May 2010

Summary

1. From a general point of view we should all be happy that another Nordic country wants to join the European Union, hopefully as an active and positive member. Whether Sweden always has been a strong EU supporter can be questioned. Recently, former Finnish prime minister Paavo Lipponen even accused Sweden of not always having taken its EU mandate seriously enough.

2.  There are different reasons for a country’s application for EU membership, including                         -  peace and sympathy for a co-operating Europe – also in order to tackle tough global competition                                                                                                                      -  the dominating role of the EU as a trading partner and the possibility of joining the euro later on                          -  a domestic economic emergency situation (like in Sweden in the early 1990s)                                         -  a combination of different motives.

3.  Former Polish president Aleksander Kwasniewski told me once that the first argument of peace between EU countries has been particularly important to him and most of his countrymen, since Poland in the past centuries has been a free country only for a few decades. The historical peace dimension has never been discussed very much in Sweden which is not quite justified – but understandable. In the case of distant Iceland, this possible neglect of European continental history certainly must be even more understandable.

4.  In the case of Iceland, the application for EU membership happened to a great extent due to economic crisis reasons. This is not a bad reason per se. In emergency situations, it is usually easier to secure relatively high political and public support for such a big step. But things may happen quite rapidly. This calls for good transparency and information to the voters – but also to the more domestically oriented politicians.

5.  Thus the issue of transparency should not be underestimated and should include information on the EU itself and both the advantages and the challenges for Iceland. There will be changes in legislation, institutions, the corporate sector, the banks, the labor markets, etc. Icelanders should be aware of these changes before joining the EU. However, Iceland’s previous EEA joining will make things easier in a number of areas.

 6. Another big issue will be the (probable) future Icelandic position with regards to the EMU. Current difficulties for the euro should not deter them. Currencies go up and down, particularly reserve currencies. Sure, the European Union has to work out some major structural problems in a number of member countries. But even the US and the UK – the main current speculation centers against the euro – have their homemade problems which at some point will send currencies in another direction again, this time favoring the euro.   

7.  However, the current euro crisis again stresses a fact that is sometimes neglected: Economic stability begins at home. As the examples from the Baltic countries and Greece show, strong links to the euro and EMU membership cannot serve as a rescue anchor if a country suffers from major domestic economic imbalances.

8.  In my opinion the analysis of the economic balance of a country applying for EU membership should not be limited to what is still called convergence criteria, i.e. total public debt, annual fiscal performance, inflation, the exchange rate before joining and long-term rates – but also the structural situation and the fundamental prospects of the current account. This is an issue that Iceland should think about in order to avoid joining the euro prematurely – even if many observers think that Iceland applied for EMU membership mainly with the objective to introduce the euro in the foreseeable future. Thus, preparing Iceland for the euro should include a long-term strategy for structurally improved exports and – if possible – also for some long-term reduction of imports.   

9.  This strategy has to include a number of important contributions from growth policy to the current account balance – or call it from the supply side if you want. Some of these factors that contribute to the creation of even more entrepreneurship and product development are a favorable general economic climate, improvements in education, innovation, well-functioning financial markets, good institutions, labor market immigration, etc. R&D as a share of GDP, for example, is just around 3 percent which certainly must be considered as moderate. And it should not be overlooked:  According to article 109 j 1 of the Maastricht treaty, the current account balance matters when a county wants to join the EMU. Unfortunately, nobody ever cared about this detail, probably because there are no numerical targets for an acceptable current account deficit. However, this – academically understandable – lack does not make the issue of a sustained acceptable deficit in the current account less important.  

 10.  Once Iceland has formally joined the E(M)U, North America has taken this big step as well (if we neglect the French Islands of St. Pierre and Miquelon off the coast of Canada which already have the euro). Surprised? Of course, this comment is related to Iceland, since the big island of Iceland geographically is located in both Europe and America.

