Czech Republic’s Economic Machine
Today we are going to take a trip to the lovely Czech Republic. Let’s take a look at their Economic Machine, and see if there are any opportunities in this beautiful country.
As we always do, I will be looking at the Economy through “transaction-based” approach, which means at the bottom of everything, an economy is just someone selling something and someone buying something. That is it.
As in all posts, I will look at 3 main factors to determine how the Economic Machine is working:
(1) Productivity Growth
(2) The Long Term Debt Cycle
(3) The Short Term Debt Cycle.
Let’s get started!
The Czech Republic is one of the most industrialized of the emerging markets in Europe, has a well educated population and developed infrastructure. To begin our analysis we first look at Czech Republic’s current Annual GDP Growth Rate, which expanded at 0.40% in the 3rd quarter of 2014.
On average GDP growth rate has been around 0.57% in the last 20 years, with a high of around 2.3% or so, and an all time low of around -3.3%. The chart above seems to suggest a bottom here, and I think we go up from these levels.
Keep in mind, one of my pinnacle beliefs is that movements in GDP growth are typically due to expansions or contractions in credit. So, to really understand where productivity is going you have to examine the debt cycles.
Recessions/depressions don’t occur because a drop in Productivity, as many economists think. They occur because a drop in demand, and that is largely due to a drop in credit creation.
Additionally, the most important thing to keep in mind is that debt can’t grow forever, because eventually people can no longer afford to service the debt. The debt-service payments grow faster than incomes, and you have defaults. That is how we get cycles.
Lets look at the Long Term Debt cycle to clear up the picture a bit.
2. The Long Term Debt Cycle
Long Term debt cycles typically occur over a period of 50–75 years, and are a result of debts rising faster incomes, until you get to a point where people/countries can no longer afford to service their debts, usually because interest rates are low and can’t go any lower.
We look at the Long Term Debt Cycle because the availability of credit(debt) expands spending beyond income levels. And one person’s spending is another person’s income. So, an increase in credit, increases spending, which increases income levels, which increases spending, which increases demand, which increases production, and as production increases so should income levels.
The above events are what cause the long term debt cycle.
This cycle churns and churns, and the bubble inflates and inflates, and everyone is happy. But this cannot go on forever. Eventually debts grow faster than incomes, and debt service payments become too high and people/countries can’t afford to service that debt. That is when the entire thing comes crashing down, and everything works in reverse.
Knowing where a country is in this process, and where it is likely headed, will give you insights as to how certain assets will perform.
To begin, the below chart shows the Government Debt to GDP in Czech Republic at 46.40% of GDP, which is a healthy level, and not worrisome at all. When debt levels get too high government find themselves in situations where they can no longer afford to service their debt, and thus have to cut back on spending, which pulls down the economy. But at these levels I do not have concerns that Czech Republic’s government could run into a that situation in the future, and could even expand debt levels to spur economic growth in the future.
Now, lets talk about something very important, and that is deleveraging is the process of reducing debt burdens when they become too high (i.e., debt and debt service relative to incomes).
Deleveragings typically end via a mix of 1) debt reduction, 2) austerity, 3) redistributions of wealth, and 4) debt monetization.
A depression is the economic contraction phase of a deleveraging. It occurs because the contraction in private sector debt cannot be rectified by the central bank lowering the cost of money. In depressions,
- a large number of debtors have obligations to deliver more money than they have to meet their obligations, and
- monetary policy is ineffective in reducing debt service costs and stimulating credit growth.
Typically, monetary policy is ineffective in stimulating credit growth either because interest rates can’t be lowered (because interest rates are near 0%) to the point of favorably influencing the economics of spending and capital formation (this produces deflationary deleveragings), or because money growth goes into the purchase of inflation-hedge assets rather than into credit growth, which produces inflationary deleveragings.
Depressions are typically ended by central banks printing money to monetize debt in amounts that offset the deflationary depression effects of debt reductions and austerity.
One could consider Interest Rates in Czech Republic, which are currently at 0.05%, which is almost as low as it can go. And it seems that at this level we are at the bottom or near bottom of the long term cycle in rates.
With rates at this level, central bankers have no room to lower rates if needed to increase growth in debt, which ultimately spurs growth in the overall economy. Within the last 20 years, central bankers have dropped rates dramatically to spur lending and economic growth. Further below we will see if this has helped spur growth.
Lets switch to Money Supply (M0) in Czech Republic, which has been steadily rising for the last 20 years.
