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Wednesday, July 30, 2008

The Baltics - Moving Closer to a Correction?

By Claus Vistesen Copenhagen

Last time I had the Baltics under the spotlight I asked two overall questions. The first dealt with the extent to which the Baltics had entered a recession in the beginning of 2008 and the second question surrounded the risk of the Baltic pegs to the Euro. This time around and with the recent Q2 GDP release from Lithuania it would be nice to revisit the first of these questions. And with the market focus looking to shift from inflation to growth the second question is likely to become in vogue once again.

As the Q1 GDP numbers came in for the Baltics I concluded that it was very likely that the region had entered a recession. In light of the proverbial definition of a recession as a consecutive quarter contraction it seems clear the Lithuania managed to smartly skirt the recession in H01 2008. As far as I can see at this point and from Eurostat's data Estonia was the only one of the three Baltic economies that contracted in Q1 2008 (-0.5% and 0.1% for Latvia).

However and as ever before, the Baltics is increasingly getting stuck in stagflation and one of a particular sinister kind. In the case of the Baltics they may already be seeing the beginnings of a hard landing, whereas others continue to build up steam making it almost inevitable that they too will erupt at some point.

As can be observed, Lithuania just managed to avoid a contraction in Q1 and rebounded nicely in Q2. Yet, in light of the run-up to these numbers and the fact that Lithuania, on a y-o-y basis, grew at its lowest rate since 2004, I have little problem in maintaining my view that this is a hard landing. As for the break up of Lithuania's position it is a bit difficult to tell since the components do not feature seasonally adjusted figures. However, it seems that especially companies paired their investments going in to 2008 while consumers are still going strong. All three forward looking indicators in the form of confidence measures show that the expected trajectory of overall momentum is firmly down.

The other graphs reveal with some clarity I think that the Baltics may now be entering a whole new different growth dynamic with inflation and wages continuing their upward drift at one and the same time as growth is faltering. In this way, it is hardly about the potential recession and slowdown itself but about the economy, and growth rate, which will emerge. This point is similar to one I made recently in the context of the Eurozone and I do think it is important to realize the hole some of the CEE economies are about to dig themselves out of. In fact, depending on the reversion into wage and asset price deflation I would say that this slowdown marks a significant structural break in these economies' growth path.

Consequently, there is simply no way in which these economies can muster the inflows they have been receiving, and many face a decisive need to turn the boat around and become export dependent. The key link will be the extent to which we, absent a currency to devalue, will observe wage deflation to reign in the external position. Consequeuntly, with a fixed exchange rate to the Euro and an extremely wide external position the only way a correction can come is then through severe wage and by consequence price/asset deflation. The alternative would of course be to the abandon the pegs but that would then open up Pandora’s box as the currency most likely would plummet to reflect the external balance leaving Baltic consumers with Euro denominated loans and cash flows in domestic currency (get detailed argument and analysis here, here and here).

Another crucial link here would be Scandinavian banks who are effectively supplying these Euro denominated loans and thus how they, effectively, are financing the external deficits. We have thus on several occasions been hearing faint but rising voices about how, in particular, Swedish banks are exposed to the Baltic slowdown.

In a recent detailed analysis John Hempton from Bronte Capital serves up some nice points on the whole situation. What is particularly interesting is that he takes the time to scrutinize the books of Swedbank who is operating its subsidiary Hansabank which is, by far, the biggest foreign bank in the Baltics.

One of the important points to latch on to was the one conveyed in my last look at the macroeconomic balance sheet of the Baltic economies. In this analysis I showed that while loans in local currency are now falling on a stock basis (i.e. the amount of loans being paid out or written off outnumber the number of new loans taken out) it is still growing in Euro denomination effectively keeping growth in the overall stock of loans in the positive; even if the trend is inexorably down. Once I have Q2 data for all the Baltic economies I will post briefly on the development.

Yet, if you dig into the Q2 accounts of Swedbank (who are operating under the branded name Hansabank in the Baltics) you will see that they are still churning out positive growth rates in lending in Q1 and Q2. Over the course of H01 2008 Swedbank consequently expanded their lending operations with 7% in the Baltics and over the entire year, this number stands at 21%. If we compare this to the growth in deposits in the Baltics the H01 figure is 1% whereas it is 11% over the year. As such, levering of the balance sheet continued in H01 2008. In short, lending growth is still positive and the leverage multiple measured as the value of lending over deposits is growing.

I don't think it is entirely outlandish to draw a line between my initial results derived from macroeconomic data to these results from one of the biggest players on the Baltic finance market. Personally, I don't see how the growth rate can continue to stay in positive territory and this is especially the case since net interest income is now beginning to decline, if ever so slowly.

In the context of cooking, as it were, the books of Swedbank Hempton makes another interesting observation in his piece.

So what happens next?

Well if the Lati devalues (as would seem inevitable) then Hansa Bank has to pay Euro to Swedbank – and as its assets are in Lati it would be insolvent.

If the Lati doesn't devalue its only because people (i.e. Swedbank) are prepared to continue to fund it. This is not pretty at all. All in Hansa owes Swedbank over 30 billion Swedish Kroner – all denominated in Euro and which can't be paid. The equity capital of Hansa (roughly 7 billion Swedish Kroner) is also going to default.

This is a very big problem for Swedbank. Swedbank's equity is 68 billion SEK – but 20 billion is intangibles. Swedbank is probably solvent at the end of this – but only just. Swedbank will (at best) lose its independence. Swedbank is in turn wholesale funded – and the chance of it becoming Swedish Government property is not low.

Having lent that much to a country with a phoney fixed exchange rate in a currency they can't print – Swedbank management deserve it. Bad things happen to bad banks and this is a bad bank.

Now, Mr. Hempton certainly does not mince his words and even though he may come off as wing nutty the point being made is actually quite simple and valid. What he effectively is doing then is to move the perspective down a notch from the obvious macroeconomic crunch that would ensue as consumers defaulted on their loans to the predicament which would arise in the context of Swedbank's books.

What it means in macroeconomic terms is if the translation risk issue blows up, which it potentially will in the context of wage deflation (i.e. this would force down the pegs), Hansabank would effectively be screwed. Sorry for my harsh tone, but I cannot see how they could shore up their balance sheet unless the ECB moved in with a kind of 1:1 guarantee which let the Baltics de-facto adopt the Euro with one swoop. Now, if Hansabank goes, and this seems to be Hempton's argument, so could Swedbank and by derivative the inflows used to fund to external deficit to the Baltics. And then we are into the big royal mess.

