Thoughts from a Renaissance man CE3 demographics to create...

Thoughts from a Renaissance man CE3 demographics to create MENA jobs

Thoughts from a Renaissance man Economics & Strategy

29 June 2017

Half of the EU has not seen employment this high since at least 2006. Wage growth should pick up in CE3. We see Morocco, Tunisia, Egypt, Turkey and perhaps Ukraine as unintended beneficiaries.

We flagged the impact of demographics in 2014; we revisit the theme a year earlier than expected

European bulls may have noticed that 13 EU member states have reached “peak” employment rates. Central Europe is leading the

charge, and this is now driving wages growth. Hungarian wages rose 15% YoY in April. Kia gave its highest ever pay increase in

March, but only to Slovak workers. Faced with labour unrest, VW has given a double-digit wage increase in CE3. Unemployment

rates have roughly halved from Estonia to Poland over the past five years. This is partly due to Germany, which is also at “peak”

employment of 79%. Its industrial health tends to lift its Central European supply chain. But another driver is the demographic

pressures we flagged in 2014. We said then that wages could become an inflation problem, but not for a few years. First,

demographics would help cut unemployment and we would see a rise in the participation rate. We promised to revisit this issue in

2018-2020, but pressures are building earlier than we expected. A host of questions are raised by these trends.

CE3 rate hikes, higher domestic demand and still being cheap vs Spain

First, will the boom in Central European wages force aggressive interest rate hikes? Probably not in the near term. So far, CE3 has

looked more like Japan. Despite 3-5% unemployment, and a workforce shrinking by 1% a year, overall wage inflation has been

relatively modest (this is true in the US too). But the latest wave of automotive industry pay hikes suggest inflation should pick up;

especially when labour participation rates are as high as 77% in the Czech Republic. We and the market expect the first 25-bpt

hike here, followed by Poland and Hungary. Romania should have further to run than these three, given labour costs are two-thirds

of Hungary’s levels and the employment rate has far more room to rise. Second, how will growth change? Domestic demand

should become a key driver in Central Europe, rather than investment; as recognised in the quadrupling of some retail stocks since

2014. Never again is Central Europe likely to offer what it did in the 1990s: the best combination globally of high education, low

cost and high labour supply. The next wave of investment into industrial sectors may have to go a little farther afield.

North Africa, Turkey and Ukraine may replace CE3 as favoured industrial FDI destinations

We think rising Central European costs can benefit Morocco, Tunisia, Egypt, Turkey and potentially Ukraine or Iran. We have

already been positively surprised by the extent to which Morocco now rivals CE3 as an investment choice for French firms. Wages

seem to be much lower and should not face the same upward pressure. Even though demographic trends are not that different to

CE3 (only Egypt and Turkey have rising numbers of 15-24 year olds over 2015-2020), the total employment rate in MENA

countries we focus on is around 40-50% compared with 60-80% in Europe. There is much more potential supply of labour on the

EU’s doorstep – and this untapped resource is largely female. Educational access, particularly for females aged 11-17, has

expanded dramatically in the past 20 years. In Turkey, despite a government that offers inducements to women to remain at home,

the consequence has been a rise in the female employment rate from one in four women to one in three over the past decade,

which is responsible for over fourth-fifths of the rise in the overall employment rate to 54%. We suspect similar change is coming in

North Africa over the coming decade. Cheap wages and better human capital means MENA should become more attractive to

FDI. This can answer the “where will the jobs come from” question about MENA.

We think the convergence theme is back in Central Europe, but this time with a focus on wages not private sector debt ratios or bond convergence. We do not expect FDI to leave Central Europe; rather their workers will move up the value-added curve. But when European business confidence is high again, we think the next wave of investment expansion will lap the shores of Turkey and the southern Mediterranean. MENA governments should prepare for this by prioritising political stability and pro-FDI reforms.

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Renaissance Capital 29 June 2017

Thoughts from a Renaissance man

The numbers on the front page (cited in the FT article of 27 June 2017 Labour shortage

threatens growth in central Europe) are pretty eye-catching. Wage pressures have arrived

in Central Europe a good two-to-three years earlier than central bankers expected when

we raised this very issue back in 2014 (see Thoughts from a Renaissance Man: Who can

cope with a shrinking workforce?, 23 September 2014). Our 2014 report was triggered

when we looked at strong demographic growth in frontier markets and were a little

surprised to see how poor the demographic numbers were for European markets.