On May 11, the Chinese administration published with well-known speed some very interesting statistical data for April which seem to confirm my previous concerns from February 10. In this outlook on China for 2010/11, I had some remarks that get more momentum when reading some of the latest statistics. (These remarks from February are still available by taking the following steps to get to my LNU blog:      In Swedish, LNU.se à Forskning , med hänvisning till min blogg längst ner till vänster, där man för övrigt också kan hitta min senaste blogg före denna med allehanda tvivel angående en snar EMU-anslutning av de baltiska länderna).

In February, some of my concerns were expressed the following way:

-About inflation:  “There is an obvious risk that Chinese inflation later this year can go through the unofficial comfort ceiling of 4 percent…”

-About monetary/credit policy and the bubble risk:  “The risk is obvious that the government’s far too loose monetary policy has contributed to the dumping of money in risky and unprofitable projects” and that “recent tightening still means expansionary money/credit policy…Assuming the continuation of an only slightly more restrictive policy by the central bank, there will be at least twice the amount of new loans as in the years before 2009…Some more efficient fight against credit exuberance and inflation should come in the forthcoming quarters…”

-About exchange rate policy:  “I expect a return to the previous cautious Chinese appreciation policy in the latter part of 2010 or the first half of 2011 – but not before a more stable and export performance has been visible for at least a couple of months…”

Recent statistics shows some real Chinese hard facts. First, inflation in April got back to the uncomfortable trend from the beginning of this year (CPI: 2.8 %). Second, new bank loans soared in April to 774 billion renminbi or roughly 113 billion USD – an increase that cannot be regarded as soft as the dampening officials would like to see. Consequently, gradually increasing cash requirements by the banks are not enough. China also needs higher interest rates. With new information about inflationary pressure and ongoing strongly increasing credit activities, there is no reason to revise my forecast from February: “The most likely scenario is therefore that China this year will go for at least two interest rate hikes with 0.27 percentage points each time (2+7=9=good number). Another one or two hikes within the forthcoming year (comment: until the end of February 2011) would certainly not be a surprise if GDP growth has been established on a relatively steady course…” This latter assumption seems to become verified in the forthcoming quarters.

It can be added that I now tend to revise my forecast on Chinese GDP growth in 2010 from 9-9 ½% to 10-10 ½%. In other words: In my eyes, Chinese interest hikes are on their way even more likely. So is probably the renewed switch of Chinese exchange rate policy later this year from strictly pegging the USD to a slight appreciation process vis-à-vis the USD. Strategic exchange rate decisions, however, are an issue for the highest Chinese leaders. For this reason, currency forecasts for the RMB should be handled with necessary cautiousness – despite the strictly border control of financial cross-border transactions.

Summary: Unfortunately, my recent warnings on the Chinese economy seem to be on track.

Sammanfattning

Vissa (relativt) nya EU-länder ser ånyo ett EMU-medlemskap inom några få år som en gångbar försäkring mot framtid finansiella spekulationer. Om vi emellertid har lärt oss något av Grekland-krisen, måste det rimligen vara ett en valutaunion inte kan skydda mot hemmagjorda strukturella obalanser – inte ens mindre, av finansmarknaderna vanligen försummade länder. Därför kan inte tillräckligt varnas för en alltför tidig EMU-anslutning av exempelvis de baltiska länderna, vilka alltjämt har en längre tid med tuffa strukturella anpassningar framför sig.

1. In recent months, some new EU-member states (NMS) against raise the issue of an early joining of the EMU/euro, like, for example, Estonia already next year and the two other Baltic countries only a few years later. I have been warning for a premature EMU joining by NMS since 2002 – and I still have the same concerns: Countries should only join the EMU when they are structurally well-trimmed. Greece was not, and that’s why they are in deep troubles now.

2.  It’s the wrong believe that EMU membership shelters against existing economic imbalances and speculations of financial markets. Stability begins at home. No artificial measure whatsoever can break this fundamental rule.

