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Wednesday, October 24, 2007

Catch Up Growth and Demographics - Evidence from Eastern Europe

by Claus Vistesen: Copenhagen

Performing a simple series of adept Googling exercises around various sources on the internet you can easily discover that certain species of the lynx are able to travel at speeds of up to 50 kph (31 mph). Wikipedia informs us that the Eurasian lynx, on average, commands a hunting area of between 20-60 square kilometers in which the lynx is able to walk and run about 20 kilometers in one single night. All in all, a pretty rugged and constitutional little thing this lynx.

In this way, and perhaps because, at that particular point in time, the Eastern European Economies looked as if nothing could come in their way of economic prosperity and growth they were paired, by the Economist, with the region's sturdy feline coining the notion of 'Lynx Economies.' Thus, 'that particular point in time' was sometime back in the spring of 2006 where the Economist's (and my own) coverage of the CEE and Baltic economies came in hot on the heels of publications by the World Bank and and the Vienna Institute of Comparative Economic Studies speaking favorably of the future prospects of economic prosperity and thus 'catch-up' growth in the CEE and Baltic Economics.

Yet, merely 1 year and a tad later things seem to have changed quite significantly with respect to the discourse on the economic situation in Eastern Europe. Many of the contributors to this blog has been pitching on the change in discourse but also some of major institutional actors have been flagging the red banner. Not least the World Bank seems to have changed their attitude somewhat with most notably a recent report on the demographics of Eastern Europe entitled From Red to Gray - The Third Transition of Ageing Populations in Eastern Europe and the former Soviet Union as well as a recent writ with specific focus on the macroeconomic risks prevailing in the region. Yet, also the IMF in their latest World Economic Outlook devotes a chapter to the managing of large capital inflows where Eastern European economies also take center stage of the general tone of warning; in essence this note of warning concerning Eastern Europe seems to be the general talk of the day amongst economic analysts and journalists. As such, perhaps even the lynxes roaming the forests and planes of Eastern Europe are beginning to feel that the otherwise catchy notion conjured by journalists at the Economist is becoming something of a stretch according to the reality of the situation. Sure, things are moving fast now but it is what happens next which might finally serve to make the allegory rather unrealistic. In this entry I set out to explicitly investigate an issue which in fact has been treated several times on this blog and perhaps most often in the context of the CEE and Baltic Economies. Simply put and in the form of one simple question;

  • How do changing demographics and more specifically the final and ongoing stages of the demographic transition affect the notion and principle of economic catch up growth and thus economic convergence as it is stipulated by (neo-classical) economic growth theory?

As I have hinted above in the introduction my main subject of analysis on which the general theoretical argument is based is the current and ongoing situation in the CEE and Baltic economies. A lot has been written about this recently not least from the hands of the contributors to this blog (see also above). As a one-stop overview of the concrete issues at hand this recent note by Edward over at Global.Economy.Matters should provide you with suitable ammunition to get you started. In particular, the following three point overview of the current economic situation in Eastern Europe should always be in the back of your mind as we move forward from this point ...

Basically the principal outstanding issues confronting the EU10 countries are threefold:

  • Labour capacity constraints (which are normally a by product of long-term low fertility and large scale recent migration flows) are producing significant wage inflation and strong overheating.
  • A structural dependence on external financing - which is in part a by-product of the effect of low levels of internal saving, and which is another factor which separates the EU 10 from those like India or China who are benefiting from a typical demographic dividend driven catch up, is leading to large current account deficits, and potentially high levels of financial instability.
  • A loss of control over domestic monetary policy due to eurozone convergence processes which - with or without the presence of formal pegs - make gradual downward adjustment in currency values as a alternative to strong wage deflation virtually impossible. This issue is compounded by the likely private "balance sheet consequences" of any sustained downward movement in the domestic currency given the widespread use of mortgages which are not denominated in the local currency.
Traditionally a rigorous economic analysis in the light of the immediate events would focus a lot on point 2 and 3 but in this note we shall look specifically at number 1 and the issues of labour capacity, its constraints, and what it means of the economic growth of less to medium developed countries. Now, the most obvious caveat in this entry is that I really don't have the time at this point to really lay out the whole theoretical framework of economic growth theory and as such the precise slot in which my argument should be inserted within the wider theoretical framework. This will be the topic of a more rigorous article not suited for the blog format. However, I still need to attach some comments to set the scene where I should also immediately note that my previous note here at DM about catch up growth in Eastern Europe serves as a good state of the game post for what comes next.