Figure 1: Many frontier and African countries should see GDP rise by 3-4% a year purely due to demographics

Source: UN

Central bank officials told us to relax. Yes, the workforce was shrinking, but this would

initially be helpful in reducing high rates of unemployment. In addition, the labour force

participation rate was relatively low in most of Central and Eastern Europe, so higher

participation rates could offset the shrinking in the labour force. Also immigration could

always be a solution for some. Already in 2014, officials pointed to Ukrainians fleeing the

conflict with Russia, and adding to the labour force in Poland.

Figure 2: A number of European countries have worse demographics than Japan

Source: UN

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https://research.rencap.com/eng/download.asp?id=17982


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We produced the following graph and agreed that the Central European central bankers

had a point. Greece and Spain might see unemployment fall, while countries such as

Hungary or Romania might see participation rates rise. None of them (bar perhaps

Estonia or the Czech Republic) should have an inflation problem within a few years. Note

the chart below still uses ILO data we collected in 2014, and unemployment rate data we

updated in late 2015. We argued then that even countries that might have a problem,

such as Germany, could address this by encouraging immigration (we saw this in 2016

Syrian refugees). It turned out Russia did not have a problem because plunging oil prices

send the economy into recession, but demographic pressures did mean that

unemployment never rose above 6% even as GDP shrank by 4%. Meanwhile Poland

attracted perhaps a million Ukrainians to ease its labour market shortages (on 28 June, a

Czech official told us that their automotive industry is now also seeking 150,000 workers

from Ukraine).

Figure 3: This 2014 chart (updated in 2015) showed wage/inflation pressure was unlikely for most countries in the medium-term

Source: ILO, Bloomberg, Renaissance Capital

ILO data don’t come out frequently enough to update this graph. So to illustrate where we

are now, we look at Eurostat employment participation rates (not quite the same measure,

but it serves a similar purpose).

Below is the most surprising graph in this report.

First, it shows that 13 of 27 EU countries at the end of 2016 had reached the highest

employment rate in any year since 2006. Germany has seen the largest increase of any

major economy. Both Germany and the UK are at record highs. We excluded France as

we only have three years of data, but the latest figure was also the highest at 70%, so we

could say 14 of 28 countries have reached record highs.

This is supportive of the European equity bulls.

Second, it shows the success that Spain and Greece are having in increasing the

employment ratio, helped by a working age population decline of 0.4% annually. We left

Iceland in the chart too, to highlight its success. Curiously it is often overlooked countries

such as Belgium and Finland that have seen the lowest increase in the employment rate

over the past 10 years.

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GermanyCzech Republic

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Countries with shrinking working age (20-64) population over 2015-2020

PROBLEMCORNER

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Figure 4: Nearly half of the EU countries have not seen the employment ratio this high since at least 2006

*Non-EU countries

Source: Eurostat

Third, we can see the Central European central bankers were right. Participation rates

have risen significantly, helped in Hungary’s case by government schemes to reward

those in work while cutting benefits to those out of work.

This raises the question of how much further these participation rates can go. Romania’s

rate of 66%, Poland’s of 69%, or Hungary’s of 72% remain low relative to Germany at

79% or the UK at 78%. But the Czech Republic or Estonia at 77% look closer to peak

employment. This ratio suggests the Czechs will hike interest rates before Hungary

or Poland. This would appear to be recognised by the markets. Two-year yields are

already 30 bpts above the Czech National Bank (CNB) policy rate. The main scope to

raise the participation rate further comes via increases in the retirement age and bringing

in more women to the labour force, but it is hard to imagine the overall rate increasing

much further. For more on these issues, see page 48 of the latest CNB inflation report.

Figure 5: The market is looking for a CNB rate hike

Source: Bloomberg

Fourth, this chart rammed home just how low the employment participation rates are in

the MENA region. The latest Eurostat data for Tunisia (2013) puts the figure at 44%, while

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Today's figure minus the low (pp change, rhs) Lowest (lhs) Highest (rhs) 2016 (rhs)

Non-EUcountries

Nearly half of all EU countries in 2016 were at the highest employment rate they have seen since 2006Many in central/eastern Europe have increased employment by 8-10pp since the lows (usually 2010-13)

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it is 41% for Morocco (2015) and Egypt (2014), and just 40% in Algeria. Also interesting

was the rise in Turkey, from 48% in 2006 to (a still low by European standards) 54% in

2016. We see Turkey as a leading indicator for what may be coming in North Africa. The

implication is that perhaps 20 ppts of the workforce in Turkey could join the ranks

of the employed over the long term, and 30 ppts of the workforce in North Africa.

Women are the solution. In Turkey, less than one in four were formally employed in 2006,

while now the figure is one in three. Why? A former economist colleague, Mert Yildiz,

says it is because it is becoming harder for families to manage on just one (male) income.

