Monday, December 28, 2009

A Zero Too Far

Paul Krugman in the NYT

Maybe we knew, at some unconscious, instinctive level, that it would be an era best forgotten. Whatever the reason, we got through the first decade of the new millennium without ever agreeing on what to call it. The aughts? The naughties? Whatever. (Yes, I know that strictly speaking the millennium didn’t begin until 2001. Do we really care?)

But from an economic point of view, I’d suggest that we call the decade past the Big Zero. It was a decade in which nothing good happened, and none of the optimistic things we were supposed to believe turned out to be true.

It was a decade with basically zero job creation. O.K., the headline employment number for December 2009 will be slightly higher than that for December 1999, but only slightly. And private-sector employment has actually declined — the first decade on record in which that happened.

It was a decade with zero economic gains for the typical family. Actually, even at the height of the alleged “Bush boom,” in 2007, median household income adjusted for inflation was lower than it had been in 1999. And you know what happened next.

It was a decade of zero gains for homeowners, even if they bought early: right now housing prices, adjusted for inflation, are roughly back to where they were at the beginning of the decade. And for those who bought in the decade’s middle years — when all the serious people ridiculed warnings that housing prices made no sense, that we were in the middle of a gigantic bubble — well, I feel your pain. Almost a quarter of all mortgages in America, and 45 percent of mortgages in Florida, are underwater, with owners owing more than their houses are worth.

Last and least for most Americans — but a big deal for retirement accounts, not to mention the talking heads on financial TV — it was a decade of zero gains for stocks, even without taking inflation into account. Remember the excitement when the Dow first topped 10,000, and best-selling books like “Dow 36,000” predicted that the good times would just keep rolling? Well, that was back in 1999. Last week the market closed at 10,520.

So there was a whole lot of nothing going on in measures of economic progress or success. Funny how that happened.

For as the decade began, there was an overwhelming sense of economic triumphalism in America’s business and political establishments, a belief that we — more than anyone else in the world — knew what we were doing.

Let me quote from a speech that Lawrence Summers, then deputy Treasury secretary (and now the Obama administration’s top economist), gave in 1999. “If you ask why the American financial system succeeds,” he said, “at least my reading of the history would be that there is no innovation more important than that of generally accepted accounting principles: it means that every investor gets to see information presented on a comparable basis; that there is discipline on company managements in the way they report and monitor their activities.” And he went on to declare that there is “an ongoing process that really is what makes our capital market work and work as stably as it does.”

So here’s what Mr. Summers — and, to be fair, just about everyone in a policy-making position at the time — believed in 1999: America has honest corporate accounting; this lets investors make good decisions, and also forces management to behave responsibly; and the result is a stable, well-functioning financial system.

What percentage of all this turned out to be true? Zero.

What was truly impressive about the decade past, however, was our unwillingness, as a nation, to learn from our mistakes.

Even as the dot-com bubble deflated, credulous bankers and investors began inflating a new bubble in housing. Even after famous, admired companies like Enron and WorldCom were revealed to have been Potemkin corporations with facades built out of creative accounting, analysts and investors believed banks’ claims about their own financial strength and bought into the hype about investments they didn’t understand. Even after triggering a global economic collapse, and having to be rescued at taxpayers’ expense, bankers wasted no time going right back to the culture of giant bonuses and excessive leverage.

Then there are the politicians. Even now, it’s hard to get Democrats, President Obama included, to deliver a full-throated critique of the practices that got us into the mess we’re in. And as for the Republicans: now that their policies of tax cuts and deregulation have led us into an economic quagmire, their prescription for recovery is — tax cuts and deregulation.

So let’s bid a not at all fond farewell to the Big Zero — the decade in which we achieved nothing and learned nothing. Will the next decade be better? Stay tuned. Oh, and happy New Year.

Tuesday, December 22, 2009

ECB Tender Hints At Weak Spots In Improving Market

By Geoffrey T. Smith


FRANKFURT (Dow Jones)--The European Central Bank on Wednesday wrapped up its anti-crisis program of extraordinarily long-term lending to banks with a funding operation that is likely to keep short-term euro interest rates ultra-low at least for another six months.

Analysts said the results of the tender suggested that much of the banking system can now live without the ECB's life-support mechanism, but that a small number of banks are still highly dependent on it, and the European banking system still has plenty of weak points that could cause trouble in the future.

The ECB said it injected EUR96.937 billion at a 12-month lending operation, the last of three that it announced in the spring in order to guarantee that banks in the 16-country currency bloc have access to longer-term funding to weather the credit crisis.

Market conditions have eased substantially since then. The interest rates at which solid banks lend to each other for short periods--even without the safety of collateral--are now below the ECB's reference rate of 1%.

Analysts said that the money allotted Wednesday--which will increase the total amount of ECB money in the market by around 14%--will keep the Euro Overnight Index Average, or EONIA, which is the key rate for interbank overnight money, around its recent level of 0.30%-0.35%. It was little changed after the operation, as was the euro, which ticked only fractionally higher against the dollar Wednesday.

Actual overnight rates have barely moved from this level since the ECB's first 12-month tender--a mammoth EUR442.24 billion in June--created a structural surplus of money in the market and reduced the cost of borrowing accordingly.

Silvio Perruzzo, an economist with Royal Bank of Scotland in London, said he doesn't expect EONIA to move until the funds from this first 12-month tender mature next June, taking away much of the excess liquidity currently in circulation.

As in the previous two 12-month tenders, the ECB gave banks all the money they asked for. However, in contrast to those tenders, it said the effective interest rate wouldn't be a fixed 1%, but rather would be tied to the average rate at the main one-week refinancing operations over the next year.

This move was generally interpreted as an effort to stop banks from indulging in risk-free carry trades--using money borrowed at low, fixed rates to finance bets on government bonds or foreign-currency deposits offering higher rates. The indexation means that banks won't know the final cost of the funds until a year from now.

Banks have deployed the cheap ECB billions mainly in two ways this year: either hoarding them to insure themselves against possible defaults by other banks, or throwing them at perceived low-risk instruments, particularly government bonds. The latter has generated handsome paper profits for the banks but raised concerns about a possible bubble in those markets.

"Indexation has halted the speculative demand," said Lena Komileva, an analyst with Tullet Prebon in London. She estimated that the market had needed only EUR70 billion from the bank, and that the remaining EUR27 billion was "precautionary."

The number of banks bidding, at 224, was down by more than 60% from 589 at the previous 12-month operation in September, indicating that many more banks now have access to the market instead of relying on the ECB, Komileva said.

However, the banks that remain dependent on the ECB appear to be even more dependent than they were three months ago, the average bid rising from EUR128 million to EUR433 million.

"Those banks which went to the ECB this time are clearly those which are having difficulty funding themselves in the market," RBS's Perruzzo said.

Tullet Prebon's Komileva said the tender suggests an increasing polarization in the euro-zone money market, between those banks that are successfully overcoming the crisis and those that aren't. Greek and Austrian banks in particular have been in the spotlight in the last week amid a fresh wave of fears over their exposure, respectively, to domestic fiscal problems and continuing pressures from bad loans in central and eastern Europe.

"Structurally, the tender shows more normal conditions in the core [European market], but the periphery is still struggling," Komileva said.

The ECB, as ever, declined to comment on which banks participated in the tender. Last month, the Greek central bank had urged Greek commercial banks to show restraint at the tender, rather than increase their dependence on ECB funding.

The ECB plans one final six-month tender in March to smooth its exit from longer-term refinancing operations. After March, none of its operations will be longer than the three-month tenders the ECB had offered since its inception in 1999. The central bank plans to end most of its other non-standard policy measures over the course of 2010, as the banking sector completes its return to health after the financial crisis.

