeing a “very fragile trend” in the ruble, with a lot of downside potential: and I completely agree with her. What we have is a lot of volatility and a lot of market nervousness. Just this morning Bloomberg cited a research report from the ING Group warning that "the ruble may drop as much as 5.8 percent to the weakest end of Russia’s target exchange-rate basket as the central bank aims to revive credit by lowering key interest rates by up to 4 percentage points.” (research note here).

My feeling is that a 400 basis-point reduction would have an even bigger impact than even ING expect. Basically central banks in a number of central and east European countries are caught in a kind of trap, where the high level of forex borrowing both households and companies have engaged in makes local monetary policy rather impotent, and worse, this impotence itself becomes a self perpetuating situation. The trap perpetuates itself since people become reluctant to take out local currency denominated loans due to the high interest rate they carry, so they take out either dollar- or euro-denominated ones and thus make matters even worse, making the possibly erroneous assumtion that end game of all this will be either a dollar collapse (the Russian view) or eventual euro membership (in places like Hungary and Romania). Those doing the borrowing thus feel themselves to be completely covered, and fail to take into account the capital loss that could follow a large correction in their own local currency.

Slowly monetary policy makers in the most affected countries are coming to recognise that they need to address the issue, and somehow or other to get rates down, since the problem is not going to simply go away, and the meanwhile the respective economies keep on shrinking, with no positive boost from local monetary policy. But it is just when they start to lower rates that things start to turn nasty on them, since the whole situation is non-linear. Supporting a currency with high interest rates works for as long as it does on the win-win dynamic of yield differential AND a rising currency, but once the so called carry trade "punters" get the idea that political pressures to address the economic contraction may force substantial rate cuts on the government and the monetary authorities, and that the expectation of such rate cuts may lead the other "punters" to sell local instruments and exit the market, then the "thinking punter" finds he or she also needs to sell, and this is how we get to see that "will the last one out of the door please turn the lights off" type of self fulfilling herd behaviour.

I would say Serbia, Ukraine, Hungary, Romania and Russia are all vulnerable to this kind of outcome. Of course, from a macro economic viewpoint they can all start to bring interest rates down as inflation steadily drops, but I'm not sure that the inflation element is an important consideration for the short term carry-trade people, since it is the absolute yield differential, and the currency dynamics that would seem to matter most.


Sharp GDP Contraction

Evidently the background to all this nervousness is last week's announcement from the economy Ministry that Russia’s economy may shrink by as much as 8 to 8.5 percent this year. Gross domestic product probably contracted by an annual 10.2 percent in the first six months and may slump at a 6.8 percent annual rate in the second half, according to the latest Ministry forecast.

Behind this drop in GDP lies the fact that Rusia's exports were down by 47.4 year on year in the January to May period, largely due to falling prices for oil and raw materials. The economy ministry also said it expected capital investment to fall by around 21 percent this year as utility and energy companies, which account for about a third of total investment, cut spending programs. The ministry forecast is based on an oil prices scenario of an average $54 a barrel in 2009.

Further, industrial production is expected to shrink between 11 percent and 13 percent as manufacturing falls by as much as 17 percent. Inflation of between 12 percent and 12.5 percent is forecast, down from last year’s 13.3 percent. And retail sales are expected to suffer an annual contraction of 5.8 percent.


For the 2010 to 2012 period the ministry currently predicts a 1 percent expansion next year, followed by a 2.6 percent one in 2011 and 3.8 percent one in 2012. This “moderately optimistic" scenario would produce a deficit of 6.5 percent in 2010, followed by further deficits of 4 percent and 3 percent over the following two years. Government officials have recently stated they expect Russia to have a budget deficit of around 9% of GDP in 2009, up from an earlier 7.4% estimate.

Short Term Indicators Show Continuing Contraction

Industrial production shrank a record annual pace of 17.1 percent in May, while capital investment fell the most since December 1998, dropping an annual 23.1 percent.

