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Tuesday, January 29, 2008

Emerging Market Correction and Pressure on the Forint

by Edward Hugh: Barcelona

Unfortunately Hungary's coming correction seems to be getting very near now. Portfolio Hungary reports this morning on the latest readings on the Calyon Risk Aversion Barometer. Caylon reported on Monday that global equity gyrations continue to dictate the direction of emerging market currencies, with risk aversion remaining high and European equities closing lower again on Monday. Indeed many currencies remained under pressure throughout the trading session yesterday. Budapest Economics also said yesterday that the HUF continued to be the most vulnerable currency in the region, with the currency temporarily hitting 259 against the euro yesterday, although it did finally manage to stabilize at slightly stronger levels by the end of the session.

Mitul Kotecha, head of global FX research at Calyon, confirmed the Budapest economics view, saying Hungary's forint appeared to be highly exposed to rising risk aversion. “Reflecting the vulnerability to risk aversion, correlations between the Calyon Risk Aversion Barometer and some emerging currencies are quite high at present," Kotecha is quoted as saying, adding that Hungary's forint “appears highly exposed to rising risk aversion, with the 1-month correlation between the Barometer and EUR/HUF at a strong 0.85." Of course, the HUF is also suffering from deteriorating domestic fundamentals, an aspect which of course he did not ignore.

Stefan Wagstyl, picks up the theme to some extent, and has another long and relevant piece in the Financial Times this morning, reflecting just how a change in tone is taking place even as I write.

The turmoil in financial markets is turning into a nerve-racking test for the economies of central and eastern Europe and the former Soviet Union. Economists have said the fast-growing region faces a slowdown following the financial shockwaves reverberating around the globe. But the precise impact is uncertain, especially on weaker economies.

The differences are registering in the financial markets. As investors reconsider their strategies, they are becoming more risk averse. Some have turned against emerging markets, including the ex-communistregion. Others are discriminating more between countries.

The spread on five-year credit default swaps (a measure of risk) has widened by 26 basis points for the Czech Republic since last June and by 44 basis points for Poland. But for Serbia and Ukraine the increase is 151 basis points; for Kazakhstan it is 218 basis points.

Given the recent unprecedented credit-fuelled growth surge, this slowdown could be welcome in countries trying to cope with inflationary pressures, including Ukraine, Kazakhstan and Russia, and those facing labour shortages, such as Poland.

The benefits could be even greater in economies facing yawning current account deficits, notably the Baltic states, Romania, Serbia and Bulgaria. As Leszek Balcerowicz, the former Polish central bank governor, told a business conference this month: "We should welcome some amount of a slowdown, especially in the Baltic states, which have been growing the fastest . . . We don't have the information that would make us predict a hard landing. Based on the current information a soft landing in the countries which have been growing fastest is more likely."

I am not as optimistic as Wagstyl is here that we will see soft landings. The existence of virtual currency pegs - which will need to be broken during the correction - virtually guarantees an abrupt change, as does the level of household debt in non local currency .

Wagstyl had an earlier FT piece where he drew attention to the way in which ageing populations and labour shortages were playing their part in this emerging crisis.

Fuelled by strong economic growth and soaring foreign investment, employment is increasing in availability just as emigration has sucked around 5m workers from eastern to western Europe. According to Eurostat, the EU’s statistics agency, labour costs are growing at their fastest rate since the end of Communism – with a 30 per cent increase in nominal costs in Latvia in the year to last September and rises of more than 20 per cent in Romania, Estonia and Lithuania. In Poland, the largest new member, the rise was just under 12 per cent.

In real terms, average gross wages in Poland rose more than 7 per cent in the first nine months of 2007 and in Romania by nearly 16 per cent, according to the Vienna-based Wiiw research institute.

While unemployment levels in western Europe have stayed at around 8 per cent since 2002, in the east they have slid from 14 per cent to under 9 per cent. In the region’s booming capital cities, almost everybody who wants work has a job. Leszek Wronski, head of the central Europe division of KPMG, the accountant and management consultant, says: “We have a job market controlled by employees.”

Even if labour markets ease a little, there will be no return to the super-abundance of workers of five years ago. The region’s populations are ageing even faster than in western Europe and, with the added effects of migration, the number of working-age people is falling in the Baltic states and central Europe. Eurostat predicts that the population of the new member states will decline from 103.6m in 2004 to under 100.6m in 2015, with particularly sharp drops in working-age people.

However, for governments and companies alike, rising labour costs and growing skills shortages raise big questions about the region’s future competitiveness. Everything from decisions on investment location to education, migration and population policies is coming under scrutiny.

So even while he doesn't directly go into how long term fertility may be playing a role in the drama we are watching unfold before our eyes, his mention of "population policy" seems to be a euphemism for this very topic. And if fertility isn't an important determinant in what has been happening, I would be grateful is someone could explain to me why we aren't seeing similar sorts of labour shortages in places like Thailand, Turkey, Chile, Brazil or Argentina, all of whom are growing - or have been, Turkey has slowed recently - very rapidly at the present time.

Back on the 28 August 2007 - just after the financial "turmoil" started - I posted the following, in a piece which still looks extremely good when looked at in the cold light of today, on Global Economy Matters:

"But any looming "credit crunch" is also likely to affect the so called "risk appetite" (that is the willingness to invest in riskier areas or activities) and the place where this is most likely to be felt is in the emerging market area. Those emerging markets which are considered to be most vulnerable will undoubtedly have the hardest time of it, and this brings us directly to Eastern Europe I think and to economies like those in the Baltics, Latvia, Estonia and Lithuania), to Hungary, and then maybe (if there were to be contagion) to the larger economies like Poland and Romania. Alarm driven reports about the dangers of a hard landing in the Baltics have been floating around for some months now (I say alarm driven not because the danger isn't real, but because most of the reports are quite superficial, and don't really appreciate the magnitude of the problem). Whatsmore, as the Bank for International Settlements pointed out in the June edition of its quarterly review , in 2006 Eastern European economies accountedfor a staggering 60% of new emerging market credit:"

At the start of September, and as part of an in depth analysis of Turkey, I posted the extract you will find below. The issue here is foresight, and our ability to see things coming. What is happening now has been obvious for some time, completely obvious, even if many people have had difficulty in seeing it. I completely resist the idea that economics cannot be scientific. I think it has to become much more of a science. But if we are to get from here to there we first need some paradigmatic models which enable us to see things coming rather better than we appear able to do right now.

In a much quoted paper - published back in 2004 by two UCLA economists (Schneider and Tornell) - it was argued that:

"In the last two decades, many middle-income countries have experienced boom-bust episodes centered around balance-of-payments crises. There is now a well-known set of stylized facts. The typical episode began with a lending boom and an appreciation of the real exchange rate. In the crisis that eventually ended the boom, a real depreciation coincided with widespread defaults by the domestic private sector on unhedged foreign-currency-denominated debt. The typical crisis came as a surprise to financial markets, and with hindsight it is not possible to pinpoint a large "fundamental" shock as an obvious trigger. After the crisis, foreign lenders were often bailed out. However, domestic credit fell dramatically and recovered much more slowly than output."

In starting off with this quote I really want to draw attention to two things.

First off, the way in which the current sub-prime liquidity problem in the banking sector of many developed economies is now steadily extending itself into a credit crunch in several emerging market economies. We are now beginning to see a clear and all too familiar pattern. There has been a lot of talk about the Asian crisis, and evidently there are some similarities with the pre 1998 situation, especially, as I shall be arguing over the coming days, in the emerging economies of Eastern Europe.

