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Friday, October 12, 2007

The Implications Of Bulgaria's Inflation Surge

Bulgarian inflation, which is now rising faster than in any other country in the European Union, accelerated once more in September on the back of rising food, wages, utility and education costs. The Bulgarian "major groups" index rose to a nine-year high in registering an annual rate of 13.1 percent, a figure which was up from the 12 percent one registered in August. Consumer prices rose 1.3 percent on the month following a 3.1 percent increase in August.

At the same time Bulgaria's annual inflation rate, as measured by the EU- Harmonized Index of Consumer Prices, rose to 11 percent in September, from 9.3 percent in August. On this index monthly prices climbed 1.2 percent in September, after rising 2.2 percent in August.

Now one common explanation for this inflation acceleration phenomenon has been the impact that the hot and dry weather at the end of June and in July - which was then followed by floods which also destroyed crops - has had on food prices prices. But there is obviously more to this situation than food costs. In the chart above I have included both the Bulgarian "home grown" index and the EU designated harmonised one, and, if we look at the latter, we can observe the way the two lines diverge back in May just as the food price issue started to gain traction, so we can see the food effect there in the divergence. The EU harmonised index evidently gives a lower overall weighting to food.

Food prices in fact account for 35 percent of the Bulgarian consumer-price basket, and food rose 2.1 percent in September, following a 7.3 percent increase in August. This gives us a whopping 25.1% year on year food inflation rate in September. Other factors which played their part like restaurant prices, which went up 17% year on year.

But going back to the indexes, we can see that even on the harmonised basis, Bulgarian prices are "only" rising at an annual rate of 11%. But this precisely gives us a measure of the extent of the problem. It is clear that inflation has suddenly accelerated in Bulgaria, and given the way the Lev is pegged to the euro, it is hard to see what the central bank can do, since raising interest rates would, in the short term, only attract a greater inflow of funds, accelerate the overheating even further, and put strong upward pressure on the currency.

Whichever way you look at it all of this is far from over, and inflation looks set to continue at a high level, if indeed it doesn't continue to accelerate. The International Monetary Fund recently doubled its Bulgarian inflation forecast for this year to 8 percent. This now seems like it might be a conservative estimate.

Beside food one factor is certainly of growing importance: wages. And wages are, as we all know, one way or another associated with the supply of labour. And it is just in this department that countries like Bulgaria find themselves in difficulty, as the world bank recently highlighted in a report on the growing labour shortages the EU 10 countries now face. Getting a clear fix on the labour supply situation in Bulgaria is something of a headache, however, given the absence of dependable data from the Bulgarian government on Bulgarians working abroad.

This issue is an important one, since if the Bulgarians are not in Bulgaria then they are evidently not able and willing to work at the time and in the place that the employment market needs them. On the other hand if we look at the evolution of the official numbers of unemployed in Bulgaria, we will see that they have been reducing quite substantially over the last two or three years.

If we then look at the data for the number of people employed, we will see that this has been steadily rising:

Now obviously these two graphs simply don't match, since they are self evidently set on collision course, and especially in a society which has now been having very low fertility for nearly twenty years and which has a significant proportion of its working age population outside the country working elsewhere. So if we look at the next chart we can see the quarterly year on year increases in those employed. That is to say we can see how many extra people were employed in the previous year.

As we can see the "assimilation rate" of new workers into employment has been accelerating since the end of last year, and indeed in the second quarter there were 312,000 extra workers employed, a feat which would be quite impossible over the next year (if the same participation rates are maintained) since there are currently only 237,000 registered unemployed in Bulgaria, and of course the problem will not be resolved by younger labour market entrants joining the labour force, since from now on pregessively more people will be leaving than will be joining, so this factor only makes things worse.

Naturally with the labour supply being exhausted at this rate, a response from the wage rate was only to be expected, and we got it.

As we can see, wage rates have been increasing fast since the start of 2004 (and have risen by nearly 50% over that time) and have been accelerating rapidly as this year has progressed. So this story is no longer only about food. It is in large measure a labour supply capacity problem.