Russian unemployment fell back for the first time in 10 months in May, but despite the positive effect this may produce on confidence the rate is sure to rise further in the months to come.





Retail sales fell the most in almost a decade in May, sliding an annual 5.6 percent, the fourth consecutive decline and the biggest since September 1999. The average monthly wage decreased an annual 3.3 percent in May, while real disposable incomes dropped 1.3 percent.

From Inflation To Deflation?

After all the inflation which seems to have become endemic in Russia, deflation would seem to be the most unlikely of scenarios, and indeed it is not the most likely of out comes, given the capacity of the authorities to allow the value of the ruble to fall. However, downward pressure on producer prices is evident at this point, and the cost of goods leaving Russian factories and mines dropped an annual 6.5 percent in May after falling 4.1 percent in April, according to the Federal Statistics Service. Prices rose 0.6 percent from April.

Russia’s inflation rate - which fell to an 18-month low in June - is still far too high. The rate dropped to 11.9 percent from 12.3 percent in May. Consumer prices rose 0.6 percent in the month, the same rise as registered in May. Russia’s inflation rate has averaged more than 14 percent a year since the country’s 1998 default and is certainly one of the biggest headaches facing the country.

Some Rebound In June

Russia’s manufacturing industry shrank last month at the slowest pace since September, and VTB’s Purchasing Managers’ Index advanced to 47.3 from 45.3 in May. So the rate of contraction is easing.

Further Russia's service industries shrank in June at the slowest pace since the contraction began in October, according to the VTB Capital Purchasing Managers’ Index which rose to 49.7 from 46.6 in May.




As a result the VTB Capital GDP indicator showed an annual 6.4 percent rate of contraction in the second quarter following a 5.4 percent decline in the first three months of the year. But output was shown shrinking at a 4.8 percent rate in June (from a year earlier) as compared with 6.8 percent contraction rate in May.

“The GDP indicator suggests that the economic decline in the second quarter of 2009 is likely to be similar to, or slightly worse, than in the first quarter,” Aleksandra Evtifyeva, an economist at VTB Capital, said in the report. “However, the prospects for the second half look brighter.” The pace of Russia's economic contraction eased to a 5-month high of 4.8 percent year-on-year in June, compared with a 6.8 percent shrinkage in the previous month, VTB bank's GDP indicator showed on Monday. The June reading "suggests that the economic decline in the second quarter is likely to be similar to or slightly worse than in the first one," VTB Capital senior economist Aleksandra Yevtifyeva said in the report.

2009 Contraction In Double Figures?

According to the latest report from the World Bank collapsing industrial production, rising unemployment and ongoing capital flight will reduce Russia’s gross domestic product by 7.5 percent this year and restrain “intraregional trade flows and transfers,”. The Bank also highlighted that “Remittances to the broader CIS region are expected to decline for the first time in a decade, by 25 percent”.

Neil Shearing of Capital Economics forecasts a contraction of 10% this year, zero growth in 2010 and fears that Russia may be facing a kind of "lost decade", since it may well not recover the 2008 level of output till 2014, and there are still clear downside risks attaced even to this estimate.


Shearing identifies three main factors which may contribute to the lost decade. First and foremost, he notes, the banking sector remains under enormous strain. While official estimates put bad debt at around 12% of total loans this year, Shearing thinks the true figure is likely to hit something closer to 20%. On this basis, he estimates that the banking sector could require up to $60bn in additional capital – far more than the $30bn that has so far been allocated by the government.

Second, by using so much ammunition this year, authorities leave little scope for further policy stimulus. Monetary policy is somewhat hamstrung as we have seen earlier, and fiscal policy will have to be tightened over the coming years in order to rein in a ballooning budget deficit. Indeed, Laura Solanko of the Finnish Central Bank's Transition Economies Centre calls this "the largest fiscal stimulus ever" in the Russian context.

