Consequently, it seems as if the defences will hold in Latvia, but the apparent vote of confidence from the IMF and the EU commission and thus promises that the external loan financing will continue will not come for free. In order to make due on the loans the Latvian government is planning an unprecented range of spending cuts amounting to an astonishing 10% of the entire fiscal budget according to Bloomberg reporter Aaron Eglitis. These massive cuts include, among other things, a 10% pension reductions and a full fat 20% wage reductions for state employees. As prime minister Dombrovskis is quoted; these cuts should be more than enough to please the debtors in the form of the EU and, most notably, the IMF to whose mercy Latvia finds itself. One would surely hope for Dombrovskis that he is right.

And by all means, it does seem as if markets have been calmed so far [click on picture for better viewing].

As we can see overnight rates have fallen to much more comfortable levels the past few days and we have even had the news that the central bank were actually selling Lats in the open market in stead of its hitherto valiant efforts to maintain the peg, by sucking up domestic Lat liquidity pushing overnight rates up to a massive 100-200% according to a number of, I should say, unofficial reports. Medium term financing in the form of the 3 month and 6 month RIGIBOR remain elevated compared to last month, but so far the massive squeeze in short term financing seems to have abated. Overnight rates consequently fell from an officially reported high of 24.60% to 8% on the 15th of June and further down to a soothing 5% here on Tuesday.

Does it end here then? This seems to be the inevitable question we must ask ourselves.

I have my doubts. First of all, it is difficult to see the big difference here. The fundamentals still look anything but solid and the underlying weaknesses remain. As Edward noted recently in a thorough analysis of Latvia's long term economic potential, the crisis has long and deep roots which go beyond the question of default now or default later. More importantly however, Latvia has now effectively begun a great experiment to see whether it pays off to literally dismantle one's society with the aim to fulfill a distinctly narrow economic objective in the form of a fixed exchange rate. To add insult to injury, the peg itself is not the main goal. Eurozone membership is, and apart from the obvious question of whether such a membership would be a desirable outcome for Latvia at all, I have my serious doubt that we will ever get there. 

But that is somwhat for the long term. In the short term, the horizon is still littered with uncertainty and I tend to agree with Danske Bank's Lars Christenses as he dryly notes:

“There really hasn’t been any fundamental change,” said Lars Christensen, head of emerging markets at Danske Bank A/S in Copenhagen. “The only thing that has changed is how long they can postpone a devaluation. The issues are still there, and what will happen when they need the next loan installment?”

This sounds about right to me and although it distinctly seems as if Latvian policy makers are determined to do whatever it takes, the costs will be immense and one has to wonder whether the fort will hold forever? I don't think it will.

Surely, the pressure has only piled on since I last wrote about this only a few days ago (see links above). The Financial Times' blog Alphaville in this case personified by Izabella Kaminska has steadily been supplying us with the latest on the unravelling in Latvia. A particularly good piece hammers down the point that it is not only freelance bloggers such as yours truly who are questioning the Baltic (Latvian) currency peg but also, now, most professional analysts close to the situation. This is a called a market discourse and although the commitment to maintain status quo may be there one cannot make the waters go back.

However and to be fair to all parties it does seem as if the Latvian authorities got the best of the discourse this week if, that is, being the last one to shout constitutes an upper hand in this case. Consequently, both the central bank and the premier minister Valdis Dombrovkis issued strong statements to suggest that the peg will hold simply because Latvia is committed to seeing this correction through.

Latvian Prime Minister Valdis Dombrovkis pledged to push through budget cuts and ensure the inflow of international loan payments as speculation grows the Baltic state may devalue, threatening the economy of Sweden. “These rumors and speculations should finally be stopped” about the devaluation of the lats, Dombrovskis, 37, said in an interview with Latvian Independent Television today. The currency will not be devalued, he said, and the country will pass budget cuts needed to get the next tranche of money.

This is of course all well and good, but one has the distinct feeling that all this merely constitutes the inevitable last launches before the opponent finally lands the kidney blow to send you crushing into the canvas.

In terms of a more thorough look at the Latvian situation which goes beyond the immediate plethora of market jitter you could do a lot worse than visit Edward's latest post on this issue. As he sets out pointing towards, overnight interbank rates rose to a record of 20% this week and it suggest more than anything the stress being levied on the system.

Another particular issue Edward deals with is the risk of contagion and essentially fallout from a devaluation in Latvia. Certainly, this is an important question in itself but I also agree with Edward [1] in the sense that the immediate plunge in other CEE currencies not to mention the Swedish Krona following a Latvian devaluation is not really the main issue here.

For the record, I see no decoupling and a Latvian devaluation would clearly force others to do the same, most notably I would think Lithuania and Estonia. As for the ripple effects towards the entire CEE edifice, they are likely to be substantial although not necessarily catastrophic. The real issue we need to understand I think is that that IMF program has problems and that this will become clearer and clearer as we move forward. Edward points to one very important data point in the form of a real effective exchange rate where numbers have just been published in 2008 format.

This gives a very clear image of the amount of down scaling the Baltics, and indeed many of the Eastern European Economies, need. It is important to understand that there is a level effect and relative effect here in the sense that one thing is to correct relative to one's own past level, and quite another to correct relative to others. Consequently, this is a chronic problem all across Eastern Europe and thus everybody has to correct. In this sense, the IMF are submitting those with pegged exchange rates to a dose of "medicine" which is simply too strong and which the domestic "system" cannot muster.

So, my feeling is that all this goes beyond whatever effect currency speculation would have in the wake of a Latvian devaluation/default. There are clear signs that the "exit strategy" from this crisis is not working and it is next to scandalous that the IMF/EU do not realize that while these countries certainly need a strong dose of "stick" to get themselves on the right track we need to ensure that they are not obliterated over the course of the next year. I mean, this talk about Euro adoption in 2012 is just so silly and counterproductive since who the heck knows where we are in 2012. Who knows, for example, where the Eurozone itself is in 2012. Really, I cannot stress enough how these road maps of convergence need to be rethought since there has been a structural break. We need a new plan and one which factors in the change in environment.

Moreover, I think we have established by now that the Eurozone is no magic potion and in fact faces a series of very severe tests on Spain, Italy not to mention the mental crush it will be when Germany does not recover because I can tell you; in terms of domestic demand she won't.  Basically as I see it, the option has always been to "let the CEE in", but that would also take a much stronger coordination on the fiscal side and essentially joint European financing through Euro bonds. At the moment, this is far to big a step for the gents in Frankfurt and Brussels to consider.

So, no decoupling in an immediate devaluation context, but more importantly, I tend to look at this more structurally than a simple question of how much the e.g. Forint and Leu will fall in the context of a Latvian devaluation.

At the end of day, this is a question of swallowing those camels and accepting the idea that the current solution being applied is out of touch with reality. Essentially, I don't think the parties involved quite understand the structural damage many of the CEE, and Latvia in particular, have suffered. As per usual I am implicitly referring to the importance of factoring in demographics but then again; it is absolutely amazing that none of the presumed experts here have not added this variable to the equation yet. As Edward says towards the end in his entry ...

That is, the simple fact of the matter is that there is no exit strategy. The programme simply doesn't work. It is "over determined", since whichever way you look at it, there is always one more problem than there is solution. Gentlemen. I think its time to give up. Honourably, but to give up. Come on out of the bunker, white flags and hands in the air will not be called for. There's a world out here waiting for you, it's on your side, and there will be a tomorrow.

I couldn't have put it much better myself, I really couldn't.

---

[1] - There is a surprise :)

The Khan Academy is a not-for-profit organization with the mission of providing a high quality education to anyone, anywhere. We have 700+ videos on YouTube covering everything from basic arithmetic and algebra to differential equations, physics, and finance which have been recorded by Salman Khan. He has also developed a free, adaptive math program available here.

To keep abreast of new videos as we add them, subscribe to the Khan Academy channel on YouTube.

The entire video library is shown below. Just click on a category or video title to start learning from the Khan Academy!

Khan Academy is run by Salman Khan who is one of these persons that makes you feel humble (and a bit stupid) and I for one love this kind of entrepreneurship for the greater good. Clearly, I would emphasise the math resources [1] which are outstanding.  I sampled some of the videos yesterday night (sorry, but I am a wonk) and for someone who is bent hell on pursuing post graduate studies the Khan Academy provides a welcome break to reading Sydsæter et al's. "Further -ballbreaking- Mathematics for Economic Analysis". You can always quibble on the level of difficulty and for hardcore economists well trained in the fine arts of Walrasian (general) equlibrium theory, representative agent modelling and its many modern dynamic derivatives there is probably not much to be had, but for the rest of us there should be a couple of interesting shows. What is more, the format is very nice and the videos are short and concise. Personally I look forward to watching the playlist on differential equations, but there are also playlists for simple arithmetics and algrebra so this seems to be very versatile.

Now, I have no idea whether this is a well known place already (I would think it is), but it was new to me and I can only say "wow". I will certainly be coming back for more.

---

[1] - This is another very good place to go for loads of exercises.

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Here are highlights from Monday's Analyst Blog:

Dynavax Surge Not Warranted

In early morning trading, Dynavax Technologies Corp. (NASDAQ: DVAX) shares shot up dramatically (36%). However, we don't see a clear reason for that.

The surge may be related to two pieces of news: phase III Heplisav data and the swine flu breakout.

The first piece of news is about its phase III candidate Heplivsav. This morning, the company announced the oral presentation of additional phase III clinical data for Heplisav hepatitis B vaccine in a session for late-breaking abstracts at the 44th Annual Meeting of the European Association for the Study of Liver Disease (EASL) in Copenhagen, Denmark.

Skyworks Gives Stellar Guidance

Despite ahead-of-expectations Q2 results and better-than-expected Q3 guidance, shares of Skyworks Solutions, Inc. (SWKS, Buy) are lower in trading today. The company posted Q2 revenue of $173 million with non-GAAP EPS of $0.12, compared to our and consensus estimate of $168 million in revenue and proforma EPS of $0.10.

The company's expansion in high-margin, high-end smart phones and push-to-talk applications along with energy management and smart grid technologies were the main drivers of growth during the quarter. The company also captured key design wins at Huawei and ZTE for 3G and 4G base station solutions, which is expected to drive growth further in Q3.

WL Beats but Gets Downgraded

Wilmington Trust Corp. (WL) reported its 1Q09 financial results this morning. 1Q09 net income came in at $21.8 million or $0.26 per diluted share, compared to a net loss of $68.5 million $1.02 per diluted share in the prior quarter and net income of $41.4 million or $0.61 per diluted share in the prior-year quarter.

On an operating basis (excluding after-tax securities gains and write-downs), net income for 1Q09 was $17.4 million or $0.19 per diluted share, compared to a net loss of $6.1 million or $0.09 per diluted share for 4Q08. Operating earnings were substantially ahead of estimates, mainly due to a lower-than-expected provision expense which more than offset the decline in net interest income and non-interest income.

MITI Updates on Drug Development

On Friday April 24, 2009, Micromet Inc. (MITI) held a briefing for investors and financial analysts in New York to provide an update on the company's drug development pipeline.

A key highlight of the presentation was the announcement that a rapid path to market has been identified in acute lymphoblastic leukemia (ALL) for the company's lead drug candidate BiTE antibody blinatumomab (MT103) with a registration trial planned for 2010. This was in addition to a dose escalation study which is currently underway of blinatumomab for non Hodgkin's lymphoma, with final results expected to be reported at the American Society of Hematology meeting in December.

Brazilian Gov't Helps Embraer

Last week, Brazil announced an increase in credit lines to trade finance with Argentina from its existing US$120 million to US$1.5 billion.

It sounds like a huge step toward the integration of Latin American economies, but it is not. Argentina is really facing a credit shortage since the unilateral debt restructuring in 2001 and, for sure, this difficult situation has not improved lately. However, this new credit line is not supposed to solve this problem.

The original amount of US$120 million was outdated and the from a total of US$1.5 billion of the new facility, US$700 million will be just to finance Aerolineas Argentinas in the acquisition of 20 MB 190 jets from Embraer (ERJ). Embraer has been facing a difficult period in the past few months as the Global crisis reduces the demand from airline companies worldwide.

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Strengthening our global financial institutions

17. Emerging markets and developing countries, which have been the engine of recent world growth, are also now facing challenges which are adding to the current downturn in the global economy. It is imperative for global confidence and economic recovery that capital continues to flow to them. This will require a substantial strengthening of the international financial institutions, particularly the IMF. We have therefore agreed today to make available an additional $850 billion of resources through the global financial institutions to support growth in emerging market and developing countries by helping to finance counter-cyclical spending, bank recapitalization, infrastructure, trade finance, balance of payments support, debt rollover, and social support. To this end:

It is in the interest of the developed countries like the U.S. that the developing countries continue to grow.  That means that they have to have access to capital, and we are committed to making sure that they have it.  Many of these countries are really hurting now, but they were a big positive factor in world growth before the crisis hit.  Getting them moving again will help everyone.

• we have agreed to increase the resources available to the IMF through immediate financing from members of $250 billion, subsequently incorporated into an expanded and more flexible New Arrangements to Borrow, increased by up to $500 billion, and to consider market borrowing if necessary; and we support a substantial increase in lending of at least $100 billion by the Multilateral Development Banks (MDBs), including to low income countries, and ensure that all MDBs, including have the appropriate capital.

These are very significant commitments, yes they are serious about helping out the emerging markets.

18. It is essential that these resources can be used effectively and flexibly to support growth. We welcome in this respect the progress made by the IMF with its new Flexible Credit Line (FCL) and its reformed lending and conditionality framework which will enable the IMF to ensure that its facilities address effectively the underlying causes of countries' balance of payments financing needs, particularly the withdrawal of external capital flows to the banking and corporate sectors. We support Mexico's decision to seek an FCL arrangement.

Honestly I am not that familiar with the intricacies of the FCL.  However, when a crisis hits, capital tends to flow away from developing markets in a flight to safety, and the IMF is attempting to offset this.

19. We have agreed to support a general SDR allocation which will inject $250 billion into the world economy and increase global liquidity, and urgent ratification of the Fourth Amendment.

More global liquidity would be a good thing.  I don't think they are referring to unreasonable searches and seizures here though.

20. In order for our financial institutions to help manage the crisis and prevent future crises we must strengthen their longer term relevance, effectiveness and legitimacy. So alongside the significant increase in resources agreed today we are determined to reform and modernize the international financial institutions to ensure they can assist members and shareholders effectively in the new challenges they face. We will reform their mandates, scope and governance to reflect changes in the world economy and the new challenges of globalization, and that emerging and developing economies, including the poorest, must have greater voice and representation. This must be accompanied by action to increase the credibility and accountability of the institutions through better strategic oversight and decision making. To this end:

Emerging market countries will have more say in how the IMF s run. My guess that the emerging market that ends up with the biggest increase in influence there is China.

• we commit to implementing the package of IMF quota and voice reforms agreed in April 2008 and call on the IMF to complete the next review of quotas by January 2011;

China we need you to give more to the IMF and you will have a bigger say.  To a lesser extent this is true for Saudi Arabia as well.

• we agree that, alongside this, consideration should be given to greater involvement of the Fund's Governors in providing strategic direction to the IMF and increasing its accountability;
• we commit to implementing the World Bank reforms agreed in October 2008. We look forward to further recommendations, at the next meetings, on voice and representation reforms on an accelerated time scale, to be agreed by the 2010 Spring Meetings;
• we agree that the heads and senior leadership of the international financial institutions should be appointed through an open, transparent, and merit-based selection process; and building on the current reviews of the IMF and World Bank we asked the Chairman, working with the G20 Finance Ministers, to consult widely in an inclusive process and report back to the next meeting with proposals for further reforms to improve the responsiveness and adaptability of the IFIs.

Accountability and transparency is good, even at the World Bank and the IMF.  Having competent people running them is important, rather than appointing a bunch of political hacks.

21. In addition to reforming our international financial institutions for the new challenges of globalization we agreed on the desirability of a new global consensus on the key values and principles that will promote sustainable economic activity. We support discussion on such a charter for sustainable economic activity with a view to further discussion at our next meeting. We take note of the work started in other fora in this regard and look forward to further discussion of this charter for sustainable economic activity.

Resisting protectionism and promoting global trade and investment

22. World trade growth has underpinned rising prosperity for half a century. But it is now falling for the first time in 25 years. Falling demand is exacerbated by growing protectionist pressures and a withdrawal of trade credit. Reinvigorating world trade and investment is essential for restoring global growth. We will not repeat the historic mistakes of protectionism of previous eras. To this end:

World trade is a good thing, and restricting it is bad.  The recent rapid decline in world trade is very troubling.

• we reaffirm the commitment made in Washington: to refrain from raising new barriers to investment or to trade in goods and services, imposing new export restrictions, or implementing World Trade Organization (WTO) inconsistent measures to stimulate exports. In addition we will rectify promptly any such measures. We extend this pledge to the end of 2010;

No repeat of the Smoot Hawley Tarriffs.

• we will minimize any negative impact on trade and investment of our domestic policy actions including fiscal policy and action in support of the financial sector. We will not retreat into financial protectionism, particularly measures that constrain worldwide capital flows, especially to developing countries;

No saying, we need to make loans here at home, sorry poor countries no loans for you.  No "buy domestic" rules for fiscal stimulus packages.