Also, one could easily imagine a rather advanced game of Old Maid. Consequently, if Hansabank et al. suddenly move seriously into the ropes, de-pegging would almost certainly mean a significant write-off of Euro denominated loans. In this case, the Baltics may neatly shift some of the heat on to Swedbank who, almost certainly, will be running to the Riksbank and then perhaps on to the ECB.

Ultimately, I think the Baltics will fight long and hard against devaluation and much will depend on the severity of the correction. It may end up a perfect storm for them, but I want to stress that this would require the ECB to step in with some kind of de-facto, behind the curtains, guarantee to the currency board. That is to say, the ECB or the Riksbank would need to foresee the chain of events above (or a derivative thereof) and nip it, preemptively, in the b*t so to speak.

Quit With the Dooming and Glooming Already?

Uff that was some outlook was it not? I should immediately point out that much of this represent musings and it is still quite difficult to see where it ends. However, I have pointed out the shaky links between Scandinavian banks and the Baltics more than once before, so it should not come as a big surprise that I am massaging this topic.

If we move up the perspective to macroeconomics, the points above relate to a more general point concerning the Baltics and the manner in which the current imbalances potentially will be corrected. This consequently lays out a path well trodden here at Alpha.Sources. As the rest of the CEE countries, the Baltic economies have quite simply been converging too fast given their underlying capacity (read: demographic) constraints. In fact, given the loop sided nature of almost all CEE economies after two decades worth of lowest low fertility the whole convergence hypothesis was always going to hit shallow waters. As such, and coupled, in the past 5-6 years, with significant outward migration, these economies have quite simply been administering a growth strategy wholly incompatible with their underlying fundamentals.

This obviously does not mean that Eastern Europe will sink into the ground, but it does mean that a correction is due; both in terms of expectations and the trajectory of economic fundamentals. Note in passing here especially how this will affect Germany's ability to leverage its export muscle towards its Eastern borders. In a more broad policy oriented context I have also been amazed, even if I can understand it, with the push to de-peg from the Euro and subsequently raise interest rates. Sure enough, when you have imported inflation you want a strong currency but in administering this kind of policy you are also assuming that the implied process of nominal convergence can be speeded up; almost as if the CEE economies could attain nominal convergence with EU15 in one clean and bold sweep.

Conclusively, my guess is that while Q2 data will tell give us important forward looking indicators Q3 and Q4 may be where the real action is. As per reference to my points above I am watching FX markets in particular and, in the case of the Baltics, the link with Scandinavian banks and the potential ways in which these economies can correct.

Tuesday, July 29, 2008

Spanish Mortgage Lending Down Sharply In May, Bank Credit Ratings Increasingly Under Review

by Edward Hugh: Barcelona

Spanish house sales dropped sharply again in May for the fourth month running, official figures showed on Monday, and talk of price declines is now becoming much more general. House sales fell by 34 percent year-on-year in May and mortgage borrowing was down by 40.4 percent from a year earlier, according to the latest data from Spain's National Statistics Institute. The result is rather a shocker since many had obviously been clutching at straws following April's better-than-expected year on year decline in new mortgages of only 7.8%. Reality is, unfortunately, now starting to sink in.

Sales of resale properties appear to be suffering the most, down 44% to 25,280, compared to the 21% fall (to 24,890) in the number of newly built properties sold by developers. This figure is misleading, however, as the INE’s figures are based on property transactions inscribed in Spain’s property register, not new sales achieved by developers, which are down by between 40% and 60%.

To add insult to injury Barcleona property consultant Aguirre Newman have said Spain's real estate market is depressed by anything up to 1.5 million unsold new homes (ie the estimate is now moving up from the earlier estimate of Spanish builder OHL who suggested there were between 500,000 to 1 million new homes in Spain sitting empty and waiting to be sold after overbuilding.). Aguirre Newman also report that the average time needed to sell a residential property in Barcelona has now gone up to 27 months (from 17 months one year ago).

Mortgage Security Credit Downgrades

Last week it was also announced that Moody's Investors Service has put about 16.9 billion euros of Spanish residential mortgage-backed securities under review for possible downgrades after adjusting for rising default rates and slowing house price growth. Moody's say they are in the process of reviewing 68 tranches of 13 deals after updating their model.This issue of downgrades is an important one, since if the securities are downgraded then, one way or another, they will become more difficult for the banks to finance and re-finance.

"Moody's believes that many Spanish mortgage borrowers have now debt-to-income ratios above the 40 percent benchmark observed in 2005,"

Deals singled out for review tend to have higher loan-to-value ratios and higher-risk products and have been performing below expectations, Moody's said. Riskier features are thought to include involving borrowers who are not Spanish residents (such clients account for as much as 10 percent of some deals), loans to multiple borrowers, loans as part of debt consolidation and interest-only loans.

Current ratings on the different tranches of the 13 deals from issuers including BBVA and Santander vary from triple-A to junk levels as low as Ca. The review over the next three to six months is likely to produce one-notch downgrades and some two-notch downgrades.

Standard and Poor's also said on July 10 that they were considering cutting the ratings on 298 million euros of bonds backed by subordinated debt issued by nine Spanish savings banks, including the top-ranking triple-A bonds.

Standard and Poor's said its decision to review its ratings on the bonds, a deal called AyT Deuda Subordinada I that was issued in November 2006, was due to a deterioration in the underlying debt. Both these actions constitute a further sign of the problems in the Spanish financial sector and illustrate very clearly how one problem can add to another in a cycle of progressively deteriorating headaches.

Standard also Poor's also downgraded two Spanish banks and changed the outlook on three others to negative, citing "the sharp deterioration in economic conditions and increasingly difficult operating environment in Spain." According to a pre-sale report they issued in 2006, the nine banks that issued the debt backing the deal are Caja de Ahorros y Monte de Piedad de Cordoba, Caja de Ahorro Provincial de Guadalajara, Caja Provincial de Ahorros de Jaen, Caja General de Ahorros de Granada, Caja de Ahorros y Monte de Piedad de las Baleares, Caixa d'Estalvis de Girona, Caja Insular de Ahorros de Canarias, Caixad'Estalvis Comarcal de Manlleu, and Caja de Ahorros y Monte de Piedad de Madrid. The agency only rates the last of these publicly, at AA- and it was the outlook on that rating which was modified to negative.

