PRODUCTIVITY GROWTH IN BRAZIL

Carlos Pereira of the Brookings Institution (link) has reviewed the dismal productivity growth and the consequent macroeconomic indicators in Brazil in the last decade.

"Although there are several expenditures in this category, the one that stands out high above all others is outlays for social security and pensions. Practically one-third of the federal budget is devoted to these expenditures, whereas expenditures in investments were less than 6 percent in 2003. Pensions in Brazil since the 1988 constitution have been notably generous, especially in the civil service. A new group of non-contributing rural pensions was added, contributing to systematic deficits. With about 11.7 percent of GDP, Brazil has one of the highest social security expenditures in the world, especially considering that the Brazilian population is much younger than that of most countries with similar levels of expenditure."

RUSSIA'S ROAD TO ECONOMIC RECOVERY

Russia's recessionary contraction has been marked with several distinct features. First, capital account deteriorated significantly. In Q3:2009 it posted a $23.7 billion deficit, reflecting net capital outflows as a result of recovery uncertainties, exchange rate and oil price volatility and the inability of the Russian banking sector of debt repayment. Thus, net capital flows to the private sector decreased by 31.5 percent in Q3:2009.

During the economic crisis of 2008/2009, Russian fiscal policymakers increased government spending when the output gap was positive. Thus, from the mid-2008 onward, Russia faced high inflation rate which peaked well over 10 percent level. Even the fiscal outlook remains sluggish. In 2009, the non-oil government deficit is expected to reach between 11.0 and 12.5 percent of the GDP. The dynamics government deficit remains deteriorating until 2012. In 2010, the non-oil balance is expected at -14.20 percent of the GDP. In 2012, the balance is likely to improve by 1.40 percentage points from 2011. The decline of oil demand has rapidly eroded Russia's reserve fund earnings which decreased from 10.3 percent of the GDP in 2008 to 4.1 percent in 2009. Before the financial crisis, Russia's economic growth model was based mainly on fiscal policy reforms, confluence of high oil prices and access to external financing at low benchmark interest rates. The World Bank estimated that Russia's real GDP will return to pre-crisis level in late 2012. In the long term, Russia's growth quality will be improved only by more dynamic diversification of the economic basis, bold structural, governance and institutional reforms, trade openness, higher productivity growth and liberalized financial sector.

Russia's Macroeconomic Outlook
Source: Central Bank of Russia, Ministry of Finance, Bloomber
*denotes preliminary estimates

Economic Growth in Russia, Central and Eastern Europe and Advanced Economies


Source: IMF, World Economic Outlook, October 2009

RUSSIA'S MACROECONOMIC OUTLOOK

The WSJ reports that Russia's economy recorded nearly 10 percent output contraction in Q1:2009 (link). In spite of surging oil prices and strong increases in stock market index, the midterm macroeconomic outlook on Russia is not favorable in terms of economic growth, fiscal policy and macroeconomic recovery. While the local currency appreciated 0.3 percent against the U.S dollar (link), the slow recovery in the financial sector is likely to deteriorate the macroeconomic outlook. The main ailing problems of the financial sector remain high credit and liquidity risk as well as default risk. The central bank could possibly mitigate the shocks in the financial sector by building up foreign reserves to act as the lender of the last resort. However, Russia's persistent obstacle to macroeconomic stability is high inflation rate and dismal fiscal policy record. When the inflation rate is high, building foreign currency reserves may be risky, letting domestic currency overvalued. Reduction in public spending and tightening of the monetary policy to stabilize the inflation rate could essential pursue stable midterm outlook.

ECONOMIC CRISIS AND RECOVERY IN EASTERN EUROPE

The Economist has published an article about the economic slump and recovery in Eastern Europe (link).

RUSSIA'S CREDIT RATING DOWNGRADED

Unsurprisingly, Fitch has slashed (link) Russia's credit rating to BBB, just two ranks above the junk grade. The main driver behind lower credit grade is a deteriorating shape of capital markets accelerated by a snip decline in commodity prices which, of course, left an open struggle for the financial sector to refinance the external debt which is a difficult task if the financial sector suffers from unstable macroeconomic environment with high and volatile inflation rate (14.1 percent in 2008) and possible exchange-rate overshooting.