• we will notify promptly the WTO of any such measures and we call on the WTO, together with other international bodies, within their respective mandates, to monitor and report publicly on our adherence to these undertakings on a quarterly basis;

Since we know we can not be trusted on our own to stand up to the domestic political pressures that will call for protectionist steps, we want the WTO to call us out on it if we do start to go down the protectionist route

• we will take, at the same time, whatever steps we can to promote and facilitate trade and investment; and

We will actively work to promote trade.  Everyone does this for exports, the rub will be if imports are also facilitated.

• we will ensure availability of at least $250 billion over the next two years to support trade finance through our export credit and investment agencies and through the MDBs. We also ask our regulators to make use of available flexibility in capital requirements for trade finance.

MDB's are the multinational development banks, the smaller regional versions of the World Bank/IMF.  This puts an actual number, and a fairly aggressive one on the support for these institutions.  This is a very worthwhile move.

23. We remain committed to reaching an ambitious and balanced conclusion to the Doha Development Round, which is urgently needed. This could boost the global economy by at least $150 billion per annum. To achieve this we are committed to building on the progress already made, including with regard to modalities.

Let's get the stalled world trade talks back on track.  Serious differences remain though between developed and developing economies, most notably in the area of agricultural subsidies.

24. We will give renewed focus and political attention to this critical issue in the coming period and will use our continuing work and all international meetings that are relevant to drive progress.

Let's keep on meeting

Ensuring a fair and sustainable recovery for all

25. We are determined not only to restore growth but to lay the foundation for a fair and sustainable world economy. We recognize that the current crisis has a disproportionate impact on the vulnerable in the poorest countries and recognize our collective responsibility to mitigate the social impact of the crisis to minimize long-lasting damage to global potential. To this end:

If you think we are hurting, poor countries are really taking it on the chin, and we caused the problems not them, we should help them out.

• we reaffirm our historic commitment to meeting the Millennium Development Goals and to achieving our respective ODA pledges, including commitments on Aid for Trade, debt relief, and the Gleneagles commitments, especially to sub-Saharan Africa;

A historic commitment that so far has mostly gone unfulfilled, particularly from the U.S.  You think it  will be easier to increase aid now that the world is in recession than it was when the world was growing?  Nice boilerplate though.

• the actions and decisions we have taken today will provide $50 billion to support social protection, boost trade and safeguard development in low income countries, as part of the significant increase in crisis support for these and other developing countries and emerging markets;

A nice start, about one Citibank bail out for the whole world combined.

• we are making available resources for social protection for the poorest countries, including through investing in long-term food security and through voluntary bilateral contributions to the World Bank's Vulnerability Framework, including the Infrastructure Crisis Facility, and the Rapid Social Response Fund;

It will be interesting to see how many of these bilateral contributions actually come through

• we have committed, consistent with the new income model, that additional resources from agreed sales of IMF gold will be used, together with surplus income, to provide $6 billion additional concessional and flexible finance for the poorest countries over the next 2 to 3 years. We call on the IMF to come forward with concrete proposals at the Spring Meetings;

A small but useful step

• we have agreed to review the flexibility of the Debt Sustainability Framework and call on the IMF and World Bank to report to the IMFC and Development Committee at the Annual Meetings; and we call on the UN, working with other global institutions, to establish an effective mechanism to monitor the impact of the crisis on the poorest and most vulnerable.

We want the IMF, World Bank and UN to write a bunch of reports that no one will read.

26. We recognize the human dimension to the crisis. We commit to support those affected by the crisis by creating employment opportunities and through income support measures. We will build a fair and family-friendly labor market for both women and men. We therefore welcome the reports of the London Jobs Conference and the Rome Social Summit and the key principles they proposed. We will support employment by stimulating growth, investing in education and training, and through active labor market policies, focusing on the most vulnerable. We call upon the ILO, working with other relevant organizations, to assess the actions taken and those required for the future.

Some nice boilerplate about making sure that labor markets are open to both sexes, the meaning of these statements are most likely open to significant amounts of interpretation and will not be all that binding.

27. We agreed to make the best possible use of investment funded by fiscal stimulus programmes towards the goal of building a resilient, sustainable, and green recovery. We will make the transition towards clean, innovative, resource efficient, low carbon technologies and infrastructure. We encourage the MDBs to contribute fully to the achievement of this objective. We will identify and work together on further measures to build sustainable economies.

This is an endorsement of Obama's efforts to use fiscal stimulus to create green jobs and actually do something about greenhouse gases.  Most of the other developed economies are ahead of us in this regard, so not very controversial, it might have been a year ago, but not now.

28. We reaffirm our commitment to address the threat of irreversible climate change, based on the principle of common but differentiated responsibilities, and to reach agreement at the UN Climate Change conference in Copenhagen in December 2009.

Global warming should be addressed but we will take that up at the "Kyoto II" meeting in Copenhagen later this year.  "Common but differentiated responsibilities" means that there is a lot of disagreement about which countries have to do what and they wanted to paper over the differences for now.

Delivering our commitments

29. We have committed ourselves to work together with urgency and determination to translate these words into action. We agreed to meet again before the end of this year to review progress on our commitments.

We mean what we say (would you really expect them to say that they don't plan on turning these words into action).  We will see how much of the above actually happens.  In any case, it was fun getting together folks, let's do it again sometime soon.

The value of the Swiss franc has increased substantially since the beginning of the financial crisis in August 2007. This currency development has gained momentum since the National Bank's last assessment in December. Under the present circumstances, this represents an inappropriate tightening of monetary conditions. In view of this development, the SNB has decided to purchase foreign currency on the foreign exchange market, to prevent any further appreciation of the Swiss franc against the euro.

Especially noteworthy was of course the point that the SNB will be conducting open market purchases in the spot market to halt the Swissie's ascend versus the Euro. As is visible from the graph below (inspired by Macro Man's visualization), EUR/CHF reacted swiftly (click image for better viewing).

Now, the SNB's move has already been parsed by the media and some of the blogsphere's best analysts; Macro Man (see link above), Edward Hugh who posted almost simultaneously with Peter O'Neill over at AFOE, as well as Stefan Karlsson. One strengthening, narrative that is emerging is the talk about a wave of competitive devaluation which would not of course help any of the individual economies in a context of "everyone" doing it. On the other hand the Swiss might arguably have a stronger case here in this respect since it is well known that in relation to hightened risk aversion the CHF is known to appreciate significantly in line with the notion of unwinding of carry trades; see [1]. On a more general note and if the central bank is really pencilling in the kind of deflation suggested by the small snippet released in the context of the decision, it seems a prudent move to also include the currency in the overall strategy even if of course the practical deployment of currency weakening may be easier said than done. Ultimately though, the move seems to be an attempt by the SNB to wriggle the CHF out of the role (perceived or actual) of funding currency in carry trades with the subsequent safe haven flows and position unwinding to follow when markets tank.

“The effect of our interest rate cuts was neutralized by the permanent appreciation of the Swiss franc,” SNB President Jean-Pierre Roth said in an interview with SF Swiss television following today’s decision. “We decided to block a further appreciation of the Swiss franc vis-a-vis the euro. These measures are necessary for our rate cuts to have effect.”

An entirely different effect from this is the potential positive externality this may provide in relation to Eastern Europe's struggling economies and all those households who have taken out consumer credit loans and mortgages in low interest rate Swiss francs during the boom. This narrative was picked up by both Macro Man and Stefan Karlsson and is an important one to keep in my mind when the residual effects of a SNB in QE are analyzed. In Hungary who is the CE economy most exposed to translation risk from an appreciating CHF we recently had news that the government might use some of the IMF funds to help convert CHF denominated loans into Forint loans. Now, before we get too excited it is important to note that the SNB did not say anything about the CHF/HUF and what is more; most of the floating currencies in the CEE have been axed relative to the Euro. Yet, these points notwithstanding, easier access to Swiss francs in a general context mean that the sting might just be taken off of those nervous sentiments concerning translation risk in the CEE.

Sure enough, the initial reactions from CEE markets have been positive and almost cheerful. Consequently, a host of banks, particularly in Poland and Hungary, saw their share prices rise smartly on the news as it, at least for a while, eased the risk that the translation risk on the majority of their loans (assets) would force them into default. Also, both the Zlothy and the Forint clawed back some of their recent lost ground on the SNB's decision.

A Lasting Impact

Surely, the SNB's move represents somewhat of a sea change in the context of the CHF. Traditionally and in this current market environment, there is no guarantee that QE necessarily will lead to a significant depreciation of your currency. The argument here would one of relative debasement and if everybody conducts their own homegrown version of QE, then the result may well be status quo or at least depend on a host of other factors than the pure quantitative effect of the policy. One of these factors in this respect is clearly the commitment by the SNB to intervene when and where ever the CHF is deemed to be to high relative to the Euro (are we getting a target here?) and according to the currency wonks at Dailyfx the bearish theme for the CHF is set to linger. Personally, I am a bit skeptical here and much will depend on the famous credibility of the SNB's commitment and thus by derivative the market's appetite to test this very same commitment. 

As for the mitigating effects on the CEE, the impact is likely to be limited in terms of concrete economic impact in the context of pass through effects. However, it may represent a signal and a glimmer of light which could prompt action on how to deal with the translation risk in a proper manner. What is more, it should not only be in Eastern Europe that that bankers are breathing a little lighter. Surely then, the Austrian banking sector heads will be sending a couple of bottles of their finest Öbstler to the governor of the SNB and if I was the head of Unicredit I would be dispatching a vintage bottle of Grappa. In conclusion, it is difficult to see just what the actual impact will be here, but it does represent a rare extension of a helping hand to Eastern Europe even if it was not, initially, meant as one.

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[1] Remember one of the underlying arguments here.

Towards a Common European Answer?

As I mentioned last week, Q4 was an absolute horror story in terms of European data with an aggregate Eurozone contraction of qoq GDP standing at -1.5% as well as cartoonish numbers from Eastern Europe. Unfortunately, the abyss does not seem to be any less daunting one week later and if anything, it seems that the chasm may have widened. Consider for example that Ukraine's economy contracted a full 20% yoy as measured by, an adimittedly dodgy, monthly GDP estimate. It should come as little surprise that the country is now being put into spotlight for a potential sovereign default. At least, the latest brief on Eastern Europe by Danske Bank goes a long way to convince me that the end may soon come for Ukraine. Not only do we have considerable insecurity about the proposed IMF package negotiated earlier this year, the rating agencies are also naturally on high alert. Here is Danske;

The ratings agency Standard & Poor's this week warned Ukraine it could face another ratings cut, saying it distrusted Ukraines ability to implement a crucial IMF deal. The agency said it could cut Ukraine's B foreign currency rating and B-plus local currency rating by one or more notches.

Hence Ukraine's commitment to adjust is wavering against a backdrop of contracting growth, es-pecially in the manufacturing sector (industrial production dropped an exorbitant 34.1% y/y in January), and the upcoming presidential elections in January 2010. Recently an IMF mission failed to sign off on a first review of Ukraine's performances under the USD 16.4bn IMF pro-gramme during a recent visit, sparking fears of non-implementation. Ukraine says it may approach other countries including Russia for additional financial help.

 

Yep, it does not sound good and the prospect of Ukraine betting on the whims of Mother Russia certainly cannot be accommodative for foreign investors' willingness to finance the ballooning current account deficit (well, they aren't of course which is also why the Hryvnia is collapsing).

Further afield in the context of Eastern Europe it seems as people are finally waking up to the fact that the unfolding mess will need a common European response. There are of course obvious political reasons for this, but also in economic ones since if something is not done to stop the whirlwind it is likely that the European banking sector will get dragged down too due to their exposure to Eastern European economies. Edward simply notes that we should let the east into the Eurozone now as well as he has forcefully argued why we need a common EU bond scheme to get to heart of the problem with the widening of financing conditions for Eurozone economies. And don't for a minute think that EU bonds to help Italy et al. issue bonds to pay to clean up the mess has nothing to do with the CEE. Basically, contagion works in mysterious ways sometimes and with the amount of direct exposure of European banks to Eastern Europe sovereign debt ratings and spreads could easily be hit by this.  Today, FT's correspondent Munchau chimes in with a similar point. Once again, I think it is important to point out that if we let things go their own way, the whole European economic system is at risk. This view is further given life by Morgan Stanley in their recent installment on the Polish economy which, as the biggest CE economy, is also riddled with the same weaknesses as its peers. I would especially note the following bit which is a general and important point ...

The notion that the euro area (mostly made up of Western European countries) can just ignore the issues ongoing in Eastern Europe is fundamentally flawed, in our view, for at least two reasons. First, Austrian (mainly), but also German, Italian and French banks have lent aggressively in the region, and have an interest in ensuring that CEE can see through the current downturn. Second, the trade linkages between the euro area and Central and Eastern Europe have expanded significantly over the recent years: the euro area now runs a €50 billion annual trade surplus with the CEE (CE + Baltics + Bulgaria), by our calculations.

Alas, how many times have I not hoped that Trichet and his fellow chums in Frankfurt would pay just a little bit attention to the unfolding tragedy to the East. So far, they have stayed firmly in the Ivory Tower, but I reckon that this will change.

And don't think for a minute that the clock is not ticking. Last week also brought the news that the Latvian government has chosen to resign. Now, apart from likely confirming Manuel Alvarez-Rivera's prediction that Latvia is headed for an early election it also brings up the question of where exactly that political stability and will the IMF called for in connection to their policy of maintaining the peg is. My feeling is that the IMF has its credibility firmly on the line here, and one has to wonder how this idea about the policies demanding a strong political consensus fits together with what we are observing.

And the going is getting increasingly tough in key areas;

Latvia, Estonia and Lithuania, facing a prolonged recession, say they will protect their currency pegs whatever the cost. That strategy may be as crippling as the alternative, economists say. The three-nation Baltic region is in its deepest crisis since breaking from the Soviet Union in 1991. Latvia, which spent $1.26 billion in 11 weeks defending the lats last year, was forced to turn to an International Monetary Fund-led group for a $9.6 billion bailout. Its economy may contract 12 percent this year, while Estonian gross domestic product may shrink by as much as 9 percent and Lithuania’s GDP by 4.9 percent.

Latvian Premier Ivars Godmanis resigned on Feb. 20 and Lithuania’s two-month-old cabinet is struggling to win over a skeptical electorate after the two nations suffered the largest street riots since independence last month. Keeping the peg “will likely mean a number of years of very low economic growth,” said Lars Christensen, chief economist at Danske Bank AS in Copenhagen. “Wages and prices will have to fall to reestablish competitiveness.”

One has to wonder why there is such asymmetry with respect to the economies in Eastern Europe? I mean, Ukraine and Russia has been devaluing like there is no tomorrow and also the Forint has taken a solid beating. Even though the two former might be outside the IMF's definition of political will and stability I think we should remember two things; one is that the economies who are now devaluing in nominal terms will be Baltics' main competitors for exports and secondly, the adverse effect of balloning debt and bankruptcies will also ensue in the context of deflation to restore competitiveness. No easy solutions here, but if the Baltics are not accepted de-facto into the Eurozone I still hold that they will need to devalue.

The coming week will be interesting not least in relation to how European leaders respond to the realization that this now actually, and without doubt, demands a solution in which nations just as banks may need to be bailed out.

Getting to the Heart of the Matter on the Global Economy

Leaving the travails of the Eurozone and her Eastern brethren for a minute I was also positively surprised by a couple of well put points by two of the big boys in relation to economic punditry. Let us begin with Martin Wolf writing about the lessons to be derived from Japan in a world of balance sheet deflation . Now, the first thing to dispense is obviously what a balance sheet recession is [1]. Well, the term originates from from economist Richard Koo and basically advocates that in situations like this, a strong fiscal stimulus is the most effective remedy. I tend to agree here, but I will leave that discussion for. Rather, I would like to turn the attention to one of Wolf's last remarks with respect to summing up the global situation (emphasis added);

It is, for this reason [see the article], fanciful to imagine a swift and strong return to global growth. Where is the demand to come from? From over-indebted western consumers? Hardly. From emerging country consumers? Unlikely. From fiscal expansion? Up to a point. But this still looks too weak and too unbalanced, with much coming from the US. China is helping, but the eurozone and Japan seem paralysed, while most emerging economies cannot now risk aggressive action.

Where indeed Mr. Wolf where indeed. Regular and perceptive readers will know that this is one of my main hobby horses in the context of the global economy. In fact, as recent as two months I, sort of, took the same Wolf to task on his piece on global imbalances in which he argued that credit worthy surplus nations should put into place measures to expand domestic demand. As I pointed out at the time this may be easier said than done especially because there are underlying structural reasons as to why surplus nations cannot easily ramp up demand to suck up excess global capacity. I am happy to see Wolf framing the situation as he does here because it means, in my humble opinion, that it brings us one step closer to the understanding of what the heck is going on here.

Adding to the choir Paul Krugman also joins in on Koo and Wolf and apart from the standard fiddle about the importance of fiscal policy (which I agree with, remember) Krugman also makes another point. Quite simply, Krugman points towards the well known fact that whatever recovery Japan has had since 2000 it has been all about exports (and foreign asset income); and at the end we get this:

And needless to say, we can’t all export ourselves out of a global slump.