Sunday, December 20, 2009

Why Standard and Poor's Are Right To Worry About Spanish Finances

"Spain's weaknesses over the developing crisis reflect mainly the reversal of the continuous domestic demand expansion of over a decade, which was associated with high indebtedness of the private sector, large external deficits and debt, an oversized housing sector compared with the euro area average and fast rising asset prices, notably of real estate assets."
European Commission assessment of Spain's Response to the Excess Deficit Procedure, Brussels 11 November 2009.

“The latest services PMI data suggests that the Spanish economy remains on a downward trajectory. The fact that variables such as activity, new orders and employment all fell at sharper rates during November is real cause for concern, with the prospects for 2010 becoming increasingly gloomy. Businesses report that consumers remain cautious of making any major purchases, particularly those requiring credit. It appears that any economic recovery over the next twelve months will be gradual and drawn-out.”
Andrew Harker, economist at Markit commenting on the November Spanish Services PMI survey.
According to Spanish Prime Minister José Luis Rodriguez Zapatero Spain's government is firmly committed to reducing its fiscal deficit, and is intent on lowering it as requested by the EU Commission by 1.5% of GDP annually, until it finally brings it within the EU 3 per cent of gross domestic product limit by 2013 at the latest. What's more he is quite explicit about how this is going to be possible: Spain is right now, and even as I write, on the verge of emerging from the long night of recession in whose grip it has now been for several quarters. As such it will soon resume its old and normal path onwards down the highway of high speed growth. There is only one snag here: few external observers are prepared to share Mr Zapatero's optimist.

“The return to growth and the expected fiscal consolidation will allow us to reach the stability pact objectives by 2013,” Mr Zapatero said in a speech last week, using a rhetoric by which few outside Spain are now convinced, and indeed only the day before the credit rating agency Standard & Poor’s had revised its outlook for Kingdom of Spain sovereign debt to negative from stable. The decision followed their earlier move last January to downgrade Spanish debt by revising their long term rating from AAA to AA+. S&Ps justified their latest decision by stating that they now believe Spain will experience a more pronounced and persistent deterioration in its public finances and a more prolonged period of economic weakness versus its peers than looked probable at the start of the year. So things have been getting worse and not better, and indeed, the EU Commission themsleves seem to take a similar view, since while they have lifted their immediate excess deficit procedure in the short term (see below) their longer term worries have only grown.

Standard and Poor's feel that reducing Spain’s sizable fiscal and economic imbalances requires strong policy actions, actions which have yet to materialize, and the EU Commission and just about everyone else agree, and the only people who seem to take the view that the current policy mix is "just fine" are José Luis Zapatero, and the political party that maintains him in office.

Effectively S&P's are concerned about two things: i) growing fiscal deficits; and ii) growth prospects:

The change in the outlook stems from our expectation of significantly lower GDP growth and persistently high fiscal deficits relative to peers over the medium term, in the absence of more aggressive fiscal consolidation efforts and a stronger policy focus on enhancing medium-term growth prospects.

Compared to its rated peers, we believe that Spain faces a prolonged period of below-par economic performance, with trend GDP growth below 1% annually, due to high private sector indebtedness (177% of GDP in 2009) and an inflexible labor market. These factors, in turn, suggest to us that deflationary pressures could be more persistent in Spain than in most other Eurozone sovereigns, which we expect would further slow the pace of fiscal consolidation in the medium term.
Even some insie Spain are now openly questioning the viability of the government's strategy. The downward revisision in Spain's credit outlook, was "hard to deny," according to Spanish representative on the European Central Bank Governing Council, Jose Manuel Gonzalez-Paramo - "The ECB is not taking issue with whether Standard & Poor's should cut Spain's rating, but the report that accompanies this warning is hard to deny" he told the Spanish Press agancy EFE, adding that he was "convinced that the Spanish authorities share this analysis and will do whatever is needed to avoid S&P's negative outlook resulting in a change in rating". However Standard and Poor's explicitly justified the negative outlook by referring to the fact that Spain was not showing signs of taking adequate action to cut its longer term fiscal deficit as required by the EU Commission, and Spanish Prime Minister Jose Luis Rodriguez Zapatero himself stated he could see no no reason why ratings agency Standard & Poor's should downgrade the long-term sovereign debt rating of Spain. So it is hard to share Gomez-Paramo's (rather diplomatic) optimism at this point.

The World Turned Inside Out

Just how realistic is the view being taking by the Spanish administration at this point, and just what are the prospects of that imminent and sutainable return to growth in the Spanish economy on which everything seems to depend? That is the question we will try to ask ourselves in that follows. Certainly the situation we are looking at is a rather peculiar one, since Mr Zapatero's recovery hope seems to be a widely shared one inside Spain. Certainly, if the ICO Consumer Confidence reading is anything to go by, Spaniards are feeling pretty hopeful at this point that the worst of the economic crisis is now behind them. Evidently confidence is still not back to its old pre-crisis level, but it is now well up from its July 2008 lows.

What is even more interesting is to look at the breakdown of some of the ICO consumer confidence index components. According to the ICO data series I looked at, the expectations index has only been above the present level three times since the series started in January 2004 (in September 2004, in January 2005, and in August 2009). That is, the Spanish people currently have the third highest level of expectations about the future registered at any point over the last five years. I find that pretty incredible. Evidently Mr Zapatero is not alone in assuming that S&P's have it wrong.

But is such a viewpoint rationally founded, and even more to the point, is there any economic justification which lies behind it? What could explain such dyed-in-the-wool optimism? It is hard to understand, unless, perhaps, the alternative - that Spain is in for a long and difficult economic correction, after many years of relatively "painless" economic growth - is very hard to contemplate for a population who are severely unaccustomed to such pressures.

Possibly the Financial Times' Victor Mallet puts his finger on another important ingredient - after two years of being told that they have been living though the worst crisis in recent memory, many Spaniards have quite simply never had it so good, so how could anything horrible possibly happen now?
The pre-Christmas mood in Madrid is a curious mixture of pessimism and cheeriness.On the one hand, anxious Spaniards are told they are suffering the worst economic crisis in 50 years and fear for their jobs. On the other, those still in employment have rarely had more money to spend. It is not surprising that the city’s restaurants are packed with noisy but neurotic diners as the holiday season approaches.

The reasons for this odd combination of economic gloom and robust personal consumption are no secret. Unemployment has risen sharply – to 18 per cent of the workforce in Spain – but emergency measures around the world to avert another depression have kept economies flush with liquidity and cut interest rates (and monthly mortgage payments) to historically low levels. Inflation is low or negative.

Low interest rates, safe jobs (or pensions) and salaries rising faster than the rate of inflation all combine to make "the worst" not that bad at all, especially if the government are shelling out 12% percent of GDP per annum to pay for it all. But as Javier Díaz-Giménez, economy professor at IESE business school says (and S&P's well know) “It is easy to raise the deficit to 10 per cent of GDP....But we really don’t know how to get back down to a deficit of 3 per cent of GDP.” This then is the problem, especially as a reducing deficit, rising taxes and utility charges, and eventually rising interest rates all make the task of restoring economic growth seem a rather daunting one.