As Solanko points out, the current crisis has hit oil and gas exports particularly hard, leading to a 47% decline in export duties and a 53% decline in proceeds from taxes on natural resource extraction during the first four months of 2009. The drop in general economic activity has further reduced proceeds from all revenue sources. General government revenues in January–April were 20% lower than a year earlier. If current trends continue, Solanko estimates that general government revenues may drop to close to 35% of GDP this year - down from around 50% in 2008.

Meanwhile, government expenditure has increased dramatically at all levels. In January–April this year, enlarged government expenditure increased by 23% to RUB 4,140 billion. The expenditure at the core of the Russian fiscal system, the federal budget, increased by an astonishing 37% compared with the same period a year earlier. Even taking the fairly high inflation into account, this equals a 20% increase in federal expenditure in real terms. Relative to GDP, general government expenditure has risen to 37% and federal expenditure to 23% of GDP, against 28% and 16%, respectively, a year earlier.

To sum up, public sector expenditure has nominally increased by 23%, and relative to GDP by a whopping 9 percentage points compared with the first four months of 2008. The sheer magnitude of such a fiscal stimulus is huge. During the 1990s, Russia’s public sector shrank dramatically, its GDP share decreasing by 12 percen-tage points to 26% of GDP in 1999. The current fiscal stimulus has shot public expenditure back to the level of the early 1990s.

As the automatic stabilisers in the Russian fiscal system are small, the expenditure increase largely reflects expenditure on anti-crisis measures and advance transfers to the regions by the federal government. The government’s anti-crisis measures announced by mid-March 2008 alone would increase federal expenditure by some RUB 2,000 billion, or 15%, in 2009. Roughly half of that is directed to strengthening the financial system, and the other half to supporting the real sector.

The current federal budget foresees a deficit of 7% of GDP, a figure only slightly larger than last year’s surplus – and only slightly smaller than the total assets of the Reserve Fund. This im-plies that most of the Reserve Fund will be exhausted by year end and the Russian government will have to reenter the domestic and external bond markets in 2010 at the latest.

And we should never forget that Russia remains in the grip of a pretty vicious credit squeeze. Bank lending to companies fell 1.5 percent in May compared with April, while retail loans dropped 1.9 percent. Overdue bank loans reached 4.6 percent of the total in May, versus 4.2 percent a month earlier. And while many Russian corporates may be restructuring their debt, the only deepening their longer term exposure to currency correction risk. As in the case of Moscow-based steelmaker OAO Mechel, who, according to Bloomberg, just agreed to refinance $2.6 billion of loans in the biggest foreign-debt restructuring by a Russian company since the credit crisis began. Such refinancing is not coming cheap - the rate was 6 percentage points over the London interbank offered rate - but even more to the point this type of restructuring may only to a certain extent postpone the inevitable, since the new debt now becomes due in December 2012. This is fine if everything is all hunky-dory come 2012, but if it isn't.....

As the OECD put it in their latest report on Russia

“The main threat to credit growth now appears to be solvency problems, arising from the declining capacity of borrowers to repay bank loans,” the bank said in an economic report released today. “The challenge is to maintain capital adequacy and prevent a sharp curtailing of lending flows.”

Lastly, Neil Shearing points out there remains little external support for the economy. With the global recovery likely to disappoint, export demand will remain weak. Oil could fall to $50pb by early-2010. As ING say:

"Oil price dynamics pose additional risks to RUB. Last week, oil prices plunged below the technically important EMA-200 level of US$63/bbl, indicating a potential further drop to US$47-54/bbl. If this happens, the RUB looks destined to weaken as well, given its greatly strengthened correlation with oil prices over the past two quarters".

And if oil does drop back to this range, and the ruble does weaken, and non performing loans rise above the 20% mark (pushed by that very same ruble weakening, and the rising unemployment), and the Russian Federal Government has to start issuing bonds in 2010, well watch out, is all I can say, since trouble will surely be in store. This is very much knife edge touch and go stuff from here on in. Grit your teeth everyone.