As such, the issue is not a "homeostatic" one, in the sense that a recession will not bring things back to where they were before, since all that will happen as the years pass is that even less people will be available for work, due to natural population drift, even assuming the best case that another wave of people do not leave during the recssion. That is a "correction" in this case will not do what it is supposed to do - namely correct - since the Bulgarian population structure is now so badly distorted, it is hard to see what can actually be done at this stage. And the situation has all the hallmarks of being about to turn critical at just this very moment in time.

Of course, the position is complicated even further by the presence of the euro peg, and the currency board, since this to all intent and purpose leaves the central bank standing on the touchline as a virtually helpless spectator.

Naturally, the press has been full of gentle comments in recent weeks about how it might be adviseable for the Baltics and Bulgaria to begin to consider whether it might not be in their interest to steadily abandon the pegs.

Only last week European Central Bank board member Lorenzo Bini Smaghi gave a speech where he blamed fixed exchange rates in Bulgaria and the three Baltic states for accelerating inflation and current-account deficits because the currency board system limits the central banks' ability to control surging price growth. According to Bini Smaghi:

Keeping nominal convergence on track is the main policy challenge in the region. The problem becomes particularly acute in countries which have given up monetary policy independence by choosing an exchange rate target or adopting a currency board arrangement.

The key question for these countries is: how is it possible to keep inflation under control by pegging the exchange rate, which means adopting de facto the monetary policy of the euro area, especially since the euro area economy is growing at a rate that is less than a third of what a catching-up economy should aim to achieve? In other words, how is it possible to keep inflation under control with very low or even at times negative real interest rates? What are the risks for financial stability of having persistently low real interest rates, much lower than the rate of growth of the economy?......

I guess the real question to ask is: how large should the budget surplus be to counteract the inflationary effects produced by a pro-cyclical monetary policy and would this be acceptable for a catching-up country? How far reaching, and acceptable to the population, should structural reforms be? All in all, the requirements for the budgetary and structural policies associated with an exchange rate linked to the euro might just be too demanding to counteract the procyclical effects of very low real interest rates. This might lead to boom and bust cycles, with potentially very severe adjustments costs that may delay real convergence.

Bini Smaghi has it right, the key question for the EU 10 countries is how to maintain the levels of "catch up" growth which would enable them to close the gap in living standards which exists between East and West, and how to do it, so to say, when they don't have the raw material (in terms of labour supply) to hand to aid them in this.

Thus in many ways the European Central Bank might be thought to be increasingly giving the impression they would not be displeased if the Baltic nations and Bulgaria drop their exchange-rate pegs because they contribute to increasing economic imbalances, according to a research note from Danske Bank:

``It seems that the ECB is suggesting what would have been unthinkable a year ago: that it is time to change the exchange- rate policies in the CEE countries with exchange-rate pegs,''

This, at any rate is the view of Lars Christensen, a senior analyst at Danske Bank. No smoke without fire is normally a good watchword in these matters.

But the problem is that these countries will find it very difficult, if not nigh impossible, to break the pegs, quite simply because of the balance sheet consequences of all the foreign currency denominated (largely euro denominated) debt the citizens of these countries have been busily acquiring in recent years, and with the reasuurance that with a peg in place, and euro membership nothing could possibly go wrong. Except it can.

I think I have said enough here for one post, so I will not go into this issue further now, other than to point out that Claus Vistesen has conveniently done a timely post on the theoretical literature on balance sheet effects so we can all to some extent prepare ourselves for what might well now be about to happen. Claus will also be covering in more depth the capital flows and foreign debt side of things. So that will have to be it for this note. I doubt however that you have now heard the last of all this, or that much time will now pass without fresh news on this whole front, especially after the recent World Bank EU10 labour shortages report and the latest issue of the IMF World Outlook which focuses on the CA and debt imbalances in Eastern Europe. Basically the acceleration we have seen in inflation across a number of the EU 10 economies will have set alarm bells off ringing all over the place. The fire may well not yet have started, but I doubt it will be long now in kindling itself.

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