Think about it this way: Spain's construction industry amounted to around 12 percent of GDP, now government borrowing of around the same size has stepped in to fill the gap, but once this poly-filla solution no longer holds, where is the employment creating activity to come from? As Michael Hennigan, Founder and Editor of Finfacts Ireland says in the (similar) Irish context:

"The scale of the task of creating sustainable jobs in the international tradable goods and services sectors, is illustrated... by stark statistics from State agency, Forfás, which show that in the ten years to 2008, less than 4,000 net new jobs were added by foreign and Irish-owned firms, while overall employment in construction, the public sector, retail and distribution, expanded by over half a million......Total Irish employment in December 1998 was 1.54 million and was 2.05 million in December 2008 - a surge of 33 per cent. In the peak boom year of 2006, 83,000 new jobs were added in the economy while direct job creation in the export sectors was less than 6,000."
I don't have the comparable Spanish figures to hand, but the situation is surely not that different.

Meanwhile Spanish Industry and Services Show No Real Signs Of Recovery

There was no let up in the contraction in the Spanish manufacturing sector in November, and PMI data pointed to a further deterioration of operating conditions. Moreover, the rates of decline of key variables such as output, new orders and employment all accelerated during the month, with the seasonally adjusted Markit Purchasing Managers’ Index falling to 45.3, from 46.3 in October. The Spanish manufacturing PMI has now been below the neutral 50.0 mark for two years, with the latest reading being the lowest since last June.

Commenting on the Spanish Manufacturing PMI survey data, Andrew Harker,
economist at Markit, said:

“The Spanish manufacturing sector looks set to endure a bleak winter period, characterised by falling new business, job cuts and heavy price discounting. The glimpse of a possible recovery seen during the summer appears to have been only a temporary reprieve, with even the stabilisation of demand now seeming some way off again.”

The impression gained from the PMI data is broadly confirmed by the monthly output statistics supplied by the Spanish statistics office (INE) to Eurostat. True, in October the output index was up fractionally over September (a preliminary 0.29% on a seasonal and calendar adjusted basis), but there is no sign of any sort of recovery and the drift is still downwards.

Output has now fallen around 32% from its July 2007 peak.

Nor is the situation in the Spanish services sector much better, and November PMI data indicated that operating conditions among Spanish service providers worsened again during the month, and at a sharper pace than in the previous survey period. Business activity, new business and employment all fell more quickly than in October. The headline seasonally adjusted Business Activity Index – which is based on a single question asking respondents to report on the actual change in business activity at their companies compared to one month ago – dropped to 46.1 in November, from 47.7 in the previous month. The latest reading pointed to the fastest rate of decline since August.

The situation is also confirmed by the Spanish INE Services Activity Index, which shows that activity was down 7.9% in October over October 2008, following a 9.8% drop in October 2008 over October 2007.

Which means that activity was own a total of 17.4% from the July 2007 peak, or an average of 23% over the three months August - October, just better than the 25% average drop registered in January to March. Which means that while there is plenty of evidence that the contraction has stabilised during the last six months, this seems to be stability with a negative (and not a positive) outlook, given that things have now started to deteriorate again, and we must never forget that this stability has been achieved via a massive fiscal injection from the government, an injection which cannot be sustained indefinitely.

Construction Activity Continues to Fall

Activity fell around one percent in October over September.

While total output is now down nearly 35 percent from the July 2006 peak. That is to say, this Christmas Spanish construction output will have been falling for nearly three and a half years, and this decline is going to be permanent, the only outsanding issue is what activity is going to replace it.

Spain's Employment Minister Celestino Corbacho was widely quoted in the Spanish press last week as saying that he could see clear signs that the housing market had "bottomed". I would really badly like to know where he is finding such signs.

In the first place Spain’s residential construction sector continues to shrink at an unprecedented rate. Housing starts fell by 47% (to 33,140) in Q3 compared to the same period in 2008, according to the latest figure from the Ministry of Housing. If we exclude social housing the fall was much greater - 61% less homes started in the period, and evn 20% down compared to the second quarter. Taken over a 12 month period total housing starts were down 35% to 444,544.

At the other end of the production line the Housing Ministry reported 83,500 construction completions in the third quarter (excluding social housing), 41% down year on the same time last year and 13% down on the previous quarter. Over a 12 month period construction completions were down 35% to 444,544, and this in a market where sales of new properties are running at a rate of something like 200,000 properties a year. That is to say, the stock of unsold houses continues to swell.

And prices continue to fall, since even though the Tinsa property price index for November showed that average prices fell by only 6.6% over the previous 12 months (down from 7.4% last month - the smallest annual fall in a year) this piece of data is not that illuminating in a market where prices have now been falling for more than twelve months. So while TINSA's own graphs makes for a very encouraging looking trend line, you need to remember that they've plotted the percentage change in house prices on an annual basis. If we look at the overall index (below) we see pretty much the same picture as with everything else, slower decline, but decline nonetheless. No bottom hit yet.

And, of course, if we look at the peak to present chart, then the percentage fall simply continues, and house prices are now down 14.75% on the December 2007 peak.

And it isn't only sceptics like me who think there is still a long, long way to go with Spain's house price adjustment. According to the latest report on the housing market by BBVA, Spanish property prices were 30% over-valued at the end of 2007, since they only fell by something like 10% in 2008, they have another 20% or so to drop before the correction is over. BBVA thus expect prices to fall by 7% in 2009, 8% next year, and 5% in 2011 Prices won’t stabilise until 2012, and the price correction is likely to be a protracted and long drawn out affair. What the likely impact of this on the real economy, and on their balance sheet, is likely to be they don't say.

BBVA mentions another key reason why the fall in Spanish house prices is far from over - the high ratio of house prices to annual disposable income. This ratio (house prices / annual disposable income) rose to 7.7 years at the height of the boom, and has now fallen back to 6.6 years. But that is a long way off the historical average of 4, not to mention the 3.5 it has fallen to in the US.

Meanwhile, a new report from BNP Paribas Real Estate, the real estate arm of French bank BNP Paribas, argues that banks in Spain (currently the largest holders of unwanted real estate) will need to start offering bigger discounts (of up to 50% in 2010 they suggest) if they are to really start to move their stock of property. Spain's banks claim to be offering discounts to buyers, but as BNP Paribas Real Estate argue, judging by the growing inventory they hold, these are not big enough to attract the volume of sales they really need.

In fact, after several months of dithering towards a recovery the Spanish housing market fnally relapsed again in October, with the number of houses falling by 24% compared to the same month last year, according to the latest figures from the National Institute of Statistics (INE).

In fact sales in October fell below the 30,000 transactions per month rate for the first time since last April. Sales were down by 10% over September. According to Mark Stucklin of Spanish Property Insight the explanation for this relapse is to be found in the breakdown between new build and resales. During the first half of 2009 sales of newly built homes were significantly higher than resales, whereas in normal years it’s the other way around. Indeed, if new build sales hadn’t been higher this year the market crash would have been significantly worse. But many of the new build sales recorded this year were actually sold off plan during the boom, and many others were banks buying properties from developers to keep them afloat, so not they were not really sales at all. Naturally, as those sources of sales start to dry up (either as the stock of sold off plan evaporates, or banks cannot accept too many more), then new build sales begin to head south.

As you can see from the above chart which Mark produced for his post, new build sales dropped sharply in October, almost to the level of resales. And if we look at the rate of monthly house sales in the P2P chart below, you will see that monthly sales have now dropped by neary 60% from their peak. That is to say, we are still having something over 400,000 new houses coming off the production line, and only a maximum of 200,000 new home purchases. Even as output drops towards an annual 100,000, this level of sales would only clear off the backlog at a rate of something like 100,000 a year, which mean we would be well over a decade clearing off that massive backlog, and meantime who foots the bill for maintaining such a large stock?