Of the nine banks, just four account for 78.9 percent of the debt which underlies the deal under review: Cordoba, Girona, Granada and Baleares, according to S&P.

Meanwhile Bloomberg this morning report that Banco Santander - Spain's biggest lender - have a group of bonds - which form part of an issue called Santander Hipotecario 4 - that are backed by mortgages that exceed property values by as much as 24 percent. Now Santander assert that they have not made any extensive use of the ECB liquidity facility involving collateral of mortgage backed securities, and there is no suggesting that Hipotecario 4 bonds - which presumeably still carry investment grade rating - have been used, but all of this does put the ECB in a very difficult position, since in principle (as with Italian government paper) they are willing to accept them. It is only the exercise of due discretion by Santander itself which means they are not already vaulted-up in Frankfurt.

Spanish lenders have, however, almost tripled borrowings from the ECB in the past year to 47 billion euros. Most ECB loans mature in one week or three months, but the bank have been providing some six month loans since the start of the credit crunch last August. Spanish banks increased their use of three- and six-month ECB loans to 27.5 billion euros as of June 30 - thus accountsing for for some 10 percent of the ECB's three- and six- month lending - up from from 2.4 billion euros a year earlier, according to Bank of Spain data. Of course the 10% level is completely in line with the level of Spain's participation in the eurosystem, so there is nothing necessarily preoccupying here, but the speed of the rise in borrowing is noteworthy.

Spanish loan defaults rose in May to 27.76 billion euros or 1.5 percent, from 12.05 billion euros or 0.77 percent a year earlier, according to the latest Bank of Spain data. Obviously the level of defaults varies from bank to bank. Banco Popular Espanol, Spain's third-biggest listed bank, scrapped its earnings forecast last week as bad loans more than tripled to 1.15 billion euros, or 1.89 percent of total debt.

Spanish AAA rated mortgage debt is now judged to be the riskiest on the continent, with investors demanding as much as 240 basis points above Euribor, up from 85 basis points at the end of 2007, according to Dresdner Kleinwort prices. That's more than twice the interest margin on equivalent securities in the Netherlands. Only bonds secured by home loans to U.K. borrowers with poor credit histories trade at higher spreads, according to Dresdner data.

Iberia To Join British Airways

And to cap a very busy day, British Airways and Spain's Iberia have announced they are in merger talks as airline industry participants seek to consolidate to compensate for rising oil costs that have been hitting both their top- and bottom-lines. As the level of economic activity has deteriorated in Spain and the UK, both airlines have struggled to keep their planes full. In the year to June, Iberia's passenger load factor, a measure of passengers to available seats, fell by 0.6 of a percentage point, to 79.6%. The same measure for British Airways dropped to 76.8% from April to June, down 3.4 percentage points.

And well-well-well, the main shareholder in Iberia is guess who, savings bank Caja Madrid, you know, the one who had an estimated one billion euro exposure to failed builder Martinsa-Fadesa, is very supportive of the Spanish airline's plan to merge with British Airways. "Caja Madrid is happy," according to reports. They would be, they have a 23 percent stake in Iberia, they had three Aaa rated bonds backed by mortgages placed on review for possible downgrade by Moody's only last week, and clearly they can't afford to have any more "lame duck bailouts" knocking around on their books at this point.

Monday, July 28, 2008

German Consumer Confidence Slides Raising Eurozone Recession Fears

by Edward Hugh: Barcelona

German consumer confidence dropped to the lowest in more than five years entering August as the sharp rise in energy and food prices continued to weaken purchasing power and the economic outlook continued to deteriorate. The GfK forward looking consumer confidence index for August declined to 2.1, its lowest level since June 2003 (and down from a revised 3.6 in July).

The sub-index measuring income expectations decreased to minus 20 from minus 7.2, while the consumers' propensity to spend component fell to minus 26.2 from minus 23.7. Economic expectations dropped to minus 8 from 7.5.

Along with fears of high inflation, many Germans are concerned that there will be a more marked cooling of the economy than previously anticipated. News from the USA of the continuing gloom in the financial markets support these assumptions and not least, the continuing high value of the euro represents a hazard to exports.
GFK's August Report

This is only the latest in a series of readings from the German economy which indicate a sharp slowdown may well now be underway (I analysed in some detail the reasons why we might expect this in my recent What Is The Recession Risk For The German Economy? article on the Roubini European EconMonitor). In a sense, given the high level of export dependence, and the complete lack of buoyancy in domestic consumption, this is exactly what we should expect to see as key export markets slow. The German Finance Ministry have already warned of a significant contraction in German GDP in the second quarter, and the signs now seem to be growing that German GDP may also contract in Q3, in which case the German economy may already be in recession.

The Ifo institute's German business confidence index dropped 3.7 points in July (to 97.5) when compared with May. This is its lowest level in three years, and the biggest one month drop since the fall which followed the 11 September attacks. Meanwhile manufacturing and services across the euro area contracted for a second month in July according to the latest PMI flash estimate, with the reading sliding more sharply than expected in July to 47.8 points from 49.3. This was well below expectations which had been for a decline to 48.7, and it was in fact the lowest reading since November 2001.

German exports declined the most in almost four years in May, as a slowdown in some key eurozone economies (Spain, Italy) and a stronger euro curbed demand. Sales abroad, adjusted for working days and seasonal changes, decreased 3.2 percent from April. That's the biggest drop since June 2004.

German industrial production declined for a third consecutive month in May. Seasonal and inflation adjusted output was down 2.4 percent from April, when it fell 0.2 percent. That is the largest month on month fall since February 1999. Output was up 0.8 percenton May 2007, on a working day adjusted basis.

Record oil and food prices pushed inflation in Germany to 3.4 percent last month, squeezing disposable incomes just as the euro's gains and a slowing global economy coupled with problems in some key eurozone economies like Spain and Italy curbed the demand for exports.

It appears that the rate of inflation is initially stagnating around the three percent mark. This means that consumers are watching any pleasing increase in their purchasing power generated by the significant wage and salary increases in some industries being steadily demolished by inflation. Even the positive effects on income of a buoyant job market are negated by price increases and so relegated to the background for the moment.
GFK's August Report

In addition German producer prices rose at their fastest pace in 26 years in June, adding to pressure on the European Central Bank to keep interest rates high even as economic growth slows. Producer prices increased by 6.7 percent from a year earlier, the most since March 1982, after rising an annual 6 percent in May.