Apart from my studies of selected pieces of the economic growth literature one of the best overviews of the concept of economic convergence as a function of the theoretical and practical assumptions vested in the growth models is to be found in an article by Norbert Fiess and Marco Fugazza on economic integration in Europe (PDF). As such it is important to note that convergence of GDP per capita levels is not a holy grail within the fields of economic growth theory. Rather, the process of convergence should be seen as an inbuilt consequence of the fact that as economies mature returns to production inputs decrease; that is to say that this discussion essentially revolves around the concept of increasing v. decreasing returns to scale in our economic model. If we think about decreasing returns to scale and introduce the concept of marginal productivity to production inputs we can then see that less developed countries are likely to exhibit higher rates of growth than their more mature counterparts in the sense that their marginal productivity is higher which then leads to a process of convergence. Now, this argument in its most strict sense is usually applied in the context of capital as a production input and coupled with the properties of an open economy and subsequent free flow of production factors this would lead to a rather rapid process of convergence or absolute convergence as the technical term. As regards to labour as a production input is has also been argued that the universal transition from an agricultural to manufacturing over to service (?) based economy produces a mechanism of convergence in the sense that this process implies a move up the value chain and thus that every unit of labour becomes more productive. Of course and even though we are talking about stylised facts here, this is also where the whole debacle begins in the context of my immediate argument because how certain is this process? Also, we need to take into account the distinction between stocks and flows (of labour) which is a crucial issue to consider when talking about ageing economies.

However and it does not take much of an economist to see that empirical facts do not support the idea of absolute convergence or at least it seems as if the process takes much longer to materialize than predicted by the theory. This has lead, among other factors, to a 'new' strand of economic growth models which allows for persistent growth divergence to exist between countries. The crucial aspect to understand here is the mechanism through which persistent divergences can occur. In this way, one of the widest contributions by economist to this thesis has dealt with the possibility that technological processes and thus accumulation of technological advances exhibits increasing returns to scale. The fundamental brilliancy of this notion is that it allows for a model where there is indeed decreasing returns to labour and capital but where different levels of technological effort leads to internal positive feedback mechanisms and thus explains persistent divergences in growth and 'prosperity' across countries.

Ok, I think that I have already said enough at this point and in order to get us back to track one crucial assumption and conceptual idea needs to be pinned down. As such and if we look at the rudimentary description of the economic growth process above it is not wholly unreasonable to argue that the growth process of an economy is somewhat directly related to the process of the demographic transition. Or as Robert Lucas puts it in a widely cited article ...

That is, the industrial revolution is invariably associated with the reduction in fertility known as the demographic transition.

As such, why don't we take a look at Eastern Europe where the economies have experienced, quite as expected by the conventional theory of economic growth, economic dynamics tantamount to catch-up or convergence. Especially the economic data since the expansion from EU15 to EU25/27 and, for some countries, the subsequent anchoring to the Euro has been very impressive indeed. Yet as Edward and I have been at pains (see link above) to explain again and again these countries are not your average emerging markets. This follows from the fact that their demographic structures have been fundamentally distorted due to a collapse of fertility in the beginning of the 1990s which has been aggravated by a persistent net outflow of migrants serving to further speed up the decline in the working and essentially also most productive cohorts. In order to capture this development and in order to frame the current situation the following point I made in a previous note is worthwhile to repeat.

In short, we are dealing with countries where the demographic transition by far, and indeed worryingly, has out paced the traditional economic process of economic convergence.