ASIA'S EMERGING ECONOMIES

The Economist discussed (link) the macroeconomic issues of emerging Asian economies.

"Asia has never before deployed its monetary and fiscal weapons with such force. Every country across the region has cut interest rates and announced a fiscal stimulus. In previous downturns, Asian governments were often constrained by dire public finances or the need to support currencies. But most countries entered this downturn with small budget deficits or even surpluses. All the main Asian emerging economies apart from India have relatively low ratios of public debt to GDP. Though the true size of the fiscal stimulus in some countries, notably China, is probably less than the headline-grabbing figures suggest, they are still impressive. After correcting for double counting and unrealistic measures, China, Singapore, South Korea and Taiwan will all enjoy a fiscal stimulus of at least 3% of GDP in 2009. China has signalled that more measures may follow over the next couple of months; it can certainly afford to spend more. On January 22nd, Singapore’s government announced a package of measures equivalent to 8% of GDP. For the first time, this will be financed partly by dipping into the government’s vast reserves...."

ARGENTINA'S STATIST SEIZURE OF PRIVATE PENSION FUNDS

Bloomberg reports that Argentina's president has announced a seizure of $29 billion of private pension funds (link).

LESSONS FROM ARGENTINA

HOW WOULD EMERGING MARKETS SURVIVE MACROECONOMIC CRISIS

Bloomberg discusses how emerging markets would survive an economic crisis (link).

INFLATIONARY PRESSURES IN GULF COUNTRIES

From FT (link):

"Inflation has replaced unemployment as the most pressing short-term problem facing the oil-rich Gulf economies, which are reaping the benefits of record oil revenues but do not have the tools available to cap rising prices, the International Monetary Fund warned on Monday. Creating jobs for the region’s growing youth population continued to be the main longer-term challenge for Middle Eastern oil exporters, said Mohsin Khan, the IMF’s regional director, but rising prices, already a concern in Qatar and the United Arab Emirates, had now extended across the Gulf Co-operation Council members to traditionally low-inflation countries such as Saudi Arabia, where inflation is approaching 10 per cent... The IMF predicts the Arab Gulf states’ consumer price index will average 7.1 per cent this year, up from 6.1 per cent in 2007 – while the broader Middle East and north Africa region will reach 10.4 per cent this year. With many regional economies pegged to the dollar, central banks lack any monetary policy tools to tackle inflation, leaving fiscal spending, rent caps and price subsidies as the only policy tools available to policymakers. In November last year, for example, rumours of a revaluation in the UAE sparked speculative inflows of $45bn (€29bn, £23bn) in one month, almost a third of the UAE’s gross domestic product... The Middle East and central Asia, which has been largely insulated from global economic uncertainty, was set to continue its strong performance, with oil-exporting countries seeing growth pick up to 6.25 per cent, the IMF said in its biannual regional economic outlook report. The region’s oil and gas exports will amount to $940bn this year, almost $200bn more than last year, as an almost fivefold increase in the price of oil fills the GCC’s coffers. The IMF estimates that the GCC’s combined GDP will reach more than $1,000bn this year, up from $805bn in 2007. The oil exporter’s growing external current account surplus, which is expected to grow to $1,400bn for 2004-2008, signals a continuing ability to invest abroad, while coping with increasing imports and investment into their domestic economies. The GCC’s current account surplus is expected to rise to $332bn from $227bn in 2007, with the UAE’s surplus rising 58 per cent and Qatar’s almost doubling. Official reserves of oil exporters had reached $800bn by the end of 2007. Foreign direct investment into the region reached $80bn in 2007, four times as high as 2002, 55 per cent of which flowed into Egypt, Saudi Arabia and the UAE."

RUSSIA'S ECONOMIC NATIONALISM

Financial Times reports that Russia's outgoing president Mr. Putin has signed an act which defined 42 sectors of the economy in which state control of the economy is expanded and foreign investment roughly restricted. Under new law, foreign-owned companies will have to seek government permission in case they want to stake more than 25 percent of the company share in the sectors where free investment and ownership participation is staunchly restricted.

LAFFER CURVE IN MONTENEGRO

Last year, Montenegro's parliament adopted a 15 percent flat tax on personal income. Tax rate on corporate profits was set at 9 percent and by 2010 Montenegro will have a 9 percent flat tax rate on corporate and individual income (link).

