“We think the most important announcement at this stage is the possibility to convert CHF loans to HUF. If households chose to do this it would ultimately mean a switch in FX mismatch from households to banks (who would then hold HUF assets but CHF liability). Banks in turn would then need to close their FX mismatch, through FX swaps (buying CHF).........It's not clear who would provide sufficient HUF liquidity to do this. Ultimately the NBH would presumably provide liquidity to avoid banks being left with a significant FX mismatch."
Martin Blum, Gyula Tóth, UniCredit, Vienna

"Herd behavior occurs when people do what others do rather than rely on their own (incomplete) information, which might be suggesting something different (Banerjee, 1992). The suppression of private information could lead to “information cascades” when decisions are made sequentially and a large enough number of people choose identical actions. In such settings, the decisions of a critical few people early on are enough to tilt group behavior toward a certain direction. Mimicking the behavior of others might be rational because of uncertainty about one’s own information as well as the need to economize on information-gathering costs. Rational herd behavior is the subject of a recent strand of behavioral finance (see Montier, 2002, for an introduction). "

Total cross-border claims of BIS reporting banks expanded by $1 trillion in the last quarter of 2006. After more modest growth in mid-2006, a pickup in interbank claims accounted for 54% of this expansion. A surge in credit to nonbank entities contributed $473 billion, pushing the stock of cross-border claims to $26 trillion, 18% higher than in late 2005.

The flow of credit to emerging markets reached new heights through the year 2006. Claims on emerging markets grew by $96 billion in the final quarter of 2006, bringing the volume of new credit throughout the year to $341 billion. This amount exceeded previous peaks ($232 billion in 2005 and $134 billion in 1996), both in nominal value and in terms of growth. The current annual growth rate has risen to 24%, having surpassed for the sixth consecutive quarter the previous peak of 17% recorded in early 1997.

Emerging Europe overtook emerging Asia as the region to which BIS reporting banks extend the greatest share of credit. Since 2002, growth in claims on the region has consistently outpaced that vis-à-vis other regions. With a record quarterly inflow, emerging Europe received over 60% of new credit to emerging markets, bringing its share in the stock of emerging market claims to 34%. Less of the new credit went to the major borrowers (Russia, Turkey, Poland and Hungary) than to a number of smaller markets, notably Romania and Malta, as well as Ukraine, Cyprus, Bulgaria and the Baltic states.


The currency denomination of cross-border claims on emerging Europe tilted further towards the euro. In the stock of claims outstanding, the euro and dollar shares were 44% and 31%, respectively, but the gap in the latest flow data was more pronounced (61% and 5%). While the sterling share has remained close to 1%, the yen has lost ground to the Swiss franc, thus continuing a trend seen over the last six years. Yet there is little evidence in the cross-border data of unusual borrowing in Swiss francs that might correspond to Swiss franc-denominated retail lending in several countries. Borrowing in the Swiss currency remains on average below 4% of cross-border claims, and exceeds 10% only in Croatia and Hungary.


Nearly 20% of reporting banks’ foreign claims were in the form of funds channelled to emerging market borrowers. Claims on residents of emerging Europe continued to account for the largest share of these funds.

So, although the BIS find "little evidence in the cross-border data of unusual borrowing in Swiss francs that might correspond to Swiss franc-denominated retail lending", they do make an exception in the cases of Hungary and Croatia, where they note that lending in Swiss francs to retail clients reaches over 10% (and of course in the Hungarian case well over 10%) of the total retail loans in those countries. Indeed, as I indicate above, swiss franc loans now seem to account for over 80% of all newly generated housing related credit in Hungary. The reason why Hungary has gone for Swiss franc rather than euro denominated loans undoubtedly has to do with the role of the Austrian banking sector in Hungary, as is explained in my fuller posting on this topic linked to below.

Additional References On Swiss Franc Loans and "Translation"

For fuller examination of just why it is that Switzerland (or for that matter Japan) have such low interest rates, see my "Swiss Franc Loans and Ageing" post.

For an examination of the potential implications of the presence of all these foreign currency loans across the EU10 in the event of any generalised emerging markets crisis see Claus Vistesen "Translation Risk in the Baltics and Other Matters".

Balance Sheet Consequences: The Academic Research


Well, given what I am saying above about the rapid and imminent demise of foreign exchange loans among Central and East European nationals, it is clear that the topic which is now about to come back into fashion (and to replace the forex loans themselves as the centre of attention - at least among theoretical economists) is that of the so called "balance sheet consequences" of excessive forex leveraging, so to give people some background, and a bit of a push start, I have hastily compiled a brief reading list on the topic.

Do Balance-Sheet Effects Matter for Brazil? Felipe Farah Schwartzman, May 2003

The past ten years have seen a number of currency crises, typically followed by a sharp drop in output in the countries involved. An explanation advanced for both the crisis and the recession is that firms in these countries had a large amount of debt indexed in foreign currency (Krugman, 1999). The exchange rate devaluation left the firms insolvent, reducing credit and production in the economy. Apart from crisis, balance-sheet effects have been advanced as an explanation for the “fear of floating” detected by Calvo and Reinhardt (2000) in developing economies in normal times.

Krugman, P. (1999), “Balance Sheets, the Transfer Problem and Financial Crisis,” in: International Finance and Financial Crises, P. Isard, A. Razin and A. Rose (eds.)

For the founding fathers of currency-crisis theory ..........the emerging market crises of 1997-? inspire both a sense of vindication and a sense of humility. On one side, the number and severity of these crises has demonstrated in a devastatingly thorough way the importance of the subject; in a world of high capital mobility, it is now clear, the threat of speculative attack becomes a central issue - indeed, for some countries the central issue - of macroeconomic policy. On the other side, even a casual look at recent events reveals the inadequacy of existing crisis models. True, the Asian crisis has settled some disputes - as I will argue below, it decisively resolves the argument between “fundamentalist” and “self-fulfilling” crisis stories........ But it has also raised new questions.

One way to describe the problem is to think in terms of Barry Eichengreen’s celebrated distinction between “first-generation” and “second-generation” crisis models. First-generation models, exemplified by Krugman (1979) and the much cleaner paper by Flood and Garber (1984), in effect explain crises as the product of budget deficits: it is the ultimately uncontrollable need of the government for seignorage to cover its deficit that ensures the eventual collapse of a fixed exchange rate, and the efforts of investors to avoid suffering capital losses (or to achieve capital gains) when that collapse occurs provoke a speculative attack when foreign exchange reserves fall below a critical level.

Second-generation models, exemplified by Obstfeld (1994), instead explain crises as the result of a conflict between a fixed exchange rate and the desire to pursue a more expansionary monetary policy; when investors begin to suspect that the government will choose to let the parity go, the resulting pressure on interest rates can itself push the government over the edge. Both first- and second-generation models have considerable relevance to particular crises in the 1990s - for example, the Russian crisis of 1998 was evidently driven in the first instance by the (correct) perception that the weak government was about to be forced to finance itself via the printing press, while the sterling crisis of 1992 was equally evidently driven by the perception that the UK government would under pressure choose domestic employment over exchange stability.

In the major crisis countries of Asia, however, neither of these stories seems to have much relevance. By conventional fiscal measures the governments of the afflicted economies were in quite good shape at the beginning of 1997; while growth had slowed and some signs of excess capacity appeared in 1996, none of them faced the kind of clear tradeoff between employment and exchange stability that Britain had faced 5 years earlier (and if depreciation was intended to allow expansionary policies, it rather conspicuously failed!) Clearly something else was at work; we badly need a “third-generation” crisis model both to make sense of the recent crises and to help warn of crises to come.

In the paper which follows Krugman sketches out yet another candidate for third-generation crisis modeling, one that emphasizes two factors that had been omitted from previous formal models to date: the role of companies’ balance sheets in determining their ability to invest, and that of capital flows in affecting the real exchange rate. The model was at that point (and as Krugman himself says) quite raw, with lots of loose ends hanging about. However, it did seem to tell a story with a much more realistic “feel” than some of the earlier efforts. It could be hoped that now that he has had time to recover from the shock of his recent Nobel, he may get interested once more in this earlier centre of his attention, since the model badly needs updating, and in particular to take account of the shift in the risk away from the corporate and towards the household balance sheet.

Balance Sheet Effects, Bailout Guarantees and Financial Crises
MARTIN SCHNEIDER UCLA and AARON TORNELL UCLA and NBER

This paper provides a model of boom-bust episodes in middle income countries. It features balance of- payments crises that are preceded by lending booms and real appreciation, and followed by recessions and sharp contractions of credit. As in the data, the non-tradables sector accounts for most of the volatility in output and credit. The model is based on sectoral asymmetries in corporate finance. Currency mismatch and borrowing constraints arise endogenously. Their interaction gives rise to self-fulfilling crises.


In the last two decades, many middle-income countries have experienced boom-bust episodes centered around balance-of-payments crises. There is now a well-known set of stylized facts. The typical episode began with a lending boom and an appreciation of the real exchange rate. In the crisis that eventually ended the boom, a real depreciation coincided with widespread defaults by the domestic private sector on unhedged foreign-currency-denominated debt. The typical crisis came as a surprise to financial markets, and with hindsight it is not possible to pinpoint a large “fundamental” shock as an obvious trigger. After the crisis, foreign lenders were often bailed out. However, domestic credit fell dramatically and recovered much more slowly than output.

This paper proposes a theory of boom-bust episodes that emphasizes sectoral asymmetries in corporate finance. It is motivated by an additional set of facts that has received little attention in the literature: the tradables (T-) and nontradables (N-) sectors fared quite differently in most boom-bust episodes. While the N-sector was typically growing faster than the T-sector during a boom, it fell harder during the crisis and took longer to recover afterwards. Moreover, most of the guaranteed credit extended during the boom went to the N-sector, and most bad debt later surfaced there. Our analysis is based on two key assumptions that are motivated by the institutional environment of middle income countries. First, N-sector firms are run by managers who issue debt, but cannot commit to repay. In contrast, T-sector firms have access to perfect financial markets. Second, there are systemic bailout guarantees: lenders are bailed out if a critical mass of borrowers defaults.

And please note the last sentence: "lenders are bailed out if a critical mass of borrowers defaults", this, I imagine, is what we are about to see happen next.

A Balance Sheet Approach to Financial Crisis
Mark Allen, Christoph Rosenberg, Christian Keller, Brad Setser, and Nouriel Roubini :

The paper lays out an analytical framework for understanding crises in emerging markets based on examination of stock variables in the aggregate balance sheet of a country and the balance sheets of its main sectors (assets and liabilities). It focuses on the risks created by maturity, currency, and capital structure mismatches. This framework draws attention to the vulnerabilities created by debts among residents, particularly those denominated in foreign currency, and it helps to explain how problems in one sector can spill over into other sectors, eventually triggering an external balance of payments crisis. The paper also discusses the potential of macroeconomic policies and official intervention to mitigate the cost of such a crisis.

“We think the most important announcement at this stage is the possibility to convert CHF loans to HUF. If households chose to do this it would ultimately mean a switch in FX mismatch from households to banks (who would then hold HUF assets but CHF liability). Banks in turn would then need to close their FX mismatch, through FX swaps (buying CHF).........It's not clear who would provide sufficient HUF liquidity to do this. Ultimately the NBH would presumably provide liquidity to avoid banks being left with a significant FX mismatch."
Martin Blum, Gyula Tóth, UniCredit, Vienna

"Herd behavior occurs when people do what others do rather than rely on their
own (incomplete) information, which might be suggesting something different
(Banerjee, 1992). The suppression of private information could lead to
“information cascades” when decisions are made sequentially and a large enough
number of people choose identical actions. In such settings, the decisions of a
critical few people early on are enough to tilt group behavior toward a certain
direction. Mimicking the behavior of others might be rational because of
uncertainty about one’s own information as well as the need to economize on
information-gathering costs. Rational herd behavior is the subject of a recent
strand of behavioral finance (see Montier, 2002, for an introduction). "

Total cross-border claims of BIS reporting banks expanded by $1 trillion in the last quarter of 2006. After more modest growth in mid-2006, a pickup in interbank claims accounted for 54% of this expansion. A surge in credit to nonbank entities contributed $473 billion, pushing the stock of cross-border claims to $26 trillion, 18% higher than in late 2005.