All of Europe's largest economies have been showing signs of slowing since the end of the first quarter. In Italy, business confidence slipped to its weakest since October 2001, according to the Isae Institute index. Spanish consumer confidence is at all time lows, while in France business confidence fell to the lowest in more than three years in July. The UK is now slowing very rapidly on the back of a credit crunch induced slowdown in the housing market.

The possibility that we may see a eurozone wide contraction in the second quarter is now a real one, and if Germany continues to contract in Q3 (as well as Spain and Italy: Spain is already in recession IMHO) then we may even see a whole zone contraction in the third quarter, giving the zone what will effectively be the first recession in its short history. Certainly the flash PMI reading for the whole eurozone manufacturing sector (which fell from 49.2 points in June to 47.5 in July) suggests that a Q3 contraction is now a real possibility. With both manufacturing and services indicators well below the 50-mark separating expansion from contraction this certainly constitutes an unequivocal recession warning. To be watched, and closely, in my considered opinion.

Friday, July 25, 2008

The Eurozone - That Sinking Feeling?

By Claus Vistesen Copenhagen

One need not be well versed in the art of reading entrails or posses any other kind of unworldly powers to see that the Eurozone economy may be about to head off over the cliff. Now, just as the Q1 GDP figure was something of a technical glitch due to the forward pushing of investment which made Germany ride an impressive 1.5% reading q-o-q, so is the corresponding Q2 figure likely to be a similar (negative) glitch. The only important question is the extent of the slowdown since without that we really cannot build any sound forecasts for an annual growth rate of the Eurozone not to speak of Germany itself.

Yet, we move beyond the immediate excitement of the upcoming GDP release and the extent to which it will have vultures gathering over an increasingly weak economy, the forward looking indicators also turned an abysmal showing. Consider then the following: In Italy, business confidence slumped to the lowest level in seven years; in France, it clocked in at the lowest since 2005 and in Germany the ever so important (for ECB policy that is) IFO survey declined to a three year low.

But the show does not, by any means of the phrase, stop here. Adding to the gloom we also got the PMI release today showing its lowest reading since 2001.

Furthermore, in Spain where it isn't the proverbial Rome but moreso Madrid (or perhaps the Cedulas?) that are burning, an already groggy economy got some additional blows in the kidneys (see also below) as we learned how secondary inflation rose to an all time highs at one and the same time as the economy shed jobs in Q2 to move into double digit territory with respect to the unemployment rate. As for real economic data consumer spending in France added a near final nail to the coffin by dropping 0.4%. Furthermore, data released on French builders also confirmed that slowdown as the index slid two points. Builders noted in particular how order books were judged to be less vibrant than normal as well as they see a slowdown in activity for the next three months.

There can be little doubt that the data releases above are suggestive of the fact that the Eurozone may well be heading for a full blown recession in Q2 and Q3. In that light, Trichet also moved in lately, and with good reason, to reassure us that while the next two quarters would see a "trough" in economic growth we would revert to normal services from Q4 and onwards.

Two important questions arise then.

First of all we have the obvious question of just how far the this slowdown will drag on and as a derivative what kind of trend will we revert to? As I have stated above it is really difficult to say anything remotely sane about GDP outlook until we get Q2 numbers (currently the Eurozone is standing at a 2.8% annualised q-o-q with Germany at 6% annualised q-o-q (!), and I am sure not even the greatest optimist would venture such a call). However, for me the question about the "trend" or "normal" pace of growth is much more interesting since my feeling is that the underlying momentum of a post recession Eurozone will surprise on the negative side. As such, it is not about the potential recession itself since these things come and go (although with a bit too high frequency in some countries it seems) but much more so, it is a question about the Eurozone which emerges and what we can reasonably expect in terms of overall gusto.

A Step too Far?

Amidst all this doom and gloom and recession sabre rattling some would perhaps feel inclined to point out that the ECB seems to be getting just what it ordered with its recent 0.25% rate increase as oil prices have dropped smartly in the past weeks. I can see this point, if anyone should feel like making it, but I am also sure that we can all agree that oil prices these days are moved by more than the ECB. In fact, a raising ECB in so far as it would pummel the USD should not make oil go anywhere but up.

Meanwhile, the governing council at the ECB must obviously be watching the incoming barrage of poor data with more than a faint eye since it comes just weeks after rates were increased. Now, I should make it clear that this was the ECB's intention all along. Ever since the crisis began it was obvious for everybody that it would push the business cycle into reverse but the ECB always opted for inflation over growth; or at least it did not succumb to the temptation to lower rates. Now the butcher is coming to collect his bill and it could seem as if the ECB's credit card is in for a nasty overdraft. Actually, this may turn out to be a quite literal conceptualization if the Spanish mortgage market is about to turn into a pile of smoldering bricks.

To sum up, Q2 GDP will be interesting to watch since it will give us a sense of overall direction. Other than that I am watching Germany very closely and most specifically the export link with Eastern Europe. Basically, Germany have been living on exports not only to its main trading partners in the Eurozone (who are all now slowing considerabl) but also on the margin to the CEE economies. Especially this last link is about to break now and the repercussions will be swift and severe in terms of economic momentum lost. Finally, one cannot help but feel that Spain may be in for the worst of all (perhaps even worse than Italy). The link between builders and their banks seems a crucial issue to watch going forward.

Want More?

Below you will find a list of statistical reports used in this piece as well as other reports. This is for the analysts and investors who want the gory details.

France Business Survev (INSEE) - Enquête mensuelle de conjoncture dans l’industrie – Juillet 2008

France Business Survev (INSEE) - Enquête mensuelle de conjoncture dans le commerce de détail et le commerce
et la réparation automobile – Juillet 2008

France Consumer Spending (INSEE) - Dépenses de consommation des ménages en produits manufacturés - Juin 2008

France Building Activity Survey (INSEE) - Enquête mensuelle de conjoncture dans le bâtiment - Juillet 2008

Germany - IFO Survey, July 2008

Spain (INE) - Industry New Orders Received Indices and Industry Turnover Indices, May 2008

Spain (INE) - Industrial Price Indices, June 2008

Spain (INE) - Services Sector Activity Indicators, May 2008

Tuesday, July 22, 2008

A Year (Week) on the Wild Side?