This is exactly what we are talking about here and apart from going to the heart of the imminent issues in Eastern Europe it also strikes right smack into the concept of economic growth theory and how to deal with the fact that the demographic transition does not occur the way it was originally anticipated. Most emphatically, we can see in the context of the Eastern European countries that the final stages of the transition have arrived far before and quicker than the twists and turns of history allowed for these economies to really get on with business. Yet, the general argument can just as easily be expanded into a discussion of the ageing part of OECD where it is painfully clear at this point that conventional economic theories are wholly incapable of explaining what is likely to happen next. In fact, we could stretch it so far as to say that modern economic growth theory is not able to explain what happens when fertility drops to a level below replacement level and stays there!

In Summary

Even though that a lot words have been written in this entry I am afraid that only superficial contributions have been made to the final answer of the proposed question. This entry principally had one main task, namely to initiate a line of reasoning which ultimately and hopefully can lead to a better understanding of modern economic growth processes in a context of the current demographic profile of many developed and developing economies. Specifically, this entry revolved around the concept of catch-up growth/convergence where the countries in Eastern Europe were suggested as an example to demonstrate how demographics can fundamentally alter the principles by which the economic growth process is likely to conform. In this way, the message is not that modern economic growth theory and growth accounting methods are rendered obsolete in the face of changing demographics but rather that considerable adjustment needs to be made; especially in the context of catch up growth/convergence but also crucially in the context of the notion of a steady state of economic growth. Returning briefly to the real world before we sign off it could seem as if the branding of the lynx economies never was more than a quick and essentially expensive make-up which is set to quickly wear off as we venture on. Specifically, recent signs coming out of the ECB and the European commission suggest that expectations are aligning towards an outlook where the process of convergence effectively risks grinding to a halt. My advice would then be not to exchange the carrot too swiftly into a stick since this would only serve to kick those who are already on the ground.

Tuesday, October 16, 2007

Mugur Isarescu Shows Us How Not To Run A Central Bank

Well according to Bloomberg this morning:

Romania's central bank will hold back from any ``sharp and sudden'' reaction to accelerating inflation and a widening current account deficit.

``Don't expect us to react in an unprofessional way or to overreact or be disorderly or push on the brakes,'' Mugur Isarescu, 58, said in an interview in Bucharest yesterday. ``There's no reason. The situation is manageable.''

Isarescu, who has headed the central bank since 1990, after the fall of communism, said there was ``not a good probability'' that the year-end annual inflation rate will be below 5 percent, though it will probably peak in October.

`We expect some impact of the drought on food prices to remain in October,'' he said. The increase may turn around starting in November and ``we hope inflation at year's end will be close to the target. We aren't only looking at one month's data and then to go and shoot a fly with a cannon. We're looking for sustainability and continuity.''

Obviously this is just not the way to handle a tricky and extremely complex situation. The remarks do not convey the level of concern and getting down to business attitude that the markets are looking for - and are right to expect - at this point. Predictably the leu has again been under siege this morning. If the central bank governor conveys the idea that he isn't particularly bothered, then its do what you like time.

Also, and as is being repeatedly stressed here on this blog, by the IMF and by the world bank, the issues which are up on the table go way, way, beyond food prices. The relate to how you can continue to fund an unsustainable current account deficit, and what to do about a fertility and out-migration driven labour shortage. They need to be addressed, and quickly - at least by offering credible policy responses - or all of this is going to explode, and soon.

Saturday, October 13, 2007

Romanian Current Account Deficit and the State of the Leu

It has been some days now since I posted a leu chart. This is largely due to the fact that the downward slide has stabilised to some extent, and even reversed. Indded the leu rose to its highest level in a month versus the euro last week after data showed inflation quickened in September, surpassing the central bank's year-end target.

The rate of consumer-price inflation climbed to a one-year high of 6 percent, exceeding the bank's year-end target of 4 percent, plus or minus one percentage point.

Florin Citu, deputy head of financial markets at ING Bank Romania is quoted as saying that "The central bank cannot escape raising interest rates....It will be very hard for the central bank to explain if they chose not to raise rates, as inflation is going to reflect in wage requests too."

