Ingredients for a rebound. There's no mistaking the ingredients for a sharp summer rebound, including a classic inventory snapback and modest improvements in some components of final demand. Aggressive vehicle production cuts (a 46%, seven-quarter plunge in motor vehicle output, with the first half down at a 36.3% annual rate) have brought motor vehicle inventories in line with sales. Indeed, the cuts in output overshot, pushing annualized US production 2-3 million units below the pace of domestic sales in the past three months. Just to catch up, vehicle production surged about 60% in July over June, and seems likely to rise further through the summer. As a result, motor vehicle output likely will add about 4 percentage points, or roughly double our estimate last month, to overall GDP.
A reduced pace of inventory liquidation elsewhere in the economy will probably also contribute to growth. Apart from motor vehicles, companies liquidated about US$100 billion in real inventories in 2Q, bringing the level of inventories in relation to sales down somewhat from its 4Q08 peak. And even if companies are still liquidating stocks, a slower pace of liquidation (which means that the change in the change in inventories is positive) will likely add more to growth in output than we expected last month. Indications of stronger orders and production in July's ISM report suggest that manufacturing outside of motor vehicles is beginning to bottom.
Better-than-expected gains in housing and construction will probably add another half point to 3Q output. Despite the obvious headwinds that still face housing, imbalances are smaller, and activity is starting to improve by more than we thought previously. The vacancy rate in one-family housing, now 2.5%, has fallen 40bp from its 4Q08 peak. And modest improvements in sales and continued declines in inventories have brought inventories of new, one-family homes down to 8.8 months' supply -from 12.4 months in January. The 2.4% June surge in one-family construction outlays signals that activity began to turn at the end of 2Q. With financial conditions gradually improving, despite lenders requiring higher downpayments, further gradual improvements in demand seem likely, and housing construction is also likely to improve further. Moreover, thanks to the funding from the American Recovery and Reinvestment Act (ARRA), it appears that state and local infrastructure outlays are starting to pick up a bit sooner than we expected a month ago.
Limited ‘payback'. This 3-4% 3Q surge in GDP growth is not sustainable, but neither a significant ‘payback' nor a double dip is likely. Vehicle sales illustrate the point. The blowout response to the ‘cash-for-clunkers' incentive program has been far stronger than we expected. With the initial US$1 billion in funding used up in a few days (even if some of the deals were booked at dealers in anticipation of the July 24 initiation date), this fiscal stimulus is getting a lot of bang for the buck. It is timely, targeted and temporary: The incentives have an immediate effect; combined with matching dealer incentives, consumers are getting a 30-40% discount off the sticker price, and consumers must use them or lose them. The deals will run out soon even if the Senate approves the US$2 billion in additional funding voted by the House before they recessed last week. If each billion in funding spurs an extra 250,000 vehicle sales, as seems possible, the annual selling rate in August may climb past the 12 million we expect for July. While the sales pace will slip back in the following months, manufacturers likely won't have to trim inventories at all in 4Q. Beyond the spillover from the vehicle rebound, improving global growth, the growing impact of fiscal stimulus and looser financial conditions may also limit the slippage in 4Q, by sustaining exports, factory output, infrastructure and housing.
Four headwinds still indicate a moderate recovery, in our view. First, financial conditions are still restrictive, reflecting the gradual improvement in bank balance sheets and securitization markets. The combination of reduced access to credit and falling home prices will keep consumers cautious and promote further deleveraging and increased saving out of current income. Second, absent a sustained pick-up in vehicle sales, the inventory-related production bounce in motor vehicles won't last. More broadly, inventories elsewhere in the economy aren't yet lean in relation to sales. Third, despite the infrastructure pick-up, stressed state and local governments are cutting current services and furloughing workers. Fourth, ‘core' consumer incomes (real, after-tax wages and salaries) are now falling again, following several one-time boosts to real after-tax income earlier this year (e.g., declines in energy prices, stepped-up tax refunds, a cut in withholding rates on April 1, and one-time checks to Social Security and SSI beneficiaries in May and June). Measured by the employment cost index, private industry wages and salaries rose just 1.5% in the year ended June, a record low. With continued pressure on wages and payrolls, and the bulk of the ARRA tax cuts likely to hit incomes only in spring 2010, real spendable income should be flat to down in 2H09.