The chart above tells the story eloquently. It shows cumulative sales over 12 months to the end of every quarter, and you can see how the market has shrunk from just above 1 million sales over the 12 months to the end of Q1 2006, to just above 400,000 sales at the end of Q3 this year. In terms of transactions, the market has shrunk by around 60% over that period.

And we get a similar picture on the mortgages front, with the volume of new residential mortgages signed in September being 62,411, down 4.2% compared to the same month last year. In value terms the fall was more pronounced, with new residential mortgages dropping 16% to 7.3 billion Euros. The good news is the annual decline in new mortgage lending has been bottoming out in the last few months. It fell 31% in June, 19% in July, 7% in August, and 4.% in September.

And looking towards the future again, the number of new homes started in the third quarter was down 54% compared to the same period in 2008, according to the latest figures from Spain’s College of Architects. Excluding social housing, there were just 17,500 planning approvals in the third quarter, compared to 28,400 last year. To put this into perspective, planning approvals were down by 94% from the 287,000 granted in the third quarter of 2006, at the height of Spain’s construction boom. The chart (below, and which comes again from Mark Stucklin) shows just how dramatically Spain’s residential construction production chain has collapsed in the last few years. This year there are likely to be a total of just over 100,000 planning approvals, the lowest level in more than 20 years.

Unemployment Rising Towards the 20 Percent Mark and Beyond

Spain's registered jobless total rose for the fourth consecutive month in November according to data from the employment office INEM, and is obviously bound to rise further as the recession drags on and the multi-billion euro stimulus package gradually loses steam. Seasonally unadjusted data showed Spanish jobless claims rose by 60,593 in November from October to reach a total of almost 3.9 million people, almost a million more than a year ago.

The rise was milder than the almost 100,000 layoffs in October and leap of around 170,000 seen in November 2008, but this should not be taken as a sign the economy will begin to create jobs any time soon. Data showed the jobless rate in the service industry rose 1.7 percent month-on-month and by 1.3 percent in construction. Joblessness also increased by 0.6 percent in the industrial sector and by 2.6 percent in agriculture.

The Spanish government has injected some 8 billion euros (nearly one percent of GDP) into the economy this year in order to create more than 400,000 mostly low-skilled jobs in order to put a temporary patch on the hole left by the paralysed housing sector. The 30,000 or so infrastructure contracts created under what is know as plan E will be completed by the end of the year, and with little sign of a general return to growth, or a revival in job creating activity the majority of those employed on these projects will surely soon be finding their way back onto the dole queues. The government has announced plans for a new 5 billion euro stimulus plan for 2010, but this, in theory, will be aimed at sustainable long-term growth sectors like renewable energy, environmental tourism and new technologies.

November's 1.5% rise in jobless claims is nonetheless weaker than the 2.6 percent rise in October, the 2.2 percent in September and the 2.4 percent in August. And the annual rate of increase fell sharply, from 42.7% in October to 29.43% in November. But does the month mark a new trend, or will we see renewed deterioration as the winter advances? The Spanish administration officially provides only quarterly (unadjusted) data on the unemployment rate but does forward a monthly (and seasonally adjusted) rate to according to the European Union statistics agency Eurostat, based on the Labour Force Survey (which is generally regarded as a more accurate (and internationally comparable) assessment of the true level of unemployment than simple Labour Office signings. This stood at 19.3 percent in October, the second highest rate in the entire EU, and behind only Latvia.

Of course, as ever with this administration, hope springs eternal. The Spanish economy will likely return to growth early next year and start creating new jobs toward the end of next year, according to Finance Minister Elena Salgado: "I think there is a high probability we will start to grow in early 2010," she told the Cadena Ser radio station, although she did admit that the trend of rising unemployment will not likely be broken until late 2010 or early 2011. "We think we will start to see net job creation in some sectors at the end of 2010, and more clearly in 2011," she said. This realism about job creation is, of course, a by-product of the very low 2010 growth rate envisaged by even the optimistic forecast of the Spanish government (less than one percent), which given the need for drastic productivity improvement in Spain would evidently not be enough to create new employment. And, of course, others are less optimistic, with both the EU Commission and the IMF foreseeing negative growth in 2010. Indeed the EU Commission still anticipates unemployment to be over 20 percent in 2011.

Basically the outlook is bleak, and unemployment is far more likely to continue rising than it is to fall. My own current estimate (which in part depends on how much consumer prices fall, on how seriously the government follows the agreed 1.5% reduction in the fiscal debt, and on how rapidly interest rate expectations rise at the ECB) is that we should be moving towards the 25% range around next summer.

Domestic Consumption Continues To Decline

Despite the best efforts of the Spanish government stimulus programme household consumption continues to decline, at a slower rate in the third quarter, but still decline. The quarter on quarter drop was 0.1% as compared with a 1.5% drop in the second quarter, and a 2.4% fall in the first one. On an annual basic household consumption was down 4.2% in the third quarter following a 7.5% drop in the second one (see chart).

And retail sales simply keep falling, more slowly than before, but down and down they go.

In October they fell back again over September, and were down a total of 10.3% from their November 2007 peak.

So Why Should We Expect Recovery In 2010?

Or better put, why should we suspect that we might not see a Spanish economic recovery in 2010? Well, let's take a quick look at some of the structural features of Spanish GDP. As the Spanish administration never lose an opportunity to point out, Spain's economic contraction to date has been significantly less extreme than both the Eurozone 16 and the EU 27 averages. GDP never actually declined as dramatically as it did in some other countries.

But looking at the situation in this way is rather misleading, since in fact, as can be seen in the chart below (which comes from the Spanish statistical office - the INE - as does the chart above) in fact domestic demand in the Spanish economy fell every bit as rapidly as in other European countries, but external demand in fact moved in such a way as to add percentage points to the final GDP reading.

In fact, on analysing the two main components of Spanish GDP from the expenditure side in in the third quarter, the INE found, on the one hand, that national demand reduced its negative contribution to annual GDP movements by nine tenths as compared with the previous quarter, from minus 7.4 to minus 6.5 points, whereas conversely, external demand reduced its positive contribution to aggregate growth seven points, from 3.2 to 2.5 points.

Now all of this is, as I say, rather strange to those unaccustomed to the niceities of GDP analysis, since the positive contribution from external trade to GDP growth has got nothing to do with extra imports, but rather it is a product of the fact that Spain was running a whopping trade deficit, and simply reducing this trade deficit gave the positive impetus to GDP, whereas the third quarter negative impact of external trade was the product of, guess what, a further deterioration in the trade balance (see chart below).

The thing is, behind the whole situation lies the problem of debt, and indebtedness. Basically, despite the fact that many, many Spaniards have never had it so good as they did in 2009, Spanish living standards have actually been falling since the amount of money available for spending has been falling, since what we need to take into account here is the sum of actual earned income PLUS what Spanish citizens are able to borrow in any given time period. Essentially when you borrow you shift disposable income from one time period to another. This is why Franco Mogigliani advanced what has come to be called the life cycle theory of saving and borrowing, since patterns change across the age groups, and naturally as whole populations age the pattern of any particular country changes. A younger country - Ireland, the US - is much more likely to be a net borrower, while an older country - Japan, Sweden, Germany - is much more likely to be a net saver.

So why is all this important. Well, during the years you borrow, you spend more. I think this is obvious, and also why when there are less capital inflows there are less imports. Capital flows are to finance borrowing, and borrowing improves living standards in the short term, until it has to be paid back. Remember the saying, I am a rich man till the day I have to pay my debts.