The flow of credit to emerging markets reached new heights through the year 2006. Claims on emerging markets grew by $96 billion in the final quarter of 2006, bringing the volume of new credit throughout the year to $341 billion. This amount exceeded previous peaks ($232 billion in 2005 and $134 billion in 1996), both in nominal value and in terms of growth. The current annual growth rate has risen to 24%, having surpassed for the sixth consecutive quarter the previous peak of 17% recorded in early 1997.

Emerging Europe overtook emerging Asia as the region to which BIS reporting banks extend the greatest share of credit. Since 2002, growth in claims on the region has consistently outpaced that vis-à-vis other regions. With a record quarterly inflow, emerging Europe received over 60% of new credit to emerging markets, bringing its share in the stock of emerging market claims to 34%. Less of the new credit went to the major borrowers (Russia, Turkey, Poland and Hungary) than to a number of smaller markets, notably Romania and Malta, as well as Ukraine, Cyprus, Bulgaria and the Baltic states.


The currency denomination of cross-border claims on emerging Europe tilted further towards the euro. In the stock of claims outstanding, the euro and dollar shares were 44% and 31%, respectively, but the gap in the latest flow data was more pronounced (61% and 5%). While the sterling share has remained close to 1%, the yen has lost ground to the Swiss franc, thus continuing a trend seen over the last six years. Yet there is little evidence in the cross-border data of unusual borrowing in Swiss francs that might correspond to Swiss franc-denominated retail lending in several countries. Borrowing in the Swiss currency remains on average below 4% of cross-border claims, and exceeds 10% only in Croatia and Hungary.


Nearly 20% of reporting banks’ foreign claims were in the form of funds channelled to emerging market borrowers. Claims on residents of emerging Europe continued to account for the largest share of these funds.

So, although the BIS find "little evidence in the cross-border data of unusual borrowing in Swiss francs that might correspond to Swiss franc-denominated retail lending", they do make an exception in the cases of Hungary and Croatia, where they note that lending in Swiss francs to retail clients reaches over 10% (and of course in the Hungarian case well over 10%) of the total retail loans in those countries. Indeed, as I indicate above, swiss franc loans now seem to account for over 80% of all newly generated housing related credit in Hungary. The reason why Hungary has gone for Swiss franc rather than euro denominated loans undoubtedly has to do with the role of the Austrian banking sector in Hungary, as is explained in my fuller posting on this topic linked to below.

Additional References On Swiss Franc Loans and "Translation"

For fuller examination of just why it is that Switzerland (or for that matter Japan) have such low interest rates, see my "Swiss Franc Loans and Ageing" post.

For an examination of the potential implications of the presence of all these foreign currency loans across the EU10 in the event of any generalised emerging markets crisis see Claus Vistesen "Translation Risk in the Baltics and Other Matters".

Balance Sheet Consequences: The Academic Research


Well, given what I am saying above about the rapid and imminent demise of foreign exchange loans among Central and East European nationals, it is clear that the topic which is now about to come back into fashion (and to replace the forex loans themselves as the centre of attention) - at least among theoretical economists) is that of the so called balance sheet cosnequences of excessive forex leveraging, so to give people some background, and a bit of a push start, I have hastily compiled a brief reading list on the topic.

Do Balance-Sheet Effects Matter for Brazil? Felipe Farah Schwartzman, May 2003

The past ten years have seen a number of currency crises, typically followed by a sharp drop in output in the countries involved. An explanation advanced for both the crisis and the recession is that firms in these countries had a large amount of debt indexed in foreign currency (Krugman, 1999). The exchange rate devaluation left the firms insolvent, reducing credit and production in the economy. Apart from crisis, balance-sheet effects have been advanced as an explanation for the “fear of floating” detected by Calvo and Reinhardt (2000) in developing economies in normal times.

Krugman, P. (1999), “Balance Sheets, the Transfer Problem and Financial Crisis,” in: International Finance and Financial Crises, P. Isard, A. Razin and A. Rose (eds.)

For the founding fathers of currency-crisis theory ..........the emerging market crises of 1997-? inspire both a sense of vindication and a sense of humility. On one side, the number and severity of these crises has demonstrated in a devastatingly thorough way the importance of the subject; in a world of high capital mobility, it is now clear, the threat of speculative attack becomes a central issue - indeed, for some countries the central issue - of macroeconomic policy. On the other side, even a casual look at recent events reveals the inadequacy of existing crisis models. True, the Asian crisis has settled some disputes - as I will argue below, it decisively resolves the argument between “fundamentalist” and “self-fulfilling” crisis stories........ But it has also raised new questions.

One way to describe the problem is to think in terms of Barry Eichengreen’s celebrated distinction between “first-generation” and “second-generation” crisis models. First-generation models, exemplified by Krugman (1979) and the much cleaner paper by Flood and Garber (1984), in effect explain crises as the product of budget deficits: it is the ultimately uncontrollable need of the government for seignorage to cover its deficit that ensures the eventual collapse of a fixed exchange rate, and the efforts of investors to avoid suffering capital losses (or to achieve capital gains) when that collapse occurs provoke a speculative attack when foreign exchange reserves fall below a critical level.

Second-generation models, exemplified by Obstfeld (1994), instead explain crises as the result of a conflict between a fixed exchange rate and the desire to pursue a more expansionary monetary policy; when investors begin to suspect that the government will choose to let the parity go, the resulting pressure on interest rates can itself push the government over the edge. Both first- and second-generation models have considerable relevance to particular crises in the 1990s - for example, the Russian crisis of 1998 was evidently driven in the first instance by the (correct) perception that the weak government was about to be forced to finance itself via the printing press, while the sterling crisis of 1992 was equally evidently driven by the perception that the UK government would under pressure choose domestic employment over exchange stability.

In the major crisis countries of Asia, however, neither of these stories seems to have much relevance. By conventional fiscal measures the governments of the afflicted economies were in quite good shape at the beginning of 1997; while growth had slowed and some signs of excess capacity appeared in 1996, none of them faced the kind of clear tradeoff between employment and exchange stability that Britain had faced 5 years earlier (and if depreciation was intended to allow expansionary policies, it rather conspicuously failed!) Clearly something else was at work; we badly need a “third-generation” crisis model both to make sense of the recent crises and to help warn of crises to come.

In the paper which follows Krugman sketches out yet another candidate for third-generation crisis modeling, one that emphasizes two factors that had been omitted from previous formal models to date: the role of companies’ balance sheets in determining their ability to invest, and that of capital flows in affecting the real exchange rate. The model was at that point (and as Krugman himself says) quite raw, with lots of loose ends hanging about. However, it did seem to tell a story with a much more realistic “feel” than some of the earlier efforts. It could be hoped that now that he has had time to recover from the shock of his recent Nobel, he may get interested once more in this earlier centre of his attention, since the model badly needs updating, and in particular to take account of the shift in the risk away from the corporate and towards the household balance sheet.

Balance Sheet Effects, Bailout Guarantees and Financial Crises
MARTIN SCHNEIDER UCLA and AARON TORNELL UCLA and NBER

This paper provides a model of boom-bust episodes in middle income countries. It features balance of- payments crises that are preceded by lending booms and real appreciation, and followed by recessions and sharp contractions of credit. As in the data, the non-tradables sector accounts for most of the volatility in output and credit. The model is based on sectoral asymmetries in corporate finance. Currency mismatch and borrowing constraints arise endogenously. Their interaction gives rise to self-fulfilling crises.


In the last two decades, many middle-income countries have experienced boom-bust episodes centered around balance-of-payments crises. There is now a well-known set of stylized facts. The typical episode began with a lending boom and an appreciation of the real exchange rate. In the crisis that eventually ended the boom, a real depreciation coincided with widespread defaults by the domestic private sector on unhedged foreign-currency-denominated debt. The typical crisis came as a surprise to financial markets, and with hindsight it is not possible to pinpoint a large “fundamental” shock as an obvious trigger. After the crisis, foreign lenders were often bailed out. However, domestic credit fell dramatically and recovered much more slowly than output.

This paper proposes a theory of boom-bust episodes that emphasizes sectoral asymmetries in corporate finance. It is motivated by an additional set of facts that has received little attention in the literature: the tradables (T-) and nontradables (N-) sectors fared quite differently in most boom-bust episodes. While the N-sector was typically growing faster than the T-sector during a boom, it fell harder during the crisis and took longer to recover afterwards. Moreover, most of the guaranteed credit extended during the boom went to the N-sector, and most bad debt later surfaced there. Our analysis is based on two key assumptions that are motivated by the institutional environment of middle income countries. First, N-sector firms are run by managers who issue debt, but cannot commit to repay. In contrast, T-sector firms have access to perfect financial markets. Second, there are systemic bailout guarantees: lenders are bailed out if a critical mass of borrowers defaults.

And please note the last sentence: "lenders are bailed out if a critical mass of borrowers defaults", this, I imagine, is what we are about to see happen next.

A Balance Sheet Approach to Financial Crisis
Mark Allen, Christoph Rosenberg, Christian Keller, Brad Setser, and Nouriel Roubini :

The paper lays out an analytical framework for understanding crises in emerging markets based on examination of stock variables in the aggregate balance sheet of a country and the balance sheets of its main sectors (assets and liabilities). It focuses on the risks created by maturity, currency, and capital structure mismatches. This framework draws attention to the vulnerabilities created by debts among residents, particularly those denominated in foreign currency, and it helps to explain how problems in one sector can spill over into other sectors, eventually triggering an external balance of payments crisis. The paper also discusses the potential of macroeconomic policies and official intervention to mitigate the cost of such a crisis.

As I peer out my window over towards the Alps and the northern entrance to Le Vallé du Rhône I can't help asking myself whether some of those experiments which are habitually conducted a mere 40 kilometers from my current habitat haven't gone terribly wrong? With every passing day getting I find it more and more difficult to avoid associating all those worthy attempts to uncover that illusive Hick's Particle with the all-encompassing black hole into which our financial markets seem to be getting sucked with a disturbing velocity, despite the numerous efforts by the global financial authorities to invent some sort of monetary equivalent to "anti-matter".

But while the current crisis is pretty much a generalised global one, if there is one region where the crisis is making its presence more acutely than elsewhere, that place is Eastern Europe, and among the ranks of the regional casualties high on the list come the three Baltics countries, Estonia, Latvia and Lithuania. That this is the case should not really strike us as so strange. On many occasions since the credit crisis went global back in the summer of 2007 many analysts (including yours truly) have been flagging the risk of a hard landing in Eastern Europe. This unfortunate situation has now by and large materialised and the only question which really arises is how hard is "hard" going to be? A couple of recent tentative signs suggest that the big eye of the credit crunch, not unlike Sauron with his glance toward Frodo et al., is fixing Eastern Europe fast in its gaze.

In terms of Russia, we have already witnessed the speed with which financial markets have turned the tide for the erstwhile high powered economy. Now that oil is dipping into negative on an annual basis, the screw may just get turned a little more.

In Ukraine, the market for the state's sovereign debt almost collapsed during the past week as credit default swaps (insurance against loses on debt) rose almost 40% to 1700 basis points as rumours mounted on an early election as well as the government made steps to take over one of the country's big banks. Furthermore and as could be expected the Hryvnia took another beating. A similar situation seems be unfolding in Hungary where prominent government and central officials were dipatched spent part of their Friday trying to avoid a rout on the Forint in the spot markets. Meanwhile, and as a natural bed-fellow to this the stock market, and especially financials, were pumelled. In many ways, the Hungarian predicament resembles more and more a tragedy in the making which is also why the IMF is moving in to calm things down as well as attempt to bring the boat back on course.