As a result of an expanded tax base and lower tax rate on productive behavior, Montenegro's Tax Administration has collected 36 percent more from annual taxes than in 2006 (here and here).

CROATIA'S EXPOSURE TO MACROECONOMIC CRISIS

In recent years, external indebtedness of Croatia has grown at the fastest pace in Europe. Croatia is, after Lebanon, the country most dependent on foreign loans. The business environment in Croatia has regionally low economic growth rates, high tax burden and inefficient administrative framework such as widespread corruption, weak property rights and extensive market regulation. The paper released by the IMF has shown how banking risks rise in Eastern Europe's case of rapid credit growth (link). On average, Croatia's economic growth between 2002 and 2006 was below 5 percent. In addition, external debt has reached 89 percent of the GDP. High government spending, exceeding 50 percent of the GDP and non-prudent fiscal policy contributed to structural risk of Croatia's economy. While expenditures and consumption-inflated indebtedness have been growing steadily, total factor productivity grew slightly by 1,2 percent. On the other hand, short-term debt increased by nearly 70 percent, from slightly below 4 percent of the GDP to way above 10 percent of the GDP. In a paper issued by the IMF, it is shown that external foreign debt liabilities of Croatia's banks are growing exponentially since 2004.

In such a turbulent picture, there is a significant amount of macroeconomic risk. In addition, there's an extensive availibility of literature and reading on the probability of macroeconomic crisis in Croatia. I suggest the website browsing of the Adriatic Institute, and a paper released by the IMF "Vunerabilities in Emerging South-Eastern Europe - How much Cause for Concern?". There're also few nice articles describing Croatia's macroeconomic prospects (here, here and here). Also, there is an article about Croatia in Washington Times (link).

FLAT TAX EXPANDS INTO GEORGIA

Alvin Rabushka of the Hoover Institution briefly outlines the adoption of the flat tax in Georgia as well as the implications of the tax reform on growth and revenue. Here is some remarkable data: by January 2005 Georgia adopted 12 percent flat tax, replacing previously imposed four-bracket system. The tax reform lower the rate of taxation on productive behavior which, in turn, had dramatic effects on economic growth, averaging 10 percent in the past three years. Tax revenue increased from 14.5 percent of gross domestic product in 2003 to 22 percent in 2006, and should reach 24 percent in 2007.

MONTENEGRO'S ROAD TO FREE MARKET ECONOMY

The International Monetary Fund recently released the report on Montenegro's overall economic performance, emphasising basic fiscal and macroeconomic policy perspectives. In English the report is availible here while it can also be reached in Montenegrin (here).

Two years after gaining a formal independence from Serbia, Montenegro's economy operated at a full capacity, having seen robust output growth rates estimated to exceed 7 percent by the end of 2007. The growth, mainly driven by a significant amount of foreign direct investment, seems to remain robust in the medium-run despite particular tensions referring to the signs of overheating. Nearly 85 percent of capital value of companies was privatized. Banking sector, telecommunications, oil distribution and import services are 100 percent privately owned. Foreign direct investment is reaching record highs. In 2006, according to Montenegro's central bank, foreign direct investment reached $680 million USD, six times higher than in 2004. In the first half of 2007, foreign direct investment increased by 78 percent, while from January to July 2007, the amount of FDI was $650 million. Thus, Montenegro has one of the highest FDI per capita, $ 1,100 USD, one of the highest shares in Europe.

Montenegro's business environment is weak by international ranking, despite of significant improvement in since the independence year. Montenegro ranks 81st in the world according to the ease of doing business. The failure of public administration to provide the operating business environment at sound quality, long licensing procedures, severe difficulties faced when registering a property, bureaucratized trading environment, and a high level of difficulty in enforcing commercial contracts, reflect the disadvantages of Montenegro's business environment (link).

Affected by international financial turbulence, Montenegro's asset prices soared in the last two years, leading to a remarkably rapid growth of credit which further fueled the investment into real estate industry. However, rapid credit growth posed signs of an overheating economy which has been a particular backlash of Montenegro's domestic economic environment.