The impact of the capital flows is that in the short term your disposable income goes up (someone gives you money to spend), while later on it goes down (as you have to subtract from earned income to pay back). This latter situation is where Spain is now. The capital flows have been sustained via the ECB liquidity process, which has fuelled domestic demand via government borrowing and spending, but at some point all of this needs to be reversed and the debts need to be paid down, and that will mean lower disposable income (in terms of money to spend) for the internal population as a whole, which is why without sales abroad domestic consumption will only continue to fall and unemployment will continue to rise. The only way to compensate for this is to export and run a trade surplus, since in this way the debt payments can be made without subtracting from current income.

Of course, borrowing is not income neutral in the longer term either, since it all depends what the borrowed funds are spent on. If you spend the borrowed money on infrastructure, education and new productive capacity (ie useful investment) then evidently you can raise the trajectory of GDP in the longer term, while if you only use it to finance short term consumption - or invest in a lot of houses no one really needs - then you simply get a destruction of internal productive capacity, massive price distortions and long term GDP on a lower trajectory. This is where Spain, Greece and much of Eastern Europe are now.

Basically, for those countries who lack their own currencies there is now real alternative to a rather painful “internal devaluation” to restore export competitiveness and the trade surplus. And this of course is why everyone from Standard and Poor's to the EU Commission and the ECB are now insisting not only on a return to fiscal order, but deep structural reforms to restore competitiveness.

EU Excessive Deficit Procedure Now The Key

On 27 April 2009 the European Council (Ecofin, the Finance Ministers of member states basically) decided, in accordance with Article 104(6) of the Treaty establishing the European Community, that an excessive deficit existed in Spain and issued recommendations to correct the excessive deficit by 2012 at the latest. At the time this appeared to imply an average annual fiscal effort of 1.25 % of GDP over the period 2010-2013. The Council also established a deadline of 27 October 2009 for effective action to be taken.

On 20 October 2009 the Council agreed that, provided that the Commission forecasts continue to indicate that the recovery in the EU economies is strengthening and becoming self-sustaining, fiscal consolidation in all EU Member States should start in 2011 at the latest, that specificities of country situations should be taken into account, and that a number of countries need to consolidate before then.

According to the Commission January 2009 interim forecast, Spain's GDP was projected to decline in by 2 % in 2009 and by a further 0.2 % in 2010. Spain's economic outlook deteriorated rapidly during the course of 2009 and the Commission autumn forecast projected a GDP decline of 3.7 % in 2009 and 0.8 % in 2010 (basically the same as the IMF October outlook). As the commission stress, the downward revision in nominal (current price terms) is even stronger, since prices (and the GDP deflator) have been falling over the period, and this is a strong negative factor for both revenue and outstanding debt to GDP levels.

Spain’s fiscal outlook also worsened in the course of 2009 reflecting this sharper-than-expected fall in economic activity. Notably, the Commission autumn forecast project the 2009 general government deficit to come in at 11.2 % of GDP, compared with the 6.2 % deficit envisioned in the January forecast. In particular, revenue has fallen sharply more than expected, as the result of the stronger-than-assumed fall in activity and of the fact that tax proceeds are reflecting falling activity much more strongly than the normal long-term tax elasticity considerations would have suggested.

Thus in the Commission review of the Spanish Excess Deficit Procedure carried out at the end of October, they found that the plans for government expenditure foreseen in the January 2009 update of the Spanish stability programme had been broadly observed (and this is the big difference with the Greek case) although the expenditure-to-GDP ratio increased on account of the lower-than-expected nominal GDP level.

The Commission now expect the 2009 deterioration in the fiscal outlook to continue into 2010, although the discretionary fiscal measures adopted by the Spanish government post January 2009 were considered to have played no role in the intervening deterioration in the fiscal outlook. They thus took the view that "unexpected adverse economic events with major unfavourable consequences for government finances" had occurred and thus recommended a provisional lifting of the Excess Deficit Procedure, conditional on substantial further progress in bringing the deficit within the 3% of GDP limit by 2013.

Looking ahead to 2010, the Commission took the view that the draft 2010 Budget Law published in late September 2009, which targeted a general government deficit of 8.1 % of GDP in 2010. was credible, given that the combined impact of the withdrawal of the temporary stimulus measures, on the one hand, and of the new discretionary measures presented in the draft 2010 Budget Law, on the other, could yield a significant improvement of the fiscal balance by some 1.75 % of GDP in 2010. Further in the light of the unanticipated deterioration in Spanish government finances an average annual fiscal effort in excess of that originally recommended - at least 1.25 % of GDP - is needed between 2010 and 2013 in order to bring the headline government deficit below the 3 % of GDP reference value by 2013. The Commission aregue that this correction would represent an average annual fiscal effort of above 1.5 % of GDP over the period 2010-2013.

The Commission autumn forecast, projects a government deficit of 11.2 % of GDP in 2009 and 10.1 % of GDP in 2010. Assuming unchanged policies, and GDP growth of 1 % in 2011, the deficit would then be 9.8 % of GDP. A credible and sustained adjustment path thus requires the Spanish authorities to implement the budgetary plans outlined in the draft 2010 Budget Law; ensure an average annual fiscal effort of above 1.5 % of GDP over the period 2010-2013; and, most importantly, to specify the measures that are necessary to achieve the correction of the excessive deficit by 2013.

As the Spanish administration constantly point out, Spain's accumulated national debt is a lot lower as a percentage of GDP than that of many other EU member states, and even after 2011 will remain below the EU average. However, as given the difficult situation likely to be faced by Spanish banks and the heavier than average weight of ageing in Spain, the burden of Spain's finances in the context of an economy which may struggle to find growth over the next decade should not be underestimated.

According to the Commission autumn forecast, general government debt is projected to reach 54.3 % of GDP in 2009, up from 39.7 % in 2008. Although it is currently still below the 60 % of GDP EU reference value, debt is expected to increase further in 2010 and 2011 to 66 % and 74 % of GDP respectively. And evidently there is strong downside risk here should growth be lower than anticipated, and/or prices fall, this number could rise significantly, and it could should Spain's banks need a substantial bailout at some point.

As the Commission point out, the long-term budgetary impact of ageing in Spain is well above the EU average - mainly as the result of a projected high increase in pension expenditure as a share of GDP over the coming decades. The budgetary position in 2009 compounds the budgetary impact of population ageing on the sustainability gap. The Commission thus stresses the importance of improving the primary balance over the medium term and of further reforms to Spain's old-age pension and health-care systems in order to reduce the risk to the long-term sustainability of public finances.

Indeed, the Council of Finance Ministers (Ecofin) specifically "invited" the Spanish authorities to improve the long-term sustainability of public finances by implementing further old-age pension and health care reform measures when they lifted the Excess Deficit Procedure at the start of December. The Council also invited the Spanish authorities to implement reforms with a view to raising potential GDP growth.

As Standard and Poor's stressed, their decision to revise the Spanish sovereign outlook to negative reflected the perceived risk of a further downgrade within the next two years in the absence of more aggressive actions by the authorities to tackle fiscal and external imbalances. It is the continuing silence which surrounds this absence which is so ominous, and makes the concerns of the EU Commission and the various ratings agencies at this point more than understandable.

Friday, November 27, 2009

Total Eclipse Of The Sun Hits Dubai World

Back in the heady days of 2006 some 30,000 cranes, roughly a quarter of total global capacity, were busy whirring away in Dubai. Today most of these devices have either left to find service in other parts of the globe, or lie silent, unused and unloved. In what is only the latest sign of the ongoing property snarl-up affecting the emirate Nakheel, Dubai World’s property developer subsidiary, asked on Wednesday for a delay in their next debt payment. The move was widely seen by investors as a technical default, raising concerns about investment in risky assets right across the globe. So while their company slogan may well be that the sun never sets over Dubai World, the fact is that Dubai World’s sun not only no longer shines, it is suffering from something more like a total eclipse.

