The coming years may prove challenging for the central banks in EMU-graduation zone. There are several reasons why:
- Agflation. Food prices are likely to rise for a number of years for several reasons: (1) rising oil prices increase demand for biofuels, so industrial demand for food commodities will rise further; (2) charging China and “US in full denial” pollute the world BIG TIME, and the biofuels production leads to higher CO2 emissions than gasoline, so global warming is likely to accelerate and lead to continued series of disaters (floods, droughts, unexpected weather changes negatively affecting crops). Agflation results from a combination of long-lasting and large demand shock, and repeating negative supply shocks related to global warming. In such case one can no longer rely on core inflation as a proper measure of underlying inflation trends. CEE countries have food share in consumption basket some 10% higher than EU15, so food inflation running at 10% pa. will lead to CPI inflation differencial of some 1% between CEE and EU15.
- Migration. In some CEE countries some 4-5% of labor force migrated to EU15 attracted by higher wages. This has led to severe tensions in many industries pushing wages and unit labor costs up. So far high corporate profits provide a cusion, but if this situation continues many corporates will have to raise prices to remain profitable.
- Large depreciation of renminbi against euro. However raising producer prices will not be easy. Renminbi has depreciated against the euro some 40%, so Chinese exporters can reduce their prices in euro and still enjoy bigger margins when measured in their local currency. This means that local companies in CEE will face increasingly tough competition from Chinese exporters in their major export markets in the EU, but also at home. We should expect significant increase in market penetration of Chinese exports. So it will be very hard for CEE companies to raise prices amid fear of hostile entry by Chinese exporters. This conclusion will hold even if one takes into account rising cargo prices.
- Appreciating CEE currencies. Sharp depreciation of renminbi against euro is recently accompanied by renewed appreciation of CEE currencies against euro, which makes the situation of CEE based exporters very hard.
- If my story is right, central banks in CEE will have to carefully analyse the above dilemma. On the one hand agflation may push CPI inflation up, and this impact may not be temporary. On the other hand very strong CEE currencies will reduce inflationary pressures, but will contribute to rising external imbalances, which in some countries are already at very high level. On the one hand higher inflation may harm competitiveness of the economy in the long run, but on the other hand very strong local currency also harms economic competitiveness by reducing investement in export-oriented manufacturing, which in emerging markets is the main source of a move towards higher technological frontier. Just to remind the reader, the share of high-tech goods in manufacturing exports in the CEE countries is lowest among all regions excluding Africa, even lower than in Latin America.
- We will see in the coming quarters what choices will be made by CEE central banks facing the above dilemma.
- And finally one comment about the eurozone entry. According to official government and NBP forecasts Poland will fulfill all eurozone entry criteria this year (fiscal deficit, public debt, inflation, long-term interest rates). The only criterion not met will be two-year ERM2 membership without significant currency depreciation. If Poland had joined the ERM2 in the first half of 2005, as I formally proposed in January 2005, we would have been able to join the eurozone in January 2008. This opportunity has been lost, and now meeting the Maastricht criteria will become more challenging. If agflation is with us to stay, and central banks decide to keep CPI close to the target, high sacrifise ratio (implied by flat Phillips curve) may require significant growth slowdown. In such case meeting fiscal criteria will be challenging amid slowing tax revenues. If, on the contrary, central banks treat agflation as a typical negative output shock, then meeting inflation criterion will be challenging. Finally, if strong exchange rate appreciation continues, we may just make it will both fiscal and inflation criteria, but we will enter eurozone with heavily overvalued exchange rate, which may harm growth for many years if not decades.
- This is a real Gordian Knot to be solved by CEE central banks and governments. The Alexandrian solution would be massive acceleration of productivity enhancing reforms. If we don’t accelerate reforms we may still be lucky, there could few years in a row with positive global crops, or someone will finally produce cheap hydrogen-powered car to replace gasoline, resulting in a collapse of oil prices. But I would not bet the country future on the assumption of being lucky.
Just to remind, this blog presents my own views.