On the other side, Montenegro's growth is not drifted by inflationary pressures. Subject to concentrated market structure, retail inflation peaked slightly ahead of central bank's expectations, particularly in the electricity sector which has not yet been demonopolized by the infusion of competitive mechanisms and price liberalization. Electricity shortages occured despite tariff increases.

The economic reforms, such as the privatization of state-owned assets and the openness to foreign trade and investment, contributed to stable macroeconomic position. The budget remained anchored in surplus. Public debt does not currently evince any sign of quick consumption-inflated indebtedness. Total public debt peaked at 38 percent of the GDP while loans denominated into foreign currency presented 27 percent of the GDP by the end of 2006. As a matter of fact, overall public debt was reduced from 88,3 percent of the GDP where it stood in 2002 (link). Foreign indebtedness is expected to decrease in the years to come due to large amount of inflows from the investors' buy-outs of state-owned assets and enterprises.

As a transition economy, Montenegro has experienced typical short-term and medium-term problems due to the rapid convergence of GDP and robust economic growth as well. Transition process, by itself, poses a lot of risk and challenges, ensuring economy's vitality and growth sustainability. First, in Montenegro, real estate and equity prices skyrocketed due to signficant demand-induced pressures and country's valuable tourism potential, which folded residential and coastal property prices upward.

Second, according to IMF, credit growth accelerated at 170 percent by August 2007, pushing the the household indebtedness to record highs. Credit growth has surpasses the amount of inflows from foreign direct investment which Montenegro has received in this year. However, deteriorating current account deficit is not alarming, neither a sign of recession or downturn, whether it applied to established economy or an economy in transition. In case of Montenegro, widening current account is a result of accountable investment imports and capital inflows whose contribution to overall output growth is significant. In relation to credit growth, it is the question whether banking industry is strained by the lack of ability to assess loans in real estate.

Third, external demand-supported pressure on wages poses a significant threat to overall competitiveness of Montenegro's booming economy. If productivity expectations are high, the spiral of wage-increases claims could have been eased by the fact of productivity outcome. But if the productivity expectations are low, the wage-increasing claims could have bursted the triggering of inflation-pressing spiral. In case of Montenegro, public sector has claimed wage increases several times. It is the question whether the sector whose contribution to growth is relatively low relative to the components of the private sector, could claim wage increases on a legitimate basis subject to distortionary effects of wage-increasing claims under conditions of low and possibly rachitic productivity performance. The rigidity of wage claims is mainly derived by the lack of labor market reforms, whereas outdated labor legislation returns uncompetitive effect respectively.

Montenegro's abundant potential of a flourishing tourist industry propelled by market optimism and Stabilization and Association Agreement with the EU, provides sound opportunities to address the abovementioned concerns. Years ago, Montenegro adopted euro as a common currency, thus eliminating the possibility of currency and exchange risk. Monetary policy's ability to tackle demand pressures is thus partly limited and that's why a prudent fiscal stance is needed in lines with transparency and restrictive expenditure agenda.

In a booming economy, such as Montenegro, fiscal policy is a powerful tool in managing the fluctuations and brisk economic progress. In the state of robust output growth rates and soaring private sector productivity, fiscal policy is ought to be countercyclical to prevent the possiblity of overheating where the expansionary fiscal policy could turn a non-inflationary economic performance into inflationary economic growth generated by fiscal expenditures on infrastructure and public or/and foreign indebtedness, while seeing the overheating of economy's overall capacity. Fiscal balance or possible surplus is favorable to the business cycle for two particular reasons: (1) it faces adverse shock with low risk and (2) it gives support when revenue growth cools the impact on public finance. Also, significant import growth, reflecting the current account deficit, presented 4-5 percent share of imports in the GDP.

The role of fiscal policy is ought not to be undermined. As a powerful tool in responding to cyclical fluctuations during a "catch-up effect" period, fiscal stability and low government spending are usually based on surplus mechanisms. By avoiding budget deficit, policy responses may prevent the demand shocks and low level of public spending is a sign of maturity that helps to detach the anticipation of inflationary pressures and its impact on macroeconomic stability.

Tax cuts implemented in previous years may be seen as a policy failure in generating greater revenue. As the Laffer curve succinctly explains, it is able to reach higher tax revenue from a broader tax base, by reducing the rates on corporate and individual income. Since the implementation of low flat taxation on major sources of productive behavior, revenues have increased rapidly. Currently, public spending stands at 45 percent of the GDP (link), and the share of capital investment is 3 percent in this respect.