So, how does this end?

Needless to say I cannot answer the last bit, but I do think that we are making progress here since apart from a poor little graduate student (in applied economics of all atrocities) some of the big ones are making some crucial points about what exactly the underlying structural dynamics are here (hint: demographics!) Here is to hoping that the thinking is being stimulated across the board.

[1] For some wonkish background on balance sheet recessions and where it comes from, Oxonomics has some further info here.

Retail Sales Fall An Annual 8%

Retail sales, excluding cars and fuel, fell by an annual 8 percent in August, the largest such decline registered since at least 2001. This follows a 6 percent in August. The year on year chart (see below) couldn't be clearer.



Sales were also down month on month (ie with respect to August), this time by a non seasonally adjusted 7%. In fact, on a seasonally adjusted basis retail sales peaked in February 2008, and have been trending down since. We still don't have the seasonally corrected data from Eurostat for September, but looking at the uncorrected data we do have from the Estonian statistics office, it does seem that retail sales were down again in Q3 over Q2.




Thus retail sales turned negative in March and the trend simply continues. The decrease in the retail sales of goods was most influenced by the stores selling manufactured goods where sales decreased by 12% compared to September 2007. Sales in non-specialized stores selling manufactured products and shops selling household goods and appliances, hardware and building materials were the worst hit.

Sales in grocery stores have, as might be expected, been rather more stable, with sales only down 3% . As had been the case in previous months, the decrease in food sales was largely influenced by the rise in food prices and the resulting decline in consumption.



Industrial Output Down 3.8%

Output adjusted for working days decreased an annual 3.8 percent, compared with a revised fall of 3.7 percent in August.

If we look at the seasonally and working day adjusted output index, then we can see that the level of output is now meandering downwards, and we now are way off the highs reached during last October and November. With this in mind we should expect the year-on-year percentage drops to start to decline after December, but it will then become much more interesting to follow the evolution of the absolute levels indicated by the general output index.

The main reason for the decline in output is evidently the lack of demand. The fall in manufacturing output was greatest in food, wood and building materials production. Food output was especially hit by the decrease in consumption resulting from this years large price increases. Although the rate of price increase has decelerated in recent months, food product prices are still up by 12% compared to September 2007.

The other area with big output drops is the manufacturing of wood and wood products, where the drop in sales in both domestic and external markets continues. The Estonian market is influenced by the construction slump, while in the external market Estonian manufactures are having a hard time due to the competitive environment and their own weaknesses in price competitiveness. Compared to September 2007, 22% less sawn timber and 9% less glue-laminated timber were produced. The largest drop (32%) was in the production of building materials which is directly connected with the decline in the construction market.

Some export-oriented industries have been continuing to expand - even in this difficult environment - especially enterprises involved in the manufacture of metal products, chemical products, and electrical machinery. Output was also up in the manufacture of machinery, radio and communication equipment, precision instruments and motor vehicles, since again a lot of the output is for export. The export share is 97% in the manufacture of radio and communication equipment and 91% in the manufacture of precision instruments.

Both Wages and Unemployment Still On The Rise


Wages continued to rise rapidly in the second quarter, up by 15.2%, even if this was the slowest pace of increse in more than two years, while the unemployment rate rose - to 3.1 percent in September - the highest level in more than three years.

Estonia's jobless rate, based on the number of unemployed registered with labor offices, rose to 3.1 percent, the highest since July 2005, from 2.9 percent in August, according to data from the Estonian Labor Market Board. The number of people signed on as seeking a job rose 6.6 percent from the previous month to 20,015. This number is of course, incredibly low by any comparable international standard, and is hard to square with a country in the midst of a very deep rcession (even after all the ritual genuflections towards the labour marekt being a lagged indicator). In order to understand how this situation is possible it is important to take into consideration Estonia's special demography and migration history.



However, it is also true to say that unemployment does normally follow changes in economic output with a time lag, se we should expected it to rise considerably in the coming months and quarters. Indeed the unemployment rate as measured by the Estonian statistics office in quarterly labor surveys is nearer to 4 percent in the second quarter (and the EU harmonised rate which is based on the survey shows 4.2% for September in the Eurostat database), and may rise as high as 10% according to recent estimates from Erkki Raasuke, head of Baltic research for Swedbank AB (not that they have been getting too much right of late, but still).


Despite the fact that unemployment will undoubtedly rise further as the recession deepens, it is the very tighness of the labour market (which is, as I say, in part a product of Estonia's demography) which prevents wage increases slowing down more rapidly, and thus the entire Estonian price system adapting to the slowdown (this phenomenon is often called "sticky wages and prices", and as we can see, the degree of viscosity here is almost treacle like). So Estonia's low earlier fertility fuelled the initial wage craze which along with the credit boom got us to the present point, and now the same lack of strength in depth in the labour market blocks the downward adjustment. In both cases the net by-product is massive pressure on the Kroon-Euro peg as Estonia struggles to find export competitiveness.


Consumer Confidence Falls Again


Unsurprisingly Estonian consumer confidence fell again in October, hitting its lowest level in more than 9 years, a sure sign the that the economy is about to shrink again, as domestic demand continues to search for a bottom. The Tallinn-based Konjunktuuriinstituut consumer confidence index declined to minus 27, its lowest reading since June 1999, and down from minus 22 in September. The institute cited worsening expectations for personal and state finances as the key drivers behind the drop.

“We expect the EU and the IMF to announce additional rescue packages for other Central and Eastern European economies in the coming days and weeks. Top of the list are the most imbalanced countries in the region - the Baltic States, Romania and Bulgaria."
Lars Christensen, Danske Bank, Copenhagen

Both Standard & Poor's and Fitch Ratings have responded over the last month to mounting risks from the global credit crunch by downgrading or revising credit rating outlooks to negative for a number of CEE economies including the Baltic states, the Balkans, Hungary and Ukraine. Moody's Investors Service has also revised its outlook to negative for Latvia and downgraded Ukraine.

S&P and Fitch both downgraded long-term sovereign ratings to Latvia and Lithuania on Oct. 27, citing recession risks and the growing need for external financing, while Estonia, had its rating cut by Fitch and outlook revised to negative by S&P. Basically, the crunch is biting in terms of both the cost and the availability of credit. This tightening in credit conditions is not, of course, new in Estonia, and in many ways we could say that the credit conditions should never have been allowed to get so "loose" in the first place. As can be seen from the chart below, the year on year rate of increase in peaked at the end of 2006, and since then the slowdown in Estonian domestic demand has been driven by the slowdown in the availability of credit (strictness off the terms, documentational requirements etc). Evidently, if such criteria had been applied much earlier, and the rate of annual increase never approached 80% all this may well have been a much less dramatic process.







The Estonian central bank said last week revised it's forecast for the economy, which has already made the turn around from being the second-fastest growing one in the EU in 2006, to being one of the most rapidly contracting ones in 2008. According to the bank the Estonian economy may shrink 1.8 percent in whole-year 2008 and 2.2 percent in 2009. As we have noted above the economy sank by 0.8% q-o-q in Q2 and by 1% year on year.



The decrease in GDP in Q2 was mainly a result of weak domestic demand, but the drop in both imports and the rate of increase in the export of goods and services meant that the contribution from external trade was negative. About the only item which maintained some momentum was government spending - buoyed by the tax income from an earier and better epoch. Compared to Q2 2007, total domestic demand was down by 2.8% , largely as a result of adecrease in private consumption and capital investments ( down by 2.0% and 2.5%, respectively).



Private consumption decreased mainly due to the decrease in expenditures on transport and clothing and footwear. The growth of expenditures on food and non-alcoholic beverages decelerated. Capital investments decreased in both the financial and the household sector. Investments in manufacturing industry were almost stationary year on year. At the same time public sector construction investments accelerated.



The decrease in exports and imports since the second half of 2007 which had been noted in Q1 went even further in the 2nd quarter. Compared to the 2nd quarter of the previous year, exports of goods and services decreased by 4.9% and imports by 8.2% (at constant chain-linked prices).




Goods exports were down by 3.2% primarily due to the decrease in exports of refined petroleum products. At the same time, exports of basic metals and electrical machinery (electrical motors and appliances), which significantly influence export movements, increased. Exports of services decreased by 8.9% primarily due to the decrease in exports of services for railway cargo, airway passengers and cargo transport and trade related exports services. The decrease in imports of goods was influenced mainly by the decrease in imports of refined petroleum products and motor vehicles. While imports decreased faster than exports, the deficit of net exports in GDP has increased since the second half of 2007 and amounted to -4.6% of GDP in the 2nd quarter. In the 1st quarter the impact of net exports was -7.1% (so the negative impact slowed vis a vis Q1).

Fiscal Crunch Coming

Basically, as the economy slows, and government income increases even while counter cyclical spending policies add to expenses, the government is moving into tricky fiscal deficit territory. Mindful of this the Estonian government approved on September 25 a draft 2009 budget which attempted to balances overall finances, including local government and the social insurance funds. The budget, which is still to be finally approved by the Estonian parliament, will fall into a deficit and need to be covered from government reserves, according to former Prime Minister Vaehi in a recent interview with the Maaleht newspaper Maaleht.

A deficit of 10 billion krooni would equal 3.5 percent of the expected gross domestic product of 283 billion krooni forecast by finance ministry in August. SEB have forecast a deficit of 1 percent of GDP in Estonia's overall finances next year.

Falling tax revenue has forced the Estonian governemnt of Prime Minister Andrus Ansip to cut spending and seek out new financing in an attempt to maintain a balanced budget, formerly a linchpin of the country's fiscal policies. The Finance Ministry have already forecast the budget will fall into a deficit of 3.1 billion krooni, or 1.2 percent of gross domestic product this year, after running surpluses in each of the last 6 years.



Two Questions In Conclusion

Basically then, it is hard to call the exact impact of trade on Q3 data without having the September trade data in front of us, since although the July and August export numbers are well below the April and May ones, we also need to take into account the accompanying drop in imports (which helps net trade, and thus is GDP positive). On the other hand the general impression you should get from all the data is that we are in for another shocker in Q3. Which leaves us with two questions:

1/ Where do we go from here?
2/ Just how long will it be before we hit generalised price deflation?

Let's take the second one first. Possibly for many people the question will appear to be a ridiculous one, but it isn't. If you look at the CPI index itself (this now becomes much more important than the year on year inflation rates, since what we need to watch for are the price movements from month to month. Now in the rate of increase from one month to another has been slowing, and in September the index was barely up over August (less than 0.5%, following a virtually stationary reading in August over July) so we should not be surprised to see the index hit a ceiling at some point, and then start to come down. Basic economic theory leads us to expect this (on the back of falling commodity and food prices and in a situation where internal capacity is way above the sum of internal and external demand available to the Estonian economy at current prices). Thus there is only one way for prices and wages to go: down. Although people may struggle with all this yet awhile before they accept the inevitable.



So what about the future of the economy in general? Well, let's take two quotes from the most recent Eesti Pank growth forecast. First, a recognition that they got it wrong in the past:

According to the base scenario of Eesti Pank's 2008 autumn forecast, Estonia's gross domestic product will decline by 1.8% in 2008 and by 2.1% in 2009. So far the economic correction has been more abrupt than expected primarily due to decreasing domestic demand. In addition to the cessation of the rapid real estate market expansion, also private consumption dropped in spring more than forecasted.

According to Eesti Pank's estimate, the economy should pick up again either at the end of 2009 or at the beginning of 2010. The average economic growth rate of 2010 will be 3%. Private consumption growth should recover in 2010 along with the revival of household confidence, whereas 2009 will be characterised by slowing wage growth and increasing unemployment.

``The agreement is designed to restore investor confidence and alleviate the stress experienced in recent weeks in the Hungarian financial markets,'' IMF Managing Director Dominique Strauss-Kahn said in a statement in Washington yesterday.

“One way to look at the EU assistance to New Member States is that this is also part of the operation aimed at making sure Euroland banks don't get into trouble. The banking systems in New Member States are practically owned by foreign (mainly Euroland) banks, and if their NMS subsidiaries get into trouble, that would not be good news for the holding companies either. In the current environment that is a strong additional argument for major Euroland countries to make sure that New Member States (and their banking systems) do not get into trouble because of the liquidity crunch."
István Zsoldos, Goldman Sachs, London

``The aid package won't make Hungary immune to the real economy effects of the financial crisis..........Where the IMF appears with its strict conditions, the requirement of consolidation inevitably leads to real economy and social consequences.''
Laszlo Andor, European Bank For Reconstruction and Development Board Member

``A sharp economic slowdown, driven by declining foreign- currency credit flows to the private sector, tight fiscal conditions and weak external demand is unlikely to be avoided''
Eszter Gargyan, Citigroup Inc, Budapest

“We expect the EU and the IMF to announce additional rescue packages for other Central and Eastern European economies in the coming days and weeks. Top of the list are the most imbalanced countries in the region - the Baltic States, Romania and Bulgaria."
Lars Christensen, Danske Bank, Copenhagen

“All in all, the crisis seems to have been averted and even though it is no doubt a major shame that Hungary got to this situation, the authorities managed well in the rough waters, far better than Iceland (major policy mistakes in particular by the CB), Ukraine (political fragmentation still a major problem, currency peg had to be abandoned after failed interventions) and Romania where politicians remain ignorant even now, after the problems are more than evident. Bulgaria also does not seem to be prepared, though the currency board, the fiscal reserves and the significant budget surplus at least provide more cushion."
Gábor Ambrus, 4Cast, London

“At the same time, there is no doubt that to ensure Hungary's long-term survival a major diet is needed (this is in fact true to every emerging country which experiences the same problem)."

“The thirst for debt financing, domestic or local, has to be drastically reduced and not just for a period of a year but for longer, given that credit markets are not going to be the same in the foreseeable future as they had been before the world 'subprime' become known outside the circles of the debt securitization market."

“This implies not only a reduction of the public debt but also the substantial reduction of the deficit of the current account which implies a major diet for consumers (how much is needed exactly is highly uncertain, given that the massive errors and omissions row on the C/A statistics render the C/A figures rather meaningless)."

“While the increased credit costs and the restricted credit availability will drive demand down, a key tool to rebalance the economy is the exchange rate. Hungary needs a week forint to ensure the sustainability of financing and in this anti inflationary global environment the NBH should in our view be ready to accept a slightly slower paced disinflation to allow the financing thirst to reduce and ensure the long term sustainability of growth."
Gábor Ambrus, 4Cast, London

“In this new situation monetary policy makers will need to rethink which way to go from here," Simor said.

If you smell a cry-baby somewhere here it would be unfair, although there is always(!) a bigger fish. As such, your humble author has no problem whatsoever admitting his inferior skills with respect to algebra and calculus relative to his peers at the same time as he can safely conclude that he has learned more quantitative "stuff" in the past two months than during an entire year (well, lifetime actually) at his program in Copenhagen.

So, he will keep on moving forward and here is to hoping that blogging can be kept at a minimum as we move towards christmas.

"Many central and eastern European countries simply don't have either the financial strength or the technical expertise to bail out banks,'' said Lars Christensen, a senior emerging-markets analyst at Danske Bank A/S in Copenhagen. "It's like an Iceland look-a-like contest and there are a number of candidates looking very fragile at the moment.''

Chaos rules among institutional investors, as well, at least the majority of the investment fund managers polled by Portfolio.hu on Wednesday admitted, speaking on condition of anonymity, that they have absolutely no idea about the possible outcome of the current financial crisis. A number of them noted they are at a loss as to what to do with their portfolios in the current situation. Interestingly enough, the only parallel the respondents were able to draw between the present predicaments and the 1998 Russian economic crisis was the mass unwinding of leveraged positions.

As one fund manager interviewed said “From this perspective, the current situation is the same as in 1998 only to the second power. Margin calls are being received, you gotta put in the deposits but as there's no money you have to execute brutal sales irrespective of the price of assets.....Frankly, I haven't got a clue as to when and how this would end, I'm just staring into empty space."

Holiday home new construction has shifted in the opposite direction from building permits. Building permits were up by 26% , while newly built holiday houses were down by 30% over the same period last year. In the first half of 2008, 650 holiday units got building permits and only 200 units were built, with the average size of 66sqm.

Industrial output fell for the first time in three and a half years in June as the looming recession in the eurozone stifled demand for products assembled in Hungary such as Audi cars and Nokia phones. This slowdown already threatened to bring Hungarian GDP growth close to recession in Q3, and the recent financial turmoil now makes it almost certain that any (possible) Q3 contraction will be followed by a further one in Q4 with worse to come as we enter 2009.

The volume of industrial exports plunged by 7.2% yr/yr vs. an increase of 0.3% in July. If we look as the seasonally adjusted industrial output index, we will see that the level of output more or less peaked in December 2007 - February 2008, with the high point being in February, and with the level of output steadily slowing since.

If we look at the most recent purchasing managers index (PMI) reading we find that the rate of expansion in Hungary's manufacturing sector expansion slowed again in September (after August's mini boost) and remained close to stagnation as new orders growth dropped sharply while the rise in output also eased, according to the monthly report from the Hungarian association of logistics, purchasing and inventory management (MLBKT). The September PMI fell to a seasonally adjusted 50.3 from 51.9 in August. The figure is the lowest for any September in the past three years. In Sept 2007 the index stood at 55.1 (a reading of 50 marks the frontier between expansion and contraction, and 50.3 is this a very, very fractional expansion, if it be confirmed by the final data from the KSH).