To The Finland Station And Back Again

by Edward Hugh: Barcelona

This post accompanies my recent piece on Sweden. I have been scratching my head and trying to see what could be learnt from making a comparison between Finland and Sweden. Some of the differences are obvious - one is in the euro, and the other isn't, once can adjust monetary policy and currency values, and the other can't. Others are less so. Finland's goods trade surplus has been declining steadily since joining EMU while Sweden's has remained relatively constant. And Swedish males live on average three years longer than their Finnish counterparts. So what is important here, and why? And if convergence theory has anything positive to be said for it, shouldn't we be able to observe so sort of convergence going on here.


First, and just to remind ourselves, here is the chart from Claus Vistesen which shows what the relation between population ageing and current account balance might look like. The key point is that as populations age beyond a certain point, a tendency to run a current account surplus emerges, as domestic demand steadily weakens, and becomes insufficient to drive growth. Evidence for this phenomenon can be found in Germany, Japan and Sweden.




The idea is that as median population age rises the current account dynamics of a country change. The last ageing phase shown to the right of the diagram is purely speculative at this point, although theory suggests that if the underlying momentum of ageing is left unaddressed it may well be what happens. But it is a development which is to be strongly avoided since although we do not yet know what happens when a society starts to dis-save at an advanced median age, the longer we can put off finding out, the better.

Which is why looking at Finland is important, since unlike the three aforementioned "ideal type" agers, Finland has in fact seen a deterioration in its external position over the last decade, and even though it has, up to now, remained a surplus country, the trend is certainly towards deficit, and this trend needs to be halted and reversed. Indeed this is the most pressing policy problem facing the Finnish authorities during the current recession.


Now, as in Finland, Sweden's external position underwent a structural shift in the mid 1990s, just as Claus's model predicts. First positive balance - the submarine breaks water - in 1994, meadian age 38.4 (quite young in international comparisons so interesting). So so far so good.

So Sweden is a sort of normal case, now let's look at Finland. Once more the mid 1990s "transition" is clear. Finland moves from deficit to surplus. But unlike the Swedish case the surplus peaks around the turn of the century, and since then has been steadily weakening.



There can be a number of explanations for this. The pattern of ageing could, for example, be different in Finland. Or the euro might be a factor, with the loss of control over monetary policy leading to a steady deterioration in the level of international competitiveness. As we will see below, some part of the explanation may be provided by each of these, but first, lets take a look as some of the empirical aspects of Finland's present recession, since it is evident that Finland, like many other countries, has entered a strong recession on the current back the global crisis.

Strong Decline In Finland's GDP

In the first three months of this year GDP was down by 2.7% when compared with the last three months of last year (an 11.2% annualised rate of contraction).

And it was down by 7.5% when compared with the first quarter of 2008 (Eurostat data).




One significant difference which can already be noted between Sweden and Finland is that while the last three months of 2008 were definitely much worse than the first three months of 2009 in Swedan, in Finland, as in many other Eurozone economies, Q1 2009 was definitely much worse than Q4 2008. And indeed, while Sweden's economy shows some definite signs of small green shoots in Q2 2009, as far as we can see, Finland's economy still remains deeply mired in recession. Finland does not have a local variant of the ubiquitous Purchasing Managers Surveys, but the statistics office does maintain a monthly gross domestic product (GDP) indicator. Now, while the methodology is very different (the PMI composites are survey based and qualitative, and much more reliable) for what it is worth Finland's GDP indicator fell 9.2 percent in April in comparison with April 2008, that is to say, the year on year contraction was greater than in the first quarter, but it is difficult to draw any definitive conclusion from this, since there are many statistical factors at work here.

According to Statistics Finland building and manufacturing industry were the hardest hit.




The April data showed production in construction and manufacturing - both key contributors to the Finnish economy - down around 17 percent year-on-year. Production in April was down 0.6 percent from March. Output in agriculture and forestry showed slight growth on an annual basis of just below two percent, while services fell six percent.

