Wednesday, November 21, 2007

It's the Economy, St00pid

Our neighbours aside, the thing that is supposed to kill Estonia is an economic implosion. Ostensibly fueled by cheap lending from the Scandinavian-owned banks, it has resulted in very high inflation and a very high current-account deficit. The harbinger of doom, they say, is the crash of the real estate market.

Now, certainly things are not as rosy as they've been in the past. But is the sky really falling?

Inflation is the first boogeyman. A year ago we were desperately trying to stuff it that last bit under 3%, so we could join the Euro. Now it's around 8%, year-on-year. Horrible, isn't it? The EEK is losing value fast!

Except it's not, because it's pegged to the Euro. All sorts of analysts have been calling on the Bank of Estonia to float the currency, but they don't seem about to do it. Pegging to the Euro makes sense because most of the Estonian economy is tied into the Eurozone. People pay their mortgages in Euros, and they get paid by companies that sell their wares for Euros. So as long as the kroon stays pegged, and stays freely exchangeable, it's losing value at the same rate as the Euro - which isn't much at all. You can go to Paris today and buy as much stuff with the same amount of kroons as you could a year ago.

What's happening isn't that the currency is losing value, but that the cost of living is going up. Prices in Estonia are going up; in fact they're inching ever closer to the Central European ones. But the economy is growing much faster than the Eurozone's - and despite a noticeable slowdown, it's still growing faster than inflation! So we are still getting more wealthy, just at a slower rate than before. As long as this keeps up, it's not an economic crisis - it's just part of the process of catching up to the European living standard. Oh, did you think you'd end up getting European salaries without European prices? Silly rabbit.

The current account deficit is a nebulous economic term: to put it very simply, it's the difference between the worth of stuff that Estonians own abroad, and the worth of stuff that foreigners own in Estonia. So we owe them more than they owe us, which is why we have the deficit.

The problem with this number is that people tend to assume it means something different; they think it's the amount of money we owe to somebody. Which is not the case. The current account deficit is the result of the specifics of the Estonian economy, which has been successful by attracting lots of foreign investment. Our favourable tax code has resulted in lots of companies using local labour to produce goods or services, but not actually selling anything here. So the Estonian subsidiary, a locally registered company, sells its product to the mother company for exactly enough to cover costs - wages of the employees, office rent, equipment purchase, etc. This makes sense because the company has no profit left over at the end of the year - everything is being reinvested. So the company doesn't pay any tax on that profit. (The government gets income tax from the individual employees' salaries.)

But the subsidiary still has revenue, and capital assets, and those do keep growing. So the foreign company's worth of stuff they own in Estonia goes up. And the current account deficit increases. Mind you, there's still money coming into the pockets of both Estonian employees and the Estonian government. But because this money is on the books as cost, it doesn't get included in the current account calculations.

Now, the current account deficit is still a bad thing for the economy, because we'd rather own stuff than be salaried employees. There are a few big movers in the right direction, like Tallink, an Estonian company which is now the biggest ferry operator on the Baltic. But a current account deficit is by no means a sign of imminent economic crash. In fact, it means that our economy is secured by the stability of established European markets. Which is nice.

The third, final and most overhyped issue is the real estate crash. The banks have been giving out lots of loans in Euros, with low interest. People have been taking advantage of that to buy lots of apartments. Because the number of people with the money to buy a home is growing, and the supply of apartments is limited, their prices skyrocketed. Because old Soviet apartment blocks are rather unpleasant, people were willing to pay more for new apartments. Because the market prices for apartments were insanely above the costs, lots of companies scampered to start developing residential properties.

This cycle continued for a while, until the end of 2006 or so, and then it hit a wall. Prices got too high, the inflation rose, the economy started to slow down, people started losing faith. The first victims were the speculators, who were trying to buy up properties still in development and sell them for a profit when they were completed. Because the bank loan rules are fairly strict, they had to turn their money around quickly. When the demand dried up, they had to get out of their investments quick. But this had a relatively minor effect on the market. There weren't very many of these guys, and what they were doing was kind of assholey, so fuck 'em.

The market ground to a halt. The number of sales fell dramatically. Prices also fell, but curiously, not all that much. There are people like this guy, and Postimees staff writers, who keep bringing up massive discounts in apartment prices as proof of a meltdown in progress. But the important thing that a lot of folks don't notice is that all these grand discounts come not from owners - but from developers.