One clear indication of problems to come can be found in the fact that European car sales fell 8.2 percent in September, extending a decline that began in May, as higher fuel prices and financial-market turmoil reduced demand. Registrations in September dropped to 1.3 million vehicles from 1.42 million a year earlier, the Brussels-based European Automobile Manufacturers' Association said in a statement earlier this week. Sales for the first nine months fell 4.4 percent to 11.7 million vehicles, compared with a 3.9 percent contraction through August.

Industrywide sales in western Europe, including the 15 countries that were members of the EU before May 2004 plus Iceland, Norway and Switzerland, slid 9.3 percent to 1.21 million vehicles. Deliveries in the 10 eastern European countries that have joined the EU since 2004 increased 7.8 percent to 93,275. The association's figures don't include deliveries in Russia.

New car sales inside Hungary are also well down, and dropped by 4.6% year on year in the January-September period, according to data published today by the Association of Hungarian Vehicle Importers (MGE) . The lions share of this drop must have come during the July to September period, since MGE only reported a 1.4% drop in the first six months of the year.


Inflation Eases Back In September, But Will We Now Head For Deflation?

Hungary's inflation saw stationary month on month in September with consumer prices remaining unchanged over August. On an annual basis prices rose by 5.7% over September 2007, greatly undershooting analysts expectations (the median forecast in the Portfolio.hu analysts poll had been 6.1% , for example)

Seasonally adjusted core inflation decelerated to an annual 5.0% from 5.8% in Aug, according to Central Statistics Office (KSH) data. In monthly terms, core CPI also remained unchanged as comparesd with the 0.3 % rise registered in August. This deceleration is pretty swift, and were in not for the sharp fall in the forint, we would now be expecting strong disinflatioary pressures to make themselves felt in the coming months.



The big surprise seemed to be in the processed food components, where a much slower disinflation (following the drop in fresh food prices resulting from this years excellent harvest)had been foreseen. Bread prices were for instance down, despite the fact that local bakers had been threatening further increases. Processed foods were flat month on month taking the year on year index down to 13.2% from 16.0% a month earlier.

In what could be interpreted as an early warning signal of what may be in store further down the road, however, durable and non-durable industrial goods prices continued to rise as the weaker forint fed rapidly through rather quickly to prices.

Producer prices were up in Hungary by only 3.2% year on year in August, down from July's 3.7% rise, and way down from April's 6.5% peak. The breakdown of these price increases is also interesting, since domestic sales prices were up 12.9% over August 2007, while export sales prices (measured in HUF) actually decreased by 3.9% year on year.

Employment Remains (more or less) Stagnant As Hungary's Population Falls

One thing the Hungarian economy is NOT doing to any great extent these days is creating employment. The number of employees in companies employing at least 5 people and in the public sector (combined) dropped by 0.5% year on year in July to hit 2.755 million. This decline follows a 0.9% annual drop in June. Actually this process is only natural (and more or less to be expected) as the Hungarian population declines, but of course it does mean that the only real way the Hungarian economy can grow is by increasing productivity, and that in June something like the first 1% of productivity any productivity improvement Hungary was getting was eaten up by diminished employment. Clearly the answer to this is to increase labour force participation rates, but while this sounds fine in theory (and is generally what is recommened by think tanks grom the World Bank to the OECD, see for eg the World Bank report from Red to Grey), but we are a long way from seeing it happen in practice in Hungary.

The distribution of the labour force is changing, however, since the number of employees in the private sector rose by 0.3% year on year in July while employment in the public sector decreased by 3.5%. On the other hand, and to put all of this in some perspective, there are now over 100,000 fewer employees in the private sector than there were in June 2003.

Hungary's present population is something like 10.03 million, and this is down from 10.22 million in 2000. The rate of decline is small, but the attrition is constant.



But as well as falling, Hungary's population is also ageing, and we know from basic life cycle theory (Modigliani) that saving and spending patterns change across the life cycle, with the propensity to borrow against future income to buy now declining significantly after 50, and since it is increasing consumer credit that drives retail sales growth in the dyamic internal consumption economies, then it is highly likely that ageing will now act as a drag on sales growth generally in Hungary. As we can see in the chart below, Hungary's median population age has been rising steadily, but the rate of ageing is now about to accelerate quite sharply, with the only real substantial unknown between now and 2020 being life expectancy, which may accelerate more than anticipated (in which case the population ageing will be even more rapid).




It's All About Exports Now

Apart from retail sales, another indicator of domestic demand which is worth thinking about is housing construction. Let's look at the chart.



As we can see the number of new buildings peaked in 2004. Since that point the sector has struggled. Obviously the absence of new households can be offset to some extent by holiday homes, but this has limits, and in the present credit crunch environment is unlikely to be as important as many anticipated. Despite the general economic slowdown there was a rebound in housing activity in 2007, but in the wake of the US financial turmoil of August 2007 this now seems to have faded. It will be many a long year (if ever) before we see construction on the 2004 scale in Hungary again, since housing is, above all, about demographics.

So what does all this mean for Hungary? Should people simply pack their bags and leave. No, not at all. What it means is that it is all about exports now, as far as the Hungarian economy goes, and the sooner Hungarian civil society (together with the civic institutions - parliament, central bank etc) faces up to this, the better.

Given the rapid ageing that Hungary is now faced with, and the need to maintain a health and pension system with some kind of minimum guarantees, then economic growth is essential, and the only way to get this economic growth is through the export sector, and this is now a hard fact of life. Indeed it is precisely because the structural commitments to current expenditure are so large in the Hungarian case, that the downturn in public sector construction has been so strong following the austerity package. The sooner everyone faces up to all of this the better.

And if we look at the short term outlook for Hungary's export sector, then it doesn't look too bright, since Hungary posted a trade deficit of EUR 103.7 million in August, according to first estimate figures released by the Central Statistics Office. This compares with a deficit of EUR 365.1 m in July and EUR -176.5 m in Aug 2007. Exports - at EUR 5,378.3 m - were down 0.7% year on year, which compares with a growth of 8.2% in July. The August drop is significant, since the last time the 12 month export index was in the negative territory was in June 2003 (-1.3%).

Imports - at EUR 5,482 m - were down 1.9% year on year, while in July they were up by12.4%.





Tightening credit standards and the cut-back in credit lines to producers and wholesalers suggest there will be a further dramatic fall in new orders, which is likely to weigh on export performance. The question is how long and how far credit standards will continue to tighten, but the chances of a prolonged deterioration in financial conditions have increased, pointing towards sustained weakness in the real economy for some time to come.



Construction Drops Back Again In July

Construction output is falling steadily in Hungary, and output fell more strongly in July - down by 11.8% year on year, than it did in June, when there was an 8.1% drop. Taking the number of working days into account, the decline was 12.8% in July, and 9.0% in June.



Adjusted seasonally and for working days, output contracted by 2.8% month-on-month from June, following a 5.5% month on month contraction in June. July was the third consecutive month when construction industry output dropped. Output in January-July was down 10.9% over the same period of 2007.



While the index will probably settle down a bit in the autumn, given the base effects due to the strong plunge in output last autumn, we are unlikely to see any short term improvement in construction output, and given the ongoing turmoil in the sector globally the position will more than likely continue to deteriorate for some time to come. Maybe someone will one day wake up to the fact that with an ever smaller and older population in the longer term you need fewer and fewer houses. As can be seen from the chart below, the level of construction activity peaked in Hungary in 2005 (along with domestic private consumption growth), and given the population situation, and that civil engineering will be continuously constrained by government budget commitments to health and pension programmes in an ageing society, it is very unlikely that we will ever again reach that level. Remember here, we are talking about the RATE of output, and not the STOCK of buildings, bridges, motorways etc. I simply can't see why none of this can enter the mindset of those who are sitting stoically, arms folded, waiting for the "inevitable" upturn in Hungarian domestic consumption. Less retail sales, less building, less people working, this is, I think, what you should expect with a declining and ageing population. And, of course, we are about to see this phenomenon repeated in one society after another as the process spreads. Hungary is simply unfortunate enough to be among the first.





Falling Retail Sales

Hungarian retail sales were down by 0.1% month on month in July, following a 0.3% drop in June, according to the most recent calendar and seasonally adjusted data from the Hungarian Central Statistics Office (KSH). Using calendar-effect adjusted data, there was a fall of 1.8% year on year in July, following a 1.9% decline in June.

Retail sales declined in 2007 by 2.9%, which compares with an increase of 4.4% in 2006 and 5.6% in 2005. As can be seen from the monthly seasonally adjusted sales index (below), Hungarian retail sales peaked in early summer 2006, from which time they have been steadily falling. As far as I can see, with an ageing and falling population, and domestic demand stagnating, is quite possible that Hungarian retail sales will never reach this historic peak again.



A Long And Deep Recession Looms Over The Horizon

Despite the slight acceleration in Hungary's annual economic growth seen in the second consecutive quarter in Q2 - which was largely as a result of a surge in agricultural output - underlying trend growth in the Hungarian economy is now extremely low - I would say between 0 and 1% per annum. So the charts are deceptive at this point, since agriculture was up 33.8% year on year, meaning that it contributed about 50% of the quarter on quarter growth despite being a very small segment of the economy. Such significant movements in GDP due to volatility in one small raw materials sector is a characteristic wich is much more typical of a developing than of a developed economy, and therefore what is so striking about Hungary's current situation is just how little it has been able to move away from this role model over the last seven or eight years, despite all the financial wizardy to which it has been subjected.

Gross domestic product was up by an annual 2 percent in Q2 2008, and this was the fastest rate since the first quarter of last year. The figure compares with the 1.7 percent growth achieved in the first three months of 2008. Over the previous quarter GDP was up by 0.6%, equalling the performance in Q1 over Q4 2007.




Agricultural production rose an "extraordinary'' 33.8 percent compared with Q2 2007, largely due to a bumper wheat harvest which was up 40 percent this year (to 5.6 million metric tons) following a very poor harvest in 2007 after frost and drought damaged the crop.

Industrial production was up only up 4.2 percent year on year, due to the slowing pace of export increase. IP had risen by 6.9 percent in the first quarter. Private Household consumption also showed some signs of life and rose 1.4 percent. This was the biggest leap in private household consumption since Q3 2006.



Indeed, quarter on quarter, household consumption was up 0.5%, which was the fastest quarterly rise since Q4 2005. Since this is really quite a surprising result it will be interesting now to see what happens as we move forward. On the other hand there is evidence that the stronger forint has been having an effect on exports. Indeed the annual growth in imports (at 11.2%) just exceeded the annual growth in exports (11.1%), hence the net impact of trade on GDP growth was marginally negative. The services and real estate sectors also slowed in Q2, with finance and real estate contracting by 0.3% quarter on quarter. Given that the rate of increase in new mortgage lending has now been slowing for some months, and new building permits are way down year on year, can we start to detect the first initial effects of the extending global credit crunch in Hungary at this point?

Investments as we have seen in a previous post were down year on year by 2.2%, while construction was down year on year by 6%. Given that the external environment in the Eurozone is now deteriorating, the industrial output (as we are also seeing for July today) is losing steam on the back of the high forint, I think we are more than likely going to see a steady reduction in the annual rate of growth as we move forward again, especially since one off factors like agriculture will not be so important, and can't be guaranteed to always show up just when you want them.

It is hard to put a precise number on future GDP growth at this point, given the dramatic events which are unfolding around us. We first need to see the actual GDP data for Q3 2008, but if we look at the industrial output, retail sales, construction and exports data presented above, it is hard not to come to the conclusion that the economy may well have contracted quarter on quarter in Q3 (even despite the good agricultural performance, which will, after all, enjoy a strong base effect from Q2), and if this is the case then with Q4 almost certain to see quite a strong contraction, it isn't unreasonable at this point to think that Hungary entered recession on 1 July 2008.

Central Bank Caught In A Double Bind

Hungary's Magyar Nemzeti Bank left its benchmark interest rate unchanged at the three-year high of 8.5 percent at its last meeting on 29 September as the global financial crisis and upside risks to inflation forced prevented the bank from initiating a rate cut cycle. Hungary's rate is currently the second-highest in the European Union after Romania, whose current base rate is 10.25 percent.

Basically I think this is the point, when the HUF rally runs out of steam
the NBH is going to be in a very difficult situation indeed, and it will run out
of steam when Hungarian housholds let up on their frenzy to borrow money in
Swiss Franc denominated loans, a decision which may be made easier for them now
that the band has been removed and the currency risk is evident to all. A
difficult decision, but then maintaining the band was only encouraging people to
keep going on contracting the loans.

Good day… And a Tub Thumpin' Thursday to you! Well… How about those wily veteran central bankers? They all got together and decided to cut rates. The Reserve Bank of Australia (RBA) went first with their 100 BPS cut, and opened the rate cut sea for the rest of the central banks around the world. The European Central Bank, The Riksbank (Sweden), Swiss National Bank, Bank of Canada, Bank of England, and the Bank of China all lined up at the rate cut table. The Bank of Japan, The Norges Bank (Norway), and Reserve Bank of New Zealand did not participate.

The Bank of Japan doesn't have any rate to cut, The Norges Bank will wait until their regularly scheduled meeting on 10/15, and the RBNZ believes that they have taken their toxic waste bond flu shot.

RBNZ Governor Bollard said last night… "New Zealand banks have high-quality assets.  Fortunately they do not have the poor quality assets that have proved so damaging overseas." Boy… Given what happened after the European Union's Finance Minister put his foot in his mouth, pointing a blaming finger at the U.S. and putting the EU's fortunes above those of the U.S., only to see the walls crumble down all around him, RBNZ Gov. Bollard, might want to talk low, talk slow, and don't talk much at all!

That's a famous John Wayne line… Just had to use that when I saw it on the Bloomie this morning!

So… The currency traders around the world, stopped when the rate announcements were made, to check the pulse of the markets. At first, we saw calm… But then, traders and investors began to say, "Uh-oh! Maybe things are worse than we imagined if central banks around the world are cutting rates"… So, getting back to the theme I talked about yesterday - where if it looks bad for the United States, buy the dollar, and if it looks good, sell the dollar - we saw the currencies go back and forth… But overnight, calm seems to have settled in, and keeping with the "theme", that means a weaker dollar.

The stock markets of Asia and Europe have generally been stronger, which could lead to a tourniquet being applied to the U.S. stocks… And again - keeping with the "theme" - that would spell a further weakening of the dollar.

This isn't rocket science; it's just what I see happening in the currencies right now. It's like looking into the mirror, as everything is opposite; but that's what's happening right here, right now!

G-7 ministers meet this week, starting tomorrow, I believe. U.S. Treasury Secretary King Henry Paulson, held a press conference yesterday afternoon, and in my opinion, effectively kicked off the G-7 meeting. King Henry was particularly focusing on the coordinated policy moves. I would think we could expect more of these kinds of global policy maneuvers going forward.

I'll tell you this… It's my opinion that the coordinated rate cut didn't do what the central bankers had hoped it would do. And that is, unlock the seized up credit markets… But, you can't blame them; the central bankers are using whatever they have at their disposal to deal with this global mess.

Speaking of messes… It was reported this morning that Kaupthing Bank, the largest Bank in Iceland, has fallen, as the government seized control. The currency CAN'T EVEN TRADE AT SPOT! That means immediate cash isn't available, folks! This is very serious stuff! Somebody expressed dissatisfaction with the price we received in the market the other day at 171. Yesterday, the last spot trades were done at 259! UGH! A foreign exchange dealer at Nordea in Copenhagen said, "Effectively the krona can't be traded at the moment because there are no banks to clear the trade."

Hopefully, that situation will be fixed quickly, and currency transactions can be cleared again, at least for spot… Oh… And that peg to the euro (EUR) that the Governor announced on Tuesday? It was dropped yesterday, because the peg to the euro at 131 could not be defended. Trades were going off at 340 krona per euro. It's a bad situation. Hopefully, a white knight will step in to help here… Unfortunately, banks around the world (except the few mentioned above) have their own problems to deal with right now. Russia made a big loan the other day, and with Russia swimming in cash from oil, maybe they could be the white knight.

Aussie (AUD) and New Zealand dollars (NZD) saw some love last night for the first time in what seems to be a month of Sundays. I wouldn't put too much into a one-night stand for these two. Yes, it's true that they have been beaten up too much and look oversold to me, but that doesn't mean the markets see it that way. We'll have to see if more than a one-night stand is in the cards for these two.

One thing keeping a lid on any big time rally for these two, especially New Zealand, is the fact that the Japanese appetite for anything offshore has gone away. Recall that I told you several times over the years that the Japanese loved to sell their currency and buy kiwi (and Aussie)? Shoot Rudy, they would even issue Japanese bonds issued in kiwi!

With the Japanese appetite for anything offshore going away (at least for now) the financing of the U.S. Current Account Deficit comes back into the worry picture. Recall, that the Current Account Deficit needs about $2 billion per day in foreign investments to keep it properly financed. And if the Japanese are slowing their offshore investments, that means the United States, too - not just New Zealand and Australia!