Declining inflation keeps the Fed on hold. Many market participants believe that aggressive monetary stimulus and a sliding dollar hint that inflation may soon rise. Moreover, the sharp downward revisions to GDP over the past year imply that productivity growth decelerated from 2.8% at the start of the recession to only 1% over that period, rather than the nearly 2% implied by previous output estimates. Some may view this deceleration in productivity as the start of a sustained decline in trend, suggesting that stagflation is a risk.
Instead, we believe that the deep recession means that inflation, already declining significantly, will decline further in coming months. Updated estimates of ‘core' consumer prices show a deceleration to 1.6% (year over year) in 2Q, a full percentage point lower than a year ago. The deeper the recession, the more slack in the economy, even if measured imperfectly by the output gap - the difference between potential and actual GDP. Slipping pay gains suggest that labor cost pressures are weakening. And in our view, productivity is simply behaving in time-honored cyclical fashion, decelerating in this recession as it has in the past two. Companies have cut payrolls and hours aggressively in response to the deep recession, but by no more in relation to the economy than in the past, so the trend in productivity growth is still around 2%. Combined with a moderate recovery and significant slack in the economy, this trend implies that inflation will probably decline further in the next several months. The combination of moderate recovery and downside inflation risks should keep the Fed on hold through mid-2010.
The severity of the financial crisis has, with some exceptions, increased the attractiveness of the ‘EMU umbrella' for hopeful applicants. And while we have likely passed the moment of maximum financial stress almost everywhere in the region, it is still plausible that policymakers in CEE find euro adoption a more attractive prospect now than they did before the financial crisis erupted last summer. While their willingness to speed up the pace of euro adoption may be greater now, their ability to do so is severely constrained by the fact that budget deficits are spinning out of control and the reference inflation criterion is falling fast. In this note, we look at how, barring a more elastic application of the criteria, euro adoption is not a realistic prospect until the second half of this decade. The next EMU candidate could be Estonia, which we expect to avoid devaluation and adopt the euro in 2011-12 (see Baltic Economics: No Longer All For One? April 21, 2009). In Central Europe, Poland might be in a position to adopt the euro in 2014-15, whereas for Hungary, Bulgaria and Romania accession is a story for the second half of the next decade, we think. The new Czech government which will come out of the October elections may adopt a more ambitious agenda, but thus far the Czechs have remained on the whole proudly euroskeptic, valuing the flexibility granted by their own currency.
Inflation Criterion: Heading Lower
The inflation criterion says that the 12-month average HICP inflation rate of the candidate country will have to be below the three best-performing countries in the EU (not EMU) +1.5%. ‘Best performing' has come to be interpreted as ‘lowest', as long as the 12-month average inflation rate stays positive. This means that even if inflation goes below zero for a few months, a country could still figure as one of the three best performers as long as the 12-month running average stays above zero. Moreover, the best-performing countries do not even have to be current EMU members. Recall that when Lithuania was rejected in 2006 for narrowly failing to meet the criterion, the three best performers were Finland, Poland and Sweden (the latter two not in EMU. Lithuania would have met the criterion had it been restricted to EMU members).
The inclusion of more countries makes the inflation criterion harder to fulfil. Essentially this is because the probability of idiosyncratic shocks that push CPI lower (tax or regulated price cuts, say) increases with the higher number of countries. Therefore, even without getting into the issue of whether 1.5% is an adequate spread to capture ‘convergence inflation' for poorer countries (Balassa-Samuelson-type dynamics), the inflation target is harder to meet now than it was for the initial EMU members. In addition, we think that the accumulated slack in the whole of the EU may well cause a decline in inflation rates in several countries in the coming few years. We do not have medium-term forecasts for each and every EU member, but our guess is that the Maastricht inflation criterion, which since January 1999 has averaged 2.7%, will be closer to 2% (it is now 2.4% and falling). This implies that, to maximize chances of meeting the criterion, the applicant's central banks will have to target inflation of 1-1.5%. This is well below any CEE central bank's current inflation target and a very tall order indeed for a convergence economy. Note that even recent entrants complied with the inflation criterion only to breach it shortly after accession. Timing seems everything. The Slovak case, which we looked at in detail last year (see Slovakia: Knocking on EMU's Door, January 9, 2008; SKK: The End-Game? May 29, 2008), suggests that this compliance may actually have never happened had it not been for a spectacular SKK appreciation versus the euro in ERM II (22%).
