The IMF is not amused, or at least better put, the IMF is not amused with Croatia. The reasons for their lack of amusement are many and various, but in particular they are displeased by the rising level of consumer and corporate indebtedness, and doubly so due to the fact that the debts are either contracted-in or indexed-to a foreign currency (mainly the euro, but the Swiss Franc is also used). They are also not unduly thrilled by the sustained and rising current account deficit, the existence of a fiscal deficit, the slow pace of structural reform and the relative lack of “greenfield site” FDI . According to the latest IMF staff report on Croatia:
Notwithstanding that the financial sector is healthy and much progress has been made in improving supervision, rapid credit growth and the possibly widespread exposure of households to currency risk remain vulnerabilities. Compounding these vulnerabilities, the current account deficit widened to about an estimated 8 percent of GDP in 2006, and the external debt ratio to 84 percent.
Sound familiar? It should do, at least to those of you with an interest in economics it should, since this profile is very typical of one we have seen extending itself right across Central and Eastern Europe in country after country in recent months. Claus Vistesen has already extensively covered (in this post) the issue of what is called “translation risk” (or what might get “lost in translation” if the effectively “euroised” currencies like the Croatian Kuna need at some point or other to come off their near-pegs with the euro – to tackle, for example, the problem of the lack of export competitiveness which results from the combination of the rapid rise in the value of the euro and the ongoing above-par inflation which is currently being sustained in many Eastern European countries).
However, despite a lot of talk about the dangers of a hard landing here, and overheating there, there is very little in the way of substantial analysis available at the moment which explains why this rapid growth/high inflation spiral should be taking place in Eastern Europe, and why it should be taking place precisely now. That is what I will attempt to do in this post now, and I will attempt to do it taking Croatia as an example, although we could be talking about Latvia, or Estonia, or Lithuania or Romania, or Bulgaria or poor old Hungary, at the end of the day the underlying issues are very, very similar.
What follows below the fold is a reduced version of a much longer posting (accompanied by data driven charts to back up the case) that I wrote for Global Economy Matters to accompany Manuel Alvarez’s detailed election coverage.
In what follows I will concentrate more on some of the more general macro economic issues that the structural problems identified above by the IMF pose for Croatia, and in doing so I will also attempt to situate them in the more general context of major macroeconomic problems which currently confront Eastern Europe.
Well, taking the points one by one, Croatia has indeed experienced steady growth and comparatively low inflation in recent years. GDP growth has been “solid” but not “exaggerated” (think the Baltics or Bulgaria), so even though the rate has at this point accelerated to an annual 6.8% in the first half of 2007 (with a high point of 7% being attained in the first quarter) the average of around 4.75% for the 2001â€“2006 period does not seem out of proportion, and is indeed very close to the IMF staff economists estimate of capacity growth for Croatia as being in the 4 – 4.5% region. Thus it is hard at this point to speak of “overheating” in the Croatian context, although the 2007 surge in both GDP growth and construction-driven consumer indebtedness does need watching carefully.
The contribution of net exports to growth has been substantially negative, with domestic demand pressures and higher international energy prices leading both the trade deficit and the current acount one to widen as the century has advanced. This sustained drop in export competitiveness should be sending out alarm signals all over the place for those with the eyes to see what is happening. Basically to understand what may happen to countries like Croatia it is important to bear in mind that we do not live in the timeless world of neo-classical growth theory, but in the world of real economies in real time where populations come and go, and, in particular, age. I will return to this point later in the post, but the big danger I see in Croatia is that as the demographics shift inexorably upwards to ever higher median ages, and as the share of fixed capital investment (which has been basically accelerated by large government funded civil engineering projects and domestic housebuilding) drops back (due to the fiscal constraints impost by a higher elderly dependent population on the one hand and the liquidity constraints on a steadily older population in terms of housebuilding activity on the other) then domestic demand will undoubtedly weaken as we have seen in other high median age societies, and Croatia will come to need to depend more and more on exports to eke out growth. This is the process we have seen in Germany since the end of the property boom in the mid 1990s, and while, as I explain in this post, Germany has been able to shift the weight of maintaining employment growth on to the export driven back foot, it is hard to see how Croatia is going to be able to do this given the relative price structures that are emerging. And time here, along with population, is becoming an increasingly scarce commodity.