By Claus Vistesen Copenhagen

[Update: Brad Setser clarifies, in the comment section, his view on Sender's FT piece referenced below]


THE last week (or was that year?) has certainly been something of a ride hasn't? In fact, I thought it would be apt to reproduce this picture by the brilliant KAL who normally spices up the Economist with his imagery that lay serious claim to the adage that a picture tells more than a thousand words. This particular specimen and the ensuing headline were on the front cover in October 1997 when markets also took investors and observers for a roller-coaster ride. I think it is quite fitting in describing the feeling many a trader and market participant must have at the moment.

Even though it could only seem as a few days ago that the credit turmoil went global with BNP Paribas' announcement that it too would be suffering subprime related write downs it is actually almost a year ago. Actually, if you use the same yardstick as I have tended to apply, the first of August will see the one year anniversary of one of the worst global financial crises (arguably) since the 1930s. The ever readable Martin Wolf (from the FT) expresses a similar sentiment in his most recent column. What is more, Wolf makes the point that we may not even have seen the end of the beginning yet. Adding to the gloom, I tend to agree with this.

Concepts such as bear market, stagflation, bailouts of tarnished financial companies, increased market volatility, and housing market busts have thus all become ingrained in investors', regulators' and not to mention central bankers' vocabulary as of late. Personally I think that we may soon add deflation to the list but more on that below.

Where Art' Thou My Fair Market?

If we begin at the first group it has not been an easy game to play; to say the least. Sure, commodities have been a solid play and in general the tendency has been one of wealth destruction in the context of risky assets as most international equity markets have seen near bear market conditions. I hear that real estate projects have been quite sluggish too. But in the current environment and given the amount of volatility, any leveraged position, in any asset class, firmly in the black one day could have easily been subjected to a margin call the next.

One excellent window into the daily workings of the market place is of course our devoted and popular Macro Man who never tires of sharing his insight with the rest of us. Usually, MM massages several topics but one interesting theme passing on his blog recently has been the difficulty with which investors, even the pros, have had exercising their hand. Consider thus the following point made by Macro Man;

As observed a few times over the last week or so, Macro Mas has found trading conditions evolve from pretty relaxing to downright terrifying at times. He's found it pretty easy to second guess every trading decision he makes, often after only a few minutes. That's an urge that he is trying to fight; in all conditions, but particularly when it gets a touch difficult, it's important to look forward rather than back.

In any event, it doesn't take much digging to confirm that conditions have been tricky, and that Macro Man hasn't dropped 50 points of trading IQ since the 4th of July. Consider that over the past 10 trading days, a period in which the SPX has dropped 5.1%, no less than seven of those days have witnessed an intraday rally of at least 1.5%. Unless one is a brilliant intraday trader- and Macro Man is not- this sort of market naturally lends itself to trades that have a, ahem, "suboptimal P/L impact."

In his examples Macro Man uses the SP500 as the main example of the adage that not only the almighty but also, it seems, the market sometimes moves in mysterious ways. These points and not least this graph fielded incited me to have a look at the intra-day volatility of the SP500. The ensuing results confirm the remarks above.

The first graph shows an implied version of volatility during the entire subprime turmoil period. As can been the past weeks have not, on the face of it, been extraordinary. Yet, if we look at intra-day volatility over the past month one can easily see the message conveyed above. The sample period in question can of course be debated ( for the short term frequency graphs I have opted for the same as Macro Man) but it is long enough the prove the point. As such and even though the trend in SP500 has been inexorably down there has been some significant spurts (or as some would call them sucker rallies) along the way. In fact, if we look at the intra-day volatility we see that a good number of spikes above 2% both with respect to the difference between high and low as well as open and close values.

In a general sense and with the distinctly execrable economic environment in the US one should also have expected more action in currencies. This is especially the case with respect to the EUR/USD that has not, despite a faint inclination, managed to break decisively above 1.60. Not unlike neglecting to change gears as you race towards the rev limiter the EUR/USD has been bouncing off against the 1.60 mark and then down again to 1.585ish. Perhaps this has more to do with the stock market than anything else as the USD moves closely together with equities through its correlation with oil; with an inverse relationship of course. In light of the point made above on the 'on-off' nature of equity markets it may just be that the USD is finding it difficult to choose a direction. One thing is certain then; there does not seem to a magic barrier surrounding the 1.60 mark but as long as the market chooses to believe in various rescue packages and the (final) inclination for the Fed to go for inflation it is unlikely that we will see a violent rally.

The latest earning reports have been a bit mixed with a significant addition to the Butcher's Bill by Merrill Lynch over to the less than expected write-off by Citigroup. I will let the gun-slingers of the world markets discern these reports but I definitely think that momentum in equities is down since the slowdown, at this point, is far from over. Although, one has to wonder whether signs that oil prices may be heading down will also provide support for equities in the immediate future. Sean Maher thinks so for one. The main point as can also be derived from the plight expressed by Macro Man would however be that even though you have the overall trend right, you should not leave you trading screen for more than a whee coffee break less you wanna be pulled down by a quick reversal.

Finally with respect to the markets and on a more general note I do tend to agree with Steen Jakobsen that the next bout of volatility will (or more aptly should) be in currency markets. At least, one has to wonder why there has not been more action on the back of the Fannie/Freddier debacle. As such, one would have expected risk aversion to have hit currency markets to a higher degree than has been seen (more about that here). However, position taking to take advantage of the expected risk reduction has so far been an ill-advised and actually a quite painful play. In this way and while the USD/JPY did have a go at 104ish it ended the week close to 107. Furthermore, the GBP/JPY clocked in at a healthy 213 while the EUR/JPY continued to flirt with 170 as it ended the week at 169.2. Interestingly and once again this may be up to the rather volatile and uneven way in which equities (e.g. SP500) have been moving down and then up again. In fact, equities ended the week with a rather strong showing which suggest that while risk correlations have not dissipated all together the link has grown weaker. In the case of the JPY, it may also be a sign that something else is going on; pressure from outflows perhaps?

Revisiting Old Arguments?

Now, this is obviously not only a story about market volatility which can thus be seen as a derivative of a much wider issue in financial markets and with respect to the global economy. More specifically it is a story about the global economy, its structure through capital flows, and the sustainability of these. In this light, a couple of important new themes have emerged lately while some old ones have been intensified.

On obvious lingering theme is the continuing weakness of the US economy and financial system which is not only sending ripples through the US society but also the global economy. As you can imagine the econsphere and media in general have been absolutely buzzing with the recent shot across the bov in the form of the debacle of Fannie and Freddie Mae. A good place to start would be Tyler Cowen who provides a good overview of the initial flurry. RGE's Finance and Market monitor which has virtually been turned into a Fannie/Freddie Mae watch this week is also a good place to; I would especially highlight the following two from James Hamilton. Also, Thursday's edition of Morgan Stanley's Global Economics Forum features a fine re-cap by Richard Berner and David Greenlaw. Finally, the Economist's print edition just fresh off of the publisher also devotes a fair amount of pages to the issue at hand.