Secondly there is the "typical crisis came as a surprise to financial markets" argument, since it puzzles me why exactly this should be, or better put, why it should be assumed as a "stylised fact" about currency crises that such major events are in principle not forseeable. I find this very hard to accept. Are we really so inept we are not able to see trouble coming when it finally does come? Is economic theory really so useless in the face of complex "on the ground" facts. Something inside me resists this view. We ought to be able to see things coming, even if we need to distinguish between the where and the when. What I mean is that it should be possible, if the theories you are working with are worth any sort of candle, to pinpoint the areas of likely vulnerability. On the other hand, given that often seemingly random events precipitate the ultimate unwind, it is pretty well impossible to say in advance which random event will turn out to be the detonator on any given occassion.

The sub prime debt issue in the US is a good case in point here, since only at the start of August the Federal Reserve were assuring everyone that problems associated with the US housing market were well under control, while obviously they weren't and aren't, and equally obviously, now, such problems will be seen from the vantage point of hindsight to have played a key role in the events which are now unfolding before our eyes.

So even with this caveat, and with due regard for the well known problem of human fallibility, lets see if this time any of us are able to do just that bit better than normal, and in attempting to see things coming lets see if we can learn something which may make us better able to handle and foresee macro economic problems in thefuture.

For a fuller analysis of the specifics of Hungary's present crisis see "Just Why Is Hungary So Different From The Rest of the EU10?", "Hungarian Central Bank Leaves Interest Rates Unchanged" and "The EU Comission Warns Hungary on 2008 Budget Deficit".

For e theoretical exposition on why fertility matters to the EU10, see Claus Vistesen "Catch Up Growth and Demographics - Evidence from Eastern Europe".

Monday, January 28, 2008

The Economic Background to Italy's Political Crisis

by Edward Hugh: Barcelona

Italy's economic and political outlook continues to deteriorate. That is the only way we can read the political turmoil which currently affects the country and the steady but relentless trickle of negative economic news which continues to arrive on our desks. In recent days we have had the November retail sales data, which showed that sales dropped 0.3% on a monthly basis in November, reversing 0.4% growth recorded in October.

Then there was the ISAE January consumer confidence index, which showed consumer confidence fell back to the lowest in more than two years in January as accelerating inflation and slowing economic growth fueled consumer pessimism.

Then again Italian industrial production fell for a third consecutive month in November.

With this kind of background it is hardly surprising that the Bank of Italy has slashed its forecast for 2008 gross domestic product, citing a worsening global outlook dominated by the US subprime crisis, weakening consumer demand and rising raw material costs. The Bank cut its 2008 growth projection for Italy to 1.0 per cent from a previous 1.7 per cent.

Jobs Boom?

The only area where the outlook is not rather bleak is the labour market, since jobs are being created, and lots of them:

while unemployment has been steadily - I could say relentlessly - dropping in Italy over the last two or three years:

Yet this is not producing the anticipated upturn in domestic demand, largely for reasons - as explained in this post here - which appear to be to do with the rapid ageing of Italy's workforce and population.

Basically the macroeconomic dynamics of what is happening in Japan at the moment are hard to assess, quite simply beacuse we have never really been here before, and there is not consensus on how to interpret what we are seeing. Italy's working age population - ex migration - has touched its ceiling, and without immigration it will now go steadily down and down. The share of the elderly population in Italy is rising and rising, placing a heavy strain on the social security and health system, yet Italy has a well nown long term growth problem, so the dynamics of how you pay for this additional strain are hard to see at this point.

Everything now depends on raising the productivity of those employed. But Italy's performance in this respect has hardly been stellar in recent years and raising productivity today is pretty much synonymous with raising the human capital component of value added. So if in volume terms the numbers of older but less qualified people working - and working in more and more fragile and less and less well-paid occupations - swamps the number of new highly educated workers in highly productive jobs (we are talking about aggregates here) then the new value created by the society in question won't compensate for the contraction in the workforce. This is particularly true when it comes to raising participation rates in that oft quoted potential labour supply, female workers over 55. Many of the women in question are excellent wives and mothers, but given their often very low level of formal education, and given their lack of real experience of work out of the home, the economic worth in value added terms of their formal labour market participation may be much lower than many expect, and certainly this is where the evidence to date is leading us.

Ageing and Export Dependency

I also feel that the Italian experience is very similar and comparable with what we have been seeing in Japan and Germany, but we have the one important little detail in the Italian case that far from being able to gain GDP growth from exports, Italy runs a goods and services trade deficit, so what should be a boon turns out in fact to be a drag on growth.

In fact if we look at a chart which shows both quarterly export growth and quarterly movements in the trade balance the fact that there is a high degree of interdependence becomes obvious. The point here is not to deduce a direct correlation, but rather to show how sensitive Italian GDP growth is to movements in net exports, and this is a by product of population ageing and its inability to depend on internal demand.

Italy's Public Debt

Of course in the forefront of what happens next is bound to be the issue of public finance, and the government debt. Only this weekend Dominique Strauss-Kahn, the new managing director of the International Monetary Fund, warned that the intensifying credit crunch is so severe that lower interest rates alone will not be enough “to get out of the turmoil we are in" in remarks which are being widely interpreted as advocating an increased use of fiscal policy. But this is precisely where Italy is "twice cursed" since she will feel the impact of the turmoil, but will be unable to make effective use of fiscal policy since she is already so much in debt.

Italy has the highest level of pension spending - as a % of GDP - of any of the original EU15 states.

She also has the highest proportion over over 65s:

and the youngest average exit age from the labour force - a combination which it is very hard to see the logic for.

So behind Prodi's sudden fall, a steady mountain of issues are busy accumulating. Back in July last year the Prodi government reach a very imprudent agreement with Italy's trade unions which effectively overturned an earlier Berlusconi era decsion to raise Italy's retirment rate from the current 57 to 60 with effect from 1st January 2007. The age will now be raised steadily and more slowly. But these low retirement ages are ridiculous when you look at Italian male life expectancy at nearly 77.5 - one of the highest in the EU.

According to Eurostat data Italy has consistently run a fiscal deficit since 1990 (when Eurostat records beign):

and the accumulated government debt has consistently been over 100% of GDP throughout the entire period.

This situation, not surprisingly has regularly attracted the attention of both the EU Commission and the Ratings Agencies. The EU Commission had the following to say on the Italian debt situation in their most recent economic forecast (November 2007):

In 2007, the general government deficit is forecast at 2.3% of GDP. The improvement with respect to the 4.4% of GDP deficit recorded in 2006 reflects buoyant revenue as well as the impact of one-offs, which turns from a negative 1.2% of GDP in 2006 into a positive 0.2% of GDP (taxes on the revaluation of companies' assets and proceeds from the sale of real estate.......The government confirmed the target of a deficit at 2.2% of GDP for 2008, with real GDP growth at 1.5%. Starting from a 1.8% of GDP baseline deficit projection based on unchanged legislation, the draft 2008 budget law adopted on 29 September has a deficit-increasing impact of 0.4 pp. The draft budget law foresees a reshuffling of expenditure as well as additional current expenditure and some tax cuts. The financing of the public sector wage agreement for the period 2006-2007 absorbs almost three quarters of the net additional expenditure.

How Long Can You Fudge the Agencies?

Now I appreciate that this deficit review procedure is fairly technical, but I think at least three things shoul be clear.

1/ That during the relatively good years of 2006 and 2007 no major structural reform has been implemented to address the underlying deficit issues, and a good deal of the burden in reducing the annual deficit has been carried by one off measures and higher than anticipated revenues due to the relatively strong recent economic growth.

2/ That the Prodi government was already in the process of loosening the budget adjustment process for 2008 - by accepting a deficit increasing draft budget - even before the impact of the downturn of finances was contemplated, which means of course that we can expect now the outcome to be worse than projected.

3/ That the need for the Prodi coalition to reach consensus with his "social partners" in govenment made the process of structural reform virtually impossible as can be seen from the size of the public sector wage agreement mentioned by the Commission and the about turn on retirement age, and it is this factor really that made the whole political process such an unstable one.