Meanwhile, while headline inflation has been normally contained within the 2â€“4% range in recent years (see chart above) – and with core inflation even lower – in recent months the inflation rate has started to tick upwards following a pattern which has recently become all too familiar across Eastern Europe. Obviously it is too early at this point to say where this is leading, but the situation does need careful monitoring, and the Croatian central bank we should remember cannot use monetary policy here (see more on policy instruments below) due to euroisation, and is left depending on the national government implementing a strong fiscal surplus to drain excess demand from the system.
Wages and salaries have been rising significantly above the rate of productivity increase over the last 18 months, but while the trend is not unimportant we are still a far cry from the 20% plus rates being seen in Ukraine, the Baltics, Romania and Bulgaria. So everything now depends on what the real available labour supply in Croatia actually is (for which see below), since this will determine the ability of Croatia to keep growing and keep a lid on the inflation issue. Retail sales, which give us another indicator of domestic demand, have been growing at a nifty but not exaggerated pace, rising 7% year on year in the January to September 2007 period.
Now one of the problems which comes into operation in a situation like Croatia’s where there is an effective euro peg, is that exchange rate and monetary policy become either effectively non-existent (the exchange rate policy case) or impotent (the monetary policy one ) to correct any growing competitiveness problems – since given the euroisation it is not practical to adjust downwards the exchange rate (since the debts would become unbearable for many people) and increasing the interest rate only puts upward pressure on the currency and attracts additional funds in search of yield which only serve to make the excess demand problem even worse. Thus the only real arm left in the government policy arsenal is the fiscal policy one, whereby the government attempts, by running a fiscal surplus, to “drain domestic demand” from the system, and thus work to effect some form of price deflation (for a fuller discussion of this complex topic in the Latvian context see this post). And this, of course, is exactly the policy that the IMF economists tirelessly advocate that the Croatian government practices.
But it is exactly here that we hit a problem, since far from running a fiscal surplus as required, the Croatian government has been running fiscal deficits, even if, up to the election year of 2007, they had been reducing.
Obviously the fact that this has been an election year hasn’t exactly helped put politicians in the frame of mind to pay the necessary heed to the IMF recommendations and spending pressures have been steadily mounting. Government approved increases in child and maternity benefits and free school textbooks (all of which are in principle a good thing in a society which is short of children) were introduced at the end of last year, adding in the process 0.3% of GDP to expenditure, without compensatory reductions in spending elsewhere (unfortunately here there are no free lunches). Demands to boost wages in the state sector have been frequent in the run up to the election, as have those to increase the pensions of post-1999 retirees â€” whether this be through a reversal of the existing pension reform parameters, or through “off-budget” accounting schemes. Now evidently increased economic growth can bring in increased revenue which can help pay for extra spending, but if the economy is already running up against its capacity limits then that growth can only have one result, increased inflation, and given the effective euro-peg this inflation means only one thing, a loss of export competitiveness. What has been happening elsewhere in Eastern Europe should give clear indication that this is no joking matter.
On the surface it would appear that spare capacity does exist in Croatia, since the unemployment rate remains high, despite recent declines that reflect both some small employment growth and a declining rate of labor-market participation. But this nominally high unemployment level may be deceptive since we do not know the quality of much of this (often elderly) reserve labour army, and indeed we do not even know how many of the people involved are even in the country (see below).
If we look at construction activity, we can see that after taking off in early 2005, and remaining strong throughout 2006, the rate has remained more or less stable in 2007, and we have not seen further dramatic increases in activity. Thus while pressure on manpower and salaries in the construction sector remains, it does not seem to be accelerating dramatically at this point. However we should note that within a constant level of activity, the relative shares have changed, and domestic homebuilding – fuelled by comparatively cheap euro or swiss franc loans, and financed by streams of income from remittances – has now become a much bigger partner, while government financed large-scale civil engineering projects have become steadily less important.
One of the things we should now be learning from looking at what is happening across Eastern Europe is that in an environment where a number of underlying problems exist – ranging from a lingering and heavy state presence in the economy, a high public sector debt and deficit level, an absence of strong goods exports competitiveness, labour supply shortages due to migration and long term low fertility, and extensive euroization of the banking sector – heavy capital inflows can come to seriously strain the entire macroeconomic framework. This risk becomes even greater if measures are not taken to drain excess liquidity from the system (by running a fiscal surplus for example), to loosen labour supply constraints by facilitating inward migration of unskilled workers, and to accelerate the pace structural reforms – and particularly those which facilitate the development of “greenfield” investment sites which help channel capital flows towards productivity-enhancing uses and in so doing raise exports.