Fiscal Criteria: 3% Looks Like a Distant Prospect; Debt Ratios Heading the Wrong Way
The fiscal criteria states that the ESA95 budget gap should not exceed 3% of GDP. Debt to GDP should not exceed 60%, or should converge to 60% from above at a satisfactory pace. The global recession has taken a heavy toll on government finances everywhere, including the EU. However, the 3% deficit criterion does not make any allowance for the economic cycle. True, the Commission does analyze fiscal adjustment on the basis of cyclically adjusted figures, but ultimately the applicant will have to show a budget deficit which is sustainably below 3% at the time of entry. The fact that (as it was with inflation) this was not the case for any of the recent EMU entrants, nor indeed with the original founding members, is irrelevant. Future members will not be cut any slack. Apart from Hungary, which tightened policy pro-cyclically in heroic fashion due to the constraints of the IMF package, every other country in Central Europe is seeing massive fiscal deterioration, with deficits heading to around 6% of GDP in the Czech Republic, Poland and Romania this year. Barring policy action, we believe that an even wider gap is likely in 2010, as growth remains well below trend. Even assuming a rather ambitious 1% of GDP adjustment per year, deficits are unlikely to be below 3% of GDP again until 2013-14. Of course, aggressive tightening and a more benign growth cycle could speed up the adjustment, but the days when the inflation criterion looked like the only serious stumbling block to accession for countries like the Czech Republic and Poland are long gone. Note also that, regardless of the merits of this approach, the EU has not indicated any intention to account for the costs related to the pension reform, which improves public finances in the medium term but increases the deficit in the short term. These costs in Poland exceed 2% of GDP.
The debt ratios look lower, but we note that even in Poland they are heading dangerously close to 60% of GDP. In Hungary, the country that at the end of 2009 will have by far the lowest budget deficit in Central Europe, the debt ratio is bound to exceed 80% of GDP. Bringing it towards 60% in the medium term will require a continuation of the current tight policy (a structural primary surplus) and a resumption of growth to 2.5-3.0%. Ambitious, though not impossible (see Hungary: The Virtues of Prudence, July 20, 2009).
Exchange Rate Criterion: de Jure versus de Facto Band
It is worth dwelling on the exchange rate criterion, though it seems relatively straight-forward. The criterion states that the candidate country should respect the normal fluctuation margins (+/- 15%) without severe tensions for at least two years. Revaluations of the central parity within ERM II are in theory allowed, devaluations are not. Slovakia's experience (two revaluations) provided an important precedent and stretched the concept of ‘stability' to its limits. In practice, the attitude to FX fluctuations within ERM II by the EU authorities is asymmetric. In case the national central bank or the ECB have to frequently support the currency to avoid it trading towards the weaker end of the band, the currency can be deemed to have failed the FX stability test. The opposite is not true on the strong side. Therefore, to guarantee fulfillment of the FX criterion, the candidate country would probably target an asymmetric band (+15% on the strong side, -2.25% on the weak side). The ERM II rulebook (unpublished and top secret) stipulates exactly when the local central bank has to intervene and when the ECB steps in. Were the ECB to step in, this may well imply that the FX stability test has been failed (there is a lot of discretion on the definition of ‘severe stress').
The recent crisis has made CE currencies highly volatile. If any of them had been in ERM II, the national central banks would have spent significant reserves trying to defend them (more than they did, anyway). A risk-loving world is essential in fulfilling the exchange rate criterion for floating currencies. We believe that the combination of the de facto asymmetric band and the need to be aggressive on inflation imply that any country that applies for ERM II membership in the near future with a view to adopting the euro three years from now would have to express a pretty explicit bias in favor of FX strength. This worked well for Slovakia, which was undergoing a phenomenal transformation in its balance of payments, courtesy of auto exports. However, as growth downshifts in CEE to a lower growth rate than in 2004-08, central banks will be more wary of accepting exchange rate gains as an implicit policy objective.