And the outlook for the rest of this year does not look much brighter. The OECD forecasts growth in the Finnish economy will fall by 4.7 percent in 2009 with a return to 0.8 percent growth next year. Significantly the OECD also stressed that uncertainty in the evolution of international trade poses the greatest risk in the outlook for the Finnish economy.

The IMF currently expects the economy to shrink by 5.2 percent this year and again by 1.2 percent next year, while the latest finance ministry forecast is for a 6.0 percent shrinkage this year followed by 0.3 percent growth next year. All the 2009 forecasts seem to be subject to downside risk, while the 2010 ones are no better than guesses, since the level of uncertainty is so high, and Finland is so dependent on external trade, but further contraction seems more probable than growth at this point.

Short Term Indicators

Industrial output fell again in May (year on year) for the seventh consecutive month, and was down by 23.2 percent over May 2008. This follows a revised fall of 21.3 in April.

Month-on-month, industrial production also fell - by 2.2 percent from April when it fell by 3.8 percent over March. So the industrial situation is deteriorating, not improving at this point. Output fell in all main sectors, with metal industry reporting the biggest decline around 28 percent, while the paper industry production also shrank by nearly 28 percent year-on-year.



Over the January to May period, industrial output decreased by close on 22 per cent from the corresponding period in the previous year. And there seems to be little improvement on the horizon. According to Statistics Finland, the value of new orders in manufacturing was 39.6 per cent lower in May 2009 than in May 2008, slightly above the January to May average decrease of 38.9 per cent year-on-year.



As in earlier months, the decline in new orders was strongest in the metal industry (47.5 per cent). In the chemical industry new orders fell by 30.7 per cent, in the textile industry by 28.5 per cent and in the manufacture of paper, and paper and board products by 19.4 per cent.

Construction activity is also well down, falling by 14.4% year on year in March (the latest detailed data we have), and by around 17% in April according to the GDP indicator.







Finland did not have a massive construction boom. The construction of new dwellings shows no obvious surge in the first decade of the century.



On the other hand rate of household indebtedness is up, with the ratio of debt to disposable income rising to 101.4 percent in 2007, from 70.3 percent in 2002. Significantly, the rate of indebtedness among households composed of persons in the key 25 to 34 age range reached 189 percent in 2007. House prices seem to be a story of one long steady march upwards since 1995, but prices did start to fall in 2008, and this trend now seems set to continue.



Retail sales, which give us a measure of domestic demand, are also falling, if still only moderately. According to Eurostat, retail trade sales fell by 2.99 percent year on year in April. According to the Finnish Statistics Office, sales between January-April were down by 1.6 percent over a year earlier. During the same time period, motor vehicle trade sales were down 31.8 percent and wholesale trade sales down 17.5 percent.






Finland's unemployment rate continues to rise, and at an accelerating pace. The increase in those unemployed from April to May alone was greater than that in the whole of last autumn, according to Statistics Finland. From January to May the seasonally adjusted jobless rate was up by two percent and there were more than 300,000 people recorded as without work in May, 60,000 more than in May 2008, taking the national unemployment rate as measured by Finland Statistics to 10.9 percent.

Using the EU (ILO compatible) methodology, Eurostat report the May unemployment rate as 8.1 percent. The OECD expect unemployment to continue to rise in Finland, and forecast an unemployment rate of 8.7 percent this year, rising to 10.8 percent next year (ILO methodology).





The OECD is also worried about employment in Finland in the longer term, and point out that while the country has taken important steps to remove the barriers to employment of older workers (see the OECD publication Ageing and Employment Policies in Finland) more needs to be done. Since the early 1990s, Finland has introduced programmes to support the employment of older workers, notably the National Programme on Ageing Workers. It has also recently undertaken a major reform of the old-age pension system and will phase out early retirement schemes.



However, Finland’s median age is rising steadily (see chart above) and the old-age dependency ratio (population aged 65 and over as a proportion of the population aged 20-64) is projected to increase from 25% in 2000 to 43% in 2025 compared with an OECD average of 22% in 2000 and 33% in 2025. This is a very steep rise, and raising employment rates among the older population is going to be the key to meeting the challenges presented by the need to find export lead growth.