There's an important difference. An owner of an apartment is getting back the money he paid for the apartment when he got it. With any new building, the sell price is going to be only slightly higher than the price the owner paid for it. A wave of massive discounts on the secondary real estate market would mean that people are actually losing money. But interestingly enough, this is not happening.

The 200 million kroons of total discount on apartments that this dude talks about is money that never existed. Nobody ever paid those 200 million kroons and then couldn't get them back. All of that money is developers' discounts; profits that they hoped to get by putting new properties on the market for improbably high prices at the peak of the boom, when they actually had some chance in hell of getting that sort of money. Now the peak has passed, the market is not willing to pay improbably high prices, and they're having to lower them. But - they're not lowering them past the level of cost. With the exception of tiny, one-shot development ventures that ran out of cheap loans before they could finish their properties (probably due to the lack of construction labour - all the workers went abroad for better pay), everyone is still getting a profit. Just not as much of one as they'd hoped.

One point that has been brought up is the number of evictions. Year-on-year, it has increased tenfold. What the sensationalist articles are slow to point out is that the absolute numbers are still very low. And we don't know how many of those evictions were speculators, who only lost tiny down payments. There were some very dodgy deals available at the height of the lending spree, but most people who buy apartments to keep, have to adhere to the mortgage rules: down payments of 10-15% or more, and the monthly payment cannot exceed 30-40% of the household net income (and that percentage includes all repayments, including car loans and credit card debt). And you have to be able to afford the mortgage when you buy the apartment; any raise or additional income you get afterwards eases the pressure.

Even for the poor buggers who bought at the peak of the price rally, there are some good news. Most mortgages in Estonia are issued in Euros at EURIBOR + the bank's margin, and the margin is usually pretty low (less than 1%). EURIBOR has now stopped growing, and might even fall - the European Central Bank has to do this to keep the world financial markets running. And as long as the economy growth stays even a little ahead of inflation, salaries in absolute EEK numbers continue to grow, and the EEK stays pegged to the Euro, the effective repayment level will only shrink. Because everyone here will be getting more kroons, but while they won't be able to buy that much more milk with them, they will be able to buy more Euros.

To conclude: yes, the Estonian economy has problems. But they're not unsolvable, and they're not grave. So could the journalists and the lemmings please stop being apocalyptic about it?


AndresS said...

Good post, but I disagree a tiny with your analysis.

First off inflation has other effects on the economy, not simply stripping value from a currency. Inflation eats into business profits, it reduces investment returns (that 10% you made off stocks this year doesn't look so good when inflation is at 8%) and forces employees to get either get more out of their jobs to stay even or see their standard of living fall and people of fixed incomes (pensioners) feel a disproportionately large amount of pain when inflation is high. Finally, a lot of the Estonian economy has been built up to this point on cheap labour, now that costs are reaching central European levels that is no longer a valid business model but little if being done to reposition the economy to a more sustainable model.

Your pretty much dead about the current account deficit, because of the large amount of foreign investment in Eesti there's bound to be a deficit, let's just hope we don't end up like the US and in debt to the rest of the world forever. :)

The biggest problem with the economy imo is that no one (ie. the government) has shown any desire to address the problems. It's not apocalyptical at the moment but that's not to say that it can't become so fairly fast. Someone (ie the government) needs to step up and address these issues so that they don't get out of hand.

Jim Hass said...

I have to agree with Andres, there are some real problems in the economy of estonia, at the moment. That wonderful/painful period of transition, with its huge productivity gains and massive economic change is winding down. There are great strengths in the people, systems and institutions there, but normal life in a capitalist economy will settle in.

The price level will slow as it approaches the euro average, and the economy will mature. Competition will squeeze profit margins, as wages catch up to euro levels, and some more firms that relied on cheap labor and other resouces will leave or go bankrupt. The labor force is getting older, and fewer unemployed means some jobs will go unfilled.

All this is not the end of the world, since it means that Estiis are no longer largely poor and underemployed, but it means that growth will slow down, business, household and government budgets cannot grow as fast, and the margin for error and the sense of optimism will shrink somewhat.

Since growth started back in the early 90's, there has been one recession. Count your blessings. As yur labor is becoming less of a bargain, you will see more of them. If you look to the experience of Portugal, you can see a cautionary tale of convergence coming to an abrupt, painful halt.

Estonia's people and policies have been remarkably successful. This success should continue, since so much is so right about the set-up there. Simple, honest and open systems like the currency board, the tax code and the social solidarity that has made a lot of reform possible since '92 has made the economy a winner.

But new issues are emerging, like allways.