Basically, the crossover we need to be thinking about in macroeconomic terms is the one between the Swiss Franc and the Hungarian Forint, given the exposure of Hungarian households to Swiss Franc denominated mortgages, and the impact on internal demand which is to be expected if the current dramatic decline continues.

Both in Estonia and Latvia output contracted for the second consecutive quarter in the second quarter while output in Lithuania stayed surprisingly strong. On the inflation front it finally seems that the pressure is abating somewhat even if of course this is a process that works with considerable rigidities relative to the decline in output. In this way, the Baltics still find themselves in a situation of stagflation.

One very interesting development in this regard however is the evolution of labour costs. If we look at the development up until Q1 2008 the y-o-y increase was one of 7-10% per quarter, but that changed strikingly in Q2. As such, in Estonia and Latvia quarterly labour costs fell to 2.9% and 2.4% respectively Lithuania entered wage deflation. It is still too early to gauge a trend here but it is obvious that for the Baltic economies to correct while simultaneously maintaining a fixed exchange rate regime the correction mechanism would fall entirely on the domestic sector's ability to become more competitive.

And this is now becoming more than a passing preoccupation.

In this way, and while the external deficits have been reduced (mainly due to a sharp drop in imports) the imbalances are still very much present, not least because a negative income balance remains to keep the balance in red. As I have argued before this can only go on until it can't, which is a cryptic way of saying that something at some point has got to give. Unfortunately for the Baltics, the watchdogs of global credit markets (the rating agencies) have begun to seriously turn their scent on to the contradictory fundamentals of these three economies.

Last week, the Baltics's sovereign ratings were consequently collectively downgraded by Fitch Ratings which followed an earlier decision by Moodys to lower the region to negative. The reason cited will not surprise regular observers of these economies (indeed readers of this blog's eastern europe installments). Head of sovereings in Europe Edward Parker from Fitch consequently noted that the worse than expected correction in financial markets coupled with the vulnerable macroeconomic enviroment as the main reasons for the downgrade. More specifically, the mixture of external deficits funded to a large extent by inflows of credit (e.g. some 30% for Lithuania) supplied by foreign banks lies at the root of the decision and incidentally, as it were, also at the root of the macroeconomic vulnerabilities of the Baltic economies.[1]

In this context it is interesting to initially peruse the graphs plotting cross currency exposure and overall leverage (Latvia data only for households).

The point conveyed by the graphs above is one of the main reasons for an increasing risk of a more than traditional adverse outcome from this crisis. It is thus important to understand that the Baltics are still dependent on inflows of foreign credit even as the economy slows and that this shows up, in part, through the substantially higher leverage in foreign currency relative to the total leverage ratio. Especially the extra graphs in the Lithuanian case is interesting in that it shows how the marginal increase in total leverage from 2003 and onwards almost exclusively can be attributed to an increase in leverage of foreign currency loans relative to foreign denominated demand deposits.

This is of course where things begin to get interesting because if we look at the companies supplying the credit to the Baltics, they are increasingly looking to get sucked down into the maelstroem that has fit financial markets. Most prominently is of course the Swedish bank Swedbank which perhaps has the biggest exposure to Baltic markets (through Hansabank). Analysts have persistently been voicing warnings on Swedbank's aggressive lending policy in the Baltics, but if we look at activity in Q2 Swedbank continued to expand credit to the Baltics. And this is not a mere problem of a Swedish bank potentially having to retreat from a growth market gone sour. No, this has the potential to become a full blown macro catastrophe in which the Swedish Riksbank will be faced with the rather odd dilemma of having to bail out a domestic bank, in part, in order to allow the relatively benigh unwinding of macroeconomic imbalances in the Baltics.

It is extremely important in this regard to be aware of the narrative that Swedbank and the rest of the short term credit providers effectively are the only ones keeping the boat afloat. The logic, as brilliantly detailed by John Hempton here, goes as follows. The credit needed on a flow basis to sustain the Baltics' external deficit is being supplied by foreign banks and mostly through loans denominated in Euros (this last thing being very important). Consequently, this presents Swedbank et al. with a rather delicate problem. For the Baltic currencies (or one of them) not to devalue they need funding and more importantly, they need funding on their way down into whatever abyss that may now have opened. Now, as my colleague Edward pointed out in another context it is not the most pleasant of dilemmas to be confronted with the choice of having your throat slit with the stanley knife or the chainsaw. However, this may the situation which now confronts Swedbank, the Baltics, as well as potentially the Swedish Riksbank in the current situation which increasingly resembles some of Kafka's best creations. Hempton makes it very clear when he says;

If the Lati doesn't devalue its only because people (i.e. Swedbank) are prepared to continue to fund it. This is not pretty at all. All in Hansa owes Swedbank over 30 billion Swedish Kroner – all denominated in Euro and which can't be paid. The equity capital of Hansa (roughly 7 billion Swedish Kroner) is also going to default.

The juicy point here is of course the presence of massive translation risk which would arise as the liabilities (denominated in Euros) multiplied in value relative to the asset side.[2] More importantly, this would not only potentially crash Swedbank but also potentially the Baltic economies, and this is something we should attempt to avoid.

However, it is not easy to see where to go from here. One fascinating correlation between micro and macro data is epitomized in the graphs below which shows the evolution in the total stock of loans broken up on currency denomination.

First of all, it is very interesting to peruse the graphs shown above in connection with the graphs plotting cross currency and overall leverage (Latvia data only for households). In my opinion these graphs, taken together, resemble the epitomy of the kind of risk the Baltics face. As such, it is not only a case of devleveraging which, given the multiples, would be bad enough; it is also about the crisis that would emerge if the pegs were abandoned to restore competitivness. However, whether to keep the pegs or not may not be entirely up the Baltic economies themselves. Rather we can easily imagine a situation in which the decision of whether to keep the pegs would reside within the halls of a Swedish bank and perhaps even ultimately the Swedish Riksbank.

How does this compute then?

One way to approach the answer is to look at the total evolution of loan stocks (accounted on a flow basis. One striking feature is that the growth of loans denominated in Euros continue to markedly outpace loans denominated in local currency. This is a well known story in the Baltics and one which I have discussed several times [3], but the key point here is that as the economic edifice now visibly crumbles credit flows continue to enter the Baltic economies. Given the rapid deteriration of the real economy this seems rather contradictorary. However, it is is not, and it essentially means two things.

First of all, it means that whoever is doing the credit service increasingly is throwing good (and presumably scare) money after bad money. From a standard profit maximizing point of view this would seem and odd behavior unless of course there is more to the story than meets the eye. This brings us to the second point and was detailed above in the context of Swedbank et al. and their exposure in foreign currency (with receivables in domestic currency). Ultimately, the situation in the Baltics surrounding the pegs is beginning to resemble more and more like the attempt to cling on to something which is becoming more and more unsustainable by the day. Obviously, the foreign banks could stick it out, but the question is whether they can afford it.

In fact, I believe the only scenario which we, with certainty, can say will not continue is the current one in which lending is expanded on a linerging basis. As such, we need de-leveraging and we are going to get it one way or the other. The only question is whether it will be through Swedbank et al. closing the tap or through a move by Baltic authorities to loosen the peg (in which case Swedbank would be in grave trouble). The alternative would of course be a significant bout of internal deflation which we, with the incoming wage cost data, may already be seeing. The problem with this process though is that it takes time at the same time as it is politically unacceptable. I would seriously question in this regard the usefulness of continuing to look toward the future for potential Euro membership. At some point it should dawn on market participants and politicians alike that this is very unlikely to materialize.

Finally, we may ask the question of whether it is enough? I don't think so and while it still may end up being part of the correction I think that the extent to which these economies need to shore up their competiveness will also include a tweak of the currency peg [4].

Where do We Go From Here?

At the current juncture in financial market the answer to such a question is bound to riddled with uncertainty. In Lithuania, the people just elected a new parliament and while people may be more worried about the immediate need to secure stable gas deliveries from Russia and winter approaches, it is difficult to see how the attention on the crisis can anything but increase as we move forward. In this respect, and as an aside, Lithuania does seem to somewhat different from its northern bretheren in that the leverage ratios and debt multiples are not as high as in neither Estonia nor Latvia. Obviously, this may ultimately come down to comparing one ugly duckling with a slightly less ugly duckling.

As regards Latvia, Alf Vanags and Morten Hansen recently published a detailed analysis on the future path of the Latvian economy faced with the incoming financial crisis and potential global recession. Their conclusion is rather dire with respect to the potential loss of output between and now and 2010. As the authors make painfully clear, this fact obviously brings into the question the whole idea of convergence towards the illusive EU15 living standards not to speak of the convergence towards their own steady state which we really don't anything about at this point.

I would tend to apply the same analysis to Estonia even if Estonia seems to benefit from a stronger external environment and in particular with the economy's strong affiliation with the Finnish economy.

Ultimately however the immediate challenge for the Baltics at this point in time is damage control and more specifically how to wrigle themselves out of the current vice of dependence on credit inflows at the same time as the economy needs to restore competiveness. So far, the show goes on with Swedbank in particular continuing to supply the credit. However, if the recession rolls in, in a manner predicted by most analysts the ensuing squeeze of consumers may make it difficult for Swedbank not to sustain massive losses, not to mention what would happen with the peg and households and companies' liabilities.

The end point of all this clearly appears to envision a fiscal response; at least as a part of the solution. What is critical for the Baltics at this point is consequently that the currenct economic downturn is managed in such a way to minimize the risk of a collapse of the financial system as foreign banks shut down operations. Whether this entails the maintaining of the Euro peg is a difficult question to answer. One thing is pretty certain however and this is that the kind of wage and price deflation needed to correct the imbalance would be a disaster for any political leadership.

Of the three economies Latvia clearly seems to be the most vulnerable to a rout, and given the proximity of the economies sudden unexpected events in one country could easily spread to the others. Here is to hoping that it does not come to that.

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[1] - Sometimes things actually fit together.

[2] - Here the asset side would be both deposits as well as future cash flows which would be in domestic currency (for households). For Swedbank itself, main point Hempton highlights is simply the fact that Hansabank would become an immensely heavy ball and chain since the whole thing would have to be written down with the devaluation itself.

[3] - See for example Christoph Rosenberg's brilliant piece on drivers of FX loans in Eastern Europe. As per reference to my own analysis (limited to Lithuania though) Rosenberg finds that lower interest rates on Euro loans as well as the fact that these economies effectively has outsourced the developmentment of their financial system to foreign banks are strong explanatory factors.

Investors remained wary of emerging-market debt as evidence mounted that most of the major major economies - the U.S., the UK, Japan and the Eurozone - are sliding into recession. This realisation has triggered a major exit from commodities, which are a significant source of export revenue for a large number of developing nations. In particular bonds extended losses on the perception that the $700 billion U.S. bank bailout would not work miracles and thus many developed economies will be struggling to digest the impact of the credit blow-out for some time to come.


Until credibility is restored, we will not see people investing in the numbers that emerging economies like India and Brazil badly need to see. But at the same time, we might ask ourselves, at theis moment in time if they don't invest in India and Brazil, then where are they going to invest? The problem is that in the present global environment people are not simply not willing to take assume what is perceived as "risky" without being paid a large - and from the emerging economy point of view - damaging premium. Of course, the situation is also confused since people are no longer clear what constitutes "risky" and what doesn't - the German government, for example, yesterday found itself forced to offer a blanket guarantee of all domestic bank deposits to head off any risk of flight from German bank accounts.