And meantime the ratings agencies are waiting in the wings. Standard & Poor's have already said that the current budget plan won't do anything to improve their rating outlook for Italian government debt (indeed they could have gone so far as to warn that it might deteriorate it), and they are already predicting that Italy may well fail to meet the agreed objective of bringing its debt below 100 percent of GDP by 2010. As and when this fear is confirmed it will be a case of watch this space, I would say, since if Italy proves incpable of resolving this situation now, what realistic hope will there be later?

Thursday, January 24, 2008

One year later, Italy's Prodi falls

by Manuel Alvarez-Rivera, Puerto Rico

When the center-left coalition government of Italian Prime Minister Romano Prodi nearly collapsed early last year, I wrote here that "the events [...] may turn out to be the prelude of a greater crisis further down the road." Well, eleven months later that's exactly what has come to pass: after just twenty months in office, Prodi resigned on January 24, having narrowly lost a vote of confidence in the Italian Senate (by 161 votes against to 156 in favor).

In many ways, history repeats itself. As in 1998, a crucial ally on the fringes of the ruling coalition (the far-left Refounded Communists in 1998, the right-of-center UDEUR of Clemente Mastella in 2008) deserts the government, depriving it of a parliamentary majority (in the Chamber of Deputies in '98, in the Senate this time around). Prodi nonetheless soldiers on, hoping to turn things around, but ultimately comes up short by a narrow margin (by one vote in 1998, by five votes today). Finally, in both instances the definitive collapse of the government comes about a year after an earlier crisis had been successfully defused.

Although Prodi easily won a vote of confidence this Wednesday in the Chamber of Deputies, where the center-left holds a substantial majority (even after the departure of UDEUR), the Senate and the Chamber of Deputies are co-equal legislative bodies, and Italian governments must have majority support in both houses of Parliament in order to remain in office.

At the time of writing, it is expected that President Giorgio Napolitano will hold consultations on Friday, January 25 concerning the formation of a new government. Nonetheless, if it's not possible to form a new government capable of commanding a majority in both the Senate and the Chamber, early elections would have to be called, presumably for both houses.

Opinion polls currently have the center-right opposition parties ahead by a large margin, and to no one's surprise their most prominent leader, former Prime Minister Silvio Berlusconi is calling for early elections. However, President Napolitano appears to favor the formation of an interim, "institutional" government that would reform the proportional representation electoral law imposed by Berlusconi's government prior to the 2006 general election. Under the current system, parties with as little as two percent of the vote (and sometimes even less) can attain parliamentary representation, resulting in a highly fragmented legislature in which a very small party such as UDEUR - which actually polled only 1.4% of the vote in 2006 - can effectively hold the balance of power; Elections to the Italian Parliament has a comprehensive review of Italy's present and preceding electoral systems.

That said, it remains far from clear if such a government could be formed and who would preside it. Senate Speaker Franco Marini has been frequently mentioned as a possible candidate, and Prodi himself has not been ruled out. Just as important, while there may be a growing consensus that the current electoral system is not working in the country's best interest, so far there has been no agreement on an alternative. As such, it's quite possible that Italy will head to the polls later this year under the existing electoral system - with its well-known shortcomings - and that the government that emerges from that election may eventually find itself in a predicament similar to that of Prodi's outgoing cabinet.

Tuesday, January 22, 2008

Towards Troubled Times?

By Claus Vistesen Copenhagen

In times like these it is probably best to sit back, relax and 'enjoy' the show. However, as part of the financial punditry and as a macroeconomist it is simply impossible to not to weigh in on events. In the following I will account for where my focus is and (oh dear, oh dear) where and what I think will happen next.

First things first. What we are seeing now is of course by and large rumblings on the equity/FX/Futures markets which have the distinct theatrical effect that they occur in real time with very rapid moves up and down. Sometimes we then get so much real time action to the downside the hitherto slow movers in the form of central banks move in with emergency moves thus initially exacerbating the volatility as selling becomes buying and vice versa depending which market you are in. My poor poor monopoly money FX portfolio is a case in point. Thanks a lot Ben :). And all this was of course utterly unfair as it happened when I was completely incapacitated at a lecture in Capital Market Theory trying to learn how to derive tangency and minimum variance portfolios under various market conditions. So, this would then merely be to say that a lot of noise and fuzz are about and a real trend is difficult to discern. However, I do think it is possible to take stock on a couple of points and hypotheses which have been advanced in the past and to have a look at where it might be interesting look as we move forward.

Will Bernanke's Move Pay Off?

Well, look at your screens? You see red or green numbers? I think this will be the real and only testing ground for this. Markets will most likely continue to suffer but if the rout continues with the same force as we have seen it does not spell good news at all since then the Fed will have played all its cards and if people loose confidence in the Fed's ability to handle the situation then of course the whole edifice begins to crumble. In time of writing and as per reference to my fall from grace in FX monopoly money land it seems that the move might just have worked as intended; at least initially. The European bourses seem to be staging a comeback here at the end of today's trading but we will just have to see I guess. What is perhaps a more interesting question is not so much whether the Fed's response will avoid 1987 and 1929 market conditions but the effect it will have on the general macroeconomic environment. In my honest opinion the global economy now stands before its greatest test in a very long time and yesterday's and today's rush of volatility seem sure to be merely a faint sign of what is to come as we move forward. As for the US, the stock market indices seem to be trending firmly down which is not a good initial sign but now we just wait and see. One thing is sure, the Fed is playing a very high stake game on this one since it was never the Fed's job to protect equity traders and if this is conceived as such it the macroeconomic merits of the move may soon drown in the ensuing debate about the loss of the Fed's credibility.

Eastern Europe

Stocks in Central and Eastern Europe continue to fall sharply. Now this may seem a quite natural backdrop of what is happening at the moment but as I have argued extensively in the context of Eastern Europe this may very well be the venue of first real macroeconomic fallout from all this and from there on the line cuts straight across to Germany, Austria, Italy etc and thus into to the very heart of the Eurozone engine room. One of those proverbial shots was already fired across the bow yesterday as we learned that Swedbank AB who is the largest bank in the Baltic region had come under the weary spotlight of Moodys for a potential downgrade. The debacle here is that if the foreign banks decide to close shop in Eastern Europe they will basically be cutting off the lifeline which at the moment is preventing some of these economies from crashing. Moving on from the Baltics to the wider sphere of Eastern Europe the situation in Romania and Hungary is of course also something to watch very carefully and in a situation where carry trades are getting unwound the pressure on the Leu and the Forint will intensify and possibly to a degree which will bring about some quite unforseen and unwanted events.

Is Decoupling Dead?

I think it is. In fact I am dead sure it is. Over at the Euromonitor Daniel Gros has a timely note in which he dishes up a rather traditional view of the Eurozone's performance vis-à-vis the American ditto. The conclusion is that whereas the Eurozone might avoid a technical recession the recovery from a very sharp slowdown might very well be longer than in the US. Now, at this point I don't to get into the technicalities of all this but merely point out that the Eurozone is not one single economy. As such, Italy is heading straight for a recession in my opinion and that with a political crisis to boot. So might Spain be if the mortgage debacle turns for the worse. I am still not convinced that the Eurozone will tumble into a recession but I do think that risks are severely tilted to the downside and quite frankly we might very well see an effect which is much worse than people expect.

Of course, all this has coincided with a subtle but highly noticable change in discourse of what exactly the rate policy should be at the ECB and when, if at all, those much predicted cuts should come. However, what is most interesting perhaps is the way in which the sentiment seems to have changed on the Euro and more specifically the EUR/USD which has been the epitomizing currency cross of the de-coupling debate. Edward sums it up nicely in a recent piece ...

