Slovakia: Appreciating into the Euro
November 08, 2006
By Oliver Weeks | London
Despite recent political noise and cautious comments from Commissioner Almunia, we think progress towards euro qualification has recently picked up in much of central Europe for the first time in several years. Strong fiscal execution reflects a combination of cyclical post-election discipline (the Czech Republic, where new elections still loom, being a notable exception), strong output growth and, in Slovakia’s case in particular, a strong fiscal inheritance from the last government. While the Slovak fiscal and inflation outlook currently point to qualification for euro entry in January 2009, there is little room for complacency. Inflation has peaked but the National Bank has been fortunate in the decline in oil prices, and the case for monetary conditions to tighten further remains strong. The bank remains cautious in commenting on exchange rate levels during ERM 2, but we still expect the board to tolerate even further SKK strength in the medium term, despite the rapid pace of recent appreciation.
Reasons to err on the side of tighter monetary policy. The National Bank’s unanimous decision to leave interest rates unchanged at its last meeting was a surprise to us and most of the market, but the bank appears comfortable with further tightening of monetary conditions. The bank’s reduced end-2007 HICP forecast, 2.6%Y, is based on endogenous assumptions for interest and exchange rates that are not revealed. The bank’s real monetary conditions index was looser in 3Q than at any time in the past two years. The statement from last week’s meeting underlines that while external conditions have been highly favourable, domestic demand pressure remains strong. The bank’s real wage growth and employment forecasts have been revised upwards throughout the forecast horizon, suggesting that an already positive output gap will be sustained for longer than previously estimated. Although base effects are likely to bring headline inflation down sharply in October, and current trends in oil prices suggest that Slovakia can meet the Maastricht inflation criterion comfortably if sustained, the case for erring on the side of caution is strong for several reasons. First there is clearly a risk of an oil price rebound (see also Slovakia: Counting on Oil, September 27, 2006). Second, if Slovakia misses qualification in 2009, the approach of parliamentary elections in 2010 may make another attempt more difficult. Third, the EC is already disinclined to make allowances in interpreting the Maastricht criteria, but the presence of politically extreme parties in Slovakia’s government suggests that particularly strict treatment is likely. Fourth, the consistency of the government’s ongoing interference with energy price setting with the Maastricht requirement for ‘sustainable’ price stability remains questionable. PM Fico’s announcement that distributor SPP will cut household gas prices by 3.1% in 2007 underlines the weakened independence of utility price regulation. While the EC has yet to protest, we think that to be safe the National Bank should be aiming for headline HICP well below the Maastricht reference rate, currently at 2.8%Y. Fiscal tightening mainly by last government. Recent fiscal data tend to reinforce the case for tight monetary policy. Revisions to 2005 and 2006 data underline that the government has a strong chance of meeting the Maastricht fiscal criterion, but due more to a strong legacy from the last government than to convincing fiscal tightening plans from the current government. The 2005 ESA deficit has been revised down from 3.5% of GDP to 3.1%, including 0.6% of GDP in transfers to private pension funds. The 2006 deficit is now targeted at 3.8% of GDP, mainly due to a write off of a loan worth 0.3% of GDP previously booked as revenue. The latest cash flow data suggest that risks are still on the downside for 2006. Central government revenue growth averages 24%Y over the last three months, while expenditure growth has slowed to 1%. Clearly the change in administration may have delayed spending plans, and we would expect the government to bring spending forward into 2006 as much as possible. Nevertheless, the degree of effective tightening likely to be required in 2007 looks limited to us. The government’s aggressive macro assumptions for the 2007 budget (real GDP growth of 7.1% and inflation of 3.1%) and assumption of lower pension fund transfers (1.1% against 1.3% of GDP) underline that it is inclined to make as few cutbacks as possible in 2007. However given how close it is likely to be to the 3.0% fiscal target, we would expect last minute cuts to capital spending and seasonal bonuses if necessary — leaving the onus clearly on the NBS to meet the inflation criterion. Balance of risk points to tolerating appreciation. Clearly there has been significant monetary tightening in the past month already through SKK appreciation. The most recent current account data are actually not strong. The detailed July release shows a deficit of SKK 85.8 billion in January-July, well above the SKK 68.6 billion estimated by the NBS a month earlier. The 12-month current account deficit currently stands at 10.0% of GDP. Our own deficit forecast stands at 9.0% of GDP for 2006, well above the NBS’s 6.7%. However, we agree that the deficit is likely to have peaked. The surge in July mainly reflects a jump in investment income outflows, likely a large repatriated dividend. With July distorted by the confused aftermath of June’s election and speculative pressure on the exchange rate, such outflows are likely to have stabilised. Indeed, the National Bank’s preliminary August deficit estimate is a more modest SKK 3.9 billion. In coming months, falling energy costs and rising car export shipments from Peugeot and then Kia are likely to bring the deficit down sharply. We see a good chance of a trade surplus in September, the first for nearly three years, and are cutting our 2007 current account deficit forecast to 5.5% of GDP, albeit still above the NBS’s 4.3% estimate. The year to date deficit is still fully covered by net inward FDI. Given the case for tighter monetary conditions and the clear strength of the export outlook, we do not expect the National Bank to resist further appreciation any time soon. With the NBS core inflation measure currently at 2.6%Y, and assuming 15% pass-through from EURSKK to core inflation, a sustained 5% FX appreciation to 35.5 from the 37.5 average year to date in 2006 would point, all else equal, to a more comfortable core inflation rate of around 1.8%. This is also consistent with the bank’s official target of a 2.0% ceiling for end-2008 headline inflation. Given that the bank is likely to want to maintain a positive interest rate differential with Euroland in the run-up to qualification, a short-term overshoot to around 35.0 at the end of 2007, allowing for forwards to converge to an eventual conversion rate around 35.5, seems likely to be tolerated. Board Member Sevcovic’s comment that the bank is watching the exchange rate may be seen as a warning that the bank may be wary of a very fast appreciation, or of being pushed into an excessively strong conversion rate, particularly if oil prices stay low. However, the bank has no reason to build reserves, and intra-band intervention within ERM remains a grey area that is likely to be entered reluctantly. Give the current strength of the economy, the balance of risks seems to us to point to tolerating even more appreciation.