According to the OECD, only around 30% of people aged 61 are currently working – a drop of more than 50 percentage points compared with 51 year olds. This steep drop in employment rates can primarily be explained by the fact that Finland has too many pathways to early retirement, notably unemployment benefits, unemployment pension, disability pension and individual early retirement pension. Already at the age of 50, 18% of individuals are receiving either unemployment or disability benefits, increasing to more than 46% by the age of 60. Moreover, in the age group 60-64 most unemployed persons transfer to the unemployment pension with a further 20% relying on disability benefits and about 10% rely on the individual early retirement pension.


Deflation dynamics


Like Sweden, the inflation data also throws into the limelight the disparity between the EU HICP measure (which does not include housing interest) and the national CPI (which does). Year-on-year inflation, calculated by Statistics Finland dropped to 0.0 per cent in May, while in April it was still 0.8 per cent. According to Statistics Finland the drop was primarily due a fall in food prices and interest rates. Between April and May, consumer prices fell by 0.2 per cent. On the EU HICP index, however, year on year inflation is currently running at 1.5 percent. Thus, in a time of falling house prices and lowered interest rates, the HICP totally underestimates the deflation danger.



It is important to remember here that two-thirds of Finland’s housing stock consists of owner-occupied homes, and home ownership is widespread in all forms of housing, including apartments as well as detached houses and row houses. Normally falling interest rates would produce rising house values, due to the affordability effect, but under current conditions we are observing the opposite. I can't help feeling that European monetary policymakers need to think more about this type of thing.


More evidence for deflationary headwinds is offered by producer prices for manufactured products, which fell by 8.1 per cent year on year in May. Export prices were down 9.8 per cent and import prices fell by 11.7 per cent. The year-on-year change in the wholesale price index was -8.9 per cent.





So Where Are We?


Finland's economy faces important challanges in both the short and long terms. Finland's state debt is low at the present time, which gives the capacity for short term stimulus and bank bailouts. But it is rising, and reached a record high of 70.6 billion euros by the end of the first quarter of 2009. General government debt, calculated according to Eurostat methodology, grew by 7.5 billion euros in January-March, and reached 38 percent of 2008 gross domestic product (GDP). Still, there is plenty of stimulus ammunition left, the important thing is to use it wisely, and try to engineer an economic transition.



The severe contraction in the Finnish economy is also likely to take its toll on bank credit fundamentals, according to the credit rating agency Moody's. The agency recently reaffirmed its negative outlook for the Finnish banking system. Up until now the Finnish banking sector - lead by Pohjola Bank and local branches of Nordea and Danske Bank - appear to have been weathering the storm without undue difficulty due to minimal exposure to toxic assets and a focus on traditional banking activities, according to Moody's. However:


"Given that the crisis on financial markets has now spread extensively into the real economy, Moody's expects Finnish banks to be adversely affected," according to the latest report. Moody's said an increase in bankruptcies was indicative of the weakened credit environment.

Corporate bankruptcies increased 33 percent in January-May from a year ago, according to Statistics Finland.


The Finnish government has already approved one supplementary budget for 2009 including a special stimulus package. The overall impact is estimated at around €2 billion (although new spending is estimated at only €1.2 billion), and includes about €140 million in transport infrastructure projects. The government has committed itself to implementing a guaranteed pension from the beginning of March 2011. This will cost around €111 million a year, and will raise the lowest pensions by about €100 a month - affecting about 120,000 people.

There have also been a number of measures aimed directly at helping corporate finance. The government now offers banks operating in Finland both deposit guarantees and capital, and will also invest its pension funds in corporate bonds, offer companies financial support through the specialised state-owned finance company, Finnvera, and provide partial financing for the construction of thousands of new homes through the state-owned credit institution Kuntarahoitus (Municipal Finance).