Figure 6: Female employment ratio has risen by 9 ppts over 2006-2016, male employment by just 2 ppts

Source: Eurostat

In addition, this is the dividend of women getting more access to education a generation

ago. Roughly half of Turkish girls aged 11-17 attended secondary school in the mid-

1990s. This means that even today, less than half of women aged 40 or higher have an

education level required to do much more than low-productivity work in agriculture. By

2003, 75% of Turkish girls aged 11-17 attended secondary school, which makes them far

more likely to be counted in the employment rate. The latest figures for Turkey are even

more encouraging, at nearly 100% enrolment in 2013. Morocco is roughly a decade

behind Turkey, but Tunisia, Egypt and Algeria all have similar ratios to Turkey.

Figure 7: North Africa now educated most of its 11-17 year old girls; which is good news for employment in the coming decades

Source: World Bank

This is important, because curiously North African demographics are not that different

from Central European demographics, if we look at the supply of young people. Algeria’s

population of 15-24 year olds is expected to shrink by 700,000 between 2015 and 2020,

the same as Poland. Tunisia will lose about 100,000, similar to Hungary and the Czech

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Republic. Only Egypt (up by 500,000) and Turkey (up by 200,000) will see an increase in

our sample of countries.

Figure 8: Many countries we follow will have less young people by 2020 than they do today

Source: UN

So what is important is that more of the existing total workforce becomes employable, due

to the lagged effect of educating women in the 1990s or because it is becoming more

culturally acceptable for women to work. And the overall working age population is still

rising in MENA even if it is falling in Emerging Europe.

Note that the rise of female employment in Turkey or Poland for that matter, is despite

government measures aimed at encouraging women to stay at home to produce more

children.

Figure 9: The size of the total workforce in central/eastern Europe and MENA

Source: UN

Our base line assumption is that falling unemployment will drive up wages in Central

Europe. The examples cited at the beginning of this piece suggest this is now happening.

But overall data suggest wage growth is not aggressive just yet. One official in the Czech

Republic suggests this could be due to fears of outsourcing. Czech Skoda workers are

fully aware that Skoda’s production in China is already higher than it is in the domestic

market, and a factory has been established in Russia too. While workers may want

German wages, they see the threat of losing their jobs to cheaper countries.

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Figure 10: Wage growth has sat consistently at 4% even as unemployment has halved in the Czech Republic

Source: Bloomberg

We were given another explanation for relatively low wages growth in Poland by a market

participant who recently visited businesses in Wroclaw. Companies there suggest there is

no point in hiking wages, as all it will do is suck workers from neighbouring factories, who

will then raise wages themselves to get their workers back again. After a round of two of

this, all companies will be employing the same number of workers, but pay will have gone

up and profitability will go down. It sounds much like investment banking near the market

peak – where employees end up capturing outsized gains while doing the same job.

Figure 11: Poland's wage growth has also averaged about 4% even as unemployment has halved

Source: Bloomberg

The relatively modest wage growth until this point is one reason why Central Europe still

looks competitive relative to Western Europe. Czech labour costs were 47% of Spanish

levels in 2012 and rose to just 48% in 2016.

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Figure 12: So far, wages growth in CEE has not greatly changed their relative level vs Spain

Source: Eurostat

We are not therefore concerned in the next year or two that Central Europeans are pricing

themselves out of jobs relative to Western Europe. More obvious is that Greeks and

Portuguese are pricing themselves back into jobs. Polish labour costs were 50% of Greek

levels in 2012 but 60% by 2016. Hungarian labour costs were 55% of Portuguese levels

in 2012, but 60% in 2016.

But we do assume that with limited room for further labour market participation, and an

ever tighter labour market, wage pressure will build. If this does not show up in wage

inflation, it may instead show up via currency appreciation. Either way, Central Europe will

no longer be the low cost, plentiful labour source of the future.

Sadly we do not have comparable labour cost data for MENA. The best proxy we can use

is to compare hourly labour costs from Eurostat with per capita GDP figures (in dollars)

from the IMF. The implication is that wages in Algeria, Tunisia, Morocco, Egypt and

Ukraine are roughly half that of Bulgaria, which itself has the cheapest wage costs in

Europe. Turkey may be closer to Poland or Hungary.

