Slovenia and EMU: Lucky 13?

When champagne bottles are opened to welcome the new year next Sunday night, the euro area will welcome member number 13: Slovenia. Unnoticed by most citizens of the currency area, the small country in southeast Europe has spent the past months for the currency changeover and is now ready to forego its national currency, the tolar.

While the discussion about the euro introduction in Lithuania, Estonia and Latvia has been rather noisy (the Lithuanians did not want to take the EU commission’s ‘No’ for a ‘No’, sending shock waves into the old member states), there was very little reporting about the actual steps taken in Slovenia to prepare for the euro introduction.

This is no mere coincidence, nor is it solely a result of Slovenia’s small size (its population is only 2 million, 0.6 percent of the euro area). In fact, Slovenia seems to be well prepared to become member of the currency union – probably better than any of the other former communist economies in central and eastern Europe.

Slovenia fulfills all of the traditional OCA criteria: Factors between Slovenia and the rest of EMU can move almost unhindered. Capital can already move freely. Slovenia’s geographical proximity to Italy and Austria and its small size make migration easy. Slovenia’s workers will soon be allowed to work everywhere in the EU, with the existing restrictions being slowly faced out in some EMU countries and set to disappear completely at the end of the decade. Moreover, Slovenia is by now closely integrated into the rest of EMU with a high share of exports and imports in GDP: A country-specific shock is not more likely than – just to pick two examples – for Belgium or Luxembourg.

Needless to say that Slovenia does not have any trouble meeting the Maastricht convergence criteria: Government debt is below 30 percent of GDP, the budget deficit at roughly 1.5 percent and inflation slightly above 2 percent.

However, it is not quite clear whether the traditional OCA criteria or the Maastricht criteria are really enough in order to judge whether joining EMU is sensible or not. When Eastern Germany introduced the Deutsche Mark in 1990 and later joined the Federal Republic of Germany, one could have argued that the simple OCA criteria where also met: Labour mobility between the East and the West was high, the on-paper-difference between the East and the West in the share of manufacturing or agriculture was rather small. Moreover, there was an inter-regional transfer system with provides poor German states with money from the rest of the country which in principle should make adjustment to asymmetric shocks more easy. Still, today, the introduction of the German Mark can hardly be seen as a success: Manufacturing industry in the East is still very weak, unemployment rates reach 30 percent in some regions and income convergence has stopped or even reversed – an outcome that some economists see as a result of a strong regional over-valuation after reunification.

Before joining a currency union, a country should therefore ask itself a set of questions in addition to looking at the Maastricht and the traditional OCA criteria. From the experience from Portugal as well as East Germany, I would propose to take the following three tests (you might want to call them the Eurozone Watch criteria):

1. Is there good reason to assume that the exchange rate for entering EMU is close to a real exchange rate with which the economy can be expected to be able to live in the future?
2. Are wage and productivity trends compatible with sustaining grosso modo the current real exchange rate position?
3. Are labour market institutions set to react quickly and appropriately to a future misalignment in the real exchange rate?

Eastern Germany missed the first two of the tests: The exchange rate with which the German Mark was introduced was probably too high. Moreover, first wage agreements tried to increase wages much stronger than productivity, pushing the region into a position of overvaluation. Even though de facto wages did correct afterwards, by the time the process was over, manufacturing industries had closed down and structural damage had been done.

When entering EMU, Portugal failed all of the tests above. The current account deficit in 1998 was already sizable, the relative unit labour cost position well above historical values. Finally, as we have seen in the past years, labour market institutions do not seem to react quickly to an over-valuation of the real exchange rate and a strong increase to unemployment.

Turning to Slovenia, the small country seems to fulfill all of the criteria. First, despite the strong economic growth (the EU commission estimates 2006 GDP growth at roughly 5 percent), the current account deficit is rather small (below 2 percent of GDP) and exports are growing much faster than imports. Thus, there is no reason to assume a significant misalignment of the real exchange rate.

Second, wage and productivity trends do not put this real exchange rate position into jeopardy: The June 2006 pay agreement stipulates nominal wages for the private sector to rise only by 2 percent. While this is only the floor, sectoral wage agreements may top up this figures and economy-wide pay-increases per worker might reach 5.4 percent (EU Commission November estimate), this value does not pose any major problems. With labour productivity growing at a rate of 4 percent, nominal unit labour costs have only risen by 1.4 percent, much less than in Italy (2.6 percent), Spain (2.5 percent) Portugal (2.3 percent) or even France (1.9 percent). Moreover, the boom in investment in equipment and software (plus 10 percent year-on-year in 2006) poses well for a continued strong increase of productivity, thus keeping unit labour cost increases low.

Third, the wage bargaining system in Slovenia seems to be well prepared to react to a possible future over-valuation: With central wage agreements being topped up with productivity-related sectoral contracts, the economy seems to be well prepared to react to shifts in the productivity trends, preventing the small country to become the next Portugal.

So, 13 might well turn out to be a lucky number this time. Welcome to the eurozone, Slovenia!

