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Saturday, November 24, 2007

A Credit Crunch in Europe?

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?

Croatia and Economic Sustainability in Eastern Europe

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:

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.

Here I will concentrate more on some of the more general macro economic issues that the structural problems identified by the IMF pose for Croatia, and in doing so I will also attempt to situate them - as is now our custom here at GEM - in the looming demographic issues which Croatia, along with the the rest of Central and Eastern Europe and the CIS, is now about to face.

Well, let's take the points one by one. In the first place 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 2001–2006 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.

Indeed contributions to growth from both private consumption and fixed capital formation have increased in the last few years, and both of these have been associated with rapidly expanding domestic credit and a continuing goods trade deficit which is the by-product of a growing dependence on imports.

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.

Now 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.

During 2007 the share of goods exports to imports (remember, due to the tourism element Croatia has a positive balance on services, but not sufficient to "sweat off" the goods trade deficit) has been hovering round the 45% to 50% mark.

Meanwhile, while headline inflation has been normally contained within the 2–4% 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 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 (in the former case) or impotent (in the latter) to correct any growing competitiveness problems - since given the euroisation it is not practical to adjust downwards the exchange rate 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 — 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.

The IMF estimate that if such spending pressures are acceded to by the incoming government then the consequent fiscal deficit could rise above 2.8 percent of GDP unless the envisaged increases are offset by cuts elsewhere. The Croatian authorities have, for example, already agreed with the public sector trade unions to a 6 percent wage increase (in place of the 5% increase initially assumed in the budget) and to paying bonuses to teachers in addition to the basic wage increase, again straining the budget wage bill. Moreover, it is anticipated that the national airline will receive additional unbudgeted subsidies.

On the surface it would appear that spare capacity does exist, 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).

It also would seem that fixed capital investment growth — after the rapid acceleration we have seen in recent years — is likely to moderate, though investment remains high as a share of GDP.

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 (see the charts on domestic mortgages below).

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.

And it is not just the IMF who has been raising the alarm signal, the Croatian National Bank has also repeatedly expressed its concern over the high rates of credit growth, and indeed has already responded with a series of prudential measures in the course of the last year. The measures include actions to raise private bank Minimum Reserve Requirements and to close loopholes in the system which allowed banks to borrow abroad via local nonbank intermediaries. The bank has also increased risk weights on unhedged foreign-currency denominated and indexed loans, introduced quarterly reporting requirements for such loans and issued new guidelines to banks on managing household and currency-induced credit risk, including a 75 percent loan-to-value ratio limit. Such measures mirror to a certain extent those which we have already seen put into effect by Central Banks in the Baltic countries. As can be seen in the chart the level of consumer indebtedness has risen sharply since the start of 2003.

and a large part of this rise in indebtedness has been mortgage-related:

Now the above chart shows the movement in credit for kuna denominated loans (and I present a chart below for loans which are explicitly denominated in foreign currency) but it is important to keep firmly in mind at this point that the Croatian economy is highly "euroised" and that 75 percent of long-term bank loans to households are index linked to foreign currencies in some way or another (mainly to the euro, though recently loans have been largely Swiss-franc, a feature which was explicitly noted by the Bank for International settlements in a recent study of the extent of Swiss Franc lending in Eastern Europe earlier this year, where Hungary and Croatia where singled out as having a significant penetration of such loans, due presumeably to the strong presence of Austrian banks in both countries).

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. So when you look at the next chart please bear in mind that this only gives an indication (and represents only a small fraction) of the true exposure which the Croatian economy has to any possible future exchange rate adjustment.

Total foreign direct investment (FDI) into Croatia is close to the regional average—but with a high share of this being associated either with privatizations or the financial sector, while “greenfield” FDI remains well below what could be thought to be desireable. 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 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 2001–05, 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 1993–2005) 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.

