Maybe to many readers of this blog Slovakia’s application for membership of the eurozone may well not appear to be the political and economic event of the year. That rapid judgement may well turn out to be wrong. What is at issue here is the future course of the collective applications for zone membership of all 9 remaining EU 10 community members (Slovenia is already in), so Slovakia’s application is being widely and actively followed, since while the consequences of a yes decision are unclear for Slovkia, the consequences of a no decision for the other 8 are even harder to foresee.
Only yesterday the IMF published a regional report on Europe’s economies which paid special attention to the complicated position of the Eastern European economies, and which warned quite specifically that Eastern European governments should make special efforts to slow domestic demand and reduce economic imbalances to counter the effect of food costs on inflation. Basically the situation varies from country to country (depending on whether they still have effective autonomous monetary policy or not) but by and large this means running fiscal surpluses.
“The impact of food price increases on headline inflation has been larger in Europe’s emerging economies than in the advanced economies,” the IMF said. “In terms of policy response, containing the second-round effects of the sharp increase in inflation will be essential.”
Essentially this is what the entire Slovak inflation “sustainability” debate is about – avoiding the impact of second round effects (see this very long, and perhaps for many overly detailed, post yesterday).
A drop in demand in western Europe for exports “is likely to be significant” because “countries in the region are highly open,” with foreign sales accounting for 30 percent to 80 percent of gross domestic product, the IMF said. “The economies’ greater openness to trade and financial flows leaves them vulnerable to spillovers from global developments,” the IMF said. “The heavy dependence on foreign capital leaves the region exposed to an abrupt retrenchment of capital inflows.”
That the pace of all of this is now hotting up was also attested to yesterday by the publication by credit rating agency Standard and Poor’s of the latest version of their sovereign debt liquidity vulnerability index. Unsurprisingly many East European economies now figure amongst those considered to be the most vulnerable.
â€œJust how vulnerable each individual sovereign could become relates directly to its degree of dependence on foreign capital inflows to finance external imbalances and avert balance-of-payments crises, said the report titled “Why The Global Credit Squeeze Could Hit European Emerging Market Sovereigns Harder Than Others”.
Hotting Up In Bratislava
In the mere 24 hours which have elapsed since I wrote my original post Bloomberg have come up with what effectively amounts to yet another “scoop”, since they have gotten their hands (I wonder how?) on a copy of a research paper prepared by the IMF for the Slovak government. The core of the paper – at least as the issue was presented to Bloomberg – is seen as turning on the rather complex topic of the so called pass-through coefficient (which basically means how much inflation is absorbed – or accelerated – by a rise in – or devaluation of – a country’s exchange rate. According to the report the IMF evaluate the exchange rate pass-through coefficient as lying in the 0.2 to 0.25 range (meaning that a 10% appreciation in the currency reduces inflation by 2 to 2.5 percentage points). Bloomberg interpret this as meaning that the IMF is siding with the Slovak government, but this is far too simplistic a way of looking at things. As I note in my full post, the Slovak government hold the pass-through coefficient to be somewhere in the region of 0.1 (meaning a 10% rise in the currency shaves only 1% off inflation), while the EU Commission and the National Bank of Slovakia hold this coefficient to be nearer to 0.2 (or at least in the 0.1 to 0.2 range). The IMF estimate – which may well be the most accurate one – seems to be even higher, but as such is nearer to the EC and NBS estimate than it is to the Slovak government one.
The point the IMF are probably making – but that the Bloomberg correspondent possibly doesn’t understand, and I myself cannot be sure without seeing the report – is that since the koruna has only risen slightly over the last 12 months (about 2.8%, although it did rise around 10% in the year to March 2007, at which time Slovakia was allowed by the EU to raise the central parity of the koruna by 8.5% from the rate which was first set when Slovakia entered ERM-II in November 2005), then this rise cannot possibly carry the burden of explanation as to the earlier reduction in Slovakia’s annual inflation – and in this sense the IMF seem to be saying that monetary policy and the reduction in the fiscal deficit must offer a much larger part of the explanation.
Slovakia’s inflation rate fell to an all-time low of 1.2 percent in August, according to EU methodology, before global increases in food and energy prices and surging domestic demand pushed it back to 3.6 percent this March, a 15-month high. The drop in inflation in the 12-month period ending in August corresponded to a 12 percent strengthening of the koruna against the euro over the same period.
The IMF did however state that they found no evidence that Slovak inflation had been artificially manipulated by the regulation of utility prices – although I’m not sure that anyone – at this point – has been actively suggesting that it was.
“Regulated prices do not appear to have been artificially suppressed when benchmarked against unregulated prices of similar goods and services, against price levels and developments in the EU, and against underlying price pressures from commodity prices,” the IMF said in the note
In another sign that the tempo is rising and that the final call may be very very close Slovak Prime Minister Robert Fico was out there and fighting yesterday:
Slovakia has met all the euro entry criteria and only a political decision by the European authorities could prevent it from joining the euro zone next year, Prime Minister Robert Fico said on Monday.
“In terms of the numbers Slovakia has met everything it was supposed to meet,” Fico told a news conference. He said debate was still going on about inflation sustainability, but added Slovakia should not be disqualified as inflation is rising in all of Europe. “If somebody is thinking that Slovakia should not have the euro, it would have to be political consideration not an economic one,” Fico also rejected arguments that inflation was kept artificially low by government pressure on energy prices.
Be all this as it may, the “revaluation” and “pass through” issue is – as I have been arguing – only a small part of the problem here, since in some senses this debate is now backward looking and what matters is the sustainability issue. The sustainability of Slovakia’s fiscal deficit position (with ageing population issues looming) and the sustainability of the inflation rate as the labour market tightens and wages march onwards and upwards. I notice that with all the research going backward and forwards virtually no one is commissioning any research to get a NAIRU (non-inflationary natural unemployment rate)type triangulation on any of these economies at this point. The silence on this front is getting to be absolutely deafening. The whole situation would be laughable if it weren’t so sad. I mean we are by and large talking about the wrong issues here (like currency revaluation) while in country after country (Ukraine (here) and Russia too (here) if you want to look) the inflation bonfire burns brighter and brighter on the back of structural problems on the labour supply side, problems which – to boot – have no simply and easy labour market reform “bandaid” fix.
And what will be the final outcome? Well we should get a first clear indication of what people are really thinking when the EU Commission publish their next country forecast on April 27, and on May 7 we should finally know for sure. Meantime, just keep biting your fingernails.