Poland: Facing Up to Reality; Czech Republic: Still No Rush; Hungary: Bold Steps, but Still Some Time Away
Late last year and early this year, Poland seemed to lead the pack of the new EMU hopefuls in CE, targeting ERM II entry already in 2009 and euro accession in 2012. A combination of weaker public finances, lack of internal political consensus and volatile exchange rates has persuaded the authorities to officially abandon the 2012 target (which did not come as a surprise to the market). The government has said that it will adopt a new euro roadmap in 3Q - we think the earliest feasible date would be 2014 (possibly later). In the rest of the region, the Czechs have historically been the closest to EMU in terms of the criteria, but also the ones with the least urgency to abandon their own currency. The Czech authorities seem to value the flexibility of maintaining their own currency, and the country has enjoyed low rates and stable inflation for some years already, without needing to import either from the euro area. Also, the absence of a stock of FX loans in the Czech Republic makes the issue of trying to avoid currency volatility much less pressing that elsewhere in the region. A new Social-Democrat government could try and speed up accession (elections are this autumn). However, the fiscal projections recently released by the Finance Ministry are so dire that they suggest 2015 is the earliest feasible date, barring more aggressive fiscal correction. While Hungary has implemented an impressive fiscal adjustment over the recent years, we think that it will still struggle to bring the deficit below 3%, not to mention take inflation stably below 2%. As with the rest of the region, it faces a ‘debt overhang' issue, with the stock of debt set to exceed 80% of GDP this year. The country will have no room for fiscal easing and will have to achieve growth again at a 2.5% pace if it wants to take that ratio down. Next year's elections will likely see a landslide victory for Fidesz, the current centre-right opposition party, which is currently leading by around 30 points in the opinion polls. From their recent comments, it seems unlikely that they will want to make fast EMU entry a pillar of their economic policy. Prior to the crisis, Fidesz had indicated that euro adoption would not be feasible before 2016.
In South-Eastern Europe, the recently appointed Bulgarian government has indicated that it plans to formally join ERM II later this year, presumably with a view to entering the euro area around 2013. Romania still maintains an official EMU entry target of 2014. Both schedules look highly ambitious to us, especially in light of the ongoing budget deficit deterioration in both countries (debt is much less of an issue), and the fact that Romania and Bulgaria are poorer countries, so convergence-type pressures on prices will make the inflation criterion very hard to meet. Here, too, the euro seems many years away.
EMU: How Exclusive a Club?
We have looked at euro adoption from the point of view of the applicants. What about the current members? The attitudes to euro area enlargement vary across existing EMU members and EU institutions. The European Commission is widely believed to be more pro-expansionary than the ECB. Ultimately, the decision rests with the heads of state of current EU members, and so the outcome is of a political nature, at least in part.
The euro area has a clear vested interest in what happens in Eastern Europe. Western European banks control about 80% of the CEE banking sector, trade links have deepened over the recent years and the region is now an important export market for euro area corporates. While opening the door to ERM II entry and easing conditions for euro accession would be a cheaper way to insulate the CEE region from financial shocks than continuing support under the existing EC balance of payments facility (Latvia, Hungary and Romania are already drawing from it. Others will likely follow), we believe that a big bang euro area enlargement is highly unlikely, as there is far too much resistance to any move that could jeopardize the credibility of the euro, especially at the ECB level. Therefore, the current selective approach is likely to continue. Also, a rethink of the current Maastricht criteria seems unlikely to us.
Even though the economic rationale behind them is dubious at best, sensible recommendations to amend the criteria in a more inclusive way (for example, by focusing on the average EMU deficit or better defining the reference inflation rates - see an interesting analysis by Zsolt Darvas, A Proposal for Rethinking the Euro Area Entry Criteria, www.voxeu.org) are likely to fall on deaf ears. The recent experience of Ireland, Spain or Greece - countries which benefited from negative real interest rates, ran huge current account deficits and experienced a boom-bust cycle - should if anything make the euro area authorities more aware of other, non-numerical criteria, such as income convergence. These ‘softer' considerations should not become part of the official EMU set of criteria, in the sense that the EU authorities will not insist that income levels converge to the euro area average before a country is being considered for EMU entry. However, we think that the EU authorities may start to place greater emphasis than in the past that domestic authorities do take efforts to keep wage growth and lending under control. In the extreme, they may even reject a country that temporarily fulfils all the Maastricht criteria but does not show sustainable convergence. Thus far, this had seemed to be just an empty threat.
Bottom Line
Within Central and Eastern Europe, Slovakia was the last country to exploit a window of favorable cyclical conditions to meet all the nominal convergence criteria. Estonia may be able to qualify for EMU in 2011-12, though keeping the budget in check will be a challenge there. For the rest of the region, significant delays are likely, in our view. Even for countries where the EMU debate is well underway, such as Poland, we see little chance of adoption in the next few years, and 2014-15 looks like the earliest realistic date for entry. For the rest of the region, euro area accession seems to be a story for the second half of the next decade.
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