Obviously, even after churning through the pages linked above you would hardly get that illusive "big picture". It is certain that the Fed, in conjunction with the Treasury, have rolled out the big guns in order to ensure that Freddie and Fannie do not fail. So far it has worked, since even though the shares have plummeted the debt outstanding in the form of agencies have not. This is what was initially the intention I think since a crash of the agency market would have been catastrophic.

One particularly interesting aspect here is obviously the fact that a fair part of the financing of the US external deficit and by derivative its mortgage boom was done through purchasing of agencies by foreign central banks and state investment vehicles. The link to the USD peggers are brilliantly exposed by Brad Setser as he estimates that China alone holds anywhere between $500 and $600 billion in agencies or roughly 10% of the outstanding stock.

The functioning of Bretton Woods II and the collective bet on the US consumer of last resort is well known. As such and since the external deficit in some ways has been fuelled by the financing of the housing boom it would only be natural to expect that as the debitor struggles so does the creditors. Well, unfortunately this does not seem to be the case. I say unfortunately here since the devil in me (and although I know this is not really an option) would have no problem seeing US creditors taking part of the hit from this; i.e let those bonds burn if that is what it takes. Consequently, I had to shake my heads several times when I read some of the initial reactions by foreign holders of agencies as conveyed by one of Michiyo Nakamoto's recent pieces in the FT. Consider example the following tidbits:

The Financial Supervisory Commission (FSC), Taiwan’s regulator, said the market reaction had been driven by fear rather than fact, pointing out that the US lenders’ federal backing made their debt quasi-governmental.


“We believe that the impact on Japanese banks [of their exposure to the government-sponsored enterprises] is minimal since they do not own equity,” Hironari Nozaki, banking analyst at Nikko Citigroup, said in a report yesterday. The default risk of the GSE bonds that Japanese banks owned was extremely small, he said.

Now, let me be clear that I don't really think that Paulson and Bernanke could have acted otherwise here (well, the banning of "naked" shorts is another matter) but what a royal mess we have on our hands. It is hardly a wonder that some, in the current environment, are musing about the credit worthiness of the US government all together. Obviously, this has a whiff of theatricals about it, not least in a context where one major rating agency recently downgraded India at one and the same time as Japan is upgraded (recently) and Italy maintains its rating. Anyone with a definition of "economic fundamentals" ready at hand?

In a more structural perspective the FT (and here through Reuters) also ran story well in line with current sentiment as it suggested how the big players amongst the sovereign wealth funds and central bank authorities were seriously considering to diversify away for the USD. This is hardly news as these stories have been surfacing in regular intervals since the subprime turmoil hit global markets. Given the y-o-y slide in the buck it is difficult not to put more than a little bit emphasis on this story but to me it is also somewhat of a smoke screen. As such, I wholeheartedly agree with those who believe that the Bretton Woods II is due to a revision. However, so far I can only see one strong impetus for this and that is the obvious need for the US economy to get the house in order and reduce the twin deficits. Recently quarterly reports on export contribution to US growth are good news in this regard. The other part of the equation however is still somewhat missing.

The question we need to ask is thus the extent to which the USD peggers can actually turn the ship around at this point ... you know, with respect to becoming consumption driven and all. More to point and if we accept that the US should be replaced by another economy or a group of economies it is not straight forward, at this point, to see where the candidate(s) are.

With respect to the illusive concept of diversification I rely on the principles of the comparative advantage and thus the work by Brad Setser and Rachel Ziemba. The former massages the above mentioned article posted in Reuters and unlike what you might expect he does not latch on to the fact that Gulf states are reducing their exposures to the USD (he already knows the data by heart I imagine). Rather, Setser points out the growing discontent of reserve asset managers with their investments in Europe and the US.

But perhaps the most interesting part of Sender’s article is the part suggesting that the United States’ creditors are increasingly frustrated by US policy — and no doubt also unhappy that their investments in US (and European) financial firms have performed so poorly.

The fact that this frustration is starting to spill over into the press is news. My guess is that a lot of funds are down significantly so far this year, and in some cases the falling value of their existing portfolio may be a big enough drag to nearly offset all the new oil inflows.

Regarding the prospect of some kind of USD crash I still think we need to keep our heads decidedly cool. My feeling is thus first of all that we need to tackle the extent to which we are past a point of no return. The extent to which we will see significant diversification (or depegging) therefore rests on two important obstacles in my opinion. First of all there is the question of what SAFE et al. should diversify into and whether the 'recipient(s)' would accept this? Surely, the Euro is heading for more than a bit of problems in the years to come which will make it quite clear that it cannot take up the baton for the US. Secondly, many SWFs and central banks WOULD have to incur loses on their remaining USD holdings if they decided to bury the buck. All this does not mean that we won't see diversification at all; to put this as an argument would also be somewhat of a reality defying argument. My only point would simply be that the process will not be a linear one in which the Euro takes over from the Dollar and therefore that old notions of de-coupling and rebalancing need to be taken with more than a pinch of salt.

As a final point on this, the hunger with which the recent Fannie/Freddie offerings was munched suggest, at least initially, that it is all back to business as usual. Note here that 61% of the issue was picked up by investors outside America apparently content with the higher, government backed, yield over treasuries.

To Inflate or Deflate?

If the credit crunch began with a fear of growth and damage control it has since shifted into a focus on the adverse effects from inflation. Especially, the nexus made up by the pressure from headline inflation fuelled by a weakening Dollar over to the ensuing pressure on risky assets have been much under scrutiny. In fact, it would not be a long shot to say that the graph below pretty well sums up the market's response to the credit turmoil.