Overall, the government has pledged about €60 billion in guarantees, loans and investments, and is expecting a boost of €45 billion in corporate financing. Prime Minister Vanhanen described the decisions as ‘massive, even gigantic’. The largest sums of money are in the bank support package, which aims to secure the continuity of corporate credit. In fact, the Finnish parliament has already approved guarantees of €40 billion to help banks to raise capital.


But in the longer term the issues raised at the start of this post need to be addressed. Competitiveness needs to be restored to the Finnish economy, and exports boosted, as illustrated by the REER chart below. In particular the situation pre 2007 needs to be restored. The change is not massive (maybe only 5% or so), so it is doable, and it needs to be done, especially since the Swedish Krona has been significantly devalued.




As mentioned previously, the goods trade balance has been deteriorating, and the earlier positive balance now needs to be restored.



One of the things that stands out is Finland's differential preformance vis a vis Sweden. Using data prepared by Eurostat which shows the volume indexes of GDP per capita as expressed in Purchasing Power Standards (PPS) (with the European Union - EU-27 - average set at 100) it is apparent that a gap exists (see below) and that it is not being closed. In fact, after 1998 the two lines move tantalisingly in tandem, but with Finnish per capital GDP stuck just short of the Swedish level. Any reading on these indexes of over 100 implies that the country's level of GDP per head is higher than the EU average and vice versa, and relative movements in the indexes imply that the rates of change in GDP per capita are either improving more or less rapidly than the EU average. The basic data behind the charts is expressed in PPS which effectively become a common currency eliminating differences in price levels between countries making possible meaningful volume comparisons of relative GDP per capita. Since the index is calculated using PPS figures and expressed with respect to EU27 = 100, it is only valid for cross-country comparison purposes and not for individual country inter-temporal comparisons, nonetheless charts based on such data are extraordinarily revealing.



So the real reason is why (given some sort of loose convergence expectation) this gap is not being closed. There can be several explanations. One may be differences in institutional quality (education systems, for example), another might be the impact of euro membership: it could be, for example, that, as OECD economists Jorgen Elmeskov and Romain Duval argued in a suggestive paper (Structural reforms in product and labour markets) presented at the 2005 ECB conference "What effects is EMU having on the euro area and its member countries?", that membership has up to now slowed down rather than accelerating the reform process. Thirdly, the issue could be differential demographics. Few economists seem willing to investigate this possibility in any depth, despite mounting evidence that it may be important.

One demographic indicator that springs to mind immediately when I think about these two countries is the differential in life expectancy. Swedish males live on average around 3 years longer than Finnish males (see below). Now this may be important, although no one has started to calibrate this effect yet. The economic intuition for the importance would be, think of investment in a machine (physical capital), then obviously the value of the investment is greater (other things being equal) if the machine keeps running five years longer.



Things cannot be that much different with human capital. The education and on the job training costs are similar, but the person is able to work three years less. Is it mere coincidence that labour market exit at 61 is so typical if the health outlook is worse? Here are the relative labour force participation rates for me between 55 and 65. It is my contention that this alone accounts for a substantial part of the GDP per capita difference between the two countries.



But the solution to this problem is not an easy one, and the OECD and others really need to think much more seriously about this phenomenon when they indisciminately propose raising higher-age participation rates across the board as a solution to the declining workforces problem.

What is involved here is a complex mix of health provision, lifestyle and genetic differences, and any response needs to take account of all of these.

Raising the health and life expectancy of the Finnish population would be one sure way to raising GDP per capita, another way (in the longer term) would be raising fertility back up to replacement levels, and a third path would be extending the younger labour force by encouraging immigration (which interestingly has been on the rise in the Helsinki area in recent months, although if many of the newcomers simply arrive from equally affected Estonia this is nothing more than moving the deckchairs around). Whichever way you look at it though, in both the short and longer term the deterioration in Finland's trade surplus needs to be addressed. If it isn't the outcome will not be a pleasant sight.