So the fact that the ECB may be tardy in dropping rates is no longer being read as a euro positive. Market participants seem to be reaching out further into the future, and are thinking more about the future path of relative currency values. Since the ECB can't cut, economic growth will tank more than it would do otherwise, and then the ECB will cut vigourously, so at that point the euro will fall. This seems to be the reasoning, of course, by having the thought these participants simply bring forward the moment when the decline starts, and as a result it starts to fall now. I think this is a sea change.

Sea change or not; the recent driver of currency markets where inflation expectations have had the tendency to be equated with appreciation as a function of the expectation of wider yield differential may soon come to an end. In this respect the value of the already aggressive strategy by the Fed may simply be outweighing the future discouted value of what will happen next elsewhere. This is difficult to say, but it will be interesting to watch indeed and may determine a lot of things as we move forward. In general on the whole Eurozone discourse I do feel that things are now moving in line with what me and Edward have been arguing all along; as Edward succinctly sums up.

I think Claus Vistesen and I have been arguing quite consistently since the credit crunch began on 9th August 2007 that all of this was inexorably coming (see here, and here, and here, for example), and secondly it is ever so important to grasp that what is happening is much more extensive than the discourse Junkers advances seems to recognise. There has been a change in the credit conditions, and this change is now being felt, but what it is serving to do is reveal underlying weaknesses in some key eurozone economies. Weaknesses which would exist regardless of whether or not there had been a "sub-prime bust" in the United States. Each case is different, but Spain, Italy and Germany all now seem set to go into the grinding mill, strangely it would seem to be France - as I argue here, and Claus argues here, which may withstand all this the best.

Now of course, we will have to see just where all this ends but take note that this was never about de-coupling in the first place but about how a large external deficit in the US alluded people to think not only that the USD had to fall (which it did) but that the corresponding rise in the Euro and the Yen would simply be a symptom that de-coupling was a reality. Moreover, the fundamentals were always against both the Eurozone and Japan as I have also argued on numerous occasions and essentially the whole subprime crisis only seems to have speeded things up. Consequently, I think that the correction in the Eurozone and in Japan will come swifter than many expect. One data point to watch out for is the Q4 GDP data which will confirm whether we have already moved into a recession or not and how close we are in the indvidual countries.

What Happens to FX?

Well, to be honest I am still a bit shell shocked from taking a sound beating on my monopoly money portfolio. I guess I am lucky though since I am still in positive from when I began and thus live to fight another day. It is unclear where markets are moving I think to say the least. From a technical perspective the past spurt of volatility which culminated yesterday and today have seen all kinds of break of support levels, wave corrections etc. An adept currency trader will, without a doubt be able, to infer many interesting technical points from the moves in the past week. What is unclear to me is the extent to which risk aversion will prevail. If we continue to see severe weaknesses in equity markets low yielders will continue to perform strongly (and this includes the USD by now as also noted by the recent issue of the MS GEF). However, as I mentioned above in connection to the EUR/USD it also seems as if the the market might just be discounting future interest moves a bit more vigorously than before which means that other factors may be at play. As for the Yen, it continues to shoot up a like a rocket even if today's slide on the back of profit taking and Bernanke's decision rippled through shows us that this is not a one way street (trust me, I know). At this point in time we need to understand that what happens in equity markets seem to be the main driver of currency markets too. The extent to which markets continue to slump will see a continuation of the carry trade unwinding, risk aversion, and move to safety as well as I think the Euro will suffer from this as this will be taken a de-facto sign that the ECB will have to cut sooner than later. If, on the other hand equities begin to look perkier we may just get back to the good old days where the EUR/USD sniffs at 1.50, especially since it seems given that the Fed will cut 0.5% come next week. At this point I also have to content that as goes for the Yen it seems completely disconnected from fundamentals in the Japanese economy. The question is when this will begin to have a real effect. The BOJ kept rates at 0.5% today but what happens if we see a cut, that is the big question for me.

Conclusively, as you can see I provide just as many questions as I do answers (if any on the latter front). However, this is how it looks from my table. I will continue to monitor events closely so stay tuned.

Italy's Job Rich Recession?

by Edward Hugh: Barcelona

Italy is currently entering into what offers all the indications of being a major political gridlock. Manuel Alvarez perceptively entitled his summary and analysis of Prodi's first resignation offer in February 2007 "A crisis is born in Italy", could it be that the subsequent the crisis he then anticipated is now finally about to arrive?

Whatever the outcome of what is going to be the 32 confidence vote in only 21 months the social and economic backdrop to the crisis will remain. The Italian economy is now slowing visibly, and the Bank of Italy only last week lowered their growth forecast for the Italian economy to a mere 1%. Given what is happening even as I write in global stock markets and (whatever the immediate upshot to tomorrow's vote) Italy's obvious political instability even this may be an optimistic estimate (see my 2008 forecast here). Italy's real problem is, however, neither so immediate nor so dramatic, since if we look at the chart I present below what we can see is that Italy has been suffering from a process of congenital slow growth in the much longer term.

In what follows I intend to step back from the precipice a bit, and take a rather longer term look at one feature of Italy's economic performance, its labour and employment market. In this sense this post is going to form part of a "tripple whammy" I am working on, where I will attempt to carry out an in depth examination of possible connections and interconnections which may exist between population ageing, rapid job creation and weak internal consumption in three key G7 economies: Italy, Germany (see here) and Japan.

Rising-Employment Falling-Consumption?

Well lets start by looking at the story so far, at least as far as Italy goes. Fortunately we do have a number of key stylised facts at our disposal. First off, unemployment has been steadily - I could say relentlessly - dropping in Italy over the last two or three years:

and new jobs have been created, lots of them:

Yet at the same time domestic demand has not been revived to anything like the extent that might have been expected. Retail sales have been in decline for most of the last year as you can see from this retail-sales purchasing-managers-index for Italy (remember that on the PMI reading, anything below 50 represents a contraction).

Meanwhile private household consumption, despite some early strengthening, could hardly be said to have been booming. We did see a couple of (in Italian terms) comparatively strong quarters in the first half of 2007, but then, surprisingly - as can be seen in the chart below - the rate of increase began to weaken in Q3, while, curiuosly, in the position in the Italian labour market remained, more or less, stable.

So how can we account for this apparent paradox of a steadily tightening labour market and deteriorating internal consumer demand? One explanation for this could, of course, be that labour market performance is a lagged indicator (that is that it only registers economic deterioration after other indicators have been pointing to red for some time, and this is surely true), but could there not be something more going on here? Especially since this kind of pattern is being repeated in Germany and Japan, and these two countries have, along with Italy, the highest global median age, and as a result the highest proportions of potential workers in the older age groups. There is something very different about the labour market tightening we are seeing in Italy, Japan and Germany, for example, and the kind of inflation generating labour market tightening which we are observing in Eastern Europe. So why this difference?

Italy's Age Structure

But first off let's take a look at one of the younger age groups for a minute, the 15 to 24 one. As is well known this group is now in historic decline as a proportion of the total Italian population. The decline has been very rapid, with a drop of around one third (from 15% to 10% of the population) since 1990.

What this means, logically enough, is that there are steadily less and less people in this age group to fill places in the labour market. To this numerical decline we need to add theongoing secular decline in economic activity rates among this group, as more and more of Italy's - now scarce resource - young people delay entry and seek to improve their education, their human capital rating and hence their future earning capacity.

Thus the proportion of this group which is economically active has been declining steadily, as have the absolute numbers of those who are active, and the numbers of those who are actually employed. It is perhaps worth noting that the absolute size of this age group has been virtually stationary over the last 3 or 4 years (a statistical effect), but it is now set to fall steadily.