Personally I feel that this way of reading the inflation data - as being good for the leu if it is bad for the country - is something of a fools errand at this point, since the global markets are in the process of a major re-positioning, and we are all only waiting for Jean Claude Trichet to finally declare that the next move over at the ECB will be down for the whole show to get into full swing.

The real news of the moment is the Bulgarian inflation. The airwaves are rife with speculation following Bini Smaghi's ECB speech about how long those who are pegged to the euro can actually hang out in the current climate, and recent reports from the IMF and the World Bank singling out the labour shortage and current account deficit issues in the EU 10 will hardly help. So my feeling is that the leu will not be left on one side - in a kind of Ocean of tranquility - here. My only major question is which will come first, a run for cover by one of the peggers - Estonia perhaps - in breaking the peg, or a serious attack on the leu. It is hard to say really, but whichever comes first the other will follow soon behind. This is all what you could call a "done deal" now I'm afraid. The other big question is, of course, once it all starts, where exactly will it stop?

Nearly all the news out of Romania is bad at the moment - in the sense of overheating, since declining unemployment, which means a tightening labour market and hence even more pressure on inflation, can hardly be called good news at this point, welcome as it would be in another moment.

The International Monetary Fund said earlier in the week after concluding a week-long visit to the Romania that inflation will be at 5 percent by year-end and that "inflation prospects for 2008 are worrying". Inflation prospects unfortunately are not the only thing which is worrying.

Against the euro, the leu touched 3.3298 at 6:05 p.m. in Bucharest on Thursday which was its highest level since Sept. 13. Despite the recent rebound however the leu is the worst performer among emerging-market currencies in the past three months, dropping almost 7 percent as can be seen from the chart blow.

The reaction to financial market stress since the middle of August can be observed in the second chart.

One to watch!

A much fuller appreciation of the imminence of an emerging market correction in Eastern Europe, and the factors which lie behind it, can be found here.

Update Monday morning 15 October 2007

The National Bank of Romania released Current Account data for the January-August 2007 period this morning. Although the deficit virtually doubled over the same period in 2006, there is little here to add to the news on the trade deficit last Friday, since, as the bank say in their press release:

In January-August 2007, the balance-of-payments current account posted a deficit of EUR 10,228 million. This development can be ascribed mainly to the wider trade deficit, which amounted to EUR 10,864 million, up 69 percent from the same period of last year.

According to the central bank, foreign direct investment in the first eight months of the year fell to 4.06 billion euros from 4.3 billion euros in the same period last year. Long-term foreign debt rose 19 percent at the end of August from Dec. 31 to 33.9 billion euros.

At the same time, those of you who doubt the importance of all those Romanians working abroad, note that money transfers to Romania, which come mostly from citizens sending money home from abroad, rose to 3.49 billion euros in the period from 2.77 billion euros a year earlier.

Bloomberg quote Florin Citu, deputy head of financial markets at ING Bank in Bucharest, as saying:

"The deficit this year will be humongous.....The question is whether this will be worked out gradually or by a sudden drop in the leu and a drop in economic growth. If I were a betting man, I would go for the latter."

I'm afraid I can't help but agree. The leu, of course, was under pressure again this morning. I am convinced that the whole situation in the EU 10 is now unsustainable, and that an important correction is coming, the only real doubt in my mind is whether that correction will start with a run on the leu or with one of the euro peggers - Bulgaria, Latvia, Estonia and Lithuania - making a run for cover and breaking the peg.

Time, as always, will tell.

Wednesday, October 10, 2007

Romania August 2007 Trade Gap Widens

Romania's trade deficit increased in August when compared with August 2006 as the elimination of a considerable number of trade barriers following European Union entry and a stronger currency encouraged Romanians to buy more goods from abroad.

The deficit widened to 1.77 billion euros in August from 1.3 billion euros in August 2006, according to the National Statistics Institute yesterday (these calculations are based on preliminary data). The actual deficit remained by and large unchanged when compared with the revised deficit of 1.81 billion euros registered in July.