Germany’s potential to surprise: Solid outlook for 2007

Germany might just do it again: After exceeding even the most optimistic forecasts by a wide margin in 2006 (A year ago, the consensus was at 1.5 percent with the highest forecast at 1.8 percent. Now, whole year growths for 2006 looks to come in slightly below 3 percent), a number of forecasters have seen themselves forced to correct their projections for 2007 upwards. The most impressive correction came from the Kiel Institute which roughly doubled its GDP forecast to 2.1 percent last week.

Yesterday’s increase of the Ifo business survey index by 1.9 to 108.7 points also hints at a continuing breakneck speed of expansion. The Ifo institute talks about a “boom as last observed in 1990”, the last time the index was this elevated. A raising majority of the firms moreover reports that they expect the business cycle situation to further improve over the coming six months.

The current strength of the economy is even more impressive than the simple figures suggest: Germany might attain this kind of economic growth in spite of a significant fiscal tightening and an increase in the German VAT rate from 16 to 19 percent in 2007.

Two reasons are behind the new strength of the German economy: First, a number of problems have disappeared which have dragged German growth down for the past years. Second, the business cycle has by now reached a stage in which it has at least partly become self-sustaining.

Germany had lost price competitiveness significant degree during the years immediately following German reunification. A strong increase in domestic wage costs was followed by a nominal depreciation of the currencies of many European trading partners in the EMS crisis 1992. The loss of competitiveness created downward pressure on employment and wages in Germany. A number of years of sub-trend wage increases followed which improved the firms’ situation in the world market, but also dampened disposable income and thus consumption. Now problems with price competitiveness are solved. Germany is gaining shares in the world market and employment is growing briskly again. Hiring is so strong at the moment that chances are good that wage increases will rise again from their low rate of less than 2 percent y-o-y (in nominal terms) observed during the past years, providing an additional boost to consumption.

Moreover, there are signs that the decade-long correction of the construction sector has come to an end. While the current mini-boom in construction has been boosted by the imminent rise in VAT (for housing construction, the VAT has to be paid by the house owners), there is an independent upswing in business construction (business is VAT-exempt).

Combined with the export boom, the improvement in competitiveness has led to a boom in German investments in equipment and software. In Q3, domestic machinery orders were 11.5 percent higher than a year ago. This investment boom is now the driving force of the German upswing, not the – still strong export boom – or purchases just before the VAT increase.

While some commentators have taken the drop in manufacturing orders and manufacturing production in October as a hint for a beginning slow-down, odds are that the upward trend is still intact. The parallel drop in the two time series rather hints at some volatility due to the seasonal adjustment procedure than at a real slow-down in industrial growth (while, of course, there might have been some special boost to the production of cars in advance of the VAT hike which now will disappear). Both the Ifo survey as well as purchasing manager surveys hint at a solid pace of order and production growth over the coming months.

So, chances are good that five years of extremely weak growth and investment are now followed by several years of good growth and strong investment. In 2001, German fixed capital formation fell significantly below EMU average, probably due to earlier over-investment, but possibly also because of problems in the German banking sector, depriving some companies of liquidity for their investment plans. As there is no a priori reason why over the long run German companies should invest a lower share of GDP than their counterparts in France, Italy or the Netherlands, there is hope that Germany now starts closing the gap with the rest of EMU. This could result in a number of years with high investment growth. Given that investment growth is often followed by employment growth, which also boosts incomes and consumption, this bodes well for domestic demand.

Some commentators might now argue that growth potential in Germany is too low to allow for several years of growth rates of two percent or more (incidently, only two years ago the Kiel Institute has even explained its low German growth forecast with their estimation result on potential growth – a notion which they happily omitted when they doubled their growth forecast for 2007 to more than two percent last week).

This notion is misguided. Potential growth estimates are little more than a sophisticated extrapolation of past trends. This is true not only for the crude HP-filter, but also for more complicated methods. Even if one uses a structural model in which the capital stock enters explicitly, the computations are distorted to the downside if there is a prolonged period of sub-par demand growth (which of course leads to lower investment growth) as there has been in Germany over the past years: In this case, the filter will forecast an excessively low growth of the capital stock, resulting in an excessively low potential growth estimate. As soon as capital expenditure in Germany has finished its normalisation process, these methods for computing the growth potential will also result in higher estimates of potential growth rates. Remember that the German labour force is not shrinking yet and a productivity increase of roughly two percent annually is not overly ambitious, resulting in a plausible overall potential growth rate of roughly the same magnitude.

Of course, a number of risks remain. We do not know yet how the crash of residential construction in the US will play out. While so far the scenario for a landing without an outright recession still seems the more likely outcome given the health of corporate America, there is the risk that the US economy tanks, pulling German exports down with it. Moreover, if the hawks in the ECB get their way and rise their interest rates overly quickly, the euro might surge to 1.50 $ which would surely hurt exports, investment and employment. Finally, there is the risk that fiscal tightening wit the VAT increase has a larger impact on economic activity as is hoped by most forecasters today (see my <a href=” http://www.euro-area.org/blog/?p=35”>post on Eurozone Watch on this</a>). However, these risks seem now to add up to significantly less than 50 percent, making another good year for the German economy a plausible base-line scenario.