The current account deficit has changed character in the last few years. Before, FDI (foreign direct investment) covered most of the deficit. People were investing in businesses that made the country more productive. Lately, banks have been borrrowing from abroad to finance domestic lending-- more mortages and car loans. This is understandable after years of hardship, but they raise debt without raising the ability to pay. This inflow of money raises income to all the suppliers involved. It also creates a one time bonanza in tax revenue. An economist would say it diverts resources into the non-tradable sector while it continues, and causes distress when it stops.

A sound policy is to save big one time windfalls. That is why the government sould continue to run a surplus, despite the low national debt.

Good luck folks.

Anonymous said...

Great posting, followed by well-informed and thoughtful comments which contain practical caveats.

I've been following the doomsayers in some international financial journals as well, but much prefer Flasher's more robust approach, as he's shown himself to be a keen observer of events "on the ground."
As for the economists who bruit the bleakest views, I'd recall the words of another very eminent economist:

"Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past, the ocean is flat again." -John Maynard Keynes

Alex said...

"Because old Soviet apartment blocks are rather unpleasant.."

I wouldn't say that. My building (a 5 story block in downtown Tallinn) was built in the 1950's. One thing I like about it is how quiet it is in the apartments. I've heard horror stories about the paper thin walls with shoddy new construction.

Now an earthquake would knock my building down in an instant due to the drunken, communist, pride lacking brick work under the facade. But it is really quiet!

"There's an important difference. An owner of an apartment is getting back the money he paid for the apartment when he got it."

This seems to be accurate. I'm considered selling my place to buy a bigger apartment in Tallinn. I've done a big of research via the real estate websites and talking to a couple realtors and apartments in my neighborhood (albeit a great location) are still holding well above what I originally paid only a year ago. I realize this could change, but so far nothing catastrophic.

antyx said...

I've heard horror stories about the paper thin walls with shoddy new construction.

Everybody's heard horror stories, but curiously enough, not from the owners of new construction.

New apartments use gyproc/drywall for non-supporting walls inside the apartments. This is essentially the same construction as you see in those American TV shows where they rebuild a house from scratch in seven days. But the walls between the actual apartments, the supporting walls, are usually prefab ferrocrete. There are exceptions: the renovated dorms on Narva mnt in Tartu were completely stripped down to the skeleton and repartitioned with drywall into rooms of a different size, so the sound insulation there is abominable.

My own prefab wood-frame Lego building though was advertised as second only to medieval buildings in the Old Town, the ones with meter-thick masonry, in terms of sound insulation. Indeed there is more noise coming in through the double-glazed windows than through the walls.

Mind you, old five-storey Soviet buildings are often populated by older people, who don't make much noise to begin with.

Alex said...

"Everybody's heard horror stories, but curiously enough, not from the owners of new construction."

I will concede I haven't heard anything first hand, but during big building booms like Estonia has had, I'm sure you can find some low quality new construction.

"Mind you, old five-storey Soviet buildings are often populated by older people, who don't make much noise to begin with."

That's changing as the old babushkas and dadushkas die off. People above me are a middle aged couple with a little kid and below me are two 20 something hotties with active social lives and I can't hear the kid screaming above me or the chicks screwing below me. ;-)

Anonymous said...

That's changing as the old babushkas and dadushkas die off.

Today's hotties are tomorrow's babushkas.

I can't hear the kid screaming above me or the chicks screwing below me. ;-)

Buy a stethoscope! ;-)

Giustino said...

Real estate prices are currently ridiculous. We were going to buy an apartment in a house that hadn't been renovated since the 1930s and they were charging something like $200,000. They deserve not to sell things that are that overpriced.

space_maze said...

Looking forward to your interpretation of the currency scare - if you a) have one b) can be arsed ;-)

Kristopher said...

Great explanatory journalism (economy for dummies). I feel like I almost understand economics.

Even though cost of living is approaching EU, so many good local products that still cost half of what they are in the "old" West. Most of it things like beets and cabbage and pork, but not only... So you can have it both ways some of the time.

Anonymous said...

Flasher, do you think our education system is good enough to keep us competitive in the future, or are we running on old fat?

antyx said...

I think the education system is capable of producing highly qualified specialists, but it needs more support than it's getting. We need to expand state-sponsored higher education programs, make universities more accessible, without sacrificing quality. Education is definitely the basis of Estonia's prosperous future.

Anonymous said...

I hope Mr Lukas knows this.. but for now, he seems more concerned with finding the Most Beautiful Language on Earth. How absurd.


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