One result of all this nervousness is that the cost of protecting developing nations' bonds against default has been steadily rising. Five-year credit-default swaps based on Argentina's debt climbed 44 basis points to 12.55 percentage points last week, the highest since at least June 2005. That means it costs $1.255 million to protect $10 million of the country's debt from default. Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements.


Emerging Market Stocks

Emerging-market stocks also fell substantially last week, experiencing their the biggest weekly decline in seven years, led by the banks and energy companies. The MSCI Emerging Markets Index dropped 2.3 percent on Friday to 741.73, following a 3.4 percent decline on Thursday. The index lost 10 percent on theweek, the most since the September 2001 terrorist attacks.


Turkey's benchmark index fell the most in three weeks, losing 4.2 percent to 34,553 in the first trading day since Sept. 29. Russia's Micex Index slumped 5.3 percent, extending its annual loss to 51 percent. India's Sensex index slid 4.1 percent to 12,526.32. Reliance Industries Ltd., India's biggest company by market value, slumped 7.6 percent, to its lowest in a year.

Inflation Falls

But while India's financial system has been taking a beating, Indian inflation, almost un-noticed -slipped back to a 13-week low in late September, giving the central bank some breathing space to keep interest rates unchanged and lossen the liquidity strings when it next meets at the end of this month. Wholesale prices rose 11.99 percent in the week to Sept. 20 from a year earlier after gaining 12.14 percent in the previous week, the commerce ministry said in a statement in New Delhi on Thursday.



Reserve Bank of India Governor Duvvuri Subbarao is under pressure to boost money supply as a local stock sell-off triggered by the global credit crunch has drained funds from the banking system, increasing borrowing costs. Subbarao will undoubtedly seek to steer a middle course, since, given that inflation is still double the central bank's target he will not want to seem to be "soft", while on the other hand he will want to be prudent and will try to head off an excessively rapid credit tightening on the back of the global crunch. In addition, the peak of global inflation has now undoubtedly past, and we are now likely to see growing deflationary (rather than inflationary) headwinds as capacity levels exceed demand across the whole global economy and commodity prices tumble, as Claus Vistesen explains in this excellent and timely post.

The Indian central bank had been busy tightening, and had raised the cash reserve ratio, or the proportion of deposits that lenders maintain with it as reserves, by 400 basis points to 9 percent during the period between December 2006 and July 2008 in an ongoing battle to contain inflation. The bank will make the outcome of its next meeting in Mumbai known on Oct. 24, but we can be pretty sure that the "bias" will now have shifted towards loosening liquidity conditions rather than tightening them, as the priorities have changed, and the big priority now is to avoid any systemic bank problems, to keep the cost of borrowing for Indian companies down, and to prevent consumer credit slowing too dramatically.

The Indian banking system has been under increasing strain in recent days, and one symptom of this is that the rate at which Indian banks lend to each other reached an 18-month high of 17.5 percent on Oct. 1. Indian banks borrowed an average 413 billion rupees a day from the central bank in September, almost twice the amount in August, further indicating a shortage of funds in the banking system.


Commodities Down

Commodities, as measured by the Reuters/Jefferies CRB Index of 19 raw materials, tumbled 9.9 percent last week, the most since at least 1956.

Crude oil has lost 12 percent during the week, the most since 2004. The contract for November delivery traded at $94.47 a barrel, up 0.5 percent, as of 12:11 p.m. London time. Copper fell as much as 3.1 percent to $5,670 a ton on the London Metal Exchange, the lowest since February 2007 and was down 12% on the week.

Such downward movement in commodity prices has a double-edged impact on emerging economies. On the one hand inflation, which has in large part been driven up by rising commodity prices, will reduce significantly, but on the other hand many emerging economies are dependent on revenue from commodity sales to finance growth and development. Really this is a situation which will sort the "men" from the "boys", since those emerging economies which are really going to emerge will be in a position to switch the driving force of growth from commodity and agricultural dependence to industrialisation and domestic investment and consumer demand. It is my firm belief that India is now decidedly inside the group which is in the process of making this transition.


Stocks Down

Indian stocks fell during the week, with the benchmark Sensex stock index declining to its lowest in 18 months. The Bombay Stock Exchange's Sensitive Index, dropped 529.35, or 4.1 percent, to 12,526.32, its lowest since April 2, 2007. The index posted its second weekly decline, falling 4.4 percent. The S&P CNX Nifty Index on the National Stock Exchange fell 3.4 percent to 3,818.30. The BSE 200 Index declined 3.8 percent to 1,515.29. Nifty futures for October delivery fell 2.9 percent to 3,853.


Overseas investors bought a net 845 billion rupees ($18 million) of Indian stocks on Sept. 30, trimming their net outflow this year from equities to $9.1 billion, the nation's stock market regulator said.


Forex Reserves

India's foreign exchange reserves fell marginally by USD 153 million to USD 291.819billion for the week ended September 26 from USD 291.972 billion in the previous week. Reserves had jumped by USD 2.511 billion in the previous week. Foreign currency assets (FCA), during the week, dropped to USD 282.652 billion from USD 282.811 billion a week ago, according to data issued by the RBI on Friday.

Rupee

India's rupee slumped to the lowest since 2003, adding to speculation investors will take continue taking money out of the currency. The currency completed its eighth weekly loss, the longest drop since December 2005. The rupee was down 1 percent on the day to 47.085 per dollar, the lowest since June 2003, as of the 5 p.m. close in Mumbai on Friday. The currency lost 1.15 percent this week.

September Global Manufacturing PMI Shows Sharp Contraction

September seems to have been the ultimate "mensis horribilis" for industrial output internationally - and thus it is only natural to assume that Indian industry was also adversly affected - with global manufacturing activity contracting for the fourth consecutive month, and output falling to its weakest level in over seven years according to the JP Morgan Global Manufacturing PMI, which at 44.2 hit its strongest rate of contraction since November 2001, down from 48.6 in August (Please see the end of this post for some information about countries included and the JP Morgan methodology).


According to the JP Morgan report the retrenchment of the manufacturing sector mainly reflected marked deteriorations in the trends for production, new orders and employment. The declines in output and new work received were the second most severe in the survey history, while staffing levels fell at the fastest pace for over six-and-a-half years. The Global Manufacturing Output Index registered 42.7 in September, well below the 48.5 posted for August.

The sharpest decline in production was recorded for Spain, followed by the US, Japan and then the UK. Although the Eurozone Output Index sank to its second-lowest reading in the survey history, it was above the global average for the first time in four months. Within the euro area, France and Spain saw output fall at survey record rates, while in Italy and Ireland the contractions were the second and third most marked in their respective series. Germany, which until recently was the main growth engine of the Eurozone, saw production fall for the second month running and to the greatest extent for six years. Manufacturing activity in Japan fell to the lowest in over 6- years with the Nomura/JMMA Japan Purchasing Managers Index declining to a seasonally adjusted 44.3 in September from 46.9 in August.

At 40.8 in September, the Global Manufacturing New Orders Index posted a reading well below the neutral 50.0 mark. JP Morgan noted that the trends in new work received were especially weak in Spain, the UK, France and the US, with the all bar the latter seeing new orders fall at a series record pace (for the US it was the strongest drop since January 2001). The downturn of the sector led to further job losses in September, with the rate of reduction in employment the fastest since February 2002. Conditions in the Spanish, the UK and the US manufacturing labour markets were especially weak.

Russian manufacturing shrank for a second month in September, and in so doing registered its first back-to-back contraction since November 1998, as companies cut jobs and growth in new orders slowed, according to the latest VTB Bank Europe Purchasing Managers Report. The PMI came in at a seasonally adjusted 49.8, compared with 49.4 in August. The August reading was the lowest figure in three and a half years, according to the bank statement. On such indexes a figure above 50 indicates growth while one below 50 indicates a contraction.

Manufacturing in China contracted for a second month in August, underscoring the risk of a slump in the world's fourth-biggest economy. The Purchasing Managers' Index was a seasonally adjusted 48.4, unchanged from July, the China Federation of Logistics and Purchasing said today in an e-mailed statement.




Brazil's industrial output fell a seasonally-adjusted 1.3 percent in August, the largest monthly drop this year, bolstering expectations the central bank will ease monetary tightening in response to slowing economic growth. On an annual basis, output rose 2 percent, the slowest pace since March, according to data from the national statistics agency in Rio de Janeiro.

And the situation seems to have deteriorated further in August, since the headline seasonally adjusted Banco Real Purchasing Managers’ Index (PMI) registered a 25-month low of 50.4, down from 51.1 in August.

So basically this is where we get to learn what a global credit crunch means in terms of output and economic growth.

India's Industrial Output Weakens Too

India's industrial output growth bounced back again in July (the last month for which we have official data), reaching a five-month year on year expansion rate high of 7.1%. This follows a noted slowdown where output only rose by 5.4 percent gain in June, and 4.1% in May, according to data from the Central Statistical Organisation.


But if we come to look at the manufacturing PMI we will see that India's manufacturing output has also slowed somewhat, and expanded at its slowest pace in 14 months in September according to the ABN AMRO Bank purchasing managers' index. The PMI reading - which is based on a survey of 500 companies operating in India - fell to a seasonally adjusted 57.3 in September from 57.9 in August. This reading was the lowest since July 2007. Still 57.3 still suggests Indian industry continues to grow quite vigoursly, although the report did highlight the fact that the drop in the index was mainly the result of a decline in growth of new orders, and implied a deterioration in demand conditions, both locally as well as in export markets.


Current Account and Trade Deficit

The Rupee has also been dropping in reaction to India's deteriorating current account situation. The current account deficit rocketed to $10.7 billion in the three months from April to June, up from a $1.04 billion gap in the previous quarter,according to data from the Reserve Bank of India last week.

India's trade deficit almost doubled to a record in August as a surge in crude oil prices increased the import bill and overseas sales of goods slowed. The trade deficit widened to $13.9 billion from $7.2 billion a year earlier, according to data from the Ministry of Commerce and Industry. Imports grew 51 percent, the fastest gain in seven months, to $29.9 billion, while exports expanded 27 percent to $16 billion.

A near doubling of oil prices has boosted import costs, since India relies on overseas purchases for three-quarters of its energy needs. India paid an average $8 billion a month this year for oil imports, up from $5.5 billion in 2007, as crude oil costs surged to a record $147 a barrel on July 11. In India's case the 35 percent drop in oil prices we have seen since July has been partially offset by the decline in the rupee to a five-year low.

India's oil imports in August rose 77 percent to $10.9 billion as refiners paid more for crude oil purchased overseas. Non-oil imports gained 40 percent to $18.9 billion. Imports in the five months ended August 31 rose 38 percent to $130.3 billion from $94.6 billion a year ago. That took the trade deficit to $49.2 billion, compared with $34.5 billion in the same period a year earlier. Overseas sales of Indian goods in the five months to August 31 grew 35 percent to $81.2 billion, compared with $60.1 billion, the statement said.

India and Brazil Critical Weathervanes

What I have been arguing in this post is not that everything about India's economy is perfect - far from it, but neither is it the "perfect storm" disaster which current knee jerk reactions among international investors would seem to suggest. The problems which are hitting the Indian economy at the moment, from the rapid rise in inflation to the sudden withdrawal of sentiment have a common origin: the dynamics of the global economy, and it is to these we must now look if we are to be able to sort the wood from the trees about what happens next. Basically, when the dust settles, I think it will be apparent that there are few economies left sufficiently well standing (not Russia certainly, and probably not China, given the export dependence on the developed economies) and with sufficient energy to bounce back. Many may be sceptical that Brazil and India are going to lead the coming charge (this recession cannot, after all, last forever), but I ask you, if it isn't Brazil and India, who is it going to be?