The rise in external debt has been accompanied by a major change in its distribution between domestic sectors. Prior to 2001 foreign borrowing was driven primarily by the public sector. Financing requirements were high due to massive reconstruction needs and infrastructure investment following the regional conflicts of the early 1990s. As a result, the public sector held the largest share of total external debt (44%), equivalent to around 27% of GDP in 2001. Since early 2002 the situation has changed dramatically. The public sector external debt-to-GDP ratio as well as its share in total debt has declined, partly as a result of a deliberate move towards tapping the domestic capital market. At the same time, the external debt of the private sector has started to grow strongly. This trend has been driven, in particular, by a strong increase in foreign borrowing by domestic banks, facilitated by foreign ownership and easy access to financing from parent banks in neighbouring EU countries. As a result, the gross external debt of the banking sector increased from 11% of GDP in 2001 to above 30% in 2006, and its share of total external debt almost doubled. Since 2003 direct external borrowing by firms has expanded rapidly, inter alia in response to administrative measures taken by the central bank to reduce the growth of domestic credit.


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.

One typical feature of Croatia's current account is - as I have said - the significant deficit in merchandise trade, which is offset to some considerable extent by a surplus in services, mainly resulting from tourism. However it is important to note that from 2001 to 2006 imports grew, on average, faster than exports and that the goods trade deficit rose from 20.7% to above 25% of GDP.

During the same period net income from services increased from 14.7% to around 17% of GDP and "financed" about two thirds of the trade gap. The income balance remained negative over this period, with an average deficit of 3% of GDP largely driven by net factor payments on the rising foreign debt and foreign direct investment. However, reinvested earnings recorded as offsetting FDI inflows on the financial account were equivalent to, on average, around half of the deficit of the income balance, thus reducing financing requirements considerably. 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 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 must be 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 was a small net receiver of migrants.

Now the very large movements of population in 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 surely the majority of Croatia's economic migrants who currently work abroad still entertain the hope of returning "one day". But this is not the same 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.

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.

Demographic Appendix

As a break from my previous practice I am including the demographic data on Croatia as an appendix, in a way which means that it "informs" the economic analysis (in the sense that it is ever present, and should be ever present in our minds) without occupying the centre stage. The demographic backdrop forms the context within which day-to-day policy needs to operate.

Here, then, is a collection of population data, which illustrate how the structure of the Croatian population is in the process of undergoing profound change in the years between 1990 and 2020, indeed, one could say that this is the critical socio-economic window in the history of this nation.

Firstly we have the median age. Claus and I tend to use median age data for a convenient proxy for a variety of economic phenomenon, such as saving and consumption patterns, construction activity, gross fixed capital formation, export dependence, productivity of the workforce as a collective etc. This is still all rather controversial, but one of the purposes of this blog is to test out these connections in real time as the global economy unfolds. As we can see the median age is steadily rising, and is currently in the process of crossing what Claus and I consider to be the critical 40 threshold. This means that, ceteris paribus, the structural characteristics of the Croatian economy will almost certainly change in the coming years, with a decline in construction and an ever more pronounced export dependence, something which is going to be difficult to realise given the relative currency and output prices.

There are basically three drivers of median age and population ageing - fertility, life expectancy and migration. Here we can see that Croatian fertility has been below replacement level since the late 1970s.

At the same time Croatian life expectancy has been increasing steadily.

The combined combination of these two processes is that after hoevering around the break even point in the early 1990s, the balance of Croatian births and deaths decisively turned negative around 1998.

The result of this is of course that the natural rate of growth of the Croatian population has dropped and dropped, and is now well into negative territory.

As far as migration goes, we have seen above that we have no clear data for this, although there is evidence from the remittances data that a significant number of Croatians now live and work abroad, which means that to the negative natural drift in the population we need to add an as yet unknown number of emigrants, as such the population and labour supply data that we are currently working with is almost certainly highly deficient.

All of this means that there have been deep and significant changes in the age structure of the Croatian population, and this does seem to have considerable ecnomic significance. As one example of this I will present the chart for the key 25 to 49 age group. Obviously we get some very strange readings for the years in the mid 1990s, but this is perhaps hardly surprising given what was going on, the interesting point is that this groupd definitively peaked as a population share around 2002, and has now entered decline. Among other things this will mean that obtaining collective productivity growth will now become more difficult year by year, as improvements due to sectoral shifts will be to some extent (and increasingly) offset by declining aggregate input quality in human capital terms. It is also interesting to note that this age group peaked at what is the comparatively low value of 35.9 back in 1982, which is incredibly early and as I say, very low (a phenomenon which we are seeing in one East European society after another due to their particularly unusual demographic history). I am not quite sure yet what significance to put on this feature, but surely it does have some. I guess we are now about to see what.