Figure 13: GDP comparisons imply north Africa has labour costs half that of the poorest EU members

Source: Eurostat, IMF

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Total hourly labour costs in Euros (2016) vs (2016) per capita GDP in dollars (rhs)

Hourly labour costs (Euros, lhs) Per capita GDP ($, rhs)

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Conclusion

We think convergence is back on as a theme for Central Europe, but in contrast to the

2000s, it will be focused more on wages and less on convergence of private sector debt

ratios or bond yields. Estonia is at the forefront of this, and we suspect Czech Republic

and Lithuania may be next to follow. Hungary and Poland still have room to increase

labour force participation rates, which may help delay high wage inflation. But each are

likely to experience stronger wage growth or currency appreciation over the next few

years.

With shrinking demographics, it is hard to see Central Europe ever returning to the low

cost, high labour supply, destination of choice for new waves of industrial investment.

These countries will have to move up the value-added supply chain.

The question then is, which countries will attract the sort of industrial investors who

sought out central Europe in the 1990s?

Despite poor demographics, we suspect Romania and Bulgaria still have scope to do so.

Even Greece and Portugal may be pricing themselves back into the market for such jobs.

But we think Morocco, Tunisia, Egypt and Turkey and potentially Ukraine are likely to

become more attractive to foreign direct investors over the next decade. A combination of

improving education levels especially among women, better demographics than Central

Europe, and relatively low wages, will all help. Each also has an industrial base, with

plenty of room to expand.

We suspect the Eurozone needs to experience stronger growth for a year or two before

global investors will seek to add industrial capacity around the EU-periphery. This is time

which governments could use to improve problematic security situations and make pro-

business reforms. We do not expect the wave of investment will be as great as it was into

Central Europe, when German car manufacturers and other seized the opportunity to

invest in countries an hour’s flight away with a manufacturing base and an excellent level

of education. But we do see FDI picking up significantly, helping improve per capita GDP

and in turn helping improve political stability. So we welcome every new pay demand out

of Central Europe.

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Czech Republic: Demographics are shrinking the workforce by around 1% annually. With

3% unemployment, and a high employment rate of 77%, we expect wages growth of

around 4% will pick up, and prompt CBN rate hikes and/or CZK appreciation. Wages are

already high by CEE standards, but remain cheap relative to Spain. We expect growth to

be increasingly driven by household consumption.

Greece: Demographics are shrinking the workforce by 0.4% annually, which is helping

cut the unemployment rate. The employment rate has risen 3 ppts off its lows, but at 56%

it remains 10 ppts below its highs. We see no reason to expect meaningful wages growth

in the medium term. We expect more convergence of Greek wages to Central European

levels (via Central European wages rising).

Figure 14: Two-year yields and policy rates – Greece

Source: Bloomberg

Figure 15: Unemployment and wage growth – Greece

Source: Eurostat

Hungary: Government job creation schemes and wage hikes have turbocharged the

demographically inspired trends (1% workforce shrinkage annually). The government can

step back and let the private sector take over, and there is still room to increase the

employment rate from 72% towards Czech levels of 77%. Hungarian labour costs in 2016

were just 81% of Czech levels. We expect growth to be increasingly driven by household

consumption.

Figure 16: Three-year yields and policy rates – Hungary

Source: Bloomberg

Figure 17: Unemployment and wage growth – Hungary

Source: Eurostat

Poland: With the lowest employment rate of the CE3, at 69% (likely to rise as the

workforce shrinks 1% annually), and a million or more Ukrainians in the country, we

suspect wage inflation will remain subdued for a little longer than in the Czech Republic or

Hungary. We expect growth to be increasingly driven by household consumption.

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0.6

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1.6

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200

250

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Jul-1

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Jul-1

1

Jan-

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Jul-1

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Jan-

13

Jul-1

3

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14

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4

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16

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6

Jan-


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Greece Unemployment Rate (%)Greece Wages and Salaries (% YoY), RHS

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12

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Hungary Unemployment Rate (%)Hungary Wages and Salaries (% YoY), RHS

Appendix

11



Figure 18: Two-year yields and policy rates – Poland

Source: Bloomberg

Figure 19: Unemployment and wage growth – Poland

Source: Eurostat

Romania: As in Hungary, politics is contributing to strong wages growth. The employment

rate has risen only modestly from its lows to 66%, and another 11 ppts could theoretically

be added before it reached Czech levels. Labour costs are up 34% over 2012-2016 (the

highest rise in the EU), but they remain just two-thirds of Hungary’s costs. We think

Romania can still attract investment whilst also benefiting from rising domestic demand.

Figure 20: Three-year yields and policy rates – Romania

Source: Bloomberg

Figure 21: Unemployment and wage growth – Romania

Source: Eurostat

Estonia: Has already seen high labour cost increases of 27% off a high base (relative to

Latvia or Lithuania). Unless the country can lift its employment rate to Swedish or

Icelandic levels, wage pressure is likely to continue.