According to the last reckoning, government owned Dubai World has some $59 billion in outstanding liabilities, making the company responsible for the lion’s share of the total $80-100 billion in estimated Dubai state debt. Up to now all maturing government-linked debt has been paid off in full, with government funds making up any shortfall in private funds. But the latest announcement suggests that weaknesses in the global property sector and vulnerability of the emirate’s economic model is leading the government to have second thoughts, and the clear impression is that Nakheel could be a very different story given the government's expressed intention of supporting only viable companies.
More than the scale of the issue, the problem this week in Dubai has been the uncertainty created, the underlying lack of transparency about the state of corporate and national finances and about exactly which debt will be honored, and above all about whether or not other countries – both within and outside the region - will be affected via the process known to financial analysts as contagion.

The consequences of the present payment standstill are wide ranging, as would be the impact of any eventual default. The repayment of Dubai World's $4 billion Nakheel bond was seen by investors as a key test for the emirate's ability to deal with the rest of the $80 billion or so owed by the government and its state-controlled companies. Dubai’s ability and willingness to do just this is what is now in doubt, and the way the process has been handled so far is leading to all manner of investor speculation.

The blow caused by the announcement was initially softened by news earlier the same day that the government had raised $5 billion from Abu Dhabi banks, but this optimism was soon dented as it sank in that the figure was considerably less than what the emirate had been hoping to attract from external investors and the sequencing of the two announcements is interpreted as suggesting that the Abu Dhabi money will not be spent on companies like Nakheel and Dubai World.

Indeed Dubai's growing problems had been evident for some time, with the credit rating agencies sharply downgrading Dubai government-owned corporations over the last year as expectations for the extent of likely government support have declined. Earlier this month Moody’s cut the ratings on Dubai Ports World, and Dubai Electricity and Water to Baa2 (junk status) from A3 and downgraded 4 other government linked companies, with the agency noting in its press release that the debt restructuring plan "highlights the government's intention to strictly adhere to its stated policy of supporting only those companies with viable long-term business prospects”

Aside from the Dubai issue itelf the big worry now is possible contagion to other markets, with Central and Eastern Europe in the forefront of everyone’s mind, given the overlap in bank exposure. The announcement also lead to a sharp a drop in the value of the UK pound on the fear that the Dubai government could be forced into a rapid sale of its international real estate, and since the emirate has extensive UK property holdings which might go under the hammer any such move would clearly have implications for the UK property market, and the banks that have exposure to it.

In total European banks are estimated to have some $40 billion of exposure to Dubai with Standard Chartered leading the group according to research from Credit Suisse. HSBC Holdings, Barclays, Royal Bank of Scotland Group and Lloyds Banking Group also have some, significantly lower, exposure.

Since the decision to halt payments has raised fears of the largest sovereign default since Argentina 2001, most of the attention has been focused on sovereign debt issues, and these, of course, extend far beyond the Middle East itself. In particular European bond market worries grew over the ability of riskier government borrowers from Russia to Greece and Italy to pay back their debts in the longer run. And it is just here that one of the long term consequences of what happened this week in Dubai can be found, since with government after government pressing the accelerator pedal hard to the floor on the stimulus front, and digging ever deeper into the public purse to plug gaps in the bank balance sheets, the perception that paying back all the accumulated debt may be harder than expected, especially with ageing population problems to think about, is now gaining traction among investors. And once sovereign debt default fears really come up over the investor radar, it is going to be very hard work to remove them.

Greek sovereign debt in particular is attracting a great deal of attention, and this week one historic milestone has been passed, since the cost of insuring Greek debt for the first time equalled that of insuring equivalent Turkish debt. At first sight this is very shocking news, since as recently as 2007, the Turkish CDS spread was trading at about 500 basis points on perceived fiscal risks. The Greek spread, by contrast, was nearer 15bp. The country is, after all, a member of the European Monetary Union, and its euro-denominated bonds were considered effectively protected by other euro states. But over the past year the fiscal position of many emerging markets nations, Turkey among them, has become more favourable, while that of some Eurozone countries, including Ireland and Spain as well as Greece, has steadily deteriorated.

Evidently such comparisons constitute a fairly bitter blow to Greek pride, but there is a much bigger issue here, one which goes straight to the heart of the Dubai saga. Two years ago, global investors generally did not spend much time worrying about the risk that seemingly remote, nasty events might occur. But the financial crisis has changed this perception. Having had their fingers badly burned once, investors are eager not to have it happen a second time, which is why what is happening in Dubai now makes them nervous, and why Europe’s governments would do well to think more about the future, and especially about ensuring that we don’t see Dubai like events starting to happen much nearer to home.

Saturday, November 14, 2009

How Much Of A Eurozone Rebound Was There Really In Q3?

Sorry, and I apologise in advance: in this post I'm going to be a nit-picker. The Eurozone third quarter growth story is all about differences (between countries) and these differences are in many ways all about inventories. So maybe I should have titled the post "all about inventories", following Pedro Almodovar's cinematographic lead in cycling and recycling that old "all about Eve" metaphor - necessity is the mother of invention, and movements in inventories are progenitors of both growth, and of that notorious double dip difficulty. So which one is we have on our hands here?

Indeed, the fact that the devil, as always, lies in the details should not really surprise us since economics isn't that different from other sciences, and isn't such a difficult subject to work with - even if some journalists and lot of bank analysts seem to make it look like it is by managing so frequently to make a dogs dinner out of what should really been an ever so plain, ordinary, and vanilla flavour ice cream. Let me explain.

But first off let's register a very simple plain, evident, and totally undisputed item of fact - the "eurozone sixteen" economy (whatever that rather nebulous concept actually refers to, when you dig down a little below the surface) poked its nose timidly out of recession in the third quarter of this year, with gross domestic product in the 16 countries using the euro rising 0.4 percent from the previous quarter (see chart below). This return to positive headline growth technically brings a recession which lasted five consecutive quarters of shrinking output to a close - even though output was still four percent below that registered in the same period in 2008. So we are out of recession, but are we out of the woods?

Well, basically I think we aren't, and to explain why I think we aren't I'm going to pick (yet one more time) on poor old Frank Atkins of the Financial Times. It almost hurts me to do this, since I am not trying to say that Frank is an especially bad example of economic journalism (far from it - see below) even if he is sometimes very badly served by his headline writers who over the weekend managed to switch Friday's declamatory "Germany powers eurozone recovery" (and here) to Sunday's much more modest "European recession ends with a whimper" but since this is the second time just over as many months that Frank has wheeled out the German economy "powering something or other" word out, I cannot help concluding that either he really likes the expression, or that he must know something I don't about what is actually going on in Germany, since structurally speaking it would seem to me that such "powering" is now completely impossible, given the economy's evident export dependence. Thus far from powering up anything, the German economy is always - in some significant and non-trivial sense - going to be "powered" by someone or somewhere else. The thing about Frank is - in Eurozone economic terms at any rate - he is both geographically very close to where the action is (ie in Frankfurt), and communicational very much in touch with thinking in Brussels and Franckfurt, which is what always makes what he has to say interesting, at the very least. On the other hand, since the journalistic consensus seems to have shifted over the weekend - quite literally from a bang for the buck to a whimper - we might really want to ask ourselves whether we still think the rebound is as strong as it was first claimed to be.