Finally, I present three population pyramids for Croatia, which give some quick impression of the evolving structural shifts in the age groups. The first pyramid, which comes from 1991, has a structure which is not at all unfavourable to rapid economic growth of the kind Croatia is now having. Croatia's misfortune is that it is trying to have this growth now, and not back then. The final pyramid which is an estimate based on the UN median estimate of population development gives some idea, possibly a rather optimistic one, of what Croatia's population will look like come 2020. Basically it is very hard to see how a population with such a structure is going to achieve economic growth at all.

Monday, November 5, 2007

Swiss Franc Loans and Ageing

by Edward Hugh: Barcelona

With all the fuss there has been in the popular press of late about the so-called Japanese carry trade and its impact on global liquidity (not forgetting, of course, all that attention which has been lavished on those canny Japanese housewifes who seem to have been playing the global markets so well) one important element in this fascinating global phenomenon seems to be in danger of escaping people's notice: the Swiss connection. This post, which accompanies Manuel's electoral posting, will focus on the Swiss carry phenomenon, and will attempt to situate it in the context of the battery of stylised facts which now characterise economic activity in the fastest ageing of our developed societies. Among these now reasonably well established "facts on the ground" are features like weak domestic consumption, growing export dependence, and a generally low internal interest rate environment. As we shall see, these features appear to be just as representative of what has been happening in Switzerland as they are of Japan.

An Ageing Society?

Like Japan, Switzerland is a country which has been aging fairly rapidly in recent years. Switzerlands median age, although not yet up to the heady levels of Germany, Italy and Japan (each around 43) has been climbing steadily, and is currently somewhere around 40.4.

This rising median age is the product of both 35+ years of sustained below-relacement fertiliy, and a steadily rising life expectancy.

Switzerland has also had a reasonable inward flow of migrants in relation to its total population over the last decade, with around 35,000 - 40,000 people settling in the country annually.

The end product of the inward migration and greater life expectancy is that, despite very low fertility rates over a long period of time, the Swiss population still continues to rise slowly, even while it ages.

The Economics Of An Ageing Population

Well, if we now come to examine the economic implications of this long term demographic transformation that is taking place in Switzerland, it should not surprise us at all to find that, as in the case of other elderly societies like Germany and Japan, domestic consumption is now no longer an especially strong driver of GDP growth, and exports have to take a growing share of the weight. Actually GDP growth has been neither exceptionally stellar nor exceptionally poor in Switzerland, and since the start of the century it has averaged in the region of a 1.9% annual rate.

The consumption share in Swiss GDP is way below the levels in the construction boom societies like Spain, Ireland, the United States or Australia, and has remained reasonably constant at around 58% share.

The actual annual rate of growth in private consumption has, since the early ninetees, been very weak, averaging only 0.9% per year since 1990.

At the same time Switzerland has maintained a healthy balance of payments surplus, with the surplus averaging around 6% of GDP since 2000:

Switzerland also runs a very large and substantial current account surplus too.

So Switzerland is, in a way, a very typical elderly and ageing society, following the pattern which we have been able to observe in the case of Germany and Japan with a strong balance of payments surplus, relatively flat internal demand, and a long lasting dependence on export growth for obtaining overall GDP growth. This comparative weakness in internal demand also has had the consequence of producing a fairly low inflation internal environment (Swiss inflation has averaged around 1% per annum since 2000), and Switzerland as a consequence has "enjoyed" comparatively high levels of internal liquidity and comparatively low central bank domestic interest rates (the rate which is currently at 2.79% is, incredible as this may seem to some quite high for Switzerland, due to the fact that interest rates have been under a fair amount of upward pressure recently). The Swiss central bank normally tries to "steer" its overnight rate value within a band which is set around the 3 month CHF libor rate:

Obviously, looking at the above chart it isn't hard to note the impact of the "financial turmoil" which set in in mid August, but which now, in the case of the Swiss banking sector, seems to have more or less calmed down again (something which may not be said of the eurozone banking sector at this point).

If we look at a longer-term time series, we will see that between 2002 and 2006 Swiss interest rates were incredibly low, in a way which is amazingly reminiscent of the recent path Japanese interest rates.