JP Morgan Global Manufacturing PMI Methodology


The Global Report on Manufacturing is compiled by Markit Economics based on the results of surveys covering over 7,500 purchasing executives in 26 countries. Together these countries account for an estimated 83% of global manufacturing output. Questions are asked about real events and are not opinion based. Data are presented in the form of diffusion indices, where an index reading above 50.0 indicates an increase in the variable since the previous month and below 50.0 a decrease.

The countries included are listed below by size of global GDP share, and the figures in brackets are the % og global GDP in each case (World Bank Data).

United States (30.5), Eurozone (18.7), Japan (13.9), Germany (5.6), China (4.9),United Kingdom (4.5), France (4.0), Italy (3.2), Spain(1.9), Brazil (1.9),India (1.7), Australia (1.3), Netherlands (1.1), Russia (0.9), Switzerland (0.7), Turkey (0.7), Austria (0.6), Poland (0.5), Denmark (0.5), South Africa (0.4), Greece (0.4), Israel (0.3), Ireland (0.3), Singapore (0.3), Czech Republic (0.2), New Zealand (0.2), Hungary 0.2.

Investors distanced themselves from emerging-market debt as the evidence mounted that major economies - the U.S., the UK, Japan and the Eurozone - are sliding into recession and this triggered a major exit from commodities, which is a significant source of export revenue for a large number of developing nations. In particular bonds extended losses on the perception that the $700 billion U.S. bank bailout would not work miracles and thus many developed economies will be struggling to digest the impact of the credit blow-out for some time to come.


Until credibility is restored, we will not see people investing in the numbers that emerging economies like India and Brazil badly need to see. In the present environment people are not simply not willing to take assume what is perceived as "risky" without being paid a large - and from the emerging economy point of view - damaging premium. As a result the cost of protecting developing nations' bonds against default has been steadily rising. Five-year credit-default swaps based on Argentina's debt climbed 44 basis points to 12.55 percentage points last week, the highest since at least June 2005. That means it costs $1.255 million to protect $10 million of the country's debt from default. Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements.


Emerging Market Stocks

Emerging-market stocks had the biggest weekly decline in seven years last weeks, led by banks and energy companies. The MSCI Emerging Markets Index dropped 2.3 percent on Friday to 741.73, following a 3.4 percent decline on Thursday. The index lost 10 percent on theweek, the most since the September 2001 terrorist attacks.


Turkey's benchmark index fell the most in three weeks, losing 4.2 percent to 34,553 in the first trading day since Sept. 29. Russia's Micex Index slumped 5.3 percent, extending its annual loss to 51 percent. India's Sensex index slid 4.1 percent to 12,526.32. Reliance Industries Ltd., India's biggest company by market value, slumped 7.6 percent, to its lowest in a year.

Inflation Falls

But while India's financial system has been taking a beating, Indian inflation, almost un-noticed -slipped back to a 13-week low in late September, giving the central bank some breathing space to keep interest rates unchanged and lossen the liquidity strings when it next meets at the end of this month. Wholesale prices rose 11.99 percent in the week to Sept. 20 from a year earlier after gaining 12.14 percent in the previous week, the commerce ministry said in a statement in New Delhi on Thursday.



Reserve Bank of India Governor Duvvuri Subbarao is under pressure to boost money supply as a local stock sell-off triggered by the global credit crunch has drained funds from the banking system, increasing borrowing costs. Subbarao will undoubtedly seek to steer a middle course, since given that inflation is still double the central bank's target he will not want to seem to be "soft", while on the other hand he will want to be prudent and will try to head off an excessively rapid credit tightening on the backs of the global crunch. In addition, the peak of global inflation has now undoubtedly past, and we are now likely to see growing deflationary headwinds as capacity levels exceed demand across the whole global economy, as Claus Vistesen explains in this excellent and timely post.

The central bank has raised the cash reserve ratio, or the proportion of deposits that lenders maintain with it as reserves, by 400 basis points to 9 percent since December 2006 to contain inflation. The bank will make the outcome of its next meeting in Mumbai known on Oct. 24.

The rate at which Indian banks lend to each other climbed to an 18-month high of 17.5 percent on Oct. 1 as investors hoarded cash. Indian banks borrowed an average 413 billion rupees a day from the central bank in September, almost twice the amount in August, further indicating a shortage of funds in the banking system.

Essentially the wholesale price index fell because of a decline in the prices of farm products such as cereals, fruits and vegetables. The index of primary articles, that includes food items, dropped 0.2 percent, while the indices of manufactured and fuel were unchanged in the week to Sept. 20, today's report said.

Commodities Down

Commodities, as measured by the Reuters/Jefferies CRB Index of 19 raw materials, tumbled 9.9 percent last week, the most since at least 1956.

Crude oil has lost 12 percent during the week, the most since 2004. The contract for November delivery traded at $94.47 a barrel, up 0.5 percent, as of 12:11 p.m. London time. Copper fell as much as 3.1 percent to $5,670 a ton on the London Metal Exchange, the lowest since February 2007 and was down 12% on the week.

Such downward movement in commodity prices have a double edged impact on emerging economies. On the one hand inflation, which has in large part been driven up by rising commodity prices, will reduce significantly, but on the other hand many emerging economies are dependent on revenue from commodity sales to finance growth and development.


Stocks Down

Indian stocks fell during the week, with the benchmark Sensex stock index declining to its lowest in 18 months. The Bombay Stock Exchange's Sensitive Index, dropped 529.35, or 4.1 percent, to 12,526.32, its lowest since April 2, 2007. The index posted its second weekly decline, falling 4.4 percent. The S&P CNX Nifty Index on the National Stock Exchange fell 3.4 percent to 3,818.30. The BSE 200 Index declined 3.8 percent to 1,515.29. Nifty futures for October delivery fell 2.9 percent to 3,853.


Overseas investors bought a net 845 billion rupees ($18 million) of Indian stocks on Sept. 30, trimming their net outflow this year from equities to $9.1 billion, the nation's stock market regulator said.


Forex Reserves

India's foreign exchange reserves fell marginally by USD 153 million to USD 291.819billion for the week ended September 26 from USD 291.972 billion in the previous week. Reserves had jumped by USD 2.511 billion in the previous week. Foreign currency assets (FCA), during the week, dropped to USD 282.652 billion from USD 282.811 billion a week ago, according to data issued by the RBI on Friday.

Rupee

India's rupee slumped to the lowest since 2003, adding to speculation investors will take continue taking money out of the currency. The currency completed its eighth weekly loss, the longest drop since December 2005. The rupee was down 1 percent on the day to 47.085 per dollar, the lowest since June 2003, as of the 5 p.m. close in Mumbai on Friday. The currency lost 1.15 percent this week.

September Global Manufacturing PMI Shows Sharp Contraction

September seems to have been the ultimate "mensis horribilis" for industrial output internationally, with global manufacturing activity contracting for the fourth consecutive month, and output falling to its weakest level in over seven years according to the JP Morgan Global Manufacturing PMI, which at 44.2 hit its strongest rate of contraction since November 2001, down from 48.6 in August (Please see the end of this post for some information about countries included and the JP Morgan methodology).


According to the JP Morgan report the retrenchment of the manufacturing sector mainly reflected marked deteriorations in the trends for production, new orders and employment. The declines in output and new work received were the second most severe in the survey history, while staffing levels fell at the fastest pace for over six-and-a-half years. The Global Manufacturing Output Index registered 42.7 in September, well below the 48.5 posted for August.

The sharpest decline in production was recorded for Spain, followed by the US, Japan and then the UK. Although the Eurozone Output Index sank to its second-lowest reading in the survey history, it was above the global average for the first time in four months. Within the euro area, France and Spain saw output fall at survey record rates, while in Italy and Ireland the contractions were the second and third most marked in their respective series. Germany, which until recently was the main growth engine of the Eurozone, saw production fall for the second month running and to the greatest extent for six years. Manufacturing activity in Japan fell to the lowest in over 6- years with the Nomura/JMMA Japan Purchasing Managers Index declining to a seasonally adjusted 44.3 in September from 46.9 in August.

At 40.8 in September, the Global Manufacturing New Orders Index posted a reading well below the neutral 50.0 mark. JP Morgan noted that the trends in new work received were especially weak in Spain, the UK, France and the US, with the all bar the latter seeing new orders fall at a series record pace (for the US it was the strongest drop since January 2001). The downturn of the sector led to further job losses in September, with the rate of reduction in employment the fastest since February 2002. Conditions in the Spanish, the UK and the US manufacturing labour markets were especially weak.

Russian manufacturing shrank for a second month in September, and in so doing registered its first back-to-back contraction since November 1998, as companies cut jobs and growth in new orders slowed, according to the latest VTB Bank Europe Purchasing Managers Report. The PMI came in at a seasonally adjusted 49.8, compared with 49.4 in August. The August reading was the lowest figure in three and a half years, according to the bank statement. On such indexes a figure above 50 indicates growth while one below 50 indicates a contraction.

Manufacturing in China contracted for a second month in August, underscoring the risk of a slump in the world's fourth-biggest economy. The Purchasing Managers' Index was a seasonally adjusted 48.4, unchanged from July, the China Federation of Logistics and Purchasing said today in an e-mailed statement.




Brazil's industrial output fell a seasonally-adjusted 1.3 percent in August, the largest monthly drop this year, bolstering expectations the central bank will ease monetary tightening in response to slowing economic growth. On an annual basis, output rose 2 percent, the slowest pace since March, according to data from the national statistics agency in Rio de Janeiro.




So basically this is where we get to learn what a global credit crunch means in terms of output and economic growth.




Current Account and Trade Deficit

The Rupee has also been dropping in reaction to India's deteriorating current account situation. The current account deficit increased to $10.7 billion in the second quarter of 2008 from a $1.04 billion gap in the previous quarter,according to data from the Reserve Bank of India last week.

India's trade deficit almost doubled to a record in August as a surge in crude oil prices increased the import bill and overseas sales of goods slowed. The trade deficit widened to $13.9 billion from $7.2 billion a year earlier, according to data from the Ministry of Commerce and Industry. Imports grew 51 percent, the fastest gain in seven months, to $29.9 billion, while exports expanded 27 percent to $16 billion.

A near doubling of oil prices has boosted import costs, since India relies on overseas purchases for three-quarters of its energy needs. India paid an average $8 billion a month this year for oil imports, up from $5.5 billion in 2007, as crude oil costs surged to a record $147 a barrel on July 11. In India, the 35 percent drop in oil prices since July has been partially offset by the decline in the rupee to a five-year low. India's oil imports in August rose 77 percent to $10.9 billion as refiners paid more for crude oil purchased overseas. Non-oil imports gained 40 percent to $18.9 billion. Imports in the five months ended August 31 rose 38 percent to $130.3 billion from $94.6 billion a year ago. That took the trade deficit to $49.2 billion, compared with $34.5 billion in the same period a year earlier.

Overseas sales of Indian goods in the five months to August 31 grew 35 percent to $81.2 billion, compared with $60.1 billion, the statement said.


Overseas sales of Indian goods in the five months to August 31 grew 35 percent to $81.2 billion, compared with $60.1 billion, the statement said.

India's current account deficit widened to a record in the three months to June as a surge in crude oil prices increased the nation's import bill. The shortfall, the amount by which imports exceed exports, remittances and other income from abroad, increased to $10.72 billion from a $1.04 billion gap in the previous quarter, the Reserve Bank of India said in a statement in Mumbai. Analysts expected a deficit of $11.52 billion.

It has been a while since I last had Japan under the spotlight where and where I noted that Japan almost certainly would be tumbling into or very close to recession. Since then, data have been pointing only one way really and with the recent downward revision of an already quite awful Q2 GDP reading Japan now seems certain to be flirting with a recession.