"Germany’s economy expanded by 0.7 per cent in the third quarter", Frank told us (in Friday's version) "marking a sharp acceleration in the pace of recovery in Europe’s largest economy, but the pick-up in France fell short of expectations."

Well, here we have two facts - the Germany economy did grow by 0.7%, and growth in the French economy was below consensus expectations - and one opinion, that the growth represented a sharp acceleration in the German recovery. In fact, in France output expanded by 0.3% in the third quarter, a very similar pace to that seen in the second quarter, but significantly below consensus expectations which were for a 0.6% growth rate.

But really the issue this raises isn't actually one about the French economy at all, but about how the economists in question managed to talk themselves into having such ludicrous expectations, and about what methodology exactly it was they were using to arrive at them. Certainly I am a leading "bull" on the French economy, but I never came anywhere near the quoted number in my estimations, and indeed in my most recent full analysis of the French economy, published 27 October last on A Fistful Of Euros and elsewhere, I actually said this:

"French GDP surprised positively with a 0.3% quarterly gain in the second quarter. Given the data we are seeing, a forecast of 0.2% quarterly growth for both the third and final quarters would not seem to be an unreasonable expectation at this point, which would mean the French economy would shrink by something under 2.5% in 2009, well below the average Eurozone contraction rate."

So you could say, rather than being disappointed I should have been rather surprised on the upside by the outcome, since growth at 0.3% came in higher than my expectation (0.2%). But truth be told, I really wouldn't want to make this claim very strongly, since I was in fact practicing what we Catalans call the ancient art of "trampa" (astute trickery), sin being intentionally excessively prudent in order to outperform, and also trying to shift attention away from the short term headline number issues about this quarters French GDP number to the longer term issue of what happens to monetary policy in a "Eurozone 16" if France recovers significantly more sharply than everyone else.

Before continuing further, I would also make a second point, one which I think is pretty relevant to the whole debate about where the Eurozone actually stands in the here and now, and that is that my most recent piece was actually written about the OCTOBER PMI data, that is I was already looking ahead and talking about prospects for the fourth quarter, whereas Friday's release was actually backward looking, and taking us back in time, in order to revisit not Brideshead, but economic data from the third quarter in an attempt to get a better picture of what was happening back then, even if, as we are now about to see, since Friday's release was only a "flash" one, we still lack most of the detailed breakdown which would enable us to do just that. So in many ways Friday's news was already history (which makes it even more surprising how consensus interpretations have shifted over the weekend) and what really interests us is what is happening now, and where the current so called "recovery" is actually heading. And just to rub our noses right in it, we could remember that a week on Monday (23 November) we will have the Markit Flash PMIs for November (and this will already give us two thirds of the fourth quarter data to play around with, which should help us come up with quite realistic estimates of what eventual GDP will look like).

Thus, despite my openly professed French "bullishness" I do want to stress that I am only expecting modest growth again from France in the fourth quarter, but the important point we should expect this growth to be sustained going forward, and it is this that makes France so different from much of the rest of the Eurozone, since France has the capacity to generate autonomous (endogenously driven) growth in consumer demand and it is precisely this feature that makes the French economy so special (in the Eurozone context) at this point. Anyone looking for dramatic (sustained) surges in the any of the advanced economies at this point is, basically, living on another planet (possibly, I suspect, the one we are all being expected to send our exports to).

Now, after so much palaver, why do I consider this digging for details to be so important? Well, lets look at this from the German Federal Statistics Office:

"In a quarter-on-quarter comparison, when adjusted for price, seasonal and
calendar variations, especially exports as well as capital formation in
machinery and equipment and in construction had a positive impact on growth.
However, a large quarter-on-quarter increase was also recorded for imports
which, among other things, led to a build-up in inventories. Final consumption
expenditure of households, however, was down and slowed down economic growth."

Now if you look at the chart below, you will see that German growth was in the second quarter was, more than anything, a statistical quirk which resulted from a balancing act between strong swings in inventories and in net trade. In the third quarter, as far as we can see (since we don't have that ever so important detailed breakdown), this position has quite literally been inverted, as the earlier trade bonus has been eaten away by growth in imports (largely to stock up on export oriented inventories, not items destined towards domestic consumption) and this part we more or less know, since we do have all the trade data in for the quarter.

So we need to see the MAGNITUDE of the German inventory shift, and then we can get an idea of how much this could unwind in Q4. The current position reminds me very much of Q1 2008, when Germany put in a record annualised growth rate (1.7% q-o-q, 7.2% annually) only then to slouch off into recession and four consecutive quarters of GDP contraction. One reason for this surge in GDP, then, was that the huge growth registered was a by product of a massive inventory pile-up (see chart), a pile up which was precisely the result of an anticipated continuation in demand, demand which, as it happened, never materialised.

Now the current position is not as bad as Q1 2008, since the size of the distortion is not so great, and the general external environment may be more supportive in Q4 2009, but still I think the general structural point holds. Indeed the October PMI suggests inventories are coming down again, with Markit reporting that "companies remained cautious regarding input buying and stock levels" and that the "October data showed that both inventories of purchases and finished goods fell sharply over the month". Finally, we should not let this last point from the German Federal Statistics Office Report escape our notice, since at the end of the day it holds the key:

"Final consumption expenditure of households, however, was down and slowed down economic growth."

So now, by way of comparison, let's turn our attention to France, and see what was actually happening there. Now, according to the quarterly report from analysts at Nomura:

"France is the only country to publish a components breakdown and the details are disappointing, with domestic private demand still very depressed. Most of the growth came from public spending and net trade; private consumption was flat, while fixed investment from firms and even more from households retrenched heavily. Inventories continued to decline."

Well, as Nomura say, France has published a table showing the breakdown, and just for the record, here it is:

Now the Nomura people say "with domestic private demand still very depressed", but, I'm sorry, if you take a look at line three in the table, which shows quarter on quarter household consumption, you will see this is stable, and up. In fact France has not shown one single quarter of quarter over quarter contraction in household spending during the whole crisis. This is what I mean when I say robust. Now you could say that this is all about cash for clunkers, and to some extent you would be right, but other countries have had cash for clunkers programmes, and domestic consumption hasn't held up anything like as well, so the outstanding issue for economic theory, and for eurozone monetary and fiscal policy, is why, why does the French economy and none other exhibit this profile?

Now you might want to argue that French household consumption was stationary in the third quarter (and this is what many of the analysts point to), but I would respond by pointing out it is still well up on consumption in the third quarter of 2008 due to the earlier quarters of growth. OK, so we don't exactly have a consumption boom (yet), but is anyone really expecting one at this point? Even in Norway? All I am saying, and saying almost boorishly, to the point that it irritates, is that French consumption has the potential to rise in the coming quarters, while German consumption doesn't, and this is going to be the key FACT about the Eurozone in the months and quarters ahead. And if you find economic at times a boring and tedious subject, then I'm sorry, sometime things are just like that.

And please, please, note this: "Inventories continued to decline."

Look at the next to last line in the table. French inventories fell by 1.5% quarter over quarter. So, to put things plainly, the real difference between those headline GDP numbers for Germany and France is that Germany increased inventories while France ran them down, and government spending in both cases played a large part in the growth. The thing is, in the fourth quarter it is quite likely that Germany will have to run down some of those inventories, while France may start to increase them. Either way, I repeat, at this point French growth (even if at a tortoise pace) looks a lot more robust and a lot more sustainable than growth in any other Eurozone country, and if things turn out as they appear to be, then we will one more time need to be asking ourselves just what it is that is wrong with "convergence theory", since whatever the actual reason behind the present Eurozone divergences, the plain fact of the matter is that they exist.