So if new employees will be hard to come by in this age group as we move forward, where can employment growth come from? Well basically there are two evident potential sources of labour, immigration and older workers. It is hard to envisage any large increase in employment in the 25 to 34 or the 35 to 54 age groups since - as can be seen from the chart below - activity rates among these groups are already fairly high, and even the slight fall-off which can be seen to have taken place recently in the 25 to 34 age group seems to be the result of a decline in female activity rates, and this is almost to be hoped for if Italy is to do one thing which is very important for its long term future, and that is have more children. Squeezing this particular lemon too hard at this point in time is only likely to obtain short term benefit in return for substantial negative long term outcomes.

Turning now to the principle sources of potential long run labour supply, in the first place it is obvious enough that there has been a significant surge in the size of the immigrant workforce in recent years (see chart below, and my other post for more details).

The other main potential source of additional labour in an ageing economy is the over 55 age group (and as we move forward of course increasingly it will become the over 65 one). Now many international agencies (the World Bank, the OECD, the IMF, the EU Commission etc) are pinning their hopes on the idea that the effects of population ageing may be to some extent offset by increasing the participation rates of these older workers, presenting impressive looking projections all the way out to 2050 to back their view that this is a workable solution. Yet since we have, in the here and now, a number of examples of societies who are trying quite hard to follow recommendations here, I do think it is important to examine in detail what is actually happening in these societies and try to really start to estimate the longer term macroeconomic consequences of this shift.

Now the important thing to bear in mind when we speak of older workers is that the important decision they need to take is about whether or not to continue working, and what is very clear in the Italian context is that workers in the 55 to 64 age group are increasingly taking the decision to stay at work, in some form or another.

Not only is the activity rate - which has, it must be said, been ridiculously low for this group, especially given Italy's very high life expectancy level - on the way up, the unemployment rate is on its way down, and the number of those employed is steadily rising.

More Work, Less Pay?

What is also significant about this trend is that it is also associated with a significant growth in part time and temporary work. The question really is who is doing this part-time/temporary work? In Japan it has become clear that many people now leave their "lifelong" job at 55, only to continue working in some way shape or form for another 15 years or so (both the Economist and the Financial Times have recently run articles about this trend in Japan - see here - although they fail to explicitly lock-it-in to the ageing population issue, which I think is where it belongs) . The work ethic in Japan is probably quite different from the one in Italy, but the similarities in the way the labour markets are evolving are really quite striking . In the German context it is also clear that the growth in part time and in non-social-security covered employment has been significant. And of course, in Germany, as I explain at considerable length here, the big increase in employment is in comparatively low skill, low wage work, which very often draws the over 55s into employment in much the same way and for much the same reasons as it does in Italy and Japan.

So what IS observable in the case of all 3 of these economies is that they are experiencing at one and the same time skill-shortages in some key areas of economic activity (due to the growing population crunch among the young - Japan for example is notoriously short of nurses) and generating large volume employment in more tenuous and lower skilled categories of work, since such work meets the skill and performance profile of the workforce they really have available. Thus, even as these labour markets tighten we find NO real evidence of significant wage-squeeze push.

From this point in we are left guessing until someone does some really systematic research, but it isn't a bad guess to suggest that the pressure on wages in the more skilled areas is being offset by a downward movement in wages in those less skilled areas where a mixture of lower skilled migrants, retirees and older workers are offering themselves for work in increasing numbers.

One other conjecture about Italy is that migrants are doing jobs in Italy which retired or semi-retired workers are doing in Germany and Japan, and hence we find that the participation rates in the 55 to 64 age group are still pretty low. At the moment I'm not quite sure what the macro economic consequences of this are going to be.

My feeling is that since people reaching 60 can now expect to live quite a long time, and since nowadays there is no great certainty attached to current levels of retirement benefit as we move forward, then older people, who are normally more prudent, will be protecting their current savings - in whatever form they may hold them - as best they can, and supplementing pensions with bits and pieces of work to maintain living standards so as to not run down their capital.

Another point here is that many retirees in Italy have a lot less in the way of accumulated wealth (and imagine the situation in a country like Hungary, which is the next one coming in this group as far as I can see, even though the median age is somewhat younger, but the male life expectancy is also much lower, and the population is already falling) in comparison with Germany and Japan.

This is why the recent deal Prodi struck with the Italian unions about postponing raising the retirement age was such a negative when viewed from where I am sitting.

So what I am suggesting is that the very weak internal consumption we are seeing in these three countries (and I would drop-in that Hungary is "coupling" here perfectly with the others, in terms of the model I am working on) is not ONLY associated with a higher propensity to save associated with older people, but also to do with the earnings profile associated with the new kinds of low level work older people are doing. In other words you can't just take the large number of new jobs being created and translate this into more consumption (as I think most of the conventional analysts are doing) since more things are happening here.

North-South Regional Stresses and Imbalances

But in any event the data we have is fascinating. The regional disequilibrium in Italy seem to be once more becoming really important (just like East-West one in Germany, and Tokyo vs the rest in Japan). While the national participation rate for the 55 to 64 age group went up from 28.9% in Q1 2004 to 33% in Q3 2007, in the mezzogiorno it has gone up from 31.8 to 35.3 over the samer period, so the South is keeping pace here, but if we look at the 65 plus group, while participation has gone from 3.4% to 4% nationally over the same period, in the mezzogiorno it has gone DOWN from 2.4 to 2.1%. The 15 to 64 participation rate also dropped from 54.1 to 52.5 over the period in the mezzogiorno while in the North it went up from 67.8 to 69.2 %. And this situation is reflected in the relative job creation performance between the North and the South.

Basically, given the very strong fiscal pressure which is about to come in Italy, and the danger IMHO of a sovereign default at some point if nothing is done to correct this very weak growth trajectory, Italy can be almost literally torn apart by this disequilibrium, especially given that it is reinforced by the unequal distribution of migrants. We have an ongoing polarisation of wealth, employment and people, and we really aren't giving sufficient consideration to the longer term political implications of the underlying economo-demographic process.

New Forms of Employment: Temporary and Part-Time Work

I have also found a limited breakdown for part time work by age. The two categories which the Italian statistics office use are "15 to 34" and "35 and over". Now strange as it may seem the number of part-time jobs for the 15 to 34 age group actually went DOWN between Q1 2004 and Q3 2007 - from 1.107 millions to 1.102 million - while among the over 35s it went up from 1.74 to 2.121 million. So Italy's new part-time workers are by-and-large not young, and it is a good bet that the majority of these new workers come from the over 55 group, and that it this kind of work which is responsible for the increase in the participation rates at the higher ages.

Of course, when we come to look at TEMPORARY work the pattern is rather different, there are an increasing number of young people (and since the number of such people is steadily declining, a rising proportion) working on temporary contracts. The number has gone up from 1.035 million in Q1 2004 to 1.368 million in Q3 2007. Over 35s (which we can pretty much imagine as over 55s, since the 35 to 55 age group is normally pretty robust in employment participation terms) goes up from 679,000 to 993,000.

By Way of a Conclusion

Basically the macro economics of all this are hard to assess. Italy's working age population - ex migration - has touched the ceiling, and without immigration it will go down and down. So everything depends on raising the productivity of those employed. But raising productivity today is pretty much synonymous with raising the human capital component and if in volume terms the numbers of older but less qualified people working - and working in more and more fragile and less and less well-paid occupations - swamps the number of new highly educated workers in highly productive jobs (we are talking about aggregates here) then the new value created by the society in question won't compensate for the contraction in the workforce. This is particularly true when it comes to raising participation rates in that oft quoted potential labour supply, female workers over 55. Many of the women in question are excellent wives and mothers, but given their often very low level of formal education, and given their lack of real experience of work out of the home, the economic worth in value added terms of their formal labour market participation may be much lower than many expect, and certainly this is where the evidence to date is leading us.

I also feel that the Italian experience is very similar and comparable with what we have been seeing in Japan and Germany, so it seems to me that there is now strong prima facie evidence that we need a big and really systematic research programme into the details of all of this, and rather less of that "gung-ho", we haven't got a problem approach, which has prevailed up to now, and which - at the end of the day - is based on the idea that raising participation rates will do the trick. As we are seeing, and unfortunately, it may well not do. It will do something, but that something may well not be enough.