The focus on inflation is understandable and important not least in the context of indications that inflation expectations have been edging up. Much debate has been devoted to the extent to which global central banks are really serious when it comes to focusing on inflation at the same time as the economic edifice is crumbling. Of course, in emerging economies such as for example in Eastern Europe, key parts of Asia and Latin America inflation is a very serious concern as many of these economies are quite literally burning up. But how much can higher domestic interest rates help here? In a world where capital goes for yield, inflation targeting by one central bank will not work if the rest of gang chooses to go for growth. Moreover, there is the delicate point with which to balance the need for emerging economies to see nominal appreciation of their currencies while avoiding to become to the new global consumer of last resort as the hot money comes flowing in. China is almost a perverse example here since, while there has been no official mutterings about a revaluation money is coming in fast on the expectation that inflation ultimately will bring the USD peg to its knees (see nice discussions here and here). In India and Brazil policy makers are wrestling with the same problem as the attempt to keep the economy balanced conflicts with the need to do something about inflation. There are no easy solutions here it seems.

In an immediate policy context, there is also a lot of sentiment flying around I think. Lowering interest rates to cushion those who should not be cushioned and, in turn, submitting the global economy to a heavy yoke of inflation is thus not popular. Bernanke and Paulson are certainly making themselves distinctly unpopular in some parts of the investment community as they have chosen to respond to the crisis by supplying ever more liquidity. But could they have done anything else?

As I have argued before it is rather funny to see the US being branded the scarlet letter of the global excess liquidity source. The point here would be that it was only 1 and a half year ago that this role was assigned to Japan and since the BOJ has not exactly managed, with great force, to shed itself of the low interest rate policy it is difficult to see whether anything has materially changed? I shall be the first to admit that excess global liquidity is a problem and that this problem to a large extent is at the heart of the current mess. However, I would also wish that more people tried to connect the dots in a slightly more sophisticated way than to blame it all on Greenspan and Bernanke.

Ultimately then, this is first and foremost a debt crisis coupled with a search for assets to match the structurally persistent availability of excess liquidity. Thus, it is also important to understand that as we are about to enter a significant bout of asset destruction and while at the same time providing more liquidity, the global yield game is likely to intensify. The debt problem and the subsequent need for many economies to significantly tighten the belt and ramp up savings is a key trigger effect here. It means that the effects on the real economy may well turn out to be deflationary in the context of some economies who simply do not have the ability to propel internal demand at the same time as turning the ship around towards more focus on saving. If you doubt me on this I suggest you take a look at Spain and quite possibly also Italy, Germany and Portugal; not to mention key economies in Eastern Europe but that may be further into the future. In the end this is also why I have been persisting in my focus on the distinction between core and headline inflation; In for example Japan (top graph) and the Eurozone:

The figures obviously do not indicate that core prices are not rising since in many economies they are; and fast too. The point I would like to emphasise here is simply the asymmetries by which the current crisis may unravel with inflation continuing on a global scale while some countries risk falling into a Japan like deflation trap, out from which it is very difficult to escape. My hypothesis is furthermore that countries with a weak demographic profile will be in the front line as potential candidates to see persistent and ongoing deflation. In a Eurozone context I have been particularly adamant in pointing towards this risk since it is quite clear I think that the ECB would find it very hard indeed, if not impossible, to administer some variant of ZIRP in the context of one country. And then we have not even talked about the effects any provisional liquidity arrangements would have on the Eurozone's countries' relative sovereign debt standing.

So far the market discourse still seems set on inflation even if the recent near collapse of the two US mortgage giants have moved the focal point a slight bit. Moreover, and as is visible in the graphs above oil has recently taken a dip which is prompting many to ask whether the current rally is, if not coming to an end, easing slightly. In-house RGE analyst Rachel Ziemba asks the same question while Paul Krugman and Stefan Karlsson chimes in. I tend to agree with the sentiment expressed by these contributions and while it is true that oil may sell off it is difficult to see a plunge. I think there is a considerable hysteris effect in operation here (in the long run) with respect to commodities in the sense that they are much more elastic to the upside than to the downside. In the short term of course it may be well be the opposite case.

My main point would simply be however that there is very little central banks can do about this. In fact, as can be seen from the recent Eurozone trade data flogging the Buck has not helped with that distinct problem. I would also add that we should never forget how rising costs of primary goods could ultimately add to the deflation pressure due to the cross price elasticity with core consumer goods. The key for me is the extent to which a given economy is able to muster the sufficient domestic demand to avoid seeing deflation in its domestic market if the going really gets tough. Italy, Spain, and Germany for example may not be able to do this.

Faint mumblings are consequently also beginning to move the focus from inflation to deflation/growth. In the Eurozone where the ECB managed to sneak a last minute raise past the post Trichet is bracing for a recession in the next two quarters which effectively means that the ECB's hands are tied. I also noted that the D-word was mentioned in a Bloomberg headline recently as Société Générale's Albert Edwards, among others, was quoted saying that deflation may be the next story to watch out for. Michael Mandel makes the same observation predicting that the next story on prices will be deflation. I hardly think that this would be a surprise. Personally, I am on record for flagging the deflation flag for quite some time and while it has nothing to do with complacency against inflation or me being an apologist, it is simply a question of adequately balancing the risks.

One Year In ... Still Some to Go

Almost one year into the credit crisis the hard truth remains that we are not near the end of the road. Things are likely to get worse before they get better.

In this note I have dealt with a couple of themes. Firstly, there is the strict market perspective where fundamentals and trading models are being revised by the day. As I noted, I do think that we need to see some volatility in currency markets soon, but in what direction obviously remains the key question.

More specifically, I have also re-visited old arguments and not least in the context of the much tarnished BWII edifice. In many ways, one could argue that it already has crumbled or at least changed significantly. It is consequently quite clear that the US decisively has signalled the unwillingness to act as the future anchor, effectively pushing the decision over to the USD peggers who are finding it more than a bit difficult to contain inflation while at the same time staying pat with their currency policy. Given the extent to which emerging market and BRIC central banks are willing to intervene it is very difficult to envision some kind of rapid move. All this has so far handed the Euro with the dubious honor of taking over from the USD. This is not very likely to be sustained, but when that is said it is also hard to see how the EUR/USD could suddenly move back into the 1.20s. The need to correct a US deficit and rebalance the US economy will mean that Trichet et al. WILL need to pay off their strategy with interests.

In a similar vein, I have emphasised the need for economies such as Brazil, India, and Turkey to accept their potentially new role in the global economy. If they do not, we will simply have too many exporters relative to importers and even if these three do not go mercantilist there will still be too much savings going for too little yield. This is still the ultimate nut to crack in the global economy and the sooner we realize that demographics have something to do with it the better.

Finally, I also noted how the discourse perhaps slowly is beginning to nudge back onto growth and, if core inflation remains subdued, deflation. So far, this is not the case but it is a narrative important to watch I think since it may change quite quickly.