As per usual, I will peruse the most recent pile of data but now that Japan stands on the brink of yet another recession in the 21^st century, I also think that it also finds itself confronted with a crucial question. What will happen to spending and the political situation in the wake of Fukuda’s resignation? I am no political specialists, but I will try to highlight the issue from an economic view point all the same.

All the Features of a Recession

As if the initial Q2 GDP reading was not tough enough clocking in at -2.4% y-o-y the revised figure released by the cabinet office of -3.0% suggests that Japan’s economy took a significant beating in Q2. On a quarterly basis Japan’s economy thus pulled the rather dubious trick of completely erasing Q1 0.7% growth rate meaning that growth in H01 2008 stands at 0% q-o-q. The corresponding figure for annual values is -0.2%. Given the sharpness of the contraction it should not surprise many that almost all components of GDP were down. Most important perhaps were net exports which failed to make a positive contribution for the first time in three years.

Especially domestic demand and investment weighed heavily on the head line figure and without neither government spending nor, more importantly, exports with net exports contributing -0.1% this is the figure you get. In general, Japan seems to be caught in somewhat of a vicious circle at the moment. With domestic demand congenitally weak and foreign demand now faltering corporate capex seems certain to fall back. Add to this, a decline in terms of trade due to the increase in imported goods prices as well as a fiscally strained government and you end up with a busted ship as they say in the sci-fi shows.

If we turn our attention to prices it seems that Japan got that last spurt of headline inflation pressure in July with all three indices posting positive rates.

The general inflation index rose 2.3% from a year earlier, but more importantly the US style core-of-core index managed to eek out a full 0.2% print. This brings the average, for this index in 2008, to 0% y-o-y. It is the first time since August 1997 that the core-of-core index posts such a gain. Clearly, and since the increase in inflation comes at a time when the economy is actually shrinking to the tune noted above, this is all about cost push inflation. The deterioration in Japan’s terms of trade represents an important underlying current here since Japan, for the most part, imports energy and food related produces. In so far as goes the domestic value chain inflation has only scarcely found its way to the market in terms of the core-of-core index, a point I have emphasized in my analysis before [insert link here].

Given the rather violent setback of global headline inflation so far in H02 2008 and the imminent outlook of oil dropping to negative growth rates y-o-y towards Q4 Japanese consumers should once again find some solace, if only a little bit, at the pumps and in the supermarket as we move towards the end of the year. Of course, this will probably mean that Japan slips back into deflation in the core of core index, but it is important to understand that this seems to be the rule rather than the exception.

A further breakdown of domestic demand shows us that household consumption expenditures have contracted in every month so far in 2008. Even if the rate of contraction seems to be edging in the right direction, it still indicates that Japan has been hit extraordinarily hard by the recent bout of global stagflation.

Japanese consumers once again cut back on fuel and food expenditures while spikes in expenditures on furniture and clothing kept the index from plummeting completely. A worrying trend in the context of domestic consumer demand is furthermore that household income and wages have almost fallen off a cliff in recent months. Total cash earnings fell back 2.5% in July and household income was down 3.5% on the year. In light of this, it is difficult to expect the Japanese consumer to be able to muster that much debated second bulwark against recession once foreign demand trends down.

As for corporate sector the overall headline news was actually a rare bright spot as industrial production climbed 0.9% in July from June where it fell 2.2%. While certainly down on an annual basis, industrial production still seems to be increasing at levels higher than those seen throughout 2006 and H01 2007. The news from the small services on the ground, in the form of Japanese small merchants, consequently point towards a further deterioration. This is no doubt strongly related to the slump in consumer confidence and spending and shows the extent to which the slowdown in demand is affecting businesses that are dependent on the home market alone.

It is also difficult to see much upside in the July number given the slew of other incoming data. As such, the overall gauges for fixed capital formation in Q2 points towards a sharp de-acceleration of activity and one really finds it difficult to conclude much else than the fact that Japan is now in a recession.

According to Morgan Stanley’s Takehiro Sato one mitigating factor here may be the relative tight management of inventories by Japanese companies in recent years. The point here would be that since Japanese companies do not have a large backload of inventories to scale down, headline production may not have to slump completely. Sato remains skeptical of this analysis and I agree. Clearly, the inventory related argument ultimately depends on the actual rate and severity of the incoming slowdown not least in Japan’s main export markets. It is clear to me that any sharp slowdown signals from China would mean for Japanese corporate capex to see a significant period of downscaling. In fact, with all external deficit economies slowing down sharply, it is difficult to have much faith in the inventory argument. The point here is simply that the level of industrial activity that the domestic sector can support in light of falling external demand may be much lower than many expect.

In this context and while exports continued to de-couple from the US in July imports also rose at record pace. The resulting narrowing of the trade surplus to an almost even balance is exactly what is robbing Japan from part of its growth engine. Clearly, and if the terms of trade are set to improve it could be all back to normal for Japan in H02 2009. However, it seems anything but certain that a correction is also coming in terms of emerging markets even if it will be relatively short lived. On that note, net exports and foreign asset income will be less of a driving force for growth in the latter part of 2008.

What is more, Japan also seems to be sporting its very own miniature residential investment crisis as bankruptcies amongst construction and real estate companies continued to climb to alarmingly high levels in August. Sato digs deeper into this issue and directs attention to the point that one of the main risks facing Japan is that credit dries up leaving even more companies without the possibility to carry on their operations. This tune is well known and has credit crunch written all over it. According to Sato, one of the main risks at the moment is consequently that the sharp contraction of credit and activity in the real estate sector could spread to other sectors. One key development to gauge here would be the trend in overall corporate bankruptcies, especially over the course of H02 2008.

Fiscal Stimulus to the Rescue?

The probability and discussion of fiscal stimulus to revive Japan’s economy got significantly more clouded with the recent decision of Prime Minister Fukuda to step down. The decision itself was not entirely unexpected as the PM, and his cabinet, has had a distinctly hard time getting their will through parliament, as the opposition controlled the lower house. According to Ken Worsley, Fukuda’s resignation is thus a part of a more fundamental strategy to install a special session in the Diet which allows the ruling party (the LDP) to pass a number of bills.

In the middle of all this there is a 2 trillion yen ($18 billion) expansive fiscal deal on the table. If the economy continues to deteriorate one would think that such a deal could be relatively swiftly passed by both chambers of the parliament. With mounting rumors of a general election in November, the current situation looks pretty unpredictable. . As with the impending and much debated consumption tax to widen the budget’s revenue base it seems that priorities in the political system are not yet straight when it comes to moving forwards, or backwards, on the fiscal front.

As could have been expected the candidates to replace Fukuda are rounding up and while I know way too little about Japanese politics to say anything about the individual contenders, it is clear that one issue high on the agenda will be what they intend to do with respect to the fiscal lever and by derivative the much debated reform ghost in Japanese politics. In this connection recent comments from various candidates reveal somewhat of a disagreement. Obviously, the difficulty with which Japan can actually use fiscal policy, saddled with a debt/GDP ratio of +180%, is not new. The outgoing PM consequently stated the following rather incredible claim a few months ago (quoted by Bloomberg).

There is nothing to be done but wait for export markets to recover.

I do find this rather interesting not least because it comes from, at the time, a leader of a country and an economy. Essentially, I agree with Fukuda though. It is very unlikely that Japan will be able to ignite domestic demand to a degree which will make the incoming slowdown milder. This is the nature of export dependency as a result of an ageing economy. However, the sentiment expressed also highlights, I think, a more profound perspective with respect to Japan’s policy makers’ relentless strides to rebalance the economy. Basically, Japan is now set on a growth path which no immediate policy can change. Anything short of a very local Japanese version of the IT induced positive productivity shock [1] would not do the trick, so there is, in fact, not much to be done. Of course, the sentiment turns almost delusional with comments quoted from Hiroaki Muto senior economist at Sumitomo Mitsui Asset Management Co. in Tokyo.

Japan's economy is weak because foreign demand is slumping and the terms of trade have been worsening, not because there are any big domestic structural problems.

I would grant Mr. Muto some of his argument in the sense that the specific deterioration in the terms of trade, this time around, has made matters worse. However, it is precisely because Japan has domestic structural problems that she is export dependent, and therefore it also because of domestic structural issues that Japan’s economy finds itself in a weak position when foreign demand falters.

This display of sentiment also seems to cut across the fistful of potential candidates on offer to replace Fukuda. Some seem to share the outgoing PM’s sentiment while some again seem to believe that a stimulus package, of some kind, would be appropriate. It is also important to note here that an 11.7 trillion yen stimulus deal is on the table. The deal is mainly targeted to alleviate funding conditions for small and medium sized companies. One of the main aspects must clearly be the extra provisions set up in the context of the shared credit responsibility implemented a year ago. Takehiro Sato and Morgan Stanley’s Japan team have been warning before of the adverse effects of letting banks assume part of the responsibility here in the sense that it would lead to a sharp retrenchment of credit to small and medium sized companies. I will let Sato himself provide the details

So alongside this new system created to ease funding problems, the new economic package also brings a wider range of safety net guarantees of different types.

Safety net guarantees lie outside the shared responsibility system, and have been used, as the name says, to provide a safety net for the SMEs that cannot access CGC-backed loans. Originally, about 70 sectors were designated as eligible for credit support based on criteria such as sales performance, but the number has almost doubled in the wake of the errant policy-induced housing shock that followed last year’s revision of the Building Standards Law. The eligibility of a debtor is decided by the external criterion of whether it is included in the specified industries and whether sales are down more than 5%Y for the latest three months, but the number of industries covered could rise as the recession deepens.

If the economy continues to deteriorate one would think that such a deal could be relatively swiftly passed by both chambers of the parliament. However, this seems far from certain with in light of the political limbo in which Japan now finds itself. As with the impending and much debated consumption tax to widen the budget’s revenue base it seems that priorities in the political system are not yet straight when it comes to moving forwards, or backwards, on the fiscal front.

More importantly, Sato also muses on the potential for the Japanese government to pull of the extra emergency provisions without having to issue more paper. I can see the argument in the sense that the government would only have to fork over its part of the cash if the debtor went belly up. In a general perspective however, any kind of slack in terms of loosening fiscal policy, which really only could be financed through the issue of government bonds, would certainly bring forth the rating agencies. Especially, any de-facto abandonment of the objective to balance the budget by 2011 would not be taken lightly [2] .

In any case, and as Sato also explains in some detail, it is not at all certain that fiscal stimulus would help boost the economy but merely shift liabilities from companies and the consumer over to the government. The key argument here is one of Ricardian Equivalence where by economic agents adjust their expectations so as to negate the initial effect from the fiscal windfall. Obviously, the shift in liabilities themselves would not be without advantage since the increased savings by households and companies would likely bring the overall discounted value of Japan’s liabilities down. [3] In essence though, this remains a very theoretical argument and should not distract us from the point that Japan is slowly but sure trending towards an end point when it comes to its public balances. At some point she simply won’t be able to pay and the international institutional set-up (rating agencies) and policy makers (G8 anyone) would be wise to think in alternative solutions here. The alternative in terms of some ageing countries’ abilities to fund their ongoing liabilities will not be pretty at all.

Moreover, if we take Sato’s argument to the extreme the theoretical future discounted value of Japan’s government debt could be made equal to the equivalent future discounted value of the entire stock of company and household savings. However, this is not the way it is likely to materialize.

As such and while I agree with Sato’s initial point that increased savings through deposits are likely to be channeled into cheap government funding, we also know that Japan’s savings are increasingly flowing out towards higher returns. Furthermore, this is a story with both a short term and a long term perspective, where the former is epitomized in Ms. Watanabe and her carry trading efforts and the latter by portfolio and investment outflows. As such, and given the current levels of Japan’s public debt ratio the theoretical process of funneling domestic savings into government bonds may not correspond to practice. I would hold this to be particularly doubtful in light of the fact that the income earned on foreign holdings of stocks and bonds are precisely what drive top line growth in Japan together with goods and services exports.