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 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

[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.

Guide to Hedge Funds in Denmark

• Denmark and Norway hedge towards the future with announcement of new regulatory regime. Aiming at attracting more oversea investors, Denmark and Norway have both announced the introduction of a more lenient regulatory framework for the hedge funds, with includes a more transparent tax regimes and less regulation for managing the funds.
• This Article discusses the taxation issues regarding establishing a hedge fund in Denmark and to its potential investors.
• Warning lights in Denmark. Investment in private equity is becoming increasingly popular in Denmark, with some investors allocating as much as ten percent of total assets. In this article, I&PE's analyst Paula Garrido examines how Denmark's pension funds are structuring their portfolios to include these alternative investments.
• This news archive contains most recent regulatory updates and developments in Nordic hedge fund industry.
• Hedge Funds in Denmark and Internationally. This comprehensive article introduces the recent development and future prospect of hedge fund industry in Denmark. In addition, it also covers various hedge fund strategies and their risks in relation to prime brokerage and to investors.
• Review of Danish Capital Market. Composed by International Monetary Fund, this report gives a broad overview of Danish capital market, with detailed descriptions of the legal framework and regulation of both of its bond and equity market. The report also provides a future guidance on its rapid growing mutual fund sector and introduces the Danish Hedge Association.
• Scandinavians Arrange Emergency Funds to keep Hedge Fund Pirates from Destroying Iceland. Norway, Sweden and Denmark of 1.5 billion Euros to support the Icelandic Krona from an attack by hedge funds. These hedge funds are wielding what Warren Buffet calls 'Weapons of Mass Financial Destruction' (a.k.a. derivatives), who have targeted the country with short-selling 'bear raids' to try and drive the 300,000 people living in Iceland and their economy into bankruptcy for a quick buck.
• The Investment Fund Industry in Denmark. Taken from the Federation of Danish Association website, this article provides a overview of the Danish Investment Fund Industry, its organizational structure, pricing and cost structure and related legislations.
• One of Denmark’s largest banks, FIH is a corporate and investment bank specializing in financial services to Danish corporate, had selected SuperDerivatives (the benchmark for derivatives pricing and the leading provider of multi-asset front office systems, risk management, revaluation and online options trading solution) in order to strengthen and expand its capacity to trade interest rate derivatives.
• On the Hedge Fund Frontier. This year Scandium Fund Ltd. ranked among the xis best performing fund of hedge funds worldwide by MARHedge. In this article, the fund’s Co-founder and portfolio manager, Mr. Casper Hallas, shared with us the secret of Scandium’s success, his investing philosophy, and his opinion of the present state and future prospects of the Danish hedge fund industry.
• Danish Pension Provider Opts for Direct Hedge Fund Investment. PFA Pension, one of Denmark’s largest institutional pension providers with responsibility for $41.6 bn of pension assets, is set to distinguish itself from the majority of European pension scheme by investing directly in hedge fund. PFA plans to increases its allocation to equities and alternatives at the expense of bonds in the hope of higher returns.
• Denmark – Fund Market 2005 – 2006. This article introduces the economic and financial background of Denmark and its key trends in asset management service, and recent regulatory development (including tax) in fund governance.
• The regulation, taxation and distribution of hedge funds in Europe: Changes and Challenges. This report summarized the most recent legal development and regulatory changes occurred in the European region (up to 2006), and what are some effects that would have on the European hedge fund industry.
• Hedge Funds and the Financial System. The increasing prevalence of hedge funds has been a key trend in the international financial markets in recent years. This report created by the Denmark’s National Bank let us look inside the brief history of the Danish hedge fund industry, its present development and its future growth potential. The paper also examines the governance and regulatory structure for these hedge funds.
• Denmark's biggest pension funds will have to report on corporate social responsibility (CSR) as part of new legislation currently under development by the Ministry of Economic and Business Affairs.Under existing law, pension funds only need to state the kind of CSR guidelines they are following if they have an impact on their financial activities. Under the changes proposed, pension funds would no longer have a choice.
• Newly-formed Danish alternative investment firm Global Evolution is looking to make a name for itself in the emerging markets. The Kolding, Denmark-based manager is prepping its Emerging Markets Multi Strategy Fund for launch sometime in January with between US$50 million and US$100 million.
• Government-sponsored pensions savings scheme allowing foreign managers to gain visibility in the Nordic region. Fund manufacturers are exploiting new distribution models in Europe, where savings are migrating from banks and insurance companies to government-sanctioned fund selection platforms. The new Danish government-sponsored pensions savings scheme, the SP Valg-Folkebörsen, is allowing foreign fund managers to gain visibility in the region.
• Copenhagen, Denmark-based Danfonds is readying its first hedge fund, Frontier Market Fund, for launch later this year with more than €25 million (US$39 million). The firm will cap the fund at €200 million (US$315 million) and is in talks with potential seed investors. The Frontier fund, which will debut after September, will look for long positions in the frontier markets of sub-Saharan Africa, central Asia and the Caucasus, the Balkans, the Baltics and the Middle East.
• At the end of 2004, the Danish government presented a bill to create a legal and supervisory basis for establishing "hedge associations" in Denmark. According to the bill, hedge associations will be the Danish equivalent of hedge funds. Like hedge funds abroad, hedge associations will have full freedom to determine their risk profile and investment strategy.
• Denmark Country Report: In 2005, Denmark achieved the highest economic growth for a number of years and the GDP grew by 3.4 %. The growth is continuing in 2006 and especially domestic demand is making a substantial contribution. Private consumption is driven by higher disposable incomes, low interest rates, new loan products and accelerating house prices.
• Hedge Nordic reports that Danish fund of hedge funds Scandium Fund Ltd. was the sixth best performer in terms of sharpe ratio among all funds of hedge funds worldwide during the past year. This is according to figures published by hedge fund database MarHedge, which receives performance reports from 547 funds of hedge funds.
• The Danish venture capital industry is very much in its infancy but recent developments are ensuring that it becomes increasingly attractive to investors. Kim Forum Jacobsen of the Danish Growth Fund charts the country's rise and discusses its potential for future growth. With a highly educated population, state-of-the-art research in areas such as biotech, wireless technologies and photonics, Denmark has all the hallmarks of an attractive market for investors.
  

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One notable recent development has been the decision by ratings agency Standard & Poor’s to award Brazil investment grade, with the foreign currency debt rating being raised to BBB- from BB+. This decision has produced considerable debate as many long term Brazil watchers believe that the upgrade comes at a time when Brazil has all the cyclical winds blowing in her favour, and ask the not unreasonable question what happens when the weather shifts? It is clear however that Brazil has made tremendous improvements over the past decade in terms of central bank independence, reigning in inflation and setting public debt on a sound footing, so whatever the fine print details, Standard and Poor’s decision can surely not be considered an imprudent one.

As regards its external balance Brazil is rather different from many other large emerging economies since while the central bank (which has a high level of independence from government) does intervene in the spot market to try to keep a lid on the Real’s rise and to built up a “war chest” of international reserves the bank has allowed the currency to rise substantially against the US dollar (as of July the Real had appreciated by some 13% against the dollar in 2008) and Brazil has also recently opened a small but quite manageable deficit on its current account, which means that Brazil as it develops is becoming a net consumer of excess capacity in the global economy. A break-down of the current account position reveals that Brazil continues to retain a surplus on the goods balance due to the importance of commodities and food but that services and in particular a negative income account are now gradually pulling the overall balance into negative territory. This is really what one could reasonably expect in the context of an emerging economy at Brazil's stage of development.



On the monetary policy front the central bank is rapidly earning a reputation for itself as Latin America’s new Bundesbank, and governor Henrique Meirelles delivered a decisively hawkish message during the last monetary council meeting to accompany the decision to hoist rates by 75 basis points to the current 13% level. Brazil's interest rate is now the the second-highest inflation-adjusted one in the world after Turkey's. Brazil's real interest rate, or the benchmark 13 percent rate minus annual inflation of 6.06 percent, is 6.94 percent. Turkey currently has the world's highest so-called real interest rate at 7.55 percent.

This decision is the continuation of a hiking campaign set in motion in order to establish strong credentials for the central bank as an inflation fighter, and to prevent generalised inflation expectations from taking a hold among the population. The central bank is attempting to keep inflation within the the official target of 4.5% and with inflation forecast to be somewhat above that figure in 2009 the central bank is simply acting accordingly.



Such aggressive tightening is, however, not without its problems, and policy makers now face a serious dilemma. Predictably, given the state of the current global environment, the central bank's larger than expected interest hike was rapidly translated into an appreciation of the Real – pushing it to its strongest level since 1999. So far, the 13% rise against the USD this year puts the real in the pole position amongst emerging market currencies versus the USD. This position is reasonably comprehensible taking into account the recent decision to award Brazil investment grade status; this coupled with a nominal yield on 10 year government notes at about 15% and a benchmark stock index – the Bovespa – which is up approximately 10% from its January level, implying a 20% gain in US dollar term, basically mean that international investors are finding it hard not to put money into Brazil at this point in time.

Consequently, with a global credit crisis far from over, a hawkish central bank, and a hard currency making exports more difficult one could only reasonably expect the economy to slow in line with weaking global momentum. The key point with respect to the Real would be that a continuing rise will push the external balance further into negative territory. Moreover, in a likely scenario where global commodity prices somewhat pare-back their recent impressive upward movement Brazil’s external bookkeeping will further come under pressure.

Outlook on Key indicators

• 
  Following the most recent rate hike market expectations have now solidified towards further interest rate increases in the pipeline. The driving orce here will, as ever, be inflation running above the central bank's nominal target. Here at Emerginvest we see the Central Bank of Brazil aiming for a nominal rate of 15% which should be reached over the course of the next three meetings.
• 
  The Real is likely to continue to be supported by a hawkish central bank but as the external balance moves steadily into negative territory macro-fundamentals may take over, and as the economy slows and inflation comes into the target zone the central bank will once more move into loosening mode pushing the Real down in the process. A violent correction however is not expected.
• 
  GDP growth is expected to moderate in 2008 compared to the levels seen in 2007 but at this point growth projections remain solid, and we certainly see Brazil’s mid term sustainable growth rate as being above the consensus 3%-5% rate once inflation is firmly under control.

2007 Data

GDP (2007) - 5.4%
Inflation (2007) - 3.6%
Current Account Deficit -0.27% of GDP
Fiscal Deficit - 2.27% GDP
Debt to GDP ratio - 42.8%


Debt Ratings (local currency, long term)

Fitch - BBB-
S&P - BBB+
Moody- Ba1


2008 Central Bank Inflation Target - 4.5% (+ or – 2pp)

Population Median Age -29 years
Total Fertility Rate (2007) -1.88 child per women
Male Life Expectancy - 68.57 years

Development Indicators Rank (131 economies in total)

Global Competitiveness (World Economic Forum)
72/131 (2007-08)
Business Competitiveness (World Economic Forum)
59/131 (2007-08)


Selected Sub-components

Institutions - 104/131
Infrastructure - 78/131
Macroeconomic Stability - 126/131
Health and Primary Education -84/131

Short Term Data

Retail Sales Growth (May, y-o-y, volume index) - 10.5%
Industrial Output (May, y-o-y) - 2.4%
Inflation (July 2008) - 6.3%
Central Bank Interest Rate (SELIC Rate) - 13.0%

Executive Summary

• Thailand's economy grew at 4.8 percent in 2007. Despite a number of factors affecting public sentiment - the political uncertainties, the imposition of capital controls in December 2006 (subsequently removed in March 2008), and the proposed amendments to the Foreign Business Act - net exports continued to provide the main support for growth while domestic demand has continued to remain weak. The Thai economy is expected to slow slightly in the second half of 2008, and then pick up speed again in 2009 as long as global energy prices continue to fall back somewhat from their June 2008 highs.


• Headline inflation had been on a downward path after peaking in mid-2006, but started to pick up in Q4 2007 on the back of escalating energy prices, and reached an annual rate of 9.2 percent in July. Core inflation has been lower, but has followed a similar trajectory, reaching 3.7 percent in July and thus falling just outside the Bank of Thailand's 0-3½ percent target band. The Bank of Thailand has, belatedly, begun a process of monetary tightening, but we do not anticipate they will move into truly “hawkish” mode.


• Following an appreciation of about 14 percent against the U.S. dollar in 2006, the baht appreciated by a more moderate 6.4 percent in 2007, in line with other regional currencies. The current account registered a surplus of over 6 percent of GDP, and reserves increased to US$87½ billion by end-2007 (equivalent to 6½ months of imports of goods and services). This appreciation has continued into 2008, and given the importance of exports to the Thai economy it is likely that restraining any further significant rise will be an important objective shaping policy formation both at the central bank and at the Ministry of Finance.

In the statement following the recent 25 basis point hike the monetary policy committee (MPC) noted that it would stand ready to counter any effects from further increases in inflation. Given this investors should begin to incorporate the idea of an increasingly hawkish BOT into their thinking. However, it remains unclear whether in fact we are not at a tipping point as far as golbal inflation goes. Should this be confirmed, and should headline inflation finally begin to offer a breathing space, then the BOT may be reluctant to raise rates to any significant extent, especially if this would mean driving up the Bhat further at a time when export growth remains the principle strong point in the economy .

The future course of the Bhat is thus difficult to call at this point in time. Clearly, if the economy continues to expand from its low “post military coup” level, and if the BOT opts for a hawkish course then the scene is set for a significant further appreciation of the Bhat. However, the general outlook for Asian economies is also one of re-coupling to the rest of the world and given that Bhat already is at a fairly high level (e.g. against the USD) we will need to see the BOT’s reaction and investors’ response before making any decisive call on the trend.

Ever since the illusive credit turmoil began sentiment in the market place has been fickle and essentially, like the assets of which it consists, volatile. We started off with an adamant focus on downside risks to growth which then turned into a focus and fear of inflation. Now, as the cyclical data has turned for the worse in Europe and many places in Asia the focus seems to be reverting to growth. Now, I won't go into the whole decoupling v recoupling discussion at this point since I think that this dichotomy is a false one. It never was about de-coupling à la traditionelle but moreso about two interrelated points. The first would be the extent to which the world already has decoupled from the US in the sense that a key group of emerging economies are now set to ascend in economic prowess. The second would be the extent to which the de-coupling thesis always built on a fallacy. The main point would be that the main fault line of slowdown was observed across economies with external deficits; something which, I am sure most will agree, is sure to impact surplus economies too.

Now, that does not completely let the ECB off the hook since by maintaining a focus on inflation it also assumed the role, if only temporary, of the new anchor in a re-wamped version of Bretton Woods II as the Euro ascended to new highs. This bet on global re-balancing was always going to end in tears and in this light the Eurozone could not decouple from the US; that much, I think, is true.

The key issue here however, as I have argued time and time again is represented in two crucial interlocked questions which together form a key structural trend in the global economy. One is what happens when the surplus economies slow down and there is not sufficient demand to pull the economy back up? Demographics and a high median age are key variables to watch in this regard. The second question is the extent to which hitherto deficit nations can turn the boat around and increase savings (i.e. rely more on exports) and what it will mean for global capital flows when they begin this process?

In the context of the CEE economies the themes above are also present. In a recent note I detailed the change in sentiment from growth to inflation and what it might mean for Eastern Europe's economies and their respective currencies. The key situation as I sketched it was one of a dilemma.

On the one hand, the rampant inflation levels suggest that the exchange rate be loosened to allow appreciation and thus pour water on the roaring inflation bonfire. On the other hand however the Baltics, as well as many other CEE countries, are saddled with extensive external deficits financed by consumer and business credit denominated in Euros. It is not difficult to see that this represents a regular vice from which it will be very difficult to escape since as long as the peg remains deflation seems the only painful alternative as a mean of correcting.

(...)

Another point which is specifically tied to Eastern Europe is that if domestic nominal interest rate increase to keep up with inflation rates it will have a strong substitution effects towards Euro denominated loans. This can become a dangerous cocktail should the tide turn against the currencies.

Now that the focus seems to be changing back again it appears to be a good time to revisit the situation

Within this global nexus of what exactly to do with inflation relative to growth, many Eastern European economies has so far opted to go for inflation by raising interest rates. At an initial glance this seems quite reasonable and in many ways the CEE central banks merely latched on to market sentiment and expectations that many emerging economies would seek to use nominal appreciation as a tool to flush out inflation.

Consequently we have seen how both Ukraine and Hungary have chosen to loosen the peg to the Euro as well as other floating currencies in Eastern Europe have seen their yield advantage increase in an attempt to flush out inflation. This has not been without problems though or more specifically it is not clear that an appreciation of the currency is all for the good. Two points here would seem particularly important. One is the simple question of whether in fact an appreciation is deflationary in a world where capital flows, and in particular the hot kind, act strongly on yield. However, another point would be specifically tied to the situation in Eastern Europe. As such, nominal appreciation of the currency also increases the purchasing power which is not what many CEE economies need at the present time as they stand before the task of correcting a rather large external balance. Moreover, rising domestic interest rates will increase and exacerbate the credit channel by which loans denominated in Euros and Swiss francs become more attractive. I have shown this to be true, for example, in the context of Lithuania. The important thing to do note here would what would happen to the servicing of these liabilities should the domestic currencies depreciate.