Monday, January 14, 2008

Soft or Hard Landing in Lithuania?

By Claus Vistesen Copenhagen

The fact that economic conditions in Eastern Europe are deteriorating is hardly news at this point. The only question which remains to be answered is the extent to which this will be a hard landing or perhaps more specifically which countries will fair better than others? It is fairly easy to get bogged down into details when it comes to Eastern Europe, something which the Eastern European Economy Watch (run by Edward and me) is a testament to. So, in this entry I will continue my review of Lithuania which, apart from my general notes on Eastern Europe, has constituted my anchor when it comes to understanding the details of the Eastern European situation or perhaps more aptly the situation in the Baltics in particular. If you want background on this you should follow the two links above which can lead you to almost everything Edward and I have written on the topic. However, and in terms of more official contributions to the issue the IMF as well as the World Bank have both made some fine reviews of the issues at hand.

As I noted above this entry will deal exclusively with Lithuania and thus by derivative the Baltics although I think that many of the issues can be extended to the region writ large. A couple of days ago Edward fired a shot across the bow in the context of the Baltics where he asked whether in fact Estonia was heading for a hard landing? The evidence seems mounting that this might be the case and after having looked at Lithuania I find little reason to disagree with him in a general context. And we haven't even noted Latvia here where arguably the most dramatic degree of excessive capital inflows, growth rates, credit exuberance, and inflation have occurred. My analysis on Lithuania will take a close look at the following factors which cuts across the gamut of issues we need to factor in:

  • General growth rates - To show the general momentum and when/where it might be turning.
  • Prices - This is a natural but increasingly lingering effect of the sizzling growth rates we have seen recently. Basically, we need to think about capacity to grow here without stoking inflation and with the expectations levied on Lithuania (alongside the rest of the region) relative to the underlying capacity (i.e. the labour market conditions mentioned below) we are basically witnessing a huge mismatch which might unwind very rapidly with detrimental consequences to the economy and society as a whole.
  • The labour market - This is a very important aspect and essentially cuts into the point that Lithuania like virtually all other countries in Eastern Europe have moved through the demographic transition too fast and too brutish essentially suffering a severe overshot where fertility has declined (throughout the 1990s and into the 21th century) to alarmingly low levels. Coupled with a steady net outflow of migration this is basically hollowing out the human capital foundation of the economy at a speed which not even Edward and I had anticipated and thus the capacity to grow sustainably as well as to enjoy that much allured process of convergence/catch-up growth.
  • External balance - The Baltics have very large current account deficits at the same time as they are running currency pegs to the Euro through currency boards. This is not necessarily a recipe for disaster but the extent of the imbalances is mounting and if expectations at some point reverse as to the sturdiness of these pegs the situation could get out of hand. As I will show the condition of the situation rests upon the ability to sustain inflows of credits to consumers (and of course FDI) and given a global credit crunch as well as an unsustainable economic environment it appears that we are moving closer to a situation where the current development cannot be sustained. In general, I think it is reasonable to assume that in a traditional currency crisis framework the currency boards would be pretty helpless in defending the domestic currencies for an extended run. Of course this then gets us into the point about the households' balance sheets and what it will mean if the pegs run loose.
Let us get on with it then and begin with a look at the general development in GDP which, relative to my previous notes, now includes Q3.

As we can confirm from the graphs above Lithuania continued to thunder along in Q3 even though this constitutes somewhat of a backward looking focus at this point in time. What should be noted however is that while quarterly GDP rose a seasonally adjusted 5.4% private consumption actually declined. This does not fit the growth path by which Lithuania and the Baltics have grown the past years and may signal that something is changing. Especially, I will be watching private consumption since we see a slowdown from here on it will be very difficult to sustain the inflows needed to finance the current external balance and obviously also the headline growth in GDP. In this light the Q3 figures come off as a bit of a fluke really but coupled with a contraction in the external deficit (i.e. as in Estonia) it may be the first signal that things are about to change for the worse in the sense that whatever these countries are ready or not the imbalances are now set to unwind. In this respect the Q4 figures will be most interesting since they will indicate the direction and even more important the speed by which this is moving.

Having looked briefly at top line GDP figures I turn now to the more nitty-gritty parts of the analysis. In this way, it would perhaps be a good idea to have a close look at the evolution in prices since the very high rate of inflation has been one of the main detrimental effect of current growth spurt and one which has eroded the external competitiveness. The main reason for this is the well known relationship between productivity growth and growth in wages and how the latter by far has outpaced the former in Lithuania and the Baltics. More so, prices become important since if we were to identify a break-point in topline GDP growth inflation should follow down. This is likely to happen sooner or later of course but the flip side of this is the point that with their currencies pegged to the Euro the only way Lithuania can ultimately correct once growth stalls is through price deflation. In fact, you could argue that if the imbalances begin to unwind disorderly it may be difficult to stop this from happening which is why of course we need to make sure we don't get to that.

The first graph is particularly interesting since it takes us into the real world so to speak as it shows us the evolution in monthly prices which confirm that the increase in price growth seems set to linger in Q4. I have chosen to add both the main core index and the core index stripped of headline inflation in light of the order du jour in current economic and financial debates. So, pick your weapon of choice. Either way, the main index running at 8% as we exit 2007 demonstrate the generally elevated pace of things. If we move into the more finer grains of the price developments we see that wage costs increases are still in the >20% ballpark and that construction input prices are also running high up the ladder which is rather significant since the construction sector has been one of the main sectors driving the expansion. As for the PPI I am happy that we are seeing an increase since I have had some issues discerning why it was that low since it marked on of the peculiar ways in which Lithuania differed from its Baltic brethren. As a conclusion, nothing new from the front it seems when it comes to inflation and we will now have to see if growth slows down just what the transmission mechanism will be. However, as I have noted we could run into deflation at some point and really this would only be a matter of how long the pegs were able to hold and thus the 'willingness' to correct through bending the stick too much into one direction (deflation, massive fiscal tightening etc) relative to the other (letting the Litas go).

If inflation is one of the chief effects of the growth momentum we have observed lately what is the course then? Clearly, a high inflation rate is to be expected in emerging markets as higher relative growth rates also lead to higher relative inflation rates following the principles of growth convergence. But why have inflation rates been as high as we have seen in Lithuania? Well, in order to understand this we need to use some basic macroeconomic intuition as I also explain in my introduction above. Essentially, we need to look at the labour market and thus always remember the two stylised facts. 1) the trend of net outward migration in the most productive labor cohorts and 2) the collapse in fertility throughout the 1990s.

You don't need to be a macroeconomic literate to see that the general condition on the labour market is one of some tightness. Depending on the measure you look at and whether it be quarterly or monthly the unemployment rate is roughly running at 4% as we exit 2007 down from about 5% in the beginning of 2007. In numerical terms this corresponds roughly to a decline from 80.000 to 60.000 depending on the figures you look at. Now, this might not mean much but we need to consider a few things. The first thing is of course the relative tightness of the labour market from a general empirical perspective where we know that once we venture into the 3-4% range we get into serious bottleneck and mismatch issues. The job vacancy rate is a good proxy here and as can be seen from the last graph we are soon running into one of those 'does not compute' issues since with 60.000 persons unemployed and 30.000 vacancies it we are looking at a vacancy ratio of about 2 which is very tight. Another thing to take into a account is the net migration rate. Since 2001, Lithuania has 'lost' around 5000-6000 people each year and if we apply this average figure for 2007 we can easily see how the string is getting tighter by the day.