As I have attempted to argue above, this similarity between Switzerland and Japan may be rather more than incidental since the underlying demographic profile is not that disimmilar. If we look at a chart for the key 25 to 49 age group, we will see that in Switzerland this group "peaked out" at around 39% of the total population between 1992 and 1995, and has been declining steadily in relative importance since that time.

The macroeconomics of why this age group is important, and why its peaking-out is a significant moment in economic terms is in fact rather straightforward. The moment of maximum 25-to-49 age group share could be thought of as the moment of maximum capacity and growth potential for any given economy. This is basically the case for two reasons. In the first place the 24 to 49 age group includes the crucial 25 to 49 household-former, first-time-homebuyer group. In terms of credit expansion, it is this group which drives a significant part of internal demand, since this is the group with the greatest propensity to borrow forward, and this is vital.

One reflection of this which can quickly be noted in the Swiss case is the comparatively low share of construction activity in the Swiss economy. Construction has in fact been increasing ever so slightly in recent years, but still is down in the 4% of GDP range:

The 25 to 49 age group also includes another important group for economic analysis, the 35 to 50 one. It is this group which drives an economy in productive terms, since these are the prime age workers. If you think of a society as a 100 metres sprint athlete, then there is an age when this athlete is at the maximum of his or her running potential, an age after which, and with the passage of time, they can only run the 100 metres more and more slowly. Well a society is the same in terms of its collective economic potential, after the 25 to 49 age group peaks an economy can only move forward more slowly, and evidently, unless the situation is addressed via either increased fertility or greater immigration, the pace becomes progressively slower as the 25 to 49 age group declines inexorably as a % of the total population.

Swiss Roll-over in Eastern Europe

Well, going back to our central topic here, which is, let us not forget, the role of Switzerlands low interest rates in stimulating a carry trade, and the impact of this carry trade in the Emerging Economies in Eastern Europe, what we need to note is that there has been a growing tendency in some parts of Central and Eastern Europe - and especially since the turn of the century - to contract loans which are denominated in Swiss Francs.

What now follows is a brief account of what we know about the current extent of this phenomenon, and about the prominent role which the Austrian banking sector seems to play in it . At the end of the post I return to the issue of Switzerland as an elderly economy with specific structural problems, problems which lead Switzerland to play such a leading role - one is both distict from yet similar to that played by Japan - in the carry trade phenomenon.

The use of non-local-currency denominated loans has become a widespread phenomenon in Eastern Europe in recent years. In Hungary the most common currency for such purrposes is the Swiss Franc and around 80% of all new home loans and half of small business credits and personal loans taken out since early 2006 have been denominated in Swiss francs. A similar pattern of heavy dependence on foreign currency denominated loans is to be found in Croatia, Romania, Poland, Ukraine (US dollar) and the Baltic States, although the mix between francs, euros, the dollar and the yen varies from country to country.

So let's look at the extent of the issue in Hungary, and some of the likely implications. First off, here's a chart showing the evolution of outstanding mortagages with terms over 5 years since the start of 2003. As we can see the outsanding debt is now over 5 time as big as it was then.

Now if we look at the growth of forint denominated mortgages over the same period, we can see that while they initially expanded very rapidly, they peaked around the start of 2005, and since that time they have tended to drift slightly downwards.

Then if we come to look at the growth of non-forint mortgages, we will see that since early 2005 the rate of contraction of such mortgages has increased steadily.

Finally, if we look at the distribution of non-forint mortgages between those in euros, and those in "other" currencies (which may contain some yen, and some USD mortgages, but in the main will be Swiss Franc ones) we can see that those in euro form only a very small part of the total.

It is perhaps also worth pointing out that the fashion for non-forint loans is not restricted solely to mortgages, car loans and other longer duration personal loans also tend to be denominated in Swiss Francs or other currencies. The reason for this is obvious, the rate of interest is cheaper. But this non forint loan predominance has two important consequences.

In the first place the Hungarian central bank does not have sufficient control over monetary policy inside the country, being to some significant extent influenced by monetary policy in Switzerland, a country we may note which is not even inside the European Union. Secondly, the difficulties which would present themselves in the event of any substantial reduction in the value of the forint would be considerable - the is known as the translation problem, and is ably reviewed by Claus in this post here - and as a result the central bank is one more time a prisoner of others in terms of monetary policy, since it cannot take interest rate decisions which might influence excessively the swiss franc-forint crossover rate.