What happens next then? Or more concretely, even though CEE currencies, in general, have enjoyed a rally on the back of market expectations of nominal appreciation fed by hawkish central banks what happens if and when central banks reverese course?

An initial warning shot across the bow was handed to us as the governor of the Czech central bank mused that he might lower rates come next meeting due to the strenght of the Koruna and the subsequent effect on exports. Also Poland recently opted to abandon the hawkish stance as rates were kept steady. In light of this event Macro Man managed, as ever, to hit the proverbial nail on the head.

There is little more bearish for a currency these days than abandoning the inflation fight in a pursuit of growth; this is particularly the case when the market is heavily positioned the other way.

The key here is that these high interest rates carry with them a high lock-in premium which makes it difficult to reduce them without causing substantial pain to the currency. Add to this that as long as interest rates stay in this territory the incentive to borrow in foreign currency remains very appealing. In fact, the incentive structure here is quite disruptive as many of these economies have higher rates on domestic currency deposits and lower rates on foreign credit. This incites consumers and companies to place their deposits in local currency while funding themselves in foreign currency. Finally, there is of course the more standard economics 1-0-1 point that whatever nominal rate is ascribed to a currency and an economy the latter needs to be able to provide the structural demand for which to satisfy the yield. Otherwise you just pour more gasoline on an already raging bonfire.

Obviously, as long as the local currency remains strong and on an upwards march or the trading band is kept in place the show goes on. But the longer this structure lingers the more difficult it will be to break free; and break free they must since I am quite sure that Eurozone membership is off, for the immediate future at least.

Another more hard hitting point would simply be that whatever growth momentum these economies had going into 2008 it is now steadily levelling off. Now, these economies need to rebalance their external accounts at the same time as they labour under the yoke of slowing growth, high interest rates which are difficult to reduce and/or a quasi fixed exchange rate to the Euro. Can you feel the chilling cold of deflation blowing across the Urals? I can.

Basically, the past years' rapid process of nominal convergence will now need to be kicked into reverse, since it is quite obvious that many CEE economies have been riding a blade too tough.

Be Careful Indeed

Last time I massaged this specific topic I summarised by ominously stating that the CEE economies and their central banks should be careful what they wished for in terms of using higher interest rates and subsequent nominal appreciation of their currencies to flush out inflation. The key point was that the effect would likely be limited and only further worsen the imbalances in the economies. And thus, here we are.

Another more subtle point in the context of market reactions would be the boomerang effect which comes from the currency appreciation as interest rates are increased (and the peg/band abandoned) to the subsequent plunge when the economic tide turns. In line with the change in global sentiment towards growth and deflation (see e.g. here) and the fact that other hitherto strong yielders (e.g. the Kiwi and Aussie) are beginning to falter we may be at an inflection point in the whole discourse of upwards movement in CEE currencies. Stephen Jen's recent tour of global FX markets is a fine addition to this argument.

As ever, this is obviously still a dilemma for most of these economies since inflation continues to rage ahead. In Romania for example the PPI rose at its highest pace since 2004. However, as long as the credit tap stays open and as long as the purchasing power is increasing so will the the demands for higher wages stay strong. This is particularly true in the context of the CEE economies as these are in possession of structurally broken population pyramids after two decades worth of lowest low fertility and, in the cast of the latter decade, net outward migration.

The main point I would like to emphasise here is that correction is coming and that it will only become harder the higher the currencies move upwards. In a more general light this correction will not be a small one and it most certainly will not be felt exclusively in Eastern Europe. Basically, the big hidden data point in all of this is the dependence of Germany on CEE imports. So far, this has moved along just nicely but Germany is in for a rude awakening once the link breaks ... and break, I am afraid, it will.

One notable recent development has been the decision by ratings agency Standard & Poor’s to award Brazil investment grade, with the foreign currency debt rating being raised to BBB- from BB+. This decision has produced considerable debate as many long term Brazil watchers believe that the upgrade comes at a time when Brazil has all the cyclical winds blowing in her favour, and ask the not unreasonable question what happens when the weather shifts? It is clear however that Brazil has made tremendous improvements over the past decade in terms of central bank independence, reigning in inflation and setting public debt on a sound footing, so whatever the fine print details, Standard and Poor’s decision can surely not be considered an imprudent one.

As regards its external balance Brazil is rather different from many other large emerging economies since while the central bank (which has a high level of independence from government) does intervene in the spot market to try to keep a lid on the Real’s rise and to built up a “war chest” of international reserves the bank has allowed the currency to rise substantially against the US dollar (as of July the Real had appreciated by some 13% against the dollar in 2008) and Brazil has also recently opened a small but quite manageable deficit on its current account, which means that Brazil as it develops is becoming a net consumer of excess capacity in the global economy. A break-down of the current account position reveals that Brazil continues to retain a surplus on the goods balance due to the importance of commodities and food but that services and in particular a negative income account are now gradually pulling the overall balance into negative territory. This is really what one could reasonably expect in the context of an emerging economy at Brazil's stage of development.



On the monetary policy front the central bank is rapidly earning a reputation for itself as Latin America’s new Bundesbank, and governor Henrique Meirelles delivered a decisively hawkish message during the last monetary council meeting to accompany the decision to hoist rates by 75 basis points to the current 13% level. Brazil's interest rate is now the the second-highest inflation-adjusted one in the world after Turkey's. Brazil's real interest rate, or the benchmark 13 percent rate minus annual inflation of 6.06 percent, is 6.94 percent. Turkey currently has the world's highest so-called real interest rate at 7.55 percent.

This decision is the continuation of a hiking campaign set in motion in order to establish strong credentials for the central bank as an inflation fighter, and to prevent generalised inflation expectations from taking a hold among the population. The central bank is attempting to keep inflation within the the official target of 4.5% and with inflation forecast to be somewhat above that figure in 2009 the central bank is simply acting accordingly.



Such aggressive tightening is, however, not without its problems, and policy makers now face a serious dilemma. Predictably, given the state of the current global environment, the central bank's larger than expected interest hike was rapidly translated into an appreciation of the Real – pushing it to its strongest level since 1999. So far, the 13% rise against the USD this year puts the real in the pole position amongst emerging market currencies versus the USD. This position is reasonably comprehensible taking into account the recent decision to award Brazil investment grade status; this coupled with a nominal yield on 10 year government notes at about 15% and a benchmark stock index – the Bovespa – which is up approximately 10% from its January level, implying a 20% gain in US dollar term, basically mean that international investors are finding it hard not to put money into Brazil at this point in time.

Consequently, with a global credit crisis far from over, a hawkish central bank, and a hard currency making exports more difficult one could only reasonably expect the economy to slow in line with weaking global momentum. The key point with respect to the Real would be that a continuing rise will push the external balance further into negative territory. Moreover, in a likely scenario where global commodity prices somewhat pare-back their recent impressive upward movement Brazil’s external bookkeeping will further come under pressure.

Outlook on Key indicators

• 
  Following the most recent rate hike market expectations have now solidified towards further interest rate increases in the pipeline. The driving orce here will, as ever, be inflation running above the central bank's nominal target. Here at Emerginvest we see the Central Bank of Brazil aiming for a nominal rate of 15% which should be reached over the course of the next three meetings.
• 
  The Real is likely to continue to be supported by a hawkish central bank but as the external balance moves steadily into negative territory macro-fundamentals may take over, and as the economy slows and inflation comes into the target zone the central bank will once more move into loosening mode pushing the Real down in the process. A violent correction however is not expected.
• 
  GDP growth is expected to moderate in 2008 compared to the levels seen in 2007 but at this point growth projections remain solid, and we certainly see Brazil’s mid term sustainable growth rate as being above the consensus 3%-5% rate once inflation is firmly under control.

2007 Data

GDP (2007) - 5.4%
Inflation (2007) - 3.6%
Current Account Deficit -0.27% of GDP
Fiscal Deficit - 2.27% GDP
Debt to GDP ratio - 42.8%


Debt Ratings (local currency, long term)

Fitch - BBB-
S&P - BBB+
Moody- Ba1


2008 Central Bank Inflation Target - 4.5% (+ or – 2pp)

Population Median Age -29 years
Total Fertility Rate (2007) -1.88 child per women
Male Life Expectancy - 68.57 years

Development Indicators Rank (131 economies in total)

Global Competitiveness (World Economic Forum)
72/131 (2007-08)
Business Competitiveness (World Economic Forum)
59/131 (2007-08)


Selected Sub-components

Institutions - 104/131
Infrastructure - 78/131
Macroeconomic Stability - 126/131
Health and Primary Education -84/131

Short Term Data

Retail Sales Growth (May, y-o-y, volume index) - 10.5%
Industrial Output (May, y-o-y) - 2.4%
Inflation (July 2008) - 6.3%
Central Bank Interest Rate (SELIC Rate) - 13.0%

Update added below (03.08.2008): New links and further discussion on this can be found in the update below. It really seems as if more than one eye is turning to the Baltics at the moment

THE weather deities are extraordinarily generous at the moment here in Copenhagen and being cooped up in a 17m2 studio does not exactly inspire to being a good protestant. However, financial markets and news streams are serving up a nice batch of data points and being the wonk I am, I am keeping tap; even if the beaches of Zealand have (and will be) frequented more than a couple of times.

Last time I had the Baltics under the spotlight I asked two overall questions. The first dealt with the extent to which the Baltics had entered a recession in the beginning of 2008 and the second question surrounded the risk of the Baltic pegs to the Euro. This time around and with the recent Q2 GDP release from Lithuania it would be nice to revisit the first of these questions. And with the market focus looking to shift from inflation to growth the second question is likely to become in vogue once again.

As the Q1 GDP numbers came in for the Baltics I concluded that it was very likely that the region had entered a recession. In light of the proverbial definition of a recession as a consecutive quarter contraction it seems clear the Lithuania managed to smartly skirt the recession in H01 2008. As far as I can see at this point and from Eurostat's data Estonia was the only one of the three Baltic economies that contracted in Q1 2008 (-0.5% and 0.1% for Latvia).

However and as ever before, the Baltics is increasingly getting stuck in stagflation and one of a particular sinister kind. In the case of the Baltics they may already be seeing the beginnings of a hard landing, whereas others continue to build up steam making it almost inevitable that they too will erupt at some point.

As can be observed, Lithuania just managed to avoid a contraction in Q1 and rebounded nicely in Q2. Yet, in light of the run-up to these numbers and the fact that Lithuania, on a y-o-y basis, grew at its lowest rate since 2004, I have little problem in maintaining my view that this is a hard landing. As for the break up of Lithuania's position it is a bit difficult to tell since the components do not feature seasonally adjusted figures. However, it seems that especially companies paired their investments going in to 2008 while consumers are still going strong. All three forward looking indicators in the form of confidence measures show that the expected trajectory of overall momentum is firmly down.

The other graphs reveal with some clarity I think that the Baltics may now be entering a whole new different growth dynamic with inflation and wages continuing their upward drift at one and the same time as growth is faltering. In this way, it is hardly about the potential recession and slowdown itself but about the economy, and growth rate, which will emerge. This point is similar to one I made recently in the context of the Eurozone and I do think it is important to realize the hole some of the CEE economies are about to dig themselves out of. In fact, depending on the reversion into wage and asset price deflation I would say that this slowdown marks a significant structural break in these economies' growth path.

Consequently, there is simply no way in which these economies can muster the inflows they have been receiving, and many face a decisive need to turn the boat around and become export dependent. The key link will be the extent to which we, absent a currency to devalue, will observe wage deflation to reign in the external position. Consequeuntly, with a fixed exchange rate to the Euro and an extremely wide external position the only way a correction can come is then through severe wage and by consequence price/asset deflation. The alternative would of course be to the abandon the pegs but that would then open up Pandora’s box as the currency most likely would plummet to reflect the external balance leaving Baltic consumers with Euro denominated loans and cash flows in domestic currency (get detailed argument and analysis here, here and here).

Another crucial link here would be Scandinavian banks who are effectively supplying these Euro denominated loans and thus how they, effectively, are financing the external deficits. We have thus on several occasions been hearing faint but rising voices about how, in particular, Swedish banks are exposed to the Baltic slowdown.

In a recent detailed analysis John Hempton from Bronte Capital serves up some nice points on the whole situation. What is particularly interesting is that he takes the time to scrutinize the books of Swedbank who is operating its subsidiary Hansabank which is, by far, the biggest foreign bank in the Baltics.

One of the important points to latch on to was the one conveyed in my last look at the macroeconomic balance sheet of the Baltic economies. In this analysis I showed that while loans in local currency are now falling on a stock basis (i.e. the amount of loans being paid out or written off outnumber the number of new loans taken out) it is still growing in Euro denomination effectively keeping growth in the overall stock of loans in the positive; even if the trend is inexorably down. Once I have Q2 data for all the Baltic economies I will post briefly on the development.

Yet, if you dig into the Q2 accounts of Swedbank (who are operating under the branded name Hansabank in the Baltics) you will see that they are still churning out positive growth rates in lending in Q1 and Q2. Over the course of H01 2008 Swedbank consequently expanded their lending operations with 7% in the Baltics and over the entire year, this number stands at 21%. If we compare this to the growth in deposits in the Baltics the H01 figure is 1% whereas it is 11% over the year. As such, levering of the balance sheet continued in H01 2008. In short, lending growth is still positive and the leverage multiple measured as the value of lending over deposits is growing.

I don't think it is entirely outlandish to draw a line between my initial results derived from macroeconomic data to these results from one of the biggest players on the Baltic finance market. Personally, I don't see how the growth rate can continue to stay in positive territory and this is especially the case since net interest income is now beginning to decline, if ever so slowly.

In the context of cooking, as it were, the books of Swedbank Hempton makes another interesting observation in his piece.

So what happens next?

Well if the Lati devalues (as would seem inevitable) then Hansa Bank has to pay Euro to Swedbank – and as its assets are in Lati it would be insolvent.

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.

This is a very big problem for Swedbank. Swedbank's equity is 68 billion SEK – but 20 billion is intangibles. Swedbank is probably solvent at the end of this – but only just. Swedbank will (at best) lose its independence. Swedbank is in turn wholesale funded – and the chance of it becoming Swedish Government property is not low.

Having lent that much to a country with a phoney fixed exchange rate in a currency they can't print – Swedbank management deserve it. Bad things happen to bad banks and this is a bad bank.

Now, Mr. Hempton certainly does not mince his words and even though he may come off as wing nutty the point being made is actually quite simple and valid. What he effectively is doing then is to move the perspective down a notch from the obvious macroeconomic crunch that would ensue as consumers defaulted on their loans to the predicament which would arise in the context of Swedbank's books.

What it means in macroeconomic terms is if the translation risk issue blows up, which it potentially will in the context of wage deflation (i.e. this would force down the pegs), Hansabank would effectively be screwed. Sorry for my harsh tone, but I cannot see how they could shore up their balance sheet unless the ECB moved in with a kind of 1:1 guarantee which let the Baltics de-facto adopt the Euro with one swoop. Now, if Hansabank goes, and this seems to be Hempton's argument, so could Swedbank and by derivative the inflows used to fund to external deficit to the Baltics. And then we are into the big royal mess.

Also, one could easily imagine a rather advanced game of Old Maid. Consequently, if Hansabank et al. suddenly move seriously into the ropes, de-pegging would almost certainly mean a significant write-off of Euro denominated loans. In this case,  the Baltics may neatly shift some of the heat on to Swedbank who, almost certainly, will be running to the Riksbank and then perhaps on to the ECB.

Ultimately, I think the Baltics will fight long and hard against devaluation and much will depend on the severity of the correction. It may end up a perfect storm for them, but I want to stress that this would require the ECB to step in with some kind of de-facto, behind the curtains, guarantee to the currency board. That is to say, the ECB or the Riksbank would need to foresee the chain of events above (or a derivative thereof) and nip it, preemptively, in the b*t so to speak.

Quit With the Dooming and Glooming Already?

Uff that was some outlook was it not? I should immediately point out that much of this represent musings and it is still quite difficult to see where it ends. However, I have pointed out the shaky links between Scandinavian banks and the Baltics more than once before, so it should not come as a big surprise that I am massaging this topic. 

If we move up the perspective to macroeconomics, the points above relate to a more general point concerning the Baltics and the manner in which the current imbalances potentially will be corrected. This consequently lays out a path well trodden here at Alpha.Sources. As the rest of the CEE countries, the Baltic economies have quite simply been converging too fast given their underlying capacity (read: demographic) constraints. In fact, given the loop sided nature of almost all CEE economies after two decades worth of lowest low fertility the whole convergence hypothesis was always going to hit shallow waters. As such, and coupled, in the past 5-6 years, with significant outward migration, these economies have quite simply been administering a growth strategy wholly incompatible with their underlying fundamentals.

This obviously does not mean that Eastern Europe will sink into the ground, but it does mean that a correction is due; both in terms of expectations and the trajectory of economic fundamentals. Note in passing here especially how this will affect Germany's ability to leverage its export muscle towards its Eastern borders. In a more broad policy oriented context I have also been amazed, even if I can understand it, with the push to de-peg from the Euro and subsequently raise interest rates. Sure enough, when you have imported inflation you want a strong currency but in administering this kind of policy you are also assuming that the implied process of nominal convergence can be speeded up; almost as if the CEE economies could attain nominal convergence with EU15 in one clean and bold sweep.