What Kind of Recession?

Now that everybody seems to agree that Japan is in a recession the focus has naturally turned towards the question of just how it will look. V(W)-shaped, U-shaped or perhaps even L-shaped are all potential scenarios at this point. Official authorities in Japan in the form of the BOJ and the Cabinet Office maintain that this will be a quick recession. The analytical landscape is less convinced though. Takehiro Sato seems to be leaning towards a somewhat nastier scenario. As I have highlighted above, a sharp emerging market correction in China would definitely be catastrophic for Japan. Also Mary Stokes from RGE sees considerable downside risk to Japan’s situation.

I tend to go for the more pessimistic of the narratives noted above. I also concur though that if headline inflation is set to decline as briskly as seems the case, it could just bring the relief Japan needs if she is not to falter completely. In the end however, external demand and asset income will, as ever, be crucial parameters to watch. This ultimately also means that Japan will suffer at the whims of the global economy.

On that note, I see considerable upside in places such as Turkey, Brazil, and India. Japan’s savers would be wise to expose themselves towards these regions in the future in their attempt to hold the most efficient global portfolio. Many great unknowns present themselves though. China’s development is crucial for the global economy, but also the potentially incoming train wreck in Eastern Europe and the instability in Russia could be one of those famous trigger points.

Conclusively, I see Japan limping ahead for the remainder of 2008 where foreign demand, all things equal, will be less of a driving force than hitherto.

[1] Given the rate of technology adoption and diffusion across economies today, it is very difficult to see how Japan would be able to sustain a relative competitive advantage in any sense of the word.

[2] Personally, I think that this is very unlikely to materialize in the first place, but as in other, more fundamental parts of life, commitments matter.

[3] I am assuming here that the government can finance its budget deficit more cheaply than individual consumers and companies.

There are many perspectives through which to look at economic development and growth. Geography, institutions or perhaps just plain good old physical capital accumulation are all important parameters. This small piece suggests a further metric and attempts to frame the argument with Chile as a case study.

Specfifically, this note explains the process known as the demographic dividend and conceptualizes it in a Chilean context. The analysis shows how Chile during the last two decades has benefited from the dividend proxied by the increasingly favorable trend in overall age structure of the society. By some measures Chile’s demographic dividend is thus ending during these very years. Yet, by adapting a slightly broader definition of the optimal working age and subsequent productivity profile, it appears that Chile still finds itself in the proverbial sweet spot and will continue to do so for the next decade. Coupled with the favorable windfall from copper exports and the subsequent transformation of this into an unprecedented net wealth position of Chile’s public accounts, the economy looks on a very solid footing to face whatever travails that might come next.

Chile's growth performance depicted by the chart is interesting in so far as it shows us the period that some scholars have dubbed Chile's Golden Age (Gallego and Loayza, 2002) due to the extended period of high growth rates. Between 1984 and 1998 Chile's growth rate in output per capita averaged 5.15% a year with a volatility of 2.64% p.a. This compares with an average growth rate in output per capita between 1998 and 2008(f) of 2.61% and a subsequent volatility of 1.73%. The 1985-1998 figures are remarkable and thus deserve some explanation.

According to Gallego and Loayza (2002) Chile's impressive growth performance primarily comes down to improvements in total factor productivity induced by increased investment in human capital and the development of a sound and coherent institutional setup. As such, and not unlike other growth accounting exercises the authors initially find that TFP accounts for the biggest share of output growth alongside the usual suspects of capital accumulation and growth in the labour force, the latter which is (in)famously coined as synonomous with population growth in the neo-classical growth model

The empirical approach is rather straight forward in terms of methodology, and is closely related to the tenets of endogenous growth theory as well as of course Mankiw, Romer and Weil's (1992) seminal findings that investment in human capital be considered an important part of capital accumulation. Formally, the authors first estimate a cross-section regression framework (GMM) based on a, more or less, standard neo-classical growth model augmented with human capital (schooling rates and life expectancy). The authors also include; government consumption to GDP, financial market development, terms of trade shocks, trade openess, and a black market premium. They find that this model account for 43% of the growth observed in Chile.

Unsatisfied with this result, the authors imbue the model with a number of variables whose origin in the growth theory framework are inspired by the tenets of endogenous growth theory. These variables include proxies for the political system, governance, public services and infrastructure, and with these, the new model moves reaches a coefficient of determination of 73%.

In line with endogenous growth theory the authors consequently find that this initial "residual" best be explained by improvements in the institutional edifice of Chile's economy. As a result and although the notorious convergence effect will tend to lead to lower overall growth rates in period t0 than in period t-1, the authors suggest that Chile focus further on institutional improvements to foster growth in the future.

Far be it from me to take issue with these results. However, in the following I propose another way to look at the past and future growth performance of Chile. It is important to understand that the two approaches are not mutually exclusive but ultimately directs the attention to a different set of governing mechanisms when it comes to economic growth.

A Demographic Dividend?

In one of their many papers on the subject David E. Bloom and David Canning (see Demographic Challenges, Fiscal Sustainability and Economic Growth, PGDA Working Paper no. 8) provide a useful historical sweep of the different approaches to demographic changes and their significance on the economic edifice. From the Malthusian epoch to a more optimist view on the benefits of vibrant population dynamics (see e.g. Simon Kuznets, Julian Simon, and Ester Boserup) and on to what Bloom and Canning coin as the “neutralists” [3] , the perspective on the importance of demographics has certainly changed a lot.

One crucial lesson to draw from the historical prism of demographic discourses is that the demographic transition is a far more complicated process than a mere transition in population growth rates as well as one of sectoral shifts in the economy. Lee (2003) consequently shows how the demographic transition also fundamentally changes the age structure of society whereas others such as Malmberg and Sommerstad (2000) and Hugh (2006) have suggested that the demographic transition be re-thought all together. Common for these contributions is the shifts in age structure, the complex mechanisms which govern these changes, and their subsequent effect and operationalization on the macroeconomic edifice.

Bloom, Canning and their fellow scholars on the PGDA at Harvard, [4] have furthermore showed how age structure makes a much more solid demographic yard stick, for gauging economic trends, than merely looking at population growth and absolute size of the population. This, I think, is the ultimate lesson to derive from decades worth of thinking on demographic processes. I would essentially divide the lesson into two irrefutable points. One is that age structure matters much more than population growth and that a simple metric such as median age can give us a tremendous amount of information on an economy's given and future growth path. The second points is simply that the demographic transition is not, by a long shot, over. In fact, nobody knows when it will end.

It is within this framework that the process known as the demographic dividend enters, and not surprisingly, it is all about age structure and how economies who go through the demographic transition at some point will find themselves with above average conditions for growth as the working age as well as productive share of the population is maximized. In terms of median age and as a crude benchmark, we can say that those economies with median ages between 25-35 are situated in or close to the optimal age structure for economic growth. Nothing comes for free however, and it is crucial to point out that the demographic dividend provides an opportunity rather than a sure benefit. For example, it seems that Eastern Europe and Russia, by and large, have gone through their demographic dividends without experiencing the corresponding win-win situation in which favorable growth conditions coincides with advances in terms of institutional quality and political stability.

The demographic dividend operates through two interconnected mechanisms in the form of falling fertility and declining infant mortality. In most countries, falling mortality as the economy moves through the demographic transition has been accompanied, with a lag, by falling fertility Bloom and Canning (2006). If we add a steady increase in life expectancy to proxy the general improvement in the health of the population these interconnected processes endow an economy with a period of, let us say, 15-20 years in which the young and working cohorts of the society are relatively big compared to the dependent cohorts. The former are often defined as the cohorts aged <20-25 [5] years and for the latter's part >65. As for quantitative importance, Bloom and Canning (2004) have shown this to have a positive effect on per capita output as well as they have famously shown how one third of the East Asian Tiger economies’ impressive growth spurt in the latter part of the 20^th century can be explained by the demographic dividend.

More generally Bloom & Canning et al. (2007) have also demonstrated, through cross sectional regression data, how age structure can significantly improve the forecast of economies' growth rate relative to world GDP.

Chile’s Demographic Dividend

If large parts of East Asia have already had their demographic dividend what about Chile then. Is Chile about to receive, or more aptly; is she in the middle of her demographic dividend?

As can readily be seen, Chile almost displays a textbook case of economic development. In this way, infant mortality has fallen back sharply since the middle of the 1970s as well as life expectancy has increased. Outside the immediate realms of economics, biologists and health economists speak of the process known as the epidemiological transition to explain the progression of the change in (and drivers of) variables such as mortality, life expectancy, and other public health metrics.

The reduction of, and subsequently the current level of, infant mortality in Chile rivals that of many developed economies. According to Albala and Vio (1995) Chile managed to reduce infant mortality by 82% between 1970 and 1992 and Jimenez and Romero (2007) further shows how provisions of services to counter perinatal risks and acute respirator distress have helped Chile to reach an impressive infant mortality rate of 8.9 infants per 1000 thousands in 2000.

With respect to life expectancy Albala and Vio (1995) describe how the mortality rate of people aged 65 and more decreased 73% between 1970 and 1992 . Especially, a reduction in the mortality from cardiovascular causes is highlighted. In a more recent paper Albala, Vio et al. (2002) also latch on to increasing risk posed by a transition from a prevalence of infectious diseases to on in which chronic diseases ascend in importance. The usual suspects here would be an increase in obesity as a result of malnutrition through the consumption of high-fat/high-carbohydrate energy-dense foods and a decrease in physical activity. Chronic diseases which spring from such developments would then be e.g. type 2 diabetes and cardiovascular diseases. Evidence of this development appears in the context of school children; from 1987 to 2000 the prevalance of obesity among first grade school children rose more than 100% for both boys and girls.

Much debate has and will be devoted to the extent that such adverse developments from economic development could, at some point, break the curve in terms of life expectancy. At this point however, it seems as if advances in healt care services and the subsequent improvements in old age life expectancy are enough to keep the curve ticking upwars.

Returning to the question of demographic dividend in Chile, the trend of the decline in infant mortality exhibits the expected negative concave relationship as per function of the fact that the value cannot fall below 0. In order to build a simple model framework and by applying the logic expressed through theory above, we can construct a rudimentary econometric model to formalize the argumet.

Consequently, we let the lagged change (one year) [6] in the infant mortality rate predict the change, in year 0, of the fertility rate. Given the properties of the time series in question, and the theoretical framework above we would expect a positive but also a concave relationship since both variables are bound by the fact that they cannot fall below 0. In general terms, this model clearly assumes that the process of decline in fertility throughout the demographic transition is infinitely simpler than it really is. The crucial point here is that while the decline in infant mortality may be able to explain the decline in fertility on a certain part of the curve it cannot, and may in fact see its sign reverse, as we move further towards replacement level fertility and beyond. One could even with reasonable claim ask whether in fact the decline in fertility towards replacement levels is driven by infant mortality reductions alone. Nevertheless, the model estimated looks as follows where both variables are in changes.

Which leads to the following estimation:

The visual inspection of the model can furthermore be derived from the graph below.

In general, the model is far from solid but it manages to get the message across in the sense that it links the decline in fertility to the lagged decline in infant mortality [7] . The key thing to remember is the implicit and theoretical concave relationship cited above; a relationship also confirmed by the scatter plot.

The interesting thing about Chile here is that, according to standard demographic theory, the demographic transition should, by and large, end now as fertility trends towards replacement level. Not a lot of serious scholars would believe that however and we can thus expect fertility to decline below replacement level (see e.g. Wolfgang Lutz here). The extent to which it does not, Chile would clearly constitute something of a remarkable case. This is also why policy makers would be wise to consider implementing steps to avoid fertility dropping into lowest-low territory [8] , since what we know with almost certainty is that the demographic transition does not stop once infant mortality hits near rock bottom.