The fashion for borrowing in Swiss francs really took off in Eastern Europe after the Swiss National Bank dropped interest rates to 0.75% in 2003 in order to stave-off a perceived deflation threat, a move which at the same time converted Switzerland into the cheapest source of loan capital in Europe. External lending in Swiss francs reached $643 billion in 2006, according to data from the Bank for International Settlements . The huge scale of the borrowing in fact drove the Swiss franc to a nine-year low against the euro, and has lead to an accelerating slide in its value over the last two years - even though by this point the Swiss National Bank had been busy raising rates (Swiss interest rates have now been increased 7 times since the 2003 trough). The extreme weakness in the Swiss Franc is in fact rather perverse (shades of Japan, of course, here), since currently Switzerland enjoys the highest current account surplus in the developed world (some 17.7% of GDP in 2006). At the same time the Swiss hold more than $500 billion in net foreign assets, making them in these terms the wealthiest nation on earth.

A recent issue of the Bank for International Settlements publication Highlights of International Banking and Financial Market Activity has some revealing comments on the Swiss situation(the data used for the report came from 2006):

Total cross-border claims of BIS reporting banks expanded by $1 trillion in the last quarter of 2006. After more modest growth in mid-2006, a pickup in interbank claims accounted for 54% of this expansion. A surge in credit to nonbank entities contributed $473 billion, pushing the stock of cross-border claims to $26 trillion, 18% higher than in late 2005.

The flow of credit to emerging markets reached new heights through the year 2006. Claims on emerging markets grew by $96 billion in the final quarter of 2006, bringing the volume of new credit throughout the year to $341 billion. This amount exceeded previous peaks ($232 billion in 2005 and $134 billion in 1996), both in nominal value and in terms of growth. The current annual growth rate has risen to 24%, having surpassed for the sixth consecutive quarter the previous peak of 17% recorded in early 1997.

Emerging Europe overtook emerging Asia as the region to which BIS reporting banks extend the greatest share of credit. Since 2002, growth in claims on the region has consistently outpaced that vis-à-vis other regions. With a record quarterly inflow, emerging Europe received over 60% of new credit to emerging markets, bringing its share in the stock of emerging market claims to 34%. Less of the new credit went to the major borrowers (Russia, Turkey, Poland and Hungary) than to a number of smaller markets, notably Romania and Malta, as well as Ukraine, Cyprus, Bulgaria and the Baltic states.

The currency denomination of cross-border claims on emerging Europe tilted further towards the euro. In the stock of claims outstanding, the euro and dollar shares were 44% and 31%, respectively, but the gap in the latest flow data was more pronounced (61% and 5%). While the sterling share has remained close to 1%, the yen has lost ground to the Swiss franc, thus continuing a trend seen over the last six years. Yet there is little evidence in the cross-border data of unusual borrowing in Swiss francs that might correspond to Swiss franc-denominated retail lending in several countries. Borrowing in the Swiss currency remains on average below 4% of cross-border claims, and exceeds 10% only in Croatia and Hungary.

Nearly 20% of reporting banks’ foreign claims were in the form of funds channelled to emerging market borrowers. Claims on residents of emerging Europe continued to account for the largest share of these funds.
So, although the BIS find "little evidence in the cross-border data of unusual borrowing in Swiss francs that might correspond to Swiss franc-denominated retail lending", they do make an exception in the cases of Hungary and Croatia, where they note that lending in Swiss francs to retail clients reaches over 10% of the total retail loans in those countries, and indeed, as I indicate above, swiss franc loans now seem to account for over 80% of new housing related credit in Hungary.

This tendency to borrow in Swiss Francs is not, however, restricted to East Europeans, as Nils Bernstein notes in this report for the BIS on the Danish economy, the Danish farmers have also been at it:

As can be seen from the above chart, Swiss Franc denominated loans have been steadily rising in Denmark since 2001. Nils Bernstein makes the following observations:

In our case, the strategy is pursued by private borrowers, often farmers it is said, who raise loans in Swiss francs rather than in Danish kroner. A lower level of interest rates for Swiss than for Danish instruments makes this advantageous, at any rate for as long as the Swiss franc does not strengthen excessively against the krone.