Figure 22: Unemployment and wage growth – Estonia

Source: Eurostat

Figure 23: Unemployment and wage growth – Lithuania

Source: Eurostat

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Poland Unemployment Rate (%)Poland Wages and Salaries (% YoY), RHS

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Romania Unemployment Rate (%)Romania Wages and Salaries (% YoY), RHS

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Estonia Unemployment Rate (%)Estonia Wages and Salaries (% YoY), RHS

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Lithuania Unemployment Rate (%)Lithuania Wages and Salaries (% YoY), RHS

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Lithuania/Croatia/Slovenia: None of these appear to have serious issues in the near

term. Lithuania is probably leading the three in terms of domestic demand lifting inflation.

Figure 24: Unemployment and wage growth - Croatia

Source: Eurostat

Figure 25: Unemployment and wage growth - Slovenia

Source: Eurostat

Egypt: Given the late 2016 devaluation, we see Egypt as one of the most plausible long-

term beneficiaries of Central European wage inflation. We suspect labour costs are half

that of Romania. The workforce is still growing, and with an employment rate of 41% in

2014, there is scope for 30 ppts of increase in coming decades, which should keep a lid

on labour pressures. This will require more women to enter the workforce, which is

plausible given the improved educational access seen in the 1990s. Egypt looks ripe to

pick up manufacturing and export orientated FDI in coming years. The government may

need to engage more with Ease of Doing Business reforms and provide reassurance

regarding political risk.

Morocco: The population is still on course to rise marginally by 2020, but the labour

market opportunity for foreign investors also centres on women. The overall employment

is still 31 ppts below Hungary and 25 ppts below Romania where the Renault Dacia was

first built. Given we assume lower labour costs, it makes sense that Renault has already

started manufacturing the Dacia in Morocco. That, and Peugeot’s investment, and others,

means there is already a challenger in place to take over from CE3 as the next

investment destination. Morocco may be held back by the historically low proportion of

educated women, the poor rank of the education that is offered (see education outcome

data in Daniel Salter’s The Focal Point: Morocco, the non-frontier frontier). But education

access has improved, and the country has an enviable record of macro-economic

stability. Politically, the stability of Morocco gives it an advantage over all others in the

MENA region.

Tunisia: Like Morocco, this also has a developed industrial base, but a better education

level, and is also cheap relative to central Europe. We suspect FDI should also be

attracted here, but as in Egypt, politics and terrorism will be obstacles to attracting

investors.

Turkey: We were positively surprised by the sustained rise in the employment rate. This

can help fuel GDP growth for decades to come, as Turkey reaps the dividends of

educated (now) nearly 100% of its girls. Turkey is the only country aside from Egypt to

see its young population rise in numbers over 2015-2020. There is a developed industrial

base, which adds to the attraction for industrial FDI. Turkey may not be as cheap as other

alternatives.

Ukraine: We believe labour costs are low, given the per capita GDP comparisons, and as

central European wages take off, we might assume this is finally Ukraine’s decade to

attract foreign direct investment. But demographic problems are more acute in Ukraine

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Croatia Unemployment Rate (%)

Croatia Wages and Salaries (% YoY), RHS

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Slovenia Unemployment Rate (%)Slovenia Wages and Salaries (% YoY), RHS

13



than any other country we cover. So the labour force is already shrinking. Mass

emigration means foreign direct investors elsewhere in CEE may already be taking

advantage of cheap Ukrainian labour by paying them to work in Polish factories. High

profile corruption problems and the ongoing tension with Russia may also deter foreign

investors.

Iran: We include Iran given it too has a manufacturing base, and a well educated

workforce, and despite poor demographics. However, we see foreign direct investors

coming to Iran to supply the domestic market, but not the European market.

See also the following publications

Morocco

Thoughts from a Renaissance Man: Morocco’s ‘first world’ problems, 29 February 2016

The Focal Point: Morocco, the non-frontier frontier, 18 January 2017

Egypt

Thoughts from a Renaissance Man: Egypt – Still bullish, 30 January 2017

Ukraine

CIS and regional economies: Rising prospects, 27 April 2017

Turkey

Thoughts from a Renaissance Man: A bear market rally in Turkey?, 5 December 2016

Turkish Renaissance: The market was a right to yawn, 24 April 2017

Iran

The Focal Point: Iran’s presidential election – What’s Persian for glasnost and

perestroika?, 22 May 2017

Frontier and Emerging Markets:

Populism Matters, 15 May 2017

The Fifth Element, 12 June 2017

The Fifth Element Data Book, 12 June 2017












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