The third quarter GDP data suggest that the region has exited recession, but the move was hardly a decisive one. Despite a 12%ar gain in industrial production across the region, GDP managed to increase by only 1.5%ar. Clearly, there was a lot of weakness in construction and services. These data will reinforce the perceptions of the consensus: that the upswing will be lackluster and bumpy. And, they present a major challenge to our more upbeat forecast of growth over the coming year. Indeed, if GDP can only increase by 1.5%ar when IP grows at a double digit pace, the largest gain since 1984, one can only worry about the future.

Ah well.

The GDP rise, incidentally, means that Greece, Spain and possibly Ireland are the only major Eurozone countries still in recession.

Thursday, October 29, 2009

Wednesday, October 28, 2009

The French Economy Rebounds And Hands The ECB A Major Dilemma

Whoever would have thought that some people once called economics the most dismal of sciences? Certainly, as the current crisis goes on and on, those of us who consider ourselves to be economists scarcely are able to find the time to squeeze in a dull moment, even here and there. But even at a broader level, interest in that most dismal of dismal topics - the theory and practice of central banking - seems now to fire up levels of enthusiasm here in Spain that make even the appetising prospect of a forthcoming Real Madrid-Barça football match pale in intensity. Even if it is the case, I have to admit, that the everyday Johnny (or Jill) come lately sitting in the bar still - truth be told - prefers the sports columns of the daily newspapers, or the lacivious details of the latest romantic adventure of one of the rich and famous to a careful perusal of the detailed minutes of the last policy rate setting meeting over at the central bank.

The reason for the sudden and unexpected upsurge in interest should, I would have thought, be obvious - since with over 85% of Spanish mortgages being variable (and thus determined by the ECB policy rate), and Spain's economy sinking into an ever deeper pit, the impact of the coming decisions (or even the hints at possible future decisions) have entered peoples lives like never before. And this is doubly the case in an environment where - as Bloomberg inform us this morning - central bankers from across the global, from Washington, to Sydney, to Oslo are likely to take increasing account of future accelerations in asset prices in an attempt to avoid repeating policy mistakes that are presumed to have inflated two speculative bubbles in a decade, culminating in the worst financial crisis since the Great Depression.

By way of illustration for their feature story the Blomberg reporters single out the prime example cases of Norway and Australia, countries whose recent stronger than average inflation and growth performance is now so well known to regular investors for the mention of their name in such reports to have become a mere commonplace, with the respective currencies being eagery purchased to the sound of hearty lipsmaking at the thought of all the juicy carry which lies ahead. Personally though, had I been doing the writing, I would have chosen a rather different example, one much nearer to the heart of Europe (and thus a little closer to my own) - France.

And why France you may ask? Well quite simply because the French economy is now plainly and evidently on the mend. That is the big, big news which can be gleaned from last Friday's Flash Markit PMI readings.

What stands out in this PMI months data is the performance of the French economy. The output Index, based on a sample of around 85% of normal monthly survey replies, indicated that growth of the French private sector was strongly sustained in October, and into a third successive month. Climbing to 58.4, from 54.8 in September, the headline index indicated that growth accelerated markedly to reach its steepest in nearly three years.

Both the manufacturing and services sectors were strongly up - manufacturing output increased for a fourth successive month and at 55.3 (from 53.0 in September) expanded at the steepest pace since May 2006. Services activity also rose well and at a level of 57.8 put in its best performance since February 2008.

This Time France, Not Spain, Is Different, But Is It Really A Case Of Vive La Difference?

So French industrial production has been steadily recovering in recent months and the latest business surveys show this should continue, even if activity is still significantly (12%, much less than many other euro area countries) below its pre-crisis level. Consumer confidence has been steadily rising for over a year - even if, again, it continues to be weak by historic standards. Household consumption has also been rising, and in fact remained positive on an annual basis throughout the crisis (see chart below), and even if the potential for substantial further acceleration seems limited, this is still the key difference between France - where there is sufficient autonomous domestic demand left for the stimulus package to work - and the other euro area economies.

In fact this seemingly unexpected leap into poll position hardly comes as a surprise to me, since I have long been arguing that the French economy would emerge as the strongest among the EU economies from the present deep recession, and some justification for this view can be found in this post here, while an earlier piece from Claus Vistesen in 2006 also gives an illustration of how we might think about the problem.

So one epoch ends, and another begins, inauspicious as the beginnings may be. And there is both good and bad news here, since this early and isolated recovery in France is bound to create difficulties of the "exit thinking" kind for policymakers over at the ECB. The most pressing of the problems will concern what to do about containing French inflation if exit dependency in Germany means that a full recovery there remains out of reach, while Italy languishes where it has always languished and Spain's seemingly intractable difficulties only increase. In other words, what will happen if - as seems obvious - the eurozone economies are in fact diverging, and not converging, and the divergence far from reducing is in fact increasing.

The long term decline in the GDP share of French manufacturing, which is closely associated with the steady opening of a trade deficit in that country, poses special threats and problems for ECB monetary policy. This long term manufacturing decline and growing external deficit are, in my opinion, the tell tale first signs of larger structural problems to come should inappropriate monetary policy be applied too hard for too long. That is to say France is well positioned to get a distortionary bubble next time round (of the exactly the kind the newly vigilant central banks should be at pains to avoid, and indeed precisely the bubble they successfully avoided last time round) unless the ECB and the French government are very clever and very agile indeed.

Above-par Inflation Looming Just Over The Horizon

In essence the return of growth in France will be welcomed with open arms across the euro area, since with it comes the prospect of opening up a larger French current account deficit and this will, of course, clearly help soak up all that newly found need to export which exists elsewhere in Europ (and especially in the South and the East). But if this should be the fate which befalls an unsuspecting French citizenry, and living in a Spain which has already been processed along this very same pipeline, then all I can say is "heaven help them" for what will then follow.

Again, all the early warning signs are there, including the prospect that France will begin to sustain above eurozone average inflation starting next year, and this will be the first time - as can be seen in the chart below - this has really happened on any sustained basis since the euro was introduced.

In fact, if we look at the second chart, which is only the above one with the reverse overlay, we can see that French inflation really only peaked its head above the average in late 2003/early 2004, and the overshoot was not that substantial.

This time things could well be very, very different, and the big change here is of course a direct result of what has just happened to Spain. Since given that Spain has now been catapulted from a high to a low growth (or even negative growth) mode, France has been ramped up the euro league table, moving from Mr Average to Monsieur Outperform, and this will have the consequence that the ECB policy rate - which will, remember, target eurozone average inflation -will be below the one which the French economy will, in reality, need. What this will mean in practice is that there is a real danger the French inflation rate will be above the policy rate - that is that negative interest rates will be applied. As we can see in the chart below, negative interest rates were applied to the Spanish economy between early 2002 and late 2006, and we all know what happened afterwards. With the return to growth French inflation is likely to rebound, and an annual rate of headline consumer price inflation of between 1.3% and 1.5% seems not unrealistic, which means, should the ECB not start to raise its refi rate early next year then France will be rebounding strongly under the twin tailwind effect of significant fiscal stimulus AND negative interest rates.

So France is about to become the ECB's stellar pupil, but looking at what actually happened to the previous prize students (Ireland and Spain) somehow I doubt that those responsible for running things at La Banque de France and the Elysee Palace will be jumping up and down with joy at the prospect. The bottom line then is that lots of difficult decisions are now looming for European policymakers - assuming they are sharp enough to spot them at this point.