The banks’ lending to households in Swiss francs has risen steadily since 2001 and today totals almost kr. 20 billion. During 2006 the increase in Swiss franc lending flattened out, however, and by the end of the year the net lending was negative. At the same time, the Swiss franc had weakened to its lowest level against the Danish krone for 8-9 years. The decline in net lending may be due to expectations that the Swiss franc would rally. This is confirmed by statistical analyses of data for a large number of years. The analyses find significant correlation between a weaker Swiss franc and diminishing net lending.

It is interesting that the Danish carry speculators show a different reaction pattern to the yen carry speculators. The yen carry speculators leave their positions when the yen strengthens, apparently fearing that the strengthening forewarns an imminent stronger adjustment of the exchange rate. Our domestic Swiss franc speculators increase their positions when the franc strengthens, apparently believing the strengthening to be temporary.

So what else has been going on in Europe involving the Swiss Franc? Well, from the outside this is very hard to determine, although in this connection the 2005 issue of the IMF publication Selected Issues Austria makes very interesting reading. Chapter two focuses on the growth of Swiss Franc denominated mortgages in Austria in the 1990s and is entitled - "What Explains the Surge of Foreign Currency Loans to Austrian Households?". The chapter was prepared by Dimitri Tzanninis, and in it you can read:

Following years of relative stability, foreign currency loans to Austrian households entered a phase of explosive growth around 1995. Even though their growth has moderated since 2001, foreign currency loans still account for about half the growth of total credit to households. By end-March 2005, 30 percent of outstanding loans to households were in foreign currency, compared with about 5 percent for the euro zone. Nearly all these loans are in Swiss francs and, to a lesser extent, Japanese yen. The vast majority of these loans finance domestic transactions. The popularity of foreign currency loans among households is a uniquely Austrian phenomenon in the euro zone.

Now the following charts make all of this even clearer. Firstly loans to Austrian households in foreign currency have risen sharply, and the process really took off in the mid 1990s:

In the second place, annual growth rates for these loans spiked sharply at the turn of the century and since that time the rate of arrival of new demand has declined significantly (this turning point coincides, of course, with the introduction of the euro, and interestingly enough Denmark is not part of the eurosystem).

In the third place we should note the way in which outstanding loans to Austrian citizens in non-domestic currency have increased (and continue to increase) as a percentage of Austrian GDP, and of total household debt:

Finally, Swiss Franc loans massively predominate in the Austrian foreign currency loan market:

As the IMF notes this was essentially a refinancing - rather than a construction - boom:

The boom in these loans appears to be reflecting currency substitution rather than a lending boom. Growth of credit to households (in all currencies) has been relatively subdued (second panel of Figure 1), suggesting that a considerable part of the growth of foreign currency loans has been the result of refinancing. Indeed, because of refinancing of previous schilling or euro loans, the contribution of foreign currency loans to the annual growth of total loans to households approached or exceeded 100 percent in six consecutive quarters beginning in late 1998.

Another interesting question to ask is just how did all of this got started, since evidently there may be lessons here for the spread of such practices in the East of Europe, and, of course, the fact that chart for the growth of foreign currency denominated loans is surprisingly reminiscent of the sort of S shaped curves which were so evident in the spread of the use of mobile phones is very revealing.

Well, apparently:

The practice of borrowing in foreign currency (mainly Swiss francs) began in the western part of the country, where tens of thousands of Austrians commute to work in Switzerland and Liechtenstein. This partly explains why the share of these loans was higher in Austria, even during the 1980s. Word of mouth and aggressive promotion by financial advisors helped spread the popularity of these loans to the rest of the country. By the mid-1990s, newspaper ads placed by banks began to appear, fueling public interest (text figure). Another factor facilitating the spread of these loans could be the belief in the stability of the exchange rate deriving from Austria’s hard currency policy (a peg of the schilling to the deutsche mark) since 1980.6 The success of this policy may have created a psychology of an exchange rate immune from risks, notwithstanding the appreciation of the Japanese yen and, to a lesser extent, the Swiss franc since the mid-1980s.