With an increase in the money supply you will typically see an increase in purchases, increased incomes, increased demand, and fast economic growth. The only worry of this increase in spending and demand is of course inflation.
Currently, the inflation rate in Czech Republic is at 0.01%, which is pretty much deflation, and a little worrisome to me.
Keep in mind the drop in oil prices, and Czech Republic is a net oil importer, so that should be good news for the consumer. I just think it is taking some time for the extra money they consumer may now have as a result of lower oil to make its way back into the economy.
Now, debt problems typically occur because financial assets are bought at high prices with credit. Let’s look at Czech Republic Stock market to get a general picture of where financial assets are currently.
This chart clearly shows the boom in 2007 or so, and the subsequent crash. And that we have had a somewhat cyclical pattern since then. We appear to be entering a flattening here, or plateau. This could be a valley at these levels, and I would look for levels to reverse in 2015 and the stock market to show some gains in the coming year.
Another key indicator is how much the Government is spending, as the Government is one of the most important aspects of the economy. If the government is increasing its spending, that will increase demand, increased demand leads to increased incomes, which leads to more spending, and eventually an increase in prices.
As seen above, Government spending in Czech Republic had been steadily increasing, but might be at a plateaued a bit here. Still, levels are overall high and I don’t see any signs of government spending falling drastically.
Now, the top of the long term debt cycle occurs when 1) debt service payments are high and/or 2) monetary policy doesn’t spur credit growth.
With Debt to GDP high, interest rates low, and inflation low, there are some problems in the Czech Republic. Still, I like to take a contrarian view point. You are supposed to sell when people are happy, and buy when people are panicking. Not that people are panicking in Czech Republic, but with QE right around the corner I think it would be wise to look for inexpensive opportunities in Europe. Czech Republic might be one.
Let’s look at the Short Term Debt Cycle to better understand this economy.
3. The Short Term Debt Cycle
Short term debt cycles occur when you have 1) spending growing faster than 2) the capacity to produce, which then leads to 3) increases in prices (inflation), and that continues until 4) spending is slowed by tightening monetary policy, and that is when a recession happens.
Recessions typically arise from a contraction in private sector debt growth, which is typically the results of central banks tightening (increasing rates) to stave off inflation. If we work that backwards we see that increasing inflation will drive central banks to tighten, which will slow private sector debt growth and bring about a recession.
So, to begin, we want to examine the growth rate in Consumer Spending (money and credit) and Government spending, and see if total spending is growing faster than the growth rate of the capacity to produce.
Below is a chart showing Consumer Spending, which has been cyclical in nature. we see a clear rise around 2007, and the subsequent crash. Consumer spending rebounded and then fell again around 2013, and looks to have rebounded as of late. We appear to be near a peak t current levels, and I would watch these figures closely for any sign of a downturn, because it may be coming soon.
Below is one of the strangest Consumer Credit charts I’ve ever seen. Apparently, consumer credit fell off a cliff in the last couple of months. Something just doesn’t seem right about that. Prior to this drop, consumer credit was growing steadily for a decade, and I would expect these numbers to be revised to show that has continued into the present.
As well, when discussing the short term debt cycle, we have to examine whether total spending is growing faster than the growth rate of the capacity to produce, because that leads to inflation, until spending is curtailed by tighten monetary policy, which brings about a recession.
To examine production capacity we look at Industrial Production, which decreased 0.40% in November of 2014 (the most recent data available). Clear cycles are evident in this chart, and I think this drop in production is only temporary, and these levels will reverse in the next couple of quarters.
Thus, at current levels, spending is obviously growing faster than the capacity to produce, so I think inflation could be a concern in the foreseeable future, which is worrisome.
Lets pull it all together.
So the recent growth numbers were not great, but I think that with the drop in oil prices we are going to see a great improvement to consumer’s in the Czech Republic. As well, I think Industrial Production will rebound in 2015, and with government debt well under control, I think we could see an increase in government spending in 2015, and continued growth in consumer spending. I think the Czech Republic is actually in a very healthy position at these levels, and could see a very fruitful 2015.
When I look at everything above, I think that Czech Republic is in the “Mid-Cycle”, which lasts an average of 2–3 quarters, and is exemplified by:
- economic growth slows substantially ( to around 2%)
- inflation remains low
- growth in consumption slows
- rate of inventory accumulations declines
- interest rates dip
- the stock market rate of increase tapers off
- the rate of decline in inflation-hedge assets slows.
But I could be totally wrong. What do you think?