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« Summer Hike at the BOJ? | Main | Lost in Translation at the ECB? »
Tuesday
Jul102007

Running out of Capacity in Central and Eastern Europe

Well, it is pretty much official now I think that some countries in Eastern Europe might be heading for an economic crash. As such, both the FT and the Economist recently ran articles on this topic in which warnings were duly handed out. On the record, I am pretty convinced myself that some countries might crash very soon among those the most notable candidates being Latvia and Lithuania. Behind this doom and gloom call is a very simple hypothesis that demographics matter for economic growth and that this fact is now hitting home big time in the CEE countries proxied by dwindling capacity to match expectations of economic growth and prosperity. Of course I am sad to say, the mainstream coverage cited above did not have the faintest squeak about demographics and the unique population regime in which the CEE countries are situated. For that reason I recommend you to read Edward Hugh's recent post at AFOE in which he pins the Economist, his note on Latvia as well as my own analysis on Lithuania. In this entry I am looking at Poland in much the same way that I have been looking recently at Lithuania. Clearly, Poland are Lithuania are different not only because of the differences in size but also because Poland seems to be equipped with much more spare capacity than is presently the case in Lithuania and the other Baltic countries for that matter. I have marked 'seems' in italic since whereas Poland's unemployment rate is still in double digit territory accounts of substantial labour shortages are mounting which suggests that high growth regions in Poland are fast running out of qualified labour. In this way, the trend in the labour force is very similar to Lithuania but where Lithuania represents a small single deck frigate which is set to quickly succumb to any water intake Poland perhaps resembles more the Titanic. However, as I will demonstrate below, through graphs, the tendency is the same which only further substantiates the claim that when it comes to the CEE economies it is in fact, at this point, all about demographics and even though I realize that I am biased in my view here from the offset I just cannot see how any reasonable economist would be able to argue otherwise.

Let us look at the data then and more specifically the short term indicators on economic growth which show how growth and wage costs have been picking up the pace lately which also shows itself in a widening current account deficit. The first graph plots (in % y-o-y) growth in GDP, wage costs and industrial production, the second plots retail sales and the third plots the evolution of the current account deficit. Note that while the graphs for GDP(etc) and the current account share time perspective in the form of quarterly indicators the graph for retail sales plots monthly y-o-y % growth rates.  

Poland.GDP.etc.jpg 

Poland.retail.sales.jpg 

Poland.current.account.jpg 

As can readily be seen, growth in Poland had been indeed picking up the pace in the past year. This has naturally pushed up the demand for labour with an ensuing rather dramatic tightening of the labour market to follow. Also wage costs are beginning to rise rapidly and as the Economist Intelligence Unit reports (sorry, no link available) labour productivity is not able to follow the speeds of wage increases which of course questions the sustainability of this brisk growth spurt. This is accentuated in the following quote which cites the view of JPMorgan ... 

In Poland, JPMorgan expects the dataflow over the next two weeks to confirm that “the labour market continues to tighten fast and that the labor productivity-wage relationship is deteriorating."

Curiously, wage costs are yet to show up in core inflation and producer price inflation where growth is still very moderate relative to the overall economic growth rate. It serves to remember here that the Polish unemployment rate is still in double digit territory which indicates that capacity needs to be a bit more strained for pressures in CPI and PPI indices to take hold. 

Like I argued with Lithuania I believe it is important to take a long hard look at the Polish labour market and population dynamics in order to see what is really going on. Regarding the latter, Poland is inhabited by about 39 million people and as almost all other CEE countries Poland is set to age very rapid as a result of a severe stagnation in fertility from 1990 and onwards still lingering today. This is a very important point to remember as we move through the graphs below. Let us begin with a long term indicator of migration flows which demonstrate that Poland has suffered from a net-outflow since 2001. The numbers might seem puny in relation to the general population size but remember two things. Firstly, Poland's demographic profile is already damaged as a result of the fertility decline and secondly that all evidence suggests the skill component of the net outflow results in a loss of net value added from the point of view of the Polish economy. In short, even if the numbers are small Poland can hardly afford to lose these people if catch-up growth is to be sustained.
 

Poland.net.migration.jpg    

This brings us to the general labour market dynamics which are presented below in terms of short-term indicators which share the time perspective as the economic data above. Essentially, two identical time series for unemployment are presented with the first being in real numbers and the second in percentage of the workforce.

Poland.unemploy.thousands.jpg

Poland.unemploy.percent.jpg 

Clearly, the situation in Poland is very different from Lithuania and as such unemployment in Poland still linger in double digit territory. However, this will not go on for much longer if the current growth rates are sustained and this is where the problems begin to emerge. As such, you could choose to flag optimism in Poland on the basis of what is after all very impressive economic momentum which at this point is even welcomely deviating from nudging up core inflation rates. However, this is also at the core of the problem with almost all CEE countries in the midst of what is currently an unprecedented spurt of global growth. These economies are thus growing briskly, quite naturally, as emerging economies but with the important qualifier that they have extremely mature and essentially loop sided demographic profiles. This means that given the underlying capacity constraints these economies are faced with they are quite simply growing much faster than is sustainable in any meaningful sense of the word. This has then, at this point, obviously caught up with market participants and financial commentators but my guess is that it is moving way faster than many seem to think. Clearly, Poland is not Lithuania where the time span is already under one year but it still raises the question of just how much further this can go given the underlying structural capacity issues. Also remember here that while structural remedies such as raising labour force participation rates as well to address the skill mismatch on the domestic labour market should be strongly advised this is just moving so fast in some countries that this really does not seem to be a viable solution to address what is clearly becoming a short term issue with long term and structural drivers. In the end, what we have now regarding the CEE economies is evidence that a demographic profile wholly out of sync with the economic stage of development effectively can halt the process of catch-up growth. In order to ram this point home here at the end we need to look at productivity and how brisk productivity needs to grow in order follow suit. And this is just the point; catch-up growth and productivity increase as an economy moves up the value chain takes time and time is exactly what the CEE countries do not have at this point with the current growth rates.