The labour market issues are important for two primary reasons. The first is the contribution of the tight labour market to inflation and wage costs and essentially how productivity increases stand no chance in following the increases in wages. The second point however is the risk that as growth stalls the unemployment rate will rise again. Now, this of course somewhat an argument non-sequitur in the sense that it is a foregone conclusion. An economy cannot 'run out' of labour but what happens to migration flows then? This is big issue for me and if a severe slump intensifies the outward migration of qualified labour (i.e. this is the labour most likely to move first) the human capital foundation of the country will simply get eroded. So, take note! This is something to watch and really I would like to see not only a endogenously generated response within Lithuania and the Baltics but also a EU wide response to this issue since it is a most pressing one and not merely one of how the EU15 can use Eu10 as a labour repository.

The final section of my note takes us to the dark vaults of balance of payment analysis and essentially constitutes an expansion relative to my previous focus on Lithuania in past notes. For an appetizer for what comes next my recent note on Poland's external position might be handy. Let us look at the graphs and then move our way through the argument.

The graphs are divided into two topics. The three first shows the evolution of the overall current account balance in various measures whereas the last two plots information on the net investment position (NIIP) which is a stock measure of the difference between a country's external financial assets and liabilities. If the NIIP is in the red as is the case here it means that external liabilities outweigh external assets.

If we look at the three first graphs we confirm the general idea that Lithuania is running a large external deficit. Especially the q-o-q measure of the trade balance expressed as percentage of GDP sums up the general picture I think with a trade deficit amounting to >35% of GDP. Another more cyclical thing note is the contraction in the external deficit in Q3 which coincides with the drop in consumption expenditure in Q3. This is not coincidental I think and as I say above we now need to watch closely what happens in Q4 since if the current trajectory continues Lithuania may run into trouble sustaining the inflows needed to cover its external deficit in the sense that we might just be moving into a situation where the trend is breaking with respect to growth in private consumption. So what is this all about then? This is where we need to the NIIP then. As two points should be noted from the graphs above apart from the obvious point that the NIIP is negative by some margin. The first is the composition of external liabilities where especially bank loans need to emphasised. What we basically have here is then the formal evidence for all the stories we have heard about how foreign banks have been entering the Eastern European/Baltic markets through provisions of consumer credit, loans and mortgages often denominated in Euros (in the Baltics) and Swiss Francs in Hungary and Romania. We see clearly then how bank loans have contributed heavily to evolution of the NIIP and if we sideline this with the evolution of private consumption not to mention the whole global credit crunch debacle it is not difficult to see how this link of the chain might be a bit corrosive as we move forward even if it is not yet certain that it will break. The second point is that we see evidence in Lithuania of the same inter temporal correlation between the inflow of direct investment and the income balance as in Poland. Basically, the inflow of direct investment means that foreigners will earn more on their assets in Lithuania than Lithuanians earn on assets abroad. This is not necessarily alarming in itself and quite natural if you factor in the economic dynamics. But in Lithuania's situation with its monetary policy tied to a currency board and with the current state of the external position a structurally deteriorating income balance will make it even harder to swing the external deficit into a comfortable territory.


So, is it crunch time in Lithuania? This is difficult to say but what is certain is a that significant slowdown is now coming. Whether it will be hard is another question. Essentially, a hard landing would entail a sharp stop in the inflows as foreign banks' subsidiaries retreat to their native territories. This could then unravel the whole edifice of a pegged currency regime and the households' un-hedged cross-currency liabilities. The real question is then whether the banks who represent the main life line for an orderly slowdown will stay pat and follow the growth down or whether they will back up their bags and cut their losses. The outlook on this will most likely hinge on two things. The general nature of the slowdown in Lithuania and by proxy the individual countries' relative slowdown in growth and secondly the risk that events in one country will spread to another. As for the first one it is likely to be rather abrupt as we see now that both consumer confidence and consumer spending indices are dropping sharply in almost every country. However, what might end up tipping the boat will be the likelihood that events in one country can spread to another. Here I am particularly looking for the risk that events in Hungary or Romania will act as the well known canary in the coalmine.

It remains to be seen at this point. Q4 will be important for Lithuania I think as well as will the general and ongoing nature of the global financial market turmoil. If things turn to the worse with respect to financial markets in general and if that famous spread between the LIBOR and the nominal rate widens again it could incite some of the banks most exposed in Eastern Europe to cut their losses while they can and if one goes they all go I think. So, this note does not emphasise panic but rather calm oversight. Yet, the risk of a hard landing is not decreasing as we move forward I think which is perhaps the real message to take away here more than an actual call. In this light, I would extent my voice to the fine people at the ECB and EU in general to keep a weary eye on events here since if things turn for the worse timely action will be needed and not a stick followed by some pointless rant about how Euro membership is now postponed for another decade.

Thursday, January 10, 2008

Cruise Control at the ECB

By Claus Vistesen Copenhagen

This is really just an update relative to my post yesterday talking about today's ECB meeting. As expected, the decision amounted to a holding operation (Q&A here) but more interestingly was the fact that Trichet and his colleagues still seem stubbornly persistent on retaining what they denote as a tightening bias or more specifically they are reserving their real option to act upon inflation. The following from Trichet's introductory statement sums up today's message ...

To sum up, a cross-check of the outcome of the economic analysis with that of the monetary analysis fully confirms the assessment that there are upside risks to price stability over the medium term, in a context of very vigorous money and credit growth and sound economic fundamentals in the euro area. At the same time, the potential impact on the real economy of the ongoing reappraisal of risk in financial markets remains uncertain. Consequently, we will monitor very closely all developments. The Governing Council remains prepared to act pre-emptively so that second-round effects and upside risks to price stability do not materialise and, consequently, medium and long-term inflation expectations remain firmly anchored in line with price stability. Reflecting its mandate, such anchoring is of the highest priority to the Governing Council.

There are a few things to note here I think. The first thing is the simple question as to when the ECB's Governing Council will start to pay attention to events in the real world. Ok, full stop here! It is indeed true that inflation forms a part of this real world picture and it is also true that the mandate by which the council is put into being is anchored in the maintenance of price stability. However, another part of the story is then that we are now dealing with the prospect of a Eurozone wide slowdown which is becoming clearer by the day. So, we can all see the tradeoff and no-one is saying that it is going to be pretty either way. But there are two issues in particular which I think are missing in the general account. The first is the idea that the Eurozone is not excluded from the rest of the world. De-coupling à la traditionelle has been weighed and found wanting and the ECB's policy stance is a bet on de-coupling which just does not seem to fit with the fundamentals. Secondly, we have the inflation issue itself which I am sure anybody can agree is not to be treated lightly. However, I can't stop but feel that we are risking falling victim to tale about how it does little service to close the barn door and mend the fence once the horse has already evaded. In this way, it is a bold game to believe that you can wait until inflation has abated since then the horse will be thundering across your neighbour's meadows. In short, I see the ECB boxing itself in on this one and although cruise control can be a pleasant companion when the road is straight and the pavement smooth you need to put your foot on the clutch if you want to shift gears. Ok enough of my own personal sentiment here. What are the likely consequences of today's ECB (non)action?

In essence, it was not today that the ECB shifted its stance towards a more balanced look at the economy but when will it be then ... that is difficult to say. One thing is certain and that is that the longer we venture into 2008 the more implausible the ECB's 'vigiliance light' against inflation will sound. Coupled with the likely trajectory of the economic data and of course pending on the inflation readings I see a slight change at the next ECB meeting (although still a hold) which could pave the way for a cut at either the April or May session. As for the EUR/USD we now need to factor in that while Trichet has played his cards such as it is Bernanke is up next and this means that, contrary to what I noted yesterday (see first link in this post), we could see a sniff at 1.50. I maintain my view however that the fundamental bias for 2008 should be for a short EUR/USD position.

Wednesday, January 9, 2008

Spains Credit Surge Comes To A Rude Halt?

by Edward Hugh: Barcelona

Well, it now seems that everyone plus their aunty is finally catching on to what is actually happening in Spain as I write. The header here is taken from the headline in a Financial Times articule this morning.