A strong inward flow of funds into Romania (including remittances) since joining the EU last January has strengthened the leu, and this has made imports cheaper. The leu - even despite the recent decline - has still gained 18 percent against the dollar and 4.7 percent against the euro over the past year.

In addition Romania became a net grain importer in the second half of the year after months of record-high temperatures and low rainfall badly affected corn and wheat crops. The drought damaged two-thirds of the 6 million hectares of crops planted this year and destroyed about 1 million hectares.

Imports in August rose an annual 18.6 percent to 3.99 billion euros, while exports increased 7.6 percent to 2.22 billion euros. Imports from other EU countries rose 20 percent as exports to the bloc increased 9.1 percent.

In the first eight months of the year, the trade deficit widened to 13.35 billion euros from 8.38 billion euros in the same period of last year. Imports increased 27.5 percent and exports rose 11.8 percent.

This situation is hardly sustainable, and when put together with all the other information we have coming out of Romania at the present time only serve to complete what is really a very worrying picture.

Romanian Inflation September 2007

Romania's inflation rate rose for a third straight month in September, raising the temperature in the great "overheating" debate and creating growing expectation of an imminent an interest rate increase. The year on year rate rose to a one-year high of 6.03 percent in September from 4.96 percent in August, according to data from the National Statistics Institute yesterday. This rate is well above the central bank's year-end target. Month-on-month consumer prices rose 1.08 percent, compared with 0.9 percent a month earlier.

Inflation has been steadily accelerating since the 3.8 per cent level registered in June, as have retails sales, construction activity and prices and wages and salaries in the construction sector. A drought damaged two-thirds of Romanian crops earlier this year, and this has clearly had an impact on food prices. However the inflation process is much more generalised, and the services sector as a whole also registered a 6 per cent year on year rate in September.

The whole situation is not aided by the weakening value of the leu, since the steady increase in value over the last two years had acted as a break on the inflationary process. The Leu has however declined 5 around percent against the euro over the last two months.

This situation, however, is far from clearcut, since a reducing leu also can help restore cost competitiveness in the export sector, a competitiveness which, as we will see in my next post, has been dramatically undermined by the surge in wage costs and the higher leu. In this sense a steady downward adjustment in the currency would perhaps be a more palatable solution to the issue of lost cost competitiveness than is the drastic wage deflation one which is being applied in Hungary.

There are however two problems here. The first one is that any such adjustment downwards in the currency needs to be gradual, not abrupt. The big danger in Romania now is of a sudden correction, and the IMF in its World Economic Outlook was warning only yesterday of the dangers which a sudden reversal of capital flows would represent in the East European context.

The second is the presence in Romania, as elsewhere across the EU10 of substantial corporate and private debt liabilities which are not leu denominated (ie they are in euro, swiss francs, dollars, or whatever). Any large reduction in the value of the leu would immediately present a problem in this regard, and this has to be one of the big risk areas for the hard landing scenario in the Romanian context.

The International Monetary Fund mission which is in Romania at the present time have explicitly warned about the problem that a widening current account deficit makes the leu much more vulnerable to external pressures, such as the reluctance of investors to put money into emerging markets amid the U.S. subprime crisis. I can only endorse that warning.

Of course the other problem here is the loss of real monetary policy influence at the central bank. Romania's central bank targets a year-end annual inflation rate of 4 percent, plus or minus a percentage point, a rate which has been adopted as part of the background scenario for Romania's possible adoption of the euro in 2014 or after. The central bank cited higher-than-expected inflation in August when it decided on Sept. 26 to keep its key interest rate unchanged at 7 percent, after cutting it four times earlier in this year.

The key rate, the annual amount the central bank offers to commercial banks for one-month deposits, was 8.75 percent when Romania joined the European Union in January, the highest in all of the 27 member countries. The next central bank interest rate decision is scheduled for Oct. 31.

The cost of services is rising alarmingly, and one of the difficulties is that prices here are often indexed to the euro. Service prices rose by a monthly 1.4 percent in September after rising 1.1 percent in August, while the annual rate was 6.3 percent, up from 6 percent in August.