Of all the transition countries that have joined or are soon to join the EU, Croatia has the highest share of euroised bank deposits, with approximately three quarters of all deposits being in euros. Virtually all loans in Croatia are indexed, and all loans depend on the exchange rate and are thus exposed to exchange rate risk. One way to remove this exchange rate risk would, of course, be to introduce the euro, but when you come to look at the economic stress issues which are emerging in one Eastern European economy after another, then it would seem that this potential solution lies a long way out in the future, at the very earliest. Meantime Croatia has to survive, and to export to live. Prices and wages as expressed in kuna need to become more competitive, and this is begining to represent a major problem.
Total foreign direct investment (FDI) into Croatia is close to the regional averageâ€”but a high share of this is associated either with privatizations or with the financial sector, while â€œgreenfieldâ€ FDI remains well below what could be thought to be desirable. This is disturbing, since FDI which exclusively takes the form of privatisation participation is effectively a form of outsourcing state debt, and at some stage all of this has to be repaid in the form of income outflows and thus may well imply negative consequences for the current account, as Hungary is currently finding out to her cost.
Net FDI inflows averaged just below 5% of GDP annually during 2001â€“05, and 1.5% of GDP of this was accounted for by privatizations. The financial sector has received a very large share of FDI (both privatization and new capital), whether we are talking about the longer term (28 percent of total inflows over 1993â€“2005) or more recently (over 50 percent of FDI in 2005, partly reflecting capital injections to foreign-owned banks). Meanwhile non-privatization, non-financial sector related FDI inflows into Croatia have remained modest.
As the header to this post suggests, we are thinking here about Croatia’s economic situation in the context of general processes which we can observe in operation across the whole of central and Eastern Europe. The most important of Croatia’s problems is undoubtedly constituted by its deteriorating external competitiveness, as reflected both the goods and services trade deficit (see above) and, in particular, in the current account deficit.
Also it is worth noting that net transfers from abroad in the form of remittances have been a growing and fairly stable source of financing. Remittances were estimated by the World Bank to have been worth around 3% of GDP in 2006. Now one of the interesting things about this data on remittances is that it can help us take a first shot at solving another of Croatia’s enigmas, the “missing labour force” one, or if you prefer, why the employment participation rate of the Croatian population seems to be so incredibly low (only 42.8% of the over 15 population in the first quarter of 2007). Now one of the factors in play here must surely be the very low participation rates of males workers in the 50 to 64 age group (only 55.9% in Q1 2007) , but another feature of this apparently very low participation rate must surely be associated with the fact that significant numbers of Croatians are working abroad without recognition of this being reflected in the published figures. (This is quite a widespread problem with the East European data, as I explain in this post here). We can get some impression of the extent of the issue if we compare the 3% of GDP number for Croatian remittances with the 4.1% for Romania and the 1.3% for Poland (World Bank data) since in both cases substantial numbers of nationals are known to be working abroad. The size of the Croatian share makes it reasonable to assume that a reasonably large number of Croatians are economic migrants working abroad, but if we come to look at the statistics provide by the Croatian Statistics Office to Eurostat, you would never imagine this was the case, since you would get the impression that Croatia has been a small net receiver of migrants since the start of the century.
Now the very large movements of population which can be observed in the Croatian data for the 1990s are undoubtedly associated with the war and political convulsions of the time, but since the turn of the century virtually no movement is observed (apart from the flow of money), and how is this possible I ask myself? Undoubtedly one of the answers is likely to be found in the definition of ‘migrant’ which is used by the local authorities, who surely, as is standard practice across Eastern Europe, only classify as migrants those who emigrate permanently. The rest simply don’t show up in the data, and clearly many Croatian economic migrants currently working abroad still entertain the hope of returning home “one day”. But this is not the same thing as being “ready and available for work tomorrow”, and the labour market data we have to go on simply don’t reflect this underlying reality, and this is important, if Croatia doesn’t one day want to find itself with an inflation bonfire getting steadily out of hand such as the one which is currently to be found in the Baltics or Bulgaria.
So, and in conclusion, what we need to draw from all of this, is the idea that inflation in Eastern Europe is a complex issue, and that the sudden appearance of this phenomenon in one country after another should be sending us all warning signals. The combination of high catch up growth, constrained labour supply (associated with out migration and low fertility), strong capital inflows via the banking system and remittances, euro-pegging (or strong linking) and the absence of exchange rate and monetary policy as effective instruments all make for a potentially explosive mixture. When you add to this the steady ageing of the population, and a likely growing dependence on exports rather than domestic demand for growth, then you can begin to get a measure of the scale of the problem Croatia is facing, and it is no mean one.