Only last September, José Luis Rodríguez Zapatero, the Spanish prime minister, announced that Spain had joined the “Champions’ League” of world economies. Europe’s fifth largest economy was growing so robustly, and creating so many jobs, it would soon be richer than Germany in per capita terms, Mr Zapatero predicted. That euphoria was short-lived. December saw a spike in inflation, a rise in unemployment and a slowdown in the economy, as the international credit squeeze gripped Spain. The government recently lowered its estimate for economic growth in 2008 from 3.3 per cent to 3.1 per cent, a figure many economists consider is still too optimistic. Inflation last month of 4.3 per cent was at the highest level in more than a decade.

So here is some of the data the FT refer to and some they don't mention at this point. Interestingly they quote the branch manager of a bank in Igualada, a small town not too far from where I live in Barcelona:

"I’ve been a bank manager for 28 years and I have never lived through a situation as dramatic as this....House prices in this town have fallen by 20 per cent, there is no demand, and no mortgage finance. Savings banks have cut off funding. Before the credit crunch, I used to do 12 mortgages a month. Since August, my branch has approved only one new loan."

The Problem of the Cedulas

The picture presented by our regional branch manager more or less sums it all up. For an explanation of why there are no morgages available at this point, and how the credit crunch actually works out in practice see this post here. But also the mention of the regional cajas is significant because of the previous role of AYT Cedulas in the Spanish market. Spains rapid housing expansion was made possible by a process of pooling mortgages from a range of smaller savings banks into one arrangement, creating in the process the euro market’s biggest covered bonds player in the form of Ayt Cedulas. How it was that a small group of previously obscure local savings banks rose meteorically to become the European leader is a story which will be fascinating when someone finally gets to tell it, but for now the important point to note is the danger that this dramatic rise can become an equally dramatic decline. Basically these types of entity are having growing difficulty rolling over their funding, and selling their packages of cedulas hipotecarias, and undoubtedly this difficulty was one of the main factors which lead Jean Claude Trichet to make unlimited finance available to the Spanish banks at 4.21%. Basically, the squeeze on 3 month euribor rates has hit the banks (who have to continually refinance part of their needs and now have to pay nearly 50 base points more - a classic liquidity problem) while the clients - who often pay a mere 0.5% over 1 year euribor - are nothing like so affected. So it is big squeeze time on bank margins.

Some background information on the system of Cedulas Hipotecarias and how this works under Spanish Law can be found in my working notes on the topic - which are being updated as I learn more. Among the august and venerable names to be found on a March 2001 2.048 Billion Euro Cedula Hipotecaria Bond Offer were (participaing percentages in brackets) Caja de Ahorros Municipal de Burgos (14.67%), Caja España de Inversiones (14.67%), Caja de Ahorros del Mediterráneo (14.62%), Caja de Ahorros de Huelva y Sevilla (8.80%), Caja de Ahorros de las Baleares (7.34%), Caja de Ahorros de Castilla la Mancha (7.34%, Caja General de Ahorros de Granada (7.34%), Caixa D’Estalvis de Sabadell (7.34%),Caja de Ahorros de Córdoba (7.34%), Caixa D’Estalvis Laietana (4.40%), Caja General de Ahorros de Canarias (1.47%), Caixa D’Estalvis del Penedés (1.47%), Caja de Ahorros de La Rioja (1.47%), Caja de Ahorros Provincial de Guadalajara (1.17%), Caja de Ahorros y Préstamos de Carlet (0.59%).

The FT makes quite a fuss about the looming non-performing loans problem - citing real estate developers like Astroc and Llanera who have gone bust, and the rise of 48 per cent in NPLs over the past year (to €1bn) according to data fromthe Bank of Spain, or the fact that banks have €293bn in outstanding loans to property developers. But at the present moment this is not the point.

Fast Deceleration in the Real Economy in Spain

What is alarming about the rate of deceleration in Spain is the rate at which the real economy is slowing, that, and the fact that inflation is spiking when precisely we should expect the deceleration to be producing a downward pressure on prices. My own interpretation of this latter point is that Spain - after nearly 15 years without recession - is unaccustomed to the kind of adjustments which are normal in a society like the UK or the US which see recessions as regular phenomenon. So the reaction and adjustment time is slower in Spain, which might suggest that people are attempting in the short term to compensate for falling sales volumes by raising prices. But this of course won't work, and at some point prices will have to come down if they want to sell (remember that since spain is in the eurozone they cannot devalue to correct price distortions). So the correction process - and particularly if there is a sharp downward correction in house prices (which are reflected in the HICP) at some point, and if there is no further large increase in oil prices which is unlikely - could lead Spain into a downward ternd in price levels, or, if you prefer, price deflation, such as we have seen in Japan. This - if it happens - will produce enormous policy problems over at the ECB, since the eurosystem was never designed to facilitate massive monetary easing a la ZIRP in one individual economy. But then, perhaps we should wait till we get there to talk about this.

As I say, I think the problem posed by defaults still lies some way out in the distance. Only as the real economy sinks deeper, and people begin to realise that this is not temporary but long term, will Spains young people really start to throw the towel in in significant numbers. So I think that we should treat each problem a day at a time here, since I am sure there will be plenty of them.

Now the data. First off two Items the article doesn't mention. Retail slaes and the EU confidence index. European retail sales fell the most in at least 10 years last November declining by 1.4 percent from November 2006 - the biggest drop since at least 1997 when the data series starts - according to eurostat yesterday. More importantly for our present purposes (although of course Europe wide data is important for a Spain which now needs to export) is the fact that Spanish retail sales declined for the third month in succession.

The break that can be seen in both the year on year data and the month on month from the summer is particularly striking.

EU Commission Confidence Index Down All Round.

The general picture of an economic slowdown in the eurozone is once more highlighted by yesterday's realease of the December data for the EU Commission Eurozone Economic Sentiment Index.

The Commission’s economic sentiment indicator is on a clear downward path. At 104.7 in December, down from 104.8 in November, the index was at its lowest since March 2006.

But perhaps more important than the steady downward drift in the general indicator are the individual country differences.

Italy, as I have outlined in greater depth here, has been steadily drifting off towards its next recession since the middle of 2007, but the big news of the moment is what is happening in Spain and Ireland, since as is well known they were the two countries in the eurozone to be most affected by the "housing fever" boom, and if you look at the chart above the correction in these countries since September is striking in its velocity. As the FT also commented yesterday:

Spain is demonstrating that prospects could vary significantly across the eurozone. Since September, confidence in the Spanish construction sector has tumbled, and the Commission’s survey results showed sentiment deteriorated in December in Spanish industry, retailing and among consumers as well.

As the FT point out, unemployment is now trending up, and the underlying situation is reflected in the shifting pattern of employment and unemployment. In this context a comparison between 2006 and 2007 is pretty revealing. If we look at the chart below we can see that in the early months of this year the employment situation was generally up over 2006. Then the situation turned (around July), and since then it is "down hill all the way" unfortunately, with unemplyment rising (as it might well do for seasonal reasons anyway, but in every case the increase is significantly more pronounced than in 2006. Spain's ever productive labour market has, unfortunately, now turned.

As the FT also points out, inflation is on the way up againin Spain,and accelerated in December to the fastest pace since the euro was introduced in 1999. Consumer prices gained 4.3 percent from a year earlier when measured using the EU harmonised index, compared with a 4.1 percent increase in November, according to data from the National Statistics Institute.

Not surprisingly, in this environment consumer confidence is plummeting, touching historic lows for the third month in succession in December, according to the index compiled by the Instituto de Credito Oficial.

OK, since I have already repeated myself enough, and time is of the essence at this point in time, if you want a fuller explanation of some of the points being argued here, please go over to this post.