This point also highlights the idea that while the demographic dividend presents a window of opportunity so does the backdrop represent a penalty. This point is crucially related to the fact that only very few economies (e.g. the US and perhaps also France) have been able to stay at, or return to, replacement levels of fertility. In most other cases, fertility seems set bound to fall further and the only real metric to gauge is the speed by which this occurs. In an emerging market context the evidence is worrying to the extent that many economies have seen their fertility rates crash completely over the course of less than a decade. The next 5-10 years in Chilean, and indeed Latin American context, will be extremely interesting to watch in this regard.

Given the fact that Chile's fertility level is already approaching replacement level, the model cited above has, in all likelihood, run its course. What will likely cause Chile's fertility rate to fall below replacement level requires an entirely different set of explanatory variables and also theoretical edifice. Key trends would for example include an elaboration of the quantum and tempo effect of fertility in a context of rapid economic development and changing social norms.

To summarize the argument in a Chilean context, the ultimate data series to gauge, in the context of the demographic dividend would be age structure and the effect from the processes described above.

As per usual, beauty is in the eye of the beholder since depending on which definition you ascribe to the optimal age structure, Chile could be said to be in and out of the demographic dividend. The truth probably is that Chile is in the twilight hours of its demographics dividend. However, with a median age of about 30 years Chile still enjoys, and will continue to do so in the immediate future, the benefits of an age structure conductive to balanced economic growth.

One important point to note here is that the 25-44 bracket peaked sometime in the middle of the 1990s. Much evidence suggests though that it is a bit untimely to make the cut at the 44 year old age group, since many people are perhaps not far from their productive peak between 44 and 64. On the other, the peak of the 25-44 age bracket may still constitute an upper level of economic capacity if viewed as the ability and propensity to sustain housing booms, large negative external balances etc.

Conclusion

Chile still has ,and will continue to enjoy for the immediate future ,a favorable age structure for harboring economic growth and dynamism. Favorable is in this context defined through the spectrum of the demographic dividend and the subsequent increase in, and high proportion of, working age people to total population. Depending on fall in fertility, the demographic dividend is definitely tapering off at this point. If experience from East Asia is anything to go by Chile as well as its Latin American peers are now set to enter a new phase of the the demographic transition in which fertility steadily moves below and beyond replacement levels. The speed here is crucial. If it happens slowly, Chile can expect to posses a relatively balanced age structure in the decades to come but if the decline is swift and lingering the effect could be otherwise.

This small piece has also touched upon the way we conceptualize economic growth and development. I would not want to discount methods such as the one deployed in Gallego and Loayza (2002). However, I have suggested that a different perspective is a also considered. I would, in particular, emphasise this in the context of the future drivers of economic growth. Nobody can disagree with the impetus to move forward on strong institutional settings. Yet, economic development is not only accompanied by a demographic dividend but also, arguably, a demographic penalty which occurs as the effect of the dividend recedes and the decline in fertility continues. This would be where concepts such as the quantum and tempo effect of fertility comes in. it is also where policy makers would be wise to consider that a relentless strive to reach the apex of the value chain will also bring with it a deficit in terms of the proper quantity/quality mix of human capital.

List of References

[1] Although Chile did not recover from the Asian currency crisis to pre 1997 levels.

[2] Bloom & Canning (2006) – Demographic Challenges, Fiscal Sustainability and Economic Growth, PGDA Working Paper no. 8.

[3] Basically, this would be the modern institutional paradigm that has emerged within the economic growth/development discourse (see e.g. Daron Acemoglu, Dani Rodrik and Amartya Sen).

[4] See numerous contributions here: http://www.hsph.harvard.edu/pgda/working.htm

[5] I would argue that this is the right threshold (unlike the <15>

[6] The time series are in changes to correct for non- stationarity. As for the lag, the optimal number of lags could be more rigorously verified on the basis of theory and the statistical properties of the time series in question (VAR)

[7] Although, as can also be observed in the graphs, it cannot predict sudden reversals in fertility trends; i.e. these would essentially be treated as exogenous shocks to this model.

There are many perspectives through which to look at economic development and growth. Geography, institutions or perhaps just plain good old physical capital accumulation are all important parameters. This small piece suggests a further metric and attempts to frame the argument with Chile as a case study.

Specfifically, this note explains the process known as the demographic dividend and conceptualizes it in a Chilean context. The analysis shows how Chile during the last two decades has benefited from the dividend proxied by the increasingly favorable trend in overall age structure of the society. By some measures Chile’s demographic dividend is thus ending during these very years. Yet, by adapting a slightly broader definition of the optimal working age and subsequent productivity profile, it appears that Chile still finds itself in the proverbial sweet spot and will continue to do so for the next decade. Coupled with the favorable windfall from copper exports and the subsequent transformation of this into an unprecedented net wealth position of Chile’s public accounts, the economy looks on a very solid footing to face whatever travails that might come next.

Chile's growth performance depicted by the chart is interesting in so far as it shows us the period that some scholars have dubbed Chile's Golden Age Gallego and Loayza (2002) due to the extended period of high growth rates. Between 1984 and 1998 Chile's growth rate in output per capita averaged 5.15% a year with a volatility of 2.64% p.a. This compares with an average growth rate in output per capita between 1998 and 2008(f) of 2.61% and a subsequent volatility of 1.73%. The 1985-1998 figures are remarkable and thus deserve some explanation.

According to Gallego and Loayza (2002) Chile's impressive growth performance primarily comes down to improvements in total factor productivity induced by increased investment in human capital and the development of a sound and coherent institutional setup. As such, and not unlike other growth accounting exercises the authors initially find that TFP accounts for the biggest share of output growth alongside the usual suspects of capital accumulation and growth in the labour force, the latter which is (in)famously coined as synonomous with population growth in the neo-classical growth model

The empirical approach is rather straight forward in terms of methodology, and is closely related to the tenets of endogenous growth theory as well as of course Mankiw, Romer and Weil's (1992) seminal findings that investment in human capital be considered an important part of capital accumulation. Formally, the authors first estimate a cross-section regression framework (GMM) based on a, more or less, standard neo-classical growth model augmented with human capital (schooling rates and life expectancy). The authors also include; government consumption to GDP, financial market development, terms of trade shocks, trade openess, and a black market premium. They find that this model account for 43% of the growth observed in Chile.

Unsatisfied with this result, the authors imbue the model with a number of variables whose origin in the growth theory framework are inspired by the tenets of endogenous growth theory. These variables include proxies for the political system, governance, public services and infrastructure, and with these, the new model moves reaches a coefficient of determination of 73%.

In line with endogenous growth theory the authors consequently find that this initial "residual" best be explained by improvements in the institutional edifice of Chile's economy. As a result and although the notorious convergence effect will tend to lead to lower overall growth rates in period t0 than in period t-1, the authors suggest that Chile focus further on institutional improvements to foster growth in the future.

Far be it from me to take issue with these results. However, in the following I propose another way to look at the past and future growth performance of Chile. It is important to understand that the two approaches are not mutually exclusive but ultimately directs the attention to a different set of governing mechanisms when it comes to economic growth.

A Demographic Dividend?

In one of their many papers on the subject David E. Bloom and David Canning (see Demographic Challenges, Fiscal Sustainability and Economic Growth, PGDA Working Paper no. 8) provide a useful historical sweep of the different approaches to demographic changes and their significance on the economic edifice. From the Malthusian epoch to a more optimist view on the benefits of vibrant population dynamics (see e.g. Simon Kuznets, Julian Simon, and Ester Boserup) and on to what Bloom and Canning coin as the “neutralists” [3] , the perspective on the importance of demographics has certainly changed a lot.

One crucial lesson to draw from the historical prism of demographic discourses is that the demographic transition is a far more complicated process than a mere transition in population growth rates as well as one of sectoral shifts in the economy. Lee (2003) consequently shows how the demographic transition also fundamentally changes the age structure of society whereas others such as Malmberg and Sommerstad (2000) and Hugh (2006) have suggested that the demographic transition be re-thought all together. Common for these contributions is the shifts in age structure, the complex mechanisms which govern these changes, and their subsequent effect and operationalization on the macroeconomic edifice.

Bloom, Canning and their fellow scholars on the PGDA at Harvard, [4] have furthermore showed how age structure makes a much more solid demographic yard stick, for gauging economic trends, than merely looking at population growth and absolute size of the population. This, I think, is the ultimate lesson to derive from decades worth of thinking on demographic processes. I would essentially divide the lesson into two irrefutable points. One is that age structure matters much more than population growth and that a simple metric such as median age can give us a tremendous amount of information on an economy's given and future growth path. The second points is simply that the demographic transition is not, by a long shot, over. In fact, nobody knows when it will end.

It is within this framework that the process known as the demographic dividend enters, and not surprisingly, it is all about age structure and how economies who go through the demographic transition at some point will find themselves with above average conditions for growth as the working age as well as productive share of the population is maximized. In terms of median age and as a crude benchmark, we can say that those economies with median ages between 25-35 are situated in or close to the optimal age structure for economic growth. Nothing comes for free however, and it is crucial to point out that the demographic dividend provides an opportunity rather than a sure benefit. For example, it seems that Eastern Europe and Russia, by and large, have gone through their demographic dividends without experiencing the corresponding win-win situation in which favorable growth conditions coincides with advances in terms of institutional quality and political stability.

The demographic dividend operates through two interconnected mechanisms in the form of falling fertility and declining infant mortality. In most countries, falling mortality as the economy moves through the demographic transition has been accompanied, with a lag, by falling fertility Bloom and Canning (2006). If we add a steady increase in life expectancy to proxy the general improvement in the health of the population these interconnected processes endow an economy with a period of, let us say, 15-20 years in which the young and working cohorts of the society are relatively big compared to the dependent cohorts. The former are often defined as the cohorts aged <20-25 [5] years and for the latter's part >65. As for quantitative importance, Bloom and Canning (2004) have shown this to have a positive effect on per capita output as well as they have famously shown how one third of the East Asian Tiger economies’ impressive growth spurt in the latter part of the 20^th century can be explained by the demographic dividend.

More generally Bloom & Canning et al. (2007) have also demonstrated, through cross sectional regression data, how age structure can significantly improve the forecast of economies' growth rate relative to world GDP.

Chile’s Demographic Dividend

If large parts of East Asia have already had their demographic dividend what about Chile then. Is Chile about to receive, or more aptly; is she in the middle of her demographic dividend?

As can readily be seen, Chile almost displays a textbook case of economic development. In this way, infant mortality has fallen back sharply since the middle of the 1970s as well as life expectancy has increased. Outside the immediate realms of economics, biologists and health economists speak of the process known as the epidemiological transition to explain the progression of the change in (and drivers of) variables such as mortality, life expectancy, and other public health metrics.

The reduction of, and subsequently the current level of, infant mortality in Chile rivals that of many developed economies. According to Albala and Vio (1995) Chile managed to reduce infant mortality by 82% between 1970 and 1992 and Jimenez and Romero (2007) further shows how provisions of services to counter perinatal risks and acute respirator distress have helped Chile to reach an impressive infant mortality rate of 8.9 infants per 1000 thousands in 2000.

With respect to life expectancy Albala and Vio (1995) describe how the mortality rate of people aged 65 and more decreased 73% between 1970 and 1992 . Especially, a reduction in the mortality from cardiovascular causes is highlighted. In a more recent paper Albala, Vio et al. (2002) also latch on to increasing risk posed by a transition from a prevalence of infectious diseases to on in which chronic diseases ascend in importance. The usual suspects here would be an increase in obesity as a result of malnutrition through the consumption of high-fat/high-carbohydrate energy-dense foods and a decrease in physical activity. Chronic diseases which spring from such developments would then be e.g. type 2 diabetes and cardiovascular diseases. Evidence of this development appears