Conclusively, my guess is that while Q2 data will tell give us important forward looking indicators Q3 and Q4 may be where the real action is. As per reference to my points above I am watching FX markets in particular and, in the case of the Baltics, the link with Scandinavian banks and the potential ways in which these economies can correct.

Especially, the last event prompted me into action as I decided to have a closer look at the Danish economy and where it might be heading. In many ways Denmark is similar to other credit crunch struck economies not least in the context of experiencing a severe unravelling of a housing boom. As we saw last week this is now beginning to have collateral damage. Yet, Denmark is also a bit different not least because the economy is going into this crisis with a positive balance both on the public but also ever so importantly on the external books. 

My note is up on Global Economy Matters and here it is as it is presented over at that space; please click on pictures for better viewing; oh and sorry for not formatting them to Alpha.Sources' template.

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Stagflation, credit crunch, bank bails-outs, and housing market busts are all concepts that are unfortunately now becoming all too familiar to the current Danish economic discourse and indeed even to the Danish public at large as they read their morning paper over breakfast, or listen to the radio on their way to work. And not of course in their United States version, but rather in their homegrown variant. But just how serious is the construction and banking problem in Denmark?

A quick initial glance at the short term data definitely suggests that a serious batch of storm clouds may well be gathering above the economy. Not only did Denmark claim the dubious honor of being the first economy in Europe to exhibit a technical recession but it was also recently handed its very own banking crisis à la Bear Stearns and Freddie/Fannie, since only last Friday the 10th largest bank, Roskilde Bank, had to go hat in hand to the central bank for a provisional liquidity guarantee as the writedowns it was about to announce to the market were judged to be too tough to swallow without risking a bank run.

However, things in Denmark need not be as serious as that initial glance might suggest, and, at this point at any rate, I would most definitely not group Denmark together with other European economies - Spain, the UK, Ireland - who who certainly seem to be facing a very tough time indeed moving forward. On the other hand, I think it is reasonably safe to say that things in Denmark will almost surely get a lot worse before they get better, and really the key question is not how deep will the recession be, but what will be the structural characteristics of the economy which subsequently emerges?


So in the analysis which follows I will attempt to answer this question question through an in-depth look at the Danish economy, where it is, where it has been, and where it is about to go.

If we start at the beginning, with headline GDP growth, it is easy to see the extent of the recent slump of the Danish economy.

As I will explain below one of the key drivers of the recent Danish consumption boom has been the upward march of house prices. Now that higher interest rates and rising energy costs are rolling in at the same time as the housing boom gets well past its peak it is only natural that consumers are scaling back. Danske Bank analysts however (the only link is in Danish I am afraid) are fairly sanguine when it comes to their assessment of the Danish consumer. They limit themselves to pointing out that when compared with other "property driven" countries such as the UK, the US, Norway and Sweden the increase in Danish consumption has not been that outstanding. I think such comparisons are - by their very nature - rather spurious. The main point we need to think about is not really the relative strength of the Danish consumer but simply how much in absolute terms we expect consumption to be a drag on growth. In this respect I tend to agree with Danske Bank that it is unlikely that consumption will plummet completely. This is true, at least, in terms of the immediate outlook where an extremely tight labour market will support consumption in the sense that people still have a steady income to spend from. Yet, the credit crunch following the subprime turmoil has not passed the Danish doorstep without paying a visit. The recent quarterly report by the Danish central bank elaborates on this in great detail. Especially chart 11 (p. 20) offers a nice perspective as it shows the year on year trend in lending growth which is inexorably moving down even if the growth rate is still positive. As a final point, Danske Banks points out that real income is still climbing if we deflate the wage bill using core prices only.

Ultimately, my feeling is that it is still too early to call it on the consumption side. The outlook is clearly deteriorating though, and consumer confidence is slumping. Much will depend on the extent to which the labour market softens in the coming quarters (and indeed years). Apart from this, the degree of the unravelling on the housing market boom and the extent to which lending institutions tighten credit standards and lending conditions will obviously also be important. Danske Bank is looking for an increase in consumption at about 1% y-o-y in 2009. Given the outlook on lending and housing I would say that Danske Bank is perhaps rather optimistic.

While it is still a bit too early to say whether consumption will drop down through the floor and descend into the basement, it does seem clear that investment is now heading into a decisive slowdown.

The very impressive recent investment performance by Danish companies - which formed the backdrop to the recent expansion - is by now pretty well known. A tight labour market and low interest rates have consequently provided Danish companies with ample reason to invest. This coupled with residential investment that has been literally booming has meant that investment was a strong driving force in the Danish economy. From 2001 to 2006/07 residential investment increased from 3% of GDP to 7%. All good things must come to and end however and it seems clear from the above graph that the trend is now much more modest and even possibly back stepping in the form of contraction. If Danske Bank are correct in their assessment of fall in residential investment to the tune of about 2% in 2008 this will be a significant drag on aggregate fixed capital formation.

Moving on to the public sector we find one major advantage for Denmark going into the coming downturn, since Denmark has been running a very healthy surplus on the public books to the tune of 4.4% in 2007. Moreover and as can be observed below Denmark is trying to be the proverbial top of the class EU student by bringing down public debt quite dramatically over the past decade.

Finally, if we come to look at the external sector we find another of the defining factors that separates Denmark from many other credit crunch struck economies.

The main point would be that even though Denmark has been ramping up consumption to a significant degree this has not lead to a deficit on the external books; even if recent quarters have seen the balance edging slightly into negative. This relatively healthy position, when taken with the situation in the public accounts, is obviously quite important. What we seem to have here is a picture of an economy that has not, on the face of it, been living beyond its means.

One important point to take away from all this I think is the idea that Denmark may be benefiting from being a small open economy situated near the apex of the global value chain. This should then translate into the fact that at any given point in time what goes out adds more value than what goes in, making it "easier" to sustain a positive external balance even if the economy is operating near full capacity. In a cyclical perspective however, there is reason to believe that with the recent surge in the Euro - and by implication the Danish Krona which is effectively locked into it - the positive balance will be more difficult to sustain in the immediate future. This would be certain to bring all kinds of ghosts forth from the past as it was exactly a ballooning external deficit which prompted the Conservative government in the 1980s to instigate the, among Danes now famous, Potatoe Treatment which was a quite harsh bout of fiscal contraction aimed at halting domestic consumption and putting a lid on housing and residential investments.

If the above charts and narrative sketch out the immediate state of play with respect to the Danish economy it could still be argued that I am missing one important aspect of the situation, since Denmark, like the rest of the world, has also caught the stagflation flu which seems to be going the rounds of the global economies right now. And just to prove that it isn't always different, Denmark's inflation is now running close to the 4% mark at one and the same time as the economy is slowing significantly.

As with the general global picture, the increase in prices is coming almost exclusively from headline pressures but many domestic economists would also point towards the fact that the failure to prevent the Danish economy from bumping up against its capacity limit will exacerbate the incoming downturn. However, if we really want to get down to business with respect to the recent performance of the Danish economy, and its immediate outlook, there are two sectors which are absolutely crucial. One is the labour market (and the associated demographic profile of Denmark) and the other is the housing sector.

We Don't have Subprime Loans in Denmark, Or ... ?

Moreover, it is very important, in a Danish context, to latch on to the crucial importance of the Copenhagen region in the whole housing discussion. Basically, and while both total turnover and prices are declining on a country-wide basis, the correction in Copenhagen has been particularly severe. This is important because the Copenhagen region naturally commands a crucial position in terms of wealth and income concentration in the Danish economy. Particularly noteworthy has been the extent to which apartments have seen a correction in prices. The situation is now one of a quite serious mismatch between the supply of housing and demand side capacity to absorb it. Obviously, everything has its price and while I have faith in the dynamics of supply and demand the key is the extent to which this price will allow existing owners to actually repay their mortgages. So far, this talk about "technical defaults" is only a fringe discourse but the longer prices fall the more this problem will grow I think.

We also need at this point to consider the relation between house prices and consumption. In overall terms, there are two ways in which we could do this. One is through a traditional academic type discussion about the so-called wealth effect in the context of home price appreciation and whether this link has been strengthened by creative credit products and, as a consequence, the ability to tap mortgage wealth for consumption. The second would be a more subtle point about the link from housing/construction to the banking sector and thus over to tightening credit standards for companies and consumers. This after all is what the lingering credit-crunch mess is all about. Roskilde Bank for example is an important warning shot across the bow in the sense that it was exactly an overly lax lending strategy towards construction/real estate investors that brought the bank to its knees last week.

At the end of the day the vulnerability of the Danish economy to a housing downturn basically boils down to the extent to which Denmark has been drinking the subprime cool aid in some way or another. Danish bureaucrats would almost certainly frown at such a suggestion, and point to the key institutions in Denmark; the so-called real estate agency institutes who hold the sole right to issue the convertible bonds used to finance homes. However, with amortization free loans, maturities running up 100 years and adjustable rates it merely seems as if Denmark has had its own distinct subprime lingo rather than holding the high ground as many claim. So far though none of these major credit institutions have shown signs of distress while at the same time many analysts expect banks in the mid-size segment (e.g. Roskilde Bank, Amagerbanken, Fionia Bank, and Forstædernes Bank) to be in the frontline of the barrage which may come next. Yet, as house prices continue to drop and as delinquencies steadily rise, it is not certain that old dictums and assertions may not be in a need of some speedy revision.

Needless to say, I believe that the housing sector and the link to the financial sector and then over to the real economy is crucial to watch in a Danish context. At this point, Denmark may very well be able to navigate the skerries which lie ahead but I definitely think that the ingredients for something much more dramatic are there.

Labour Market and Demographics; an Economy at Full Capacity

Having described the housing sector above we turn now to the labour market. Even though many would perhaps, tongue in cheek, call yours truly a bit of a demographics fundamentalist I do not think that it is entirely out of place to say that if you want to understand the Danish economy at the present moment, it is all about demographics.

As can be seen from the unemployment chart above, recent years have steadily ground down Danish spare human capital. But in reality an unemployment rate running at 3.8% in 2007 does not really tell the whole story here, since if we look at the monthly development we can see that unemployment dropped to an almost unbelievable level of 1.7% in May or a mere 47.500 people. These levels adds a whole new perspective to the adage of full employment. Even as the economy contracted in the two last quarters it still created employment, albeit at a slower pace than in recent quarters.

Obviously, the number of new jobs created will steadily decrease as the slowdown grabs hold but there is a silver lining to all this. Given the demographic analysis I field below we may in fact be witnessing an economy at its historical peak in terms of capacity to produce economic growth or more aptly economic trend growth; (migration as always may adjust the path of the process). This conclusion is mainly pinned on the supposition that economic growth at all points in time is driven by people, or more specifically; the right mix between the quality and quantity of human capital.

The formal picture of Danish demographics is shown in the chart below as it plots the Danish population and its growth rate.

The series for natural increase also includes migration which is why there is a spike around 2005-2007 as Denmark received a large batch of workers from Eastern Europe; especially Poland. However, one thing is total population growth and quite another is the proportional change of the population. Thus, if one wants to understand what it means that the economy is at its "peak" one need to accept the tenets of demographic economic analysis which isn't that difficult once you get down to the basics.

Firstly, we need to take a look at two process which combines to form a steady process of ageing of the Danish society; fertility and life expectancy. Starting with the former we actually get a quite interesting picture.

The graph above is very thus very illuminating. Not only does it show that Denmark like most other societies has gone through the demographic transition with a subsequent drop in fertility, it also shows how the decline in fertility during the final (and at this point still ongoing) stages of the demographic transition is driven by two processes. One the one hand you have the tempo effect (also called birth postponement) which covers the process by which women postpone the birth of their first child. This has a knock-on effect on the second process (the so-called quantum effect) which is really synonymous with the fact that women choose to have fewer children in total. The main quibble with measuring the quantum effect is that it can only be done post-hoc through measurement of total-cohort-fertilty, although some "on the fly" proxies such as ideal family size can be used to get an impression of what is happening.

As can be seen Danish women have definitely taken birth postponement to heart, but luckily the quantum effect in Denmark seems to be much less pronounced than in some of the very low fertility European societies. Thus, Denmark is one of the few countries (France would be another example) who have been able to rebound from close-call brush with lowest-low fertility (a TFR of 1.5). On the other hand, on the life expectancy front Denmark is not particularly different in that she is, like most other OECD countries, experiencing a steady, and nearly linear, increase in life expectancy for both sexes.

The decline in fertility and increase in life expectancy taken together serve to produce a steady population ageing process which can be fairly easily tracked through either the rise in the median age of the population, or, more intuitively, via the decline, relative to total population, of the most productive cohort. In this case, I have chosen to label the cohort the proportion of the population aged 25-49.

As can be seen this age group peaked in Denmark around 1997 and is now set to steadily decline. Clearly, and given the fact that Danish fertility seems healthy in comparative terms at about 1.8 child per women, this decline will fairly be slow.

The main point to take away from all this is thus not that Denmark should now be grouped together with the strong demographic decliners like Italy, Germany and Japan, but rather that Denmark may well, in these very quarters we are passing through now, be operating at a level in terms of disposable human capital to which it will never, all things being equal, return. This does not mean that Denmark's economy won't grow but simply that momentum of growth steadily will decline from this point on. None of this is certain of course but the real silver lining is indeed to be found in the graphs above.

Consider the following. The women born at the end of 1960s as well as the beginning of 1970s are about to finish their reproductive period and an educated guess will suggest that a total cohort fertility will clock in at about 1.8 children per women. This achievement is quite extraordinary since it comes on the back of a generation of women whose fertility slumped to 1.5-1.4 in the middle of the 1980s. However, Denmark is then only now entering the interesting period since it is absolute crucial that the women who are now set to begin birth postponement (i.e. those born in the 1980s) manage to stay at a fertility level around 1.8. In fact, the postponement effect itself may well mean that Denmark will experience a marked drop in TFR in the years to come. Moreover, it is not difficult to see that if the population momentum is to be sustained, fertility needs to be considerably higher since these women come from a comparatively small generation. This same intuition can be applied to the labour market where the generation now set to enter the labour market is comparatively small. Actually, another adverse effect of the fact that a relatively small generation is about to enter the labour market is that the housing market correction may be much longer since the first-time buyers who are coming out of school in these very years are quite simply not enough to support the glut of housing at the current high prices. Talk about bad timing!

Smooth Sailing or Dire Straits?

The immediate outlook for the Danish economy seems set to become steadily worse although there are some bright spots. The key to gauge whether the Danish slowdown will turn from bad to worse is the nexus formed by the housing/residential market and banking sector. An important indication to this potential vicious circle was given last Friday when Roskilde Bank had to throw in the towel. Real economic activity is definitely slowing but it is too early at this point to decisively call the extent of the slowdown. The bright spots, and thus what seperates Denmark from some of the other casualities of the credit crunch, is that she will be going into the slowdown with a surplus both on the public and external books. In my opinion, the housing market and the extent of the incoming correction is absolutely crucial in the context of assessing what comes next in the Danish economy. If the correction is very severe the slowdown could become disorderly. So far, I will hold off my call but the smooth sailing is definitely over and a firm grip is now needed on the helm if the upcoming skerries are to be navigatied without a capsize.

Apart from the immediate outlook in Denmark I have also fielded a demographic profile and explained how one might deduce some important information about the future path of the Danish economy from this. The key is the extent to which the current slowdown will coincide with more structural factors to make things rather more worse for the Danish economy than one might otherwise expect.

Ultimately, I do not see Spain-like conditions in Denmark but all the necessary factors are definitely in place for something rather worse than what we are currently observing.

List of Main References

Danish Central Bank (2008) - Monetary Review 2nd Quarter

Bocian Steen (2008) - Danmark i teknisk recession… men påsken driller, Danske Bank Flash Comment

Bocian Steen, & Stramer Damgaard, Tore (2008) - Danmark: Ustadigt bygevejr, Danske Bank Investment Analysis

Erland, Esenspen, Lundsgaard, Jens and Huefner, Felix (2006) - The Danish Housing Market: Less Subsidy and More Flexibility, OECD Working Paper

Lunde, Jens 2005 - Fluctuations and Stability in the Danish Housing Market: Background, Causes and Policy

European Central Bank, The (2003) - Structural Factors in EU Housing Markets.

Slacalek, Jirka (2006) - What Drives Personal Consumption? The Role of Housing and Financial Wealth, German Institute for Economic Research, DIW Berlin

If we start at the beginning, with headline GDP growth, it is easy to see the extent of the recent slump of the Danish economy.

Ultimately, my feeling is that it is still too early to call it on the consumption side. The outlook is clearly deteriorating though, and consumer confidence is slumping. Much will depend on the extent to which the labour market softens in the coming quarters (and indeed years). Apart from this, the degree of the unravelling on the housing market boom and the extent to which lending institutions tighten credit standards and lending conditions will obviously also be important. Danske Bank is looking for an increase in consumption at about 1% y-o-y in 2009. Given the outlook on lending and housing I would say that Danske Bank is perhaps rather optimistic.