As a negative aspect of fiscal and structural policy, Montenegro's policymakers approved a significant 30 percent wage increase in the public sector, which is far ahead of current productivity and output growth measures. Such expansionary effects should be wisely avoided to prevent the loss of incentives to boost the economic performance when the growth performance slows. Robert Barro, a professor of economics at Harvard University, has shown empirically that reducing the size of public sector by 10 percent, stimulates growth by 1,3-1,8 percent. As a sign of innovative policy, public sector employment and expansion might be frozen and possibly reduced to prevent further unanticipated shocks such as wage-increasing claims.

In recent years, Montenegro's economic policymakers implemented a rigorous tax reform. Flat tax was implemented on personal and corporate income and it is expected to be dropped slightly in the years to come. Tax cuts were imposed procyclically. However, complex taxation structure such as numerous exemptions, loopholes, breaks and deductions have counter-effects as they raise the cost of paying taxes, notified as a difficult tax compliance and administrative burden which costs firms and taxpayers millions. The aim of tax reform and system is to pursue the efficiency and minimal tax burden levied on firms and individual taxpayers. High tax burden, empirically and practically, constrains growth and does not meed the indicated measure of efficiency. Fiscal reform, such as braking-up the size of government spending, is expected to pursue the objectives of fiscal consolidation which contains easing pressures to anticipated as well as unanticipated external or domestic shocks. The goal of prudent fiscal sustainability in the medium-term is to meet the demands of macroeconomic and structural stability. In the medium run, demands to invest rapidly in infrastructure may be tackled. However, it would be wise to avoid infrastructure investment through the expansion of state-owned enterprises. By the means of risk-taking and efficiency of capital and technology investment, infrastructural investment is easily attainable through private sector. In case if externalities and signs of market failure appear, then public infrastructural investment may be justified, also to prevent the emergence of public or natural monopolies where one firm, in public or private ownership, could substantially abuse its market power, such as in case of railway and highway infrastructure.

In monetary area, Montenegro has stabilized low inflation rate and the monetary policy remains anti-inflationary (link). In 2006, inflation rate peaked at 2,5 percent. In the first half of 2007, inflation rate was 1,1 percent (link). S&P has given Montenegro BB+ credit rating. The abovementioned rapid growth of credit has tightened banks to raise capital adequacy ratios. This could hamper the ability of banks as well as equity funds in responding to the demand claims of investors in real estate and stock market industry (link)

At last, structural reforms demand both; challenge and perspectives. One of the greatest potential of structural reforms is to boost economy's potentials. According to the data, the government and state, still own shares in 65 companies. In 53,8 percent of those companies, government has more than 50 percent ownership share. The argument for an accelerated privatization is the fact that the allocation of labor, capital and technology resources is better utilized as well as distributed in the channel of productive use. In fact, as an owner, government has severely different interest than private investors. In addition, the data shows, that privatized companies sustain higher level of productivity than state-owned companies.

The area in which radical reforms should not be postponed, is the labor market. The aim of the labor law is to pursue flexible and dynamic environment, allowing firms to dismiss non-performing employees without high severance costs. As every economist can confirm, collective contracts and bargaining such as oligarhic bundling between monopoly structures such as federation of employers and trade unions, does not match the needs of modern market economy. Instead, flexibility and deregulated labor market are essential to maximize productivity growth and eliminate discretionary wage-increasing pressures and also fight unemployment. In this respect, Montenegro's business environment is free of unnecessary regulation which boosts the potential of private sector growth. In the long run, fiscal risks are inevitable and Montenegro's abundant potentials may be implemented not by government intervention but by low public spending and first-class investment environment that underpins the role of private sector, free of corruption, in the economic performance respectively.

Rok SPRUK is an economist.

Copyright 2007 by Rok SPRUK

SOVEREIGN FUNDS IN EMERGING MARKETS

Standard Chartered predicts the great controversy may be bubbled by the most secretive sovereign funds in emerging markets. The reports suggests more transparency such as establishing a code against protectionist pressures from western markets.

Source:
Financial Times, Sovereign funds warning, October 14 2007 (link)