Now this taste for Swiss Franc denominated loans in Austria is interesting, since as Chapter 3 of the 2007 issue of the IMF Selected Issues Austria (which is devoted to Cross-border Banking Issues for the Austrian Banks and their Supervisors) tells us:

Austrian banks play a major role in many countries in Central, Eastern, and Southeastern Europe (CESE). Almost all of the large Austrian banking groups have subsidiaries in several countries in CESE. In quite a few cases, these subsidiaries are large compared with the host country’s financial systems. Moreover, some of these subsidiaries would probably be judged to be of systemic importance to the financial systems in the host countries. At the same time, the holdings in the CESE are important for the Austrian banks, as they represent a significant part of total assets and provide a major contribution to overall profitability.

In other words the Austrian banks have leveraged expertise they developed for external currency loans based on an initial wave of domestic demand to gain a comparative advantage in a much larger market.

The Austrian financial system is dominated by the banking sector. At roughly 300 percent of GDP, total banking sector assets are far larger than those of insurance companies and pension funds. Mutual fund assets and stock market valuation have increased considerably over the last five years, but also remain small compared with the banking sector. Domestic credit provided by Austrian banks is in line with levels elsewhere in Europe.

In the early 1990s, Austrian banks were among the first to enter the Central and Eastern European (CEE) market. During that period, driven by geographical proximity, historical ties, and a saturated domestic market, most of the larger Austrian banks moved into the region. Generally, expansion started in Hungary and (then) Czechoslovakia. From there on, expansion continued, and currently comprises virtually all CEE markets. More recently, Austrian banks have entered Southeastern Europe and the CIS. Between 2003 and 2005, their expansion led to increases in domestic market shares in almost all of CESE, with the increases in Romania and Bosnia and Herzegovina especially large. Some Austrian banks have expanded further east by entering the market in some of the CIS countries, most notably in Russia and Ukraine.

As a consequence, Austrian banks now own subsidiaries that are of key importance in several of the host countries in CESE. Even though Austrian banks are not large by international standards, their CESE subsidiaries are of considerable size. As the host countries are emerging markets, their financial systems are generally small by international comparison, and their financial markets are still deepening. As a consequence, some of the Austrian-owned subsidiaries are large in relation to the size of the financial systems of the host countries and could be considered of systemic importance.

As the IMF author also goes on to note, the exposure of the Austrian banking system to any carry-trade "unwind" type development is thus proportionately much higher than that of virtually anyone else, a situation which becomes very clear when you look at the following chart:

To conclude, and returning now briefly to Switzerland, the IMF had a 2005 issue of Selected Issues Switzerland which examined a lot of the longer term demographic issues which Switzerland faces. According to this document:

"The full force of aging is projected to be felt from 2015 onward."

In relative terms this isn't a very long time horizon. The following is also worthy of note:

The rapid increase in the number of pensioners in relation to the working-age population has been remarkable. This is related to the increasing generosity of the social security system, not aging itself, and the tendency to contain long-term unemployment during the protracted stagnation of the 1990s. Since 1990, the number of pensioners increased by 35 percent while persons over 65 by only 17 percent. Still, early retirement has been less prevalent in Switzerland than in other industrial countries.

In fact GDP growth rates in Switzerland appear to have peaked in the 1980's at an average rate of 2.1%. In the 1990s Switzerland's GDP grew at an average rate of 1.1%, and between 2000 and 2004 GDP growth averaged 1.3% annually. A similar pattern can be seen in the total number of hours worked, which rose at an annual average rate of 1.1% in the 1980s, falling to a 0.1% annual rate of increase in the 1990s and FELL by an annual rate of 0.1% in the 2000 to 2004 period.

The Swiss also tend to save significantly. As the IMF notes:

"the thrifty Swiss households save about 10 percent of their disposable income and also have accumulated significant private assets."

At this stage of my analysis quite what element in this saving is population age-related, and quite what is cultural-behavioural is far from clear. This is a theme I will try to follow up on as and when time permits.

In the meantime what I have tried to draw attention to in this post is the situation vis-a-vis the Swiss Franc carry trade in Eastern and Central Europe, the role and exposure of Austrian banks in this trade, and the striking feature that Switzerland is a fairly "elderly" society. In this context the comparison with Japan simply jumps out at you. Now, as I have said above, these two economies are at one and the same time similar and different (in terms of the structural features they present). All that can be prudently said here is that what has actually been going on in Switzerland in recent years bears closer examination to try to discover what may be learnt.