Appendix 

This was really the end of this entry but if you want to catch a glimpse of how fast this might be moving I invite you to read on. However, beware ... dodgy empirical methods and math will follow! Let us try then to do a thought experiment and ask the question, how far will it take for the Polish economy to reach a 'critical' level of unemployment rate where 'critical' here is defined as either a 3% or 5% unemployment rate?

Well, before we move I need to attach some important qualifiers.

Firstly, the following thought experiment does very little to represent sound empirical economics but the general approach is still worth while I think. As such, we know that rapidly ageing societies, especially those growing rapidly as is the case here, will tend to face a structural decline in the unemployment rate and/or the labour force as more people leave the labour force compared to entrants. Add to this, in the Polish case, the trend of net outward migration as well as the high economic growth rates and suddenly an unemployment rate of 10% becomes a rather small buffer. Secondly, be aware since math will now follow. I rarely do this at Alpha.Sources and I promise you that it will not turn into a habit but I think that it is important in this case.

Regarding the method I have already hedged my bets above and please do note that the underlying assumption of trend perpetuity in the following experiment makes the predictive power virtually useless, at least at the time horizon we will be looking at. So, what are we in fact looking at?

Well, based on rough and ready calculations the average monthly decline in the unemployment rate in Poland between July-06 and May-07 stood at a monthly decline of 2.4% (i.e. in absolute terms). Based on an all things equal approach, assuming trend perpetuity, how far would it take for Poland to reach an unemployment rate of 3% and 5% respectively? To answer this we use the common expression for time value of money as an imperfect yet useful approximation:

FV = PV(1+r)n (in our case -n but that is of little matter)

where FV denotes future value at time n, PV the present value at time 0, r is the compound rate at each period, and finally n denotes the periods. In our little experiment we approximate the expression to our need by assigning the values as follows;

FV: 3% and 5%

PV 10,5% (unemployment in May 07)

r: 2.4% (average monthly decline)

n: ? (i.e. this is what we want to find out)

Calculating for 3% ...

3 = 10,5(1.024)n

solving for n ... (a bit complicated but Excel delivers in a heartbeat)

In(3/10,5)/In(1.024) = -52.8

Which translates into about 53 months to reach an unemployment rate of 3% or 53/12 = 4.4 years assuming trend perpetuity.

Calculating for 5% ...

5 = 10,5(1.024)n

solving for n ... 

In(5/10,5)/In(1.024) = -31.2

Which translates into about 31 months to reach an unemployment rate of 5% or 31/12 = 2.6 years assuming trend perpetuity.

So, was this useful at all? Well, perhaps not but do note that the assumption of 'perpetuity' as regards to a structural decline in the labour force/unemployment rate is not entirely voodoo magic when we think about the CEE societies. Clearly however, the process will be subject to notable nonlinearities as we approach ever lower levels and furthermore it is not certain that the current cyclical economic boost will continue. But the point is that, at the pace with which this is moving it is difficult to see how structural mechanisms such as improving labour market institutions, raising participation rates, and addressing the skill mismatch can keep up with the structural and cyclical run on the level of capacity if it continues much longer. Especially, the fact that these countries are now targets for a substantial part of new global credit suggests that the pressure is very high indeed. Note also that many central banks in the region would be effectively unable to act as a lot credit is denominated in foreign currency. As such, an aggressive turn of monetary policy to the loose side would entail severe balance sheet issues as the countries' domestic currencies most likely would plummet. Effectively this would mean strong appreciation of the liability side (denominated in e.g. Euro) relative to the asset side (denominated in the domestic currency). 

In the end, whatever rate of decline we assign in our little pet model here we are looking at a horizon in most CEE countries where labour markets are set to tighten significantly in the next 2 years and in some countries it will move much faster than this.

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Reader Comments (4)

I am working in Egypt developing marketing plans and capacity for the IPA responsible for attracting FDI to the industrial sector - at the moment we are focused on the automotive sector.
Your blog highlights the factors that are affecting rising labour costs in the CEE countries and the inability of productivity to keep pace.
Egypt by comparison has low labour rates; in the automotive sector these are currently calculated at less than euro 1.00/hour.
Furthermore the factors that are driving wage inflation in the CEE states are absent for the foreseeable future in Egypt. Thanks to high birth rates, Egypt has to create at least 600,000 jobs per annum just to keep unemployment lines in check; this is before a start is made on improving labour-participation rates and reducing under-employment.
Part of our argument to investors will be that if the manufacturing process is low to middle in the value chain then the investor should consider what is on offer in Egypt and its North African neighbours, all of whom share full market access to the EU and developing infrastructures that will be a positive surprise with improvements evident on a daily basis. In 2006 Egypt attracted over USD 10 billion of FDI, most in the non-oil/gas sector.
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