While it is still a bit too early to say whether consumption will drop down through the floor and descend into the basement, it does seem clear that investment is now heading into a decisive slowdown.

The very impressive recent investment performance by Danish companies - which formed the backdrop to the recent expansion - is by now pretty well known. A tight labour market and low interest rates have consequently provided Danish companies with ample reason to invest. This coupled with residential investment that has been literally booming has meant that investment was a strong driving force in the Danish economy. From 2001 to 2006/07 residential investment increased from 3% of GDP to 7%. All good things must come to and end however and it seems clear from the above graph that the trend is now much more modest and even possibly back stepping in the form of contraction. If Danske Bank are correct in their assessment of fall in residential investment to the tune of about 2% in 2008 this will be a significant drag on aggregate fixed capital formation.

Moving on to the public sector we find one major advantage for Denmark going into the coming downturn, since Denmark has been running a very healthy surplus on the public books to the tune of 4.4% in 2007. Moreover and as can be observed below Denmark is trying to be the proverbial top of the class EU student by bringing down public debt quite dramatically over the past decade.

Finally, if we come to look at the external sector we find another of the defining factors that separates Denmark from many other credit crunch struck economies.

The main point would be that even though Denmark has been ramping up consumption to a significant degree this has not lead to a deficit on the external books; even if recent quarters have seen the balance edging slightly into negative. This relatively healthy position, when taken with the situation in the public accounts, is obviously quite important. What we seem to have here is a picture of an economy that has not, on the face of it, been living beyond its means.

One important point to take away from all this I think is the idea that Denmark may be benefiting from being a small open economy situated near the apex of the global value chain. This should then translate into the fact that at any given point in time what goes out adds more value than what goes in, making it "easier" to sustain a positive external balance even if the economy is operating near full capacity. In a cyclical perspective however, there is reason to believe that with the recent surge in the Euro - and by implication the Danish Krona which is effectively locked into it - the positive balance will be more difficult to sustain in the immediate future. This would be certain to bring all kinds of ghosts forth from the past as it was exactly a ballooning external deficit which prompted the Conservative government in the 1980s to instigate the, among Danes now famous, Potatoe Treatment which was a quite harsh bout of fiscal contraction aimed at halting domestic consumption and putting a lid on housing and residential investments.

If the above charts and narrative sketch out the immediate state of play with respect to the Danish economy it could still be argued that I am missing one important aspect of the situation, since Denmark, like the rest of the world, has also caught the stagflation flu which seems to be going the rounds of the global economies right now. And just to prove that it isn't always different, Denmark's inflation is now running close to the 4% mark at one and the same time as the economy is slowing significantly.

As with the general global picture, the increase in prices is coming almost exclusively from headline pressures but many domestic economists would also point towards the fact that the failure to prevent the Danish economy from bumping up against its capacity limit will exacerbate the incoming downturn. However, if we really want to get down to business with respect to the recent performance of the Danish economy, and its immediate outlook, there are two sectors which are absolutely crucial. One is the labour market (and the associated demographic profile of Denmark) and the other is the housing sector.

We Don't have Subprime Loans in Denmark, Or ... ?

Moreover, it is very important, in a Danish context, to latch on to the crucial importance of the Copenhagen region in the whole housing discussion. Basically, and while both total turnover and prices are declining on a country-wide basis, the correction in Copenhagen has been particularly severe. This is important because the Copenhagen region naturally commands a crucial position in terms of wealth and income concentration in the Danish economy. Particularly noteworthy has been the extent to which apartments have seen a correction in prices. The situation is now one of a quite serious mismatch between the supply of housing and demand side capacity to absorb it. Obviously, everything has its price and while I have faith in the dynamics of supply and demand the key is the extent to which this price will allow existing owners to actually repay their mortgages. So far, this talk about "technical defaults" is only a fringe discourse but the longer prices fall the more this problem will grow I think.

We also need at this point to consider the relation between house prices and consumption. In overall terms, there are two ways in which we could do this. One is through a traditional academic type discussion about the so-called wealth effect in the context of home price appreciation and whether this link has been strengthened by creative credit products and, as a consequence, the ability to tap mortgage wealth for consumption. The second would be a more subtle point about the link from housing/construction to the banking sector and thus over to tightening credit standards for companies and consumers. This after all is what the lingering credit-crunch mess is all about. Roskilde Bank for example is an important warning shot across the bow in the sense that it was exactly an overly lax lending strategy towards construction/real estate investors that brought the bank to its knees last week.

At the end of the day the vulnerability of the Danish economy to a housing downturn basically boils down to the extent to which Denmark has been drinking the subprime cool aid in some way or another. Danish bureaucrats would almost certainly frown at such a suggestion, and point to the key institutions in Denmark; the so-called real estate agency institutes who hold the sole right to issue the convertible bonds used to finance homes. However, with amortization free loans, maturities running up 100 years and adjustable rates it merely seems as if Denmark has had its own distinct subprime lingo rather than holding the high ground as many claim. So far though none of these major credit institutions have shown signs of distress while at the same time many analysts expect banks in the mid-size segment (e.g. Roskilde Bank, Amagerbanken, Fionia Bank, and Forstædernes Bank) to be in the frontline of the barrage which may come next. Yet, as house prices continue to drop and as delinquencies steadily rise, it is not certain that old dictums and assertions may not be in a need of some speedy revision.

Needless to say, I believe that the housing sector and the link to the financial sector and then over to the real economy is crucial to watch in a Danish context. At this point, Denmark may very well be able to navigate the skerries which lie ahead but I definitely think that the ingredients for something much more dramatic are there.

Labour Market and Demographics; an Economy at Full Capacity

Having described the housing sector above we turn now to the labour market. Even though many would perhaps, tongue in cheek, call yours truly a bit of a demographics fundamentalist I do not think that it is entirely out of place to say that if you want to understand the Danish economy at the present moment, it is all about demographics.

As can be seen from the unemployment chart above, recent years have steadily ground down Danish spare human capital. But in reality an unemployment rate running at 3.8% in 2007 does not really tell the whole story here, since if we look at the monthly development we can see that unemployment dropped to an almost unbelievable level of 1.7% in May or a mere 47.500 people. These levels adds a whole new perspective to the adage of full employment. Even as the economy contracted in the two last quarters it still created employment, albeit at a slower pace than in recent quarters.

Obviously, the number of new jobs created will steadily decrease as the slowdown grabs hold but there is a silver lining to all this. Given the demographic analysis I field below we may in fact be witnessing an economy at its historical peak in terms of capacity to produce economic growth or more aptly economic trend growth; (migration as always may adjust the path of the process). This conclusion is mainly pinned on the supposition that economic growth at all points in time is driven by people, or more specifically; the right mix between the quality and quantity of human capital.

The formal picture of Danish demographics is shown in the chart below as it plots the Danish population and its growth rate.

The series for natural increase also includes migration which is why there is a spike around 2005-2007 as Denmark received a large batch of workers from Eastern Europe; especially Poland. However, one thing is total population growth and quite another is the proportional change of the population. Thus, if one wants to understand what it means that the economy is at its "peak" one need to accept the tenets of demographic economic analysis which isn't that difficult once you get down to the basics.

Firstly, we need to take a look at two process which combines to form a steady process of ageing of the Danish society; fertility and life expectancy. Starting with the former we actually get a quite interesting picture.

The graph above is very thus very illuminating. Not only does it show that Denmark like most other societies has gone through the demographic transition with a subsequent drop in fertility, it also shows how the decline in fertility during the final (and at this point still ongoing) stages of the demographic transition is driven by two processes. One the one hand you have the tempo effect (also called birth postponement) which covers the process by which women postpone the birth of their first child. This has a knock-on effect on the second process (the so-called quantum effect) which is really synonymous with the fact that women choose to have fewer children in total. The main quibble with measuring the quantum effect is that it can only be done post-hoc through measurement of total-cohort-fertilty, although some "on the fly" proxies such as ideal family size can be used to get an impression of what is happening.

As can be seen Danish women have definitely taken birth postponement to heart, but luckily the quantum effect in Denmark seems to be much less pronounced than in some of the very low fertility European societies. Thus, Denmark is one of the few countries (France would be another example) who have been able to rebound from close-call brush with lowest-low fertility (a TFR of 1.5). On the other hand, on the life expectancy front Denmark is not particularly different in that she is, like most other OECD countries, experiencing a steady, and nearly linear, increase in life expectancy for both sexes.

The decline in fertility and increase in life expectancy taken together serve to produce a steady population ageing process which can be fairly easily tracked through either the rise in the median age of the population, or, more intuitively, via the decline, relative to total population, of the most productive cohort. In this case, I have chosen to label the cohort the proportion of the population aged 25-49.

As can be seen this age group peaked in Denmark around 1997 and is now set to steadily decline. Clearly, and given the fact that Danish fertility seems healthy in comparative terms at about 1.8 child per women, this decline will fairly be slow.

The main point to take away from all this is thus not that Denmark should now be grouped together with the strong demographic decliners like Italy, Germany and Japan, but rather that Denmark may well, in these very quarters we are passing through now, be operating at a level in terms of disposable human capital to which it will never, all things being equal, return. This does not mean that Denmark's economy won't grow but simply that momentum of growth steadily will decline from this point on. None of this is certain of course but the real silver lining is indeed to be found in the graphs above.

Consider the following. The women born at the end of 1960s as well as the beginning of 1970s are about to finish their reproductive period and an educated guess will suggest that a total cohort fertility will clock in at about 1.8 children per women. This achievement is quite extraordinary since it comes on the back of a generation of women whose fertility slumped to 1.5-1.4 in the middle of the 1980s. However, Denmark is then only now entering the interesting period since it is absolute crucial that the women who are now set to begin birth postponement (i.e. those born in the 1980s) manage to stay at a fertility level around 1.8. In fact, the postponement effect itself may well mean that Denmark will experience a marked drop in TFR in the years to come. Moreover, it is not difficult to see that if the population momentum is to be sustained, fertility needs to be considerably higher since these women come from a comparatively small generation. This same intuition can be applied to the labour market where the generation now set to enter the labour market is comparatively small. Actually, another adverse effect of the fact that a relatively small generation is about to enter the labour market is that the housing market correction may be much longer since the first-time buyers who are coming out of school in these very years are quite simply not enough to support the glut of housing at the current high prices. Talk about bad timing!

Smooth Sailing or Dire Straits?

The immediate outlook for the Danish economy seems set to become steadily worse although there are some bright spots. The key to gauge whether the Danish slowdown will turn from bad to worse is the nexus formed by the housing/residential market and banking sector. An important indication to this potential vicious circle was given last Friday when Roskilde Bank had to throw in the towel. Real economic activity is definitely slowing but it is too early at this point to decisively call the extent of the slowdown. The bright spots, and thus what seperates Denmark from some of the other casualities of the credit crunch, is that she will be going into the slowdown with a surplus both on the public and external books. In my opinion, the housing market and the extent of the incoming correction is absolutely crucial in the context of assessing what comes next in the Danish economy. If the correction is very severe the slowdown could become disorderly. So far, I will hold off my call but the smooth sailing is definitely over and a firm grip is now needed on the helm if the upcoming skerries are to be navigatied without a capsize.

Apart from the immediate outlook in Denmark I have also fielded a demographic profile and explained how one might deduce some important information about the future path of the Danish economy from this. The key is the extent to which the current slowdown will coincide with more structural factors to make things rather more worse for the Danish economy than one might otherwise expect.

List of Main References

Danish Central Bank (2008) - Monetary Review 2nd Quarter

Bocian Steen (2008) - Danmark i teknisk recession… men påsken driller, Danske Bank Flash Comment

Bocian Steen, & Stramer Damgaard, Tore (2008) - Danmark: Ustadigt bygevejr, Danske Bank Investment Analysis

Erland, Esenspen, Lundsgaard, Jens and Huefner, Felix (2006) - The Danish Housing Market: Less Subsidy and More Flexibility, OECD Working Paper

Lunde, Jens 2005 - Fluctuations and Stability in the Danish Housing Market: Background, Causes and Policy

European Central Bank, The (2003) - Structural Factors in EU Housing Markets.

Slacalek, Jirka (2006) - What Drives Personal Consumption? The Role of Housing and Financial Wealth, German Institute for Economic Research, DIW Berlin

Setser, Brad (2006) - Is it Europe's Turn to Rise a Housing Bubble?, RGE Blog Entry

So many a long EUR/USD punter was handed a rather sharp thump in the lumber region today while their counterparts perched on the other side of the fence got some much awaited relief. At this point it is by no means a sure thing that 1.60 may not return to the table, but if the ECB lays down the whip for now I think such a move is unlikely (which, judging by my earlier attempts to call the EUR/USD this year, probably means that it is very likely).

Trichet in the Sweetspot?

Wait a minute then. Doesn't this mean that Trichet got exactly what he wanted this time around as the EUR/USD dipped alongside a rate hike? This may be the case and while I am a firm believer in not attaching excessive importance on the strength of correlations the chart below does quite neatly sum-up the ECB's present dilemma (as well as does the growing divergence between core and headline inflation as I explain here).

Perhaps I am being a little sloppy in chart construction here - since the dates don't match exactly - but then again, the point I am making is hardly rocket science. It is important to remember here that the increase in headline oil prices is absolute even if of course the appreciation of the Euro itself lowers the relative price. As Macro Man so succinctly pointed out at one point, it is exactly this issue (or the neglience thereof) which makes nominal inflation targeting such a dangerous business. Put another way, we could follow Barry Ritholtz's lead and dub the surge in crude oil prices the "Trichet Rally."

Readers could be perhaps rightly be accusing me of criticizing the ECB unjustly here. A flip side to this coin would then be to interpret the ECB's move solely in the light of anchoring inflation expectations. In such a minimalist framework - neatly skinned of such "flabby" concepts such as neutral interest rates, output gaps etc - the main thrust would seem to be that inflation is largely a reflection, not of movements in monetary aggregates, but of what people believe it is going to be in the future (but over which horizon?) and of their ability to enforce those expectations on their employers or customers.

Whatever the ultimate validity of this point of view, one thing is for sure, and that is that the recent surge in headline inflation has produced a sharp spike in inflation expectations even if investors seem, at the same time, willing to accept the credibility of the Fed's inflation fighting intentions, at least as judged by the yields they are willing to accept on US treasuries.* In this light the ECB is neatly fielding the ball across and into the court of BOE and the Fed by signalling the need for a collective response in providing a credible commitment to flush out global inflation. To add further to their shoulder padding, the ECB recently got some strong indirect support from the BIS's 77th annual report (see also Brad Setser), which elaborated in great detail on their view that it is excess liquidity that is the main source of the global economy's ills.

Of course, there can be little doubt that since a significant part of the current inflation spike is global in origin, then a credible response to inflation will entail some kind of global monetary policy response. The ECB cannot fight this one alone and as I have argued over and over again inflation targeting in a world where investors follow yield carries great risks of being counterproductive.

But how likely is it that we will see such a response, and assuming we do, what would it look like? If a significant part of the pressure on global energy and food supply-side resource constraints comes from pressures which ultimately originate in rapid growth in BRIC-like emerging economies how can monetary policy within the OECD help. Doesn't slowing growth further in the developed economies only run the risk of sending even more funds off to the emerging markets in search of yield? And, just how realistic (or fair) is it to ask citizens in what are, after all, largely poor countries, to use monetary policy to restrain their growth simply because our shoes are now starting to pinch.

Clearly, the BOE and the Fed seem, at the present time, to be pretty reluctant to follow the ECB's best foot forward, and while many emerging markets are beginning to tighten the reigns the USD pegs remain and so does Japan's near ZIRP interest rate policy. And of course even further monetary tightening in those emerging economies which are feeling the full force of the inflation pressure can have rather perverse effects, as, for example, in China, where reserves seem to have jumped by around $75bn in April and $40bn in May (to a total which is now reckoned to run at something over $1,800bn) on the back of expectations for further rate rises and currency appreciation.

Another point worth making here would be that, while I fundamentally agree with the BIS that something needs to be done to rein in global inflation, the risk of provoking outright deflation in some key low growth OECD economies is non-negligible should the slowdown be too sharp . The key here is the link between the idiosyncrasies of national demographics, internal consumer demand and thus the differential abilities to pull the local economy out of any trough it may fall into. We should remember that the world is ageing and in some corners with an unprecedented speed. In fact, my own and others' research suggests that the turn of the 20th century has seen the importance of persistent low fertility in OECD and key emerging countries spike dramatically. Quite simply, it increasingly seems to be the case that fertility does matter and especially, with a lag of 30+ years of below replacement fertility.

A detailed argument will have to wait for another day but what I am suggesting, is that if we are not all careful the world could end up with a number of "Japans" on its hands after all of this is over, and that would especially be the case if monetary policy makers became set on administering a strong dose of anti-inflammatory medicine. This is not an argument for not taking inflation seriously and acting upon such concerns, but it is one for thinking seriously about the possible consequences of your actions, since a bad outcome could mean, for example, confronting the Eurozone with an Italian economy which will never be able to repay its government debt. In a global context what we may well find is that a growing number of ageing economies emerge from the present downswing as being totalyy dependent on export growth to achieve headline GDP growth, and I am sure that it is not too difficult to see how