Food prices rose a monthly 1.9 percent in September from 1.7 percent in August and an annual 8.2 percent, from 5.4 percent. Non-food goods prices increased a monthly 0.2 percent, from 0.1 percent, and a yearly 4.1 percent, the same rate as in August.

The International Monetary Fund forecast yesterday that year-end annual inflation in Romania would be about 5 percent, which is again up from the 4.9 percent registered at the end of last year. I would say that there are upside risks on this estimate, given what we are seeing on the construction activity and labour shortages front.

The government plans for a 2008 budget deficit of about 2.7 percent of gross domestic product next year, from a deficit of between 2 percent and 2.8 percent this year. The central bank has also said that increases of wages, which grew at an annual pace of 23 percent in August, are unsustainable and are a threat to its inflation targets.

Thursday, October 4, 2007

Romania Construction Production Index August 2007

INSEE have released the August data for the level of construction output. Output increased by 10.2% over July and by 39.3% over August 2006. I think these numbers more or less speak for themselves. Here are the charts. First the index itself:

and here are the monthly year on year changes:

Romania Retail Sales August 2007

Well following hot on the heels of the IMF delegation assessment that the Romanian economy may be overheating comes some additional information that they may be right. Romanian retail sales rose at the fastest annual pace since at least 2005 in August as higher wages and a surge in consumer credit prompted citizens to shop more.

Sales increased an annual 34 percent, up from a 23 percent gain in July, according to data from the National Statistics Institute (INSEE) released today. Month on month, sales growth quickened to nearly 16 percent, up from 9.2 percent in July.

Sales of food, drinks and tobacco surged an annual 60 percent, up from 38 percent in July, while service industry sales increased 22 percent, compared with a gain of 1 percent. Sales of non-food goods gained 10 percent, from 9.1 percent. Here is the chart of the general index.

and here are the month by month annual increases so far this year. Sales certainly do seem to be accelerating at the moment.

This latest data adds to a mounting volume of evidence that Romania is overheating as consumption has steadily risen on the back of as a rising inflow of investment and worker remittances which has been developing since Romania joined the European Union on Jan. 1 2007. Before the recent downturn in the leu the currency had been strengthening and wages have been accelerating rapidly. Average net wages rose at an annual 23 percent rate in August. In general terms the leu is still up 16 percent against the dollar and 5 percent against the euro over the past year, and this is undoubtedly encouraging Romanians to buy more imports.

Private indebtedness of individuals in Romania rose at an annual 50 percent rate in August, much of it in the form of consumer loans, as wage growth increased Romanians' borrowing power, according to a report from the central bank on Sept. 25.

Tuesday, October 2, 2007

IMF Sees "Signs of Overheating" in Romania

According to Bloomberg the International Monetary Fund's mission chief in Romania, Albert Jaeger, has just said in Bucharest Romania's economy risks overheating:

"We have seen signs of overheating in the economy, particularly in the job market"

If you have been following what I have been arguing on this blog, and in particular in this post, then you will already be aware that this news comes as no great surprise to me.

Meantime, not everything is bad news in Romania at the moment. The leu, for example has to some extent reversed its recent slide.

This morning the leu rose 0.2 percent to 3.3521 per euro at 11:45 a.m. in Bucharest. This was up 2.4 percent from an eight-month low hit on Sept. 20.

The leu has in fact been the second-best performing currency against the euro in Europe and Africa today after the Romanian Finance Ministry said it would offer 1.9 billion leu ($803 million) worth of treasury bills and 2.3 billion of government bonds in the fourth quarter, up from sales worth 1.3 billion leu in the previous three months.

``Prospects of a fourfold increase in Romanian T-bills and sovereign bonds issuance in the fourth quarter should help the leu to pursue its recovery, although short term politics and global markets can act as an hindrance,'' BNP Paribas SA said in a research note published today.

Recovery, or temporary blip on the long road down? The next few weeks will surely give us the answer. Of course having the IMF mission detecting signs of overheating will hardly be good for the currency.