3.  Improving structural problems or maintaining existing good structures urge for continuous structural efforts by the government and the corporate sector. Hard structural work happens usually effectively in emergency situations like the Greek, Latvian or Icelandic – or the Swedish in the 1990s. The new market economies in Central and Eastern Europe had their big ambitions in the 1990s after the fall of the Berlin wall and the iron curtain. Most of them succeeded indeed very well – better than anyone could expect in 1989.

4.  However, since the early years of this century we also could recognize another phenomenon, i.e. that most NMS became reluctant in implementing further reforms. Reforms had become a word that many times was equalized with sacrifices by ordinary people. This declining willingness of more ambitious reform activities did not come unexpectedly because

-   the implementation of further reforms became politically tougher;
-   opponents to changes became better organized;
-   social challenges increased;
-   income distribution worsened, also regionally;
-   Buchanan’s public choice theory about re-election started to penetrate economic policy, leading to more tactical economic policy.

5.  There is an obvious risk that NMS countries with current tough fiscal restrictions and , for instance, the strongly hit Ukraine cannot quite consequently  stick to their needs austerity needs in the forthcoming years simply for social and political reasons. Structural reform policy may weaken again in line with the previously summarized explanations.

6.  But it is important to remind the readers of this blog that the former planned economies in Northern, Central and Eastern Europe are no homogeneous region anymore – but countries with quite different own conditions. Estonia, for example, will certainly achieve a faster and more sustained adaptation process than the Ukraine. The latter country, of course, is no EMU candidate – but a transition and reforming country that has been very negatively affected by the global crisis and that has been facing a lot of troubles because of domestic policy mistakes (such as the previous link of their currency, the hryvnia, to the US dollar and big amounts of foreign credits in USD for domestic Ukrainian purposes).

7.  One of the most demanding challenges for NMS will be to manage innovation, technological progress and the commercialization of new products ready for exports at a higher value-added level. Such a positive development is extremely necessary in order to avoid a renewed structural deterioration of the vulnerable current account balances in several NMS. But where should such progress come from, particularly when public spending is so restrained?

8.  This takes us to a main conclusion:  The current good shape of the current account balances in a number of NMS (Baltic states) will not go on once reasonable GDP growth has come back. Imports will grow again, that’s for sure. But will exports simultaneously grow enough to avoid a sizable, new weakening of the current account? Of course, we all hope so. Unfortunately, the contrary seems to be more probable in a number of NMS. And then (still) having a fixed currency – and  getting new pain?

9.  According to the Maastricht Treaty (article 109 j 1), the current account balance matters when entering EMU. But nobody within EU cared about this important stability indicator in the past decade. Politicians know about the risks of high inflation and budget deficits – but they usually do not understand the complexity of problems that are related to a structurally weak current account balance. This is a main reason why the advantage of a solid – not necessarily positive – balance of current account did not directly become part of the so-called convergence criteria. This should be the case in the forthcoming, reformed EU framework for macroeconomic supervision.

10. Nowadays, there are only four NMS with floating exchange rates: Poland, Hungary, Czech Republic and Romania. All the other NMS have a formal link to the euro or are – like Slovenia and Slovakia – already members of the EMU. Sure, countries with floating rates can sometimes come under appreciation pressure, like in the past quarters. Is that really bad?

11. There are also two advantages in healthy, appreciating countries. Inflation can be combated, and there is – ceteris paribus – some negative impact on competitiveness if the appreciation process is more sustained. However, hardening competition can exactly give the structural progress in products and production that is needed to perform better on exports markets in the longer run. Productivity has to be improved. New attractive and competitive products have to be developed. Germany benefited highly from this kind of exogenous pressure until the introduction of the euro.

12. It is understandable that the decision of staying outside the may give mixed feelings to many people in the new EU-member countries. But there is no doubt that joining EMU should happen from a position of structural strength – and not as a rescue anchor for future emergencies! And there will be more NMS that will join the euro. But this should not happen any time soon. Before joining the euro, a structurally healthier current account balance has to be achieved. Getting there, takes time.