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.

“Just 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.

My co-blogger on Global Economy Matters Manuel Alvarez in his post on last weekend’s Spanish election called it “Zapatero’s election to lose”, meaning by this that the opposition scarcely seemed credibly poised to win, and their best chance of victory rested on the possibility that Spain’s Prime Minister Jose Luis Rodriguez Zapatero might somehow or other manage to clutch defeat straight out of the jaws of victory (aka throw the election away). In the event he didn’t, and the Partido Popular now face another 4 years sitting it out on the opposition benches.

But there is another sense in which one might think that this was Zapatero’s election to lose, and that is connected with the scale and importance of the economic problems which are steadily arriving on the Spanish centre stage, since given the scale of what now seems to be happening in Spain I find it hard to understand how anyone would actually be able to relish having won this one. There are, surely, occasions when discretion is most certainly the better part of valour. Wolfgang Munchau effectively made a similar point in a recent Financial Times Op-ed where he suggested the the winner, whoever he should be was destined to ” spend the next four years cleaning up an economic mess on a scale not witnessed in Spain in modern times”. Continue reading →

During the Autumn of 2006 we had quite an exchange of opinion on this blog about the future destiny of the Hungarian economy, largely between me and Doug Muir. At the time Doug was relatively optimistic, and I much less so. We nearly even had a bet about whether Hungary would enter recession during 2007, a bet which it turns out I would have lost had I taken Doug up on the challenge, since, although the jury is still out on what happens in the 4th quarter, Hungary may just manage to eke out positive growth right through to years end, but only by a very short nose, as a quick glance at the chart in this post here will reveal.

In truth, at the time I didn’t really know enough about the Hungarian economy to hold a strong opinion, but I was struck by the peculiar and combustible mixture of problems that the country seemed to be facing, with deficits everywhere (both fiscal and current account), private individuals who seemed to be addicted to the contraction of non-local currency debt (largely in Swiss Francs) at a rather alarming rate, a central bank which seemed to be condemned to try and drain the ocean with a teaspoon given the limitations and strong headwinds they faced when trying to implement standard monetary policy in the face of the new rules of financial globalisation, and a population which was falling due to both the low fertility level, and the comparatively low level of male life expectancy which existed (something which complicates enormously the normal policy remedy for ageing workforces of increasing the employment participation rates of the over 60 age group).

Twelve months later, and with a brief public scuffle with the Economist safely under my arm, I have no such doubts. Hungary is heading for recession, whether the dreaded R flag is actually raised in this quarter or the next one, and when it does come, unfortunately, it is unlikely to be a brief and easily brushed-off affair, since all the dials which now point to red indicate that unwinding this particular distortion is likely to be a very slow and painful process. One of the reasons I now feel so confident in making this statement is that some 12 months ago, and hot the heels of my debate with Doug, I founded the Hungary Economy Watch weblog, to study the problem, and while scratching and scratching my head, try to work out just why it is that Hungary is apparently so different from the rest of the EU10, and indeed whether the study of Hungary and its problems might not help us see what might eventually be in store for the rest of the group after the big overheating correction finally takes place. Continue reading →

Is Europe currently facing a widespread credit crunch, or are the problems currently being experienced in the banking sector (aka “the financial turmoil of last August”) only a US phenomenon? Reading many of the articles which have been appearing in the financial press recently you could be forgiven for thinking that the latter was the case, but in fact it isn’t, and the problems which are emerging in the European banking system are every bit as important as those which are to be found in the United States, a detail which was highlighted by Bank of England governor Mervyn King’s statement earlier this week that the Bank is now preparing to cut interest rates several times over the next year in an attempt to reduce the knock-on effects which the banking sector problems will almost certainly have on the real economy.

Or again we could take our lead from the statements which are to be found in the November Edition of the ECB Monthly Bulletin – released yesterday – to the effect that the central bank is in the process of monitoring “very closely” all current developments in the eurozone banking sector and is, in particular, ready to act on interest rates as and when necessary, drawing attention to the fact that “risks to the outlook for growth are judged to lie on the downside”. Or the rather ominous “as regards the financial markets, the governing council will continue to pay great attention to developments over the period to come.” Of course many observers when they read “ready to act on interest rates” naturally genuflect towards the evident current problems in short term inflation and thing about them being moved up, but cutting through the dense undergrowth of “central- bank-speak” what such phrases really are an attempt to communicate is the idea that they take everything that is happening very seriously indeed, with the mention of “downside risk” being a pointer intended to edge expectations along in the direction of accepting any eventual rate reductions which may prove necessary.

Thus it seems a little strange, to say the least, to have to note that at one and the same time as all this growing “vigilance” is being exercised, and in the precise moment when the dollar has been hard at it “slipping and a sliding” under the very weight of these selfsame problems, the euro, in contrast, has continued to rise and rise in almost vertiginous fashion, as if tomorrow would never come. And this has been taking place despite the recent warning from Jean Claude Trichet – who seems to have expressly emerged from virtual hiding for the occasion – that “brutal (foreign exchange) moves are never welcome.” So what exactly is going on? Continue reading →