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Israel: Ruled by the Shekel
November 08, 2006
By Serhan Cevik | London
The shekel’s excessive influence on price indices may result in sub-optimal policies. During the painful period of hyperinflation in the 1980s, Israel had become a highly dollarised country, as residents struggled to protect their purchasing power and to find a point of reference for economic transactions. However, as stabilisation efforts started bearing fruit over the course of the subsequent decade and brought down inflation from the peak of 425% to single digits, Israel also enjoyed a sustained phase of financial de-dollarisation (see Akiva Offenbacher, “Dollarisation and Indexation in Israel’s Inflation and Disinflation”, Comparative Economic Studies, September 2003). Today, people talk about the ‘mountain of shekels’ instead of the challenges of a system distorted by currency substitution and backward-looking indexation. Unfortunately, although dollarisation may no longer be a concern for the Israeli economy, price indices are still influenced by its legacy. With the widespread use of dollar-denominated and indexed prices in sectors like housing, the pass-through from currency movements to inflation is almost instantaneous and consequently weakens the effectiveness of monetary policy. More than half of the pass-through effect is a result of currency indexation in the housing sector. Imported goods and services make up more or less 40% of the consumer price index, but the overwhelming determinant of the pass-through effect is the behaviour of housing and professional services that rely heavily on dollar-denominated and indexed prices in contracts and transactions. For example, almost 90% of rental agreements are indexed to the dollar, resulting in an immediate pass-through from currency fluctuations to headline inflation. As a result, albeit declining in recent years, the currency pass-through effect on domestic prices accounts for approximately 30% of the change in the consumer price index with a three-month lag (see Yoav Soffer, Exchange Rate Pass-Through to the Consumer Price Index: A Microeconomic Approach, Bank of Israel, October 2006). This is of course an unusually high coefficient for a low-inflation country and also increases inflation volatility beyond the comfort zone for an inflation-targeting regime. The sudden drop in inflation is mainly a consequence of the shekel’s appreciation. The CPI posted a month-on-month drop of 0.9% in September — the largest monthly decline in more than two decades — and a cumulative increase of just 0.8% in the first nine months of the year. As a result, the annual inflation rate suddenly eased to 1.3%, from 2.2% in August and the recent peak of 3.8% in April. The fall in energy quotes certainly contributed to lower consumer prices, but the ‘big’ drop in the CPI was mainly an outcome of the shekel’s appreciation that lowered dollar-denominated and indexed prices across the economy. For example, the housing component (which accounts for approximately 20% of the CPI basket) declined by 0.8% in September, pushing the headline inflation rate to a lower plateau. Given the shekel’s strength and the correction in oil prices, inflation is likely to remain subdued in the coming months and below the 1% mark by the end of the year. Nevertheless, the increase in the CPI excluding energy prices and exchange rate effects is still close to the upper bound of the central bank’s target range. Even after a marked tightening in bond yields, the shape of the yield curve is still very attractive. The sharp drop in inflation rates led the Bank of Israel to cut interest rates by 25bp to 5.25% at the end of last month. With a benign inflation outlook and reasonably supportive global financial conditions, the authorities even signalled the possibility of further monetary easing, to at least 5% by the end of the year. That may well be justified in light of the latest inflation data, but we think that an episode of disinflation via currency appreciation could easily veil underlying inflation pressures in the domestic economy and worsen volatility in the future. After all, the current monetary policy stance could hardly be classified as restrictive, and is not a burden on the real economy. That said, we see no reason to revise our bullish assessment for Israel’s fixed income market. If anything, even after a marked tightening in 10-year bond yields, the shape of the yield curve is still very attractive.
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