Post Script

Here at the end of my note I would like to feature (or present as it were) two pieces which I enjoyed immensely reading but never really got to comment on; an omission which I am sure my readers will excuse given the sheer amount of pundity being posted on the internet. The author is one Cassandra who, apart from doing Tokyo on a regular basis, recently returned from the soothing calm of Tyrol in Italy to resume services.

On a side note I would not be going out on a limb, I think, when I say that Cassandra, together with Macro Man and the olive producing Charles Butler make the econsphere a distinctly better place to be. The reason for the grouping of the three might seem odd at first but if you read carefully and stay with them for a while you will see that they manage to combine succint observations and deep financial knowledge with excllent writing; a combination I value greatly.

Anyway and to move things back on track before this turns into a fan letter I thought that the following pieces by Cassandra were very much to the point with respect to (attempting) a lateral cut through this whole mess in which the economy and financial system finds itself.

Liquidity Tug-o-War?

Notes to Self - End Q2 2008

A belated plug I know, but still well worth a look.

Monday, July 21, 2008

India Battles Between Rising Inflation And Lower Growth While The Rating Agencies Steadily Turn The Screw

by Edward Hugh: Barcelona

India's inflation accelerated to the fastest pace in more than 13 years at the start of July, putting pressure on the central bank to continue raising interest rates following the two increases made last month. Wholesale prices rose 11.91 percent in the week to July 5, after gaining 11.89 percent in the previous week, according to the commerce ministry in New Delhi on Friday.

It now seems very likely indeed that the Reserve Bank of India (RBI) will continue to tighten policy, since one of the major risks facing India now is that inflation becomes entrenched, and to avoid that eventuality the RBI may well need to implement a further significant policy tightening, and this of course will have implications for an Indian economy where growth is already slowing. However, with inflation at nearly 12% and the repurchase rate at 8.5% we shouldn't lose sight of the fact that India still has negative interest rates (minus 2.5% approx) thus monetary policy could be said to be still pretty accommodative, the problem is that with growth at such a fast pace, and inflation expectations rising, and thus the possibility existing of passing on increased prices to consumers, the situation could simply be self-perpetuating with interest rates at the current level. That is high but negative interest rates can, in the right circumstances (and particularly with high liquidity, and M3 money supply growth of 20.5% per annum) simply perpetuate strong price increases, and fuel compensatory wage demands which only serve at the end of the day to send things spinning round and round in an ever more vicious circle

The RBI currently expects the Indian economy to grow by 8.5 percent in the current fiscal year, slower than the 9 percent pace of the previous 12 months, but this forecast is now looking to be significantly under threat from the downside.

India's economic growth has slowed being slowing and clocked up the weakest pace since 2005 in Q1 2008, as the highest interest rates in six years discouraged consumer spending and investment, while a more complex global environment reduced the opportunities for expanding India's exports. India's economy expanded at a year on year rate of 8.8 percent in the three months to March 31, matching the revised rate of the previous quarter.

Foreign Exchange Reserves

India's foreign exchange reserves were up again in the week ended July 11 - by $123 million - according to the latest Reserve Bank of India data. The rise comes following a series of declines induced by changes in relative currency values and the drying up of earlier substantial net inflows. Forex reserves, including gold and SDR (special drawing rights), rose to $308.52 billion. The $123 million rise in the dollar value of the reserves was mirrored by a Rs 14,133 crore dip in the rupee value of funds, which strongly suggests that the increase has more to do with the value of the rupee vis a vis other currencies than any real increase in the inward flow of funds. Looking at the chart (above) it is clear real heavy net inflows came to a halt around the end of March.

M3 money supply growth slowed to 20.5 per cent during the two weeks ended 4 July - down rom 20.7 per cent two weeks earlier. The loan book at Indian scheduled banks was up by 25.7 per cent y-o-y at the close on July 4, compared with a 24.4 per cent rise a year earlier, ie loan growth is still not slowing significantly, although once you take inflation into account it is, of course, slowing. Deposit growth declined to a 21.7 per cent rate compared with a 24.6 per cent at the same point in 2007.

Money supply has now been rising at an average rate of 21.5% since the current fiscal year began on April 1. This is well above the central bank's target of 16.5% to 17% for the fiscal year ending March 2009.

Cash in the Indian money market, however, is likely to get scarcer in the near future since banks will have to place an additional part of deposits with the RBI as of July 19, when the revised norms on cash reserve requirements come into force. This tightening comes at a time when Indian banks are already been borrowing close to a daily Rs 30,000 crore from the RBI.

The raising of the cash reserve ratio to 8.75% coupled with the rise in the cost of borrowing via the the repo rate rise to 8.5% is thus now producing significant effects on day to day liquidity, and most Indian analysts are talking about a withdrawal of some Rs 16,000 crore of funds from the banking system during the coming week. While the cash reserves hike alone is expected to take Rs 8,000 crore out of the system, the RBI is also planning to issue bonds worth Rs 10,000 crore, which will simply bring cash conditions under further pressure. This move by the RBI would seem to be evidence of a certain conflict of interests between the RBI and the Gingh administration, since it was anticipated that funds from an April bond issue which is due to mature in July would be released into the banking system to ease the current cash crunch. However, since the RBI is expressly trying to create the cash crunch, it immediately announced it was itself going to issue a series of bonds as a market stabilisation measure - and effectively suck these funds straight back out again.

Analysts expect banks to be borrowing up to Rs 45,000 crore from the central bank at the daily repo window next week while borrowing rates in the inter-bank call money market are expected to rise to 9.5%. Thus the Indian banking system has been experiencing tight cash conditions for over a month now, and these conditions are likely to continue.

The Rupee

India's rupee gained for a second week last week as the largest weekly drop in crude oil prices ever spurred speculation import costs will decline. The rupee climbed to its highest level in more than three weeks on Friday as light, sweet crude for August delivery fell 41 cents to settle at $128.88 on the New York Mercantile Exchange — well below its trading record of more than $147 a week earlier. India depends on imports to meet three-quarters of its annual energy needs. The rupee also advanced on speculation gains in local equities will attract global funds.

The rupee gained 0.2 percent on the week to 42.785 per dollar at the 5 p.m. close of trading in Mumbai, the highest since June 26. It had risen as high as 42.66 earlier the day. The currency has now rebounded 1.6 percent from a 15-month low of 43.475 on July 1.

The 37 percent rise in crude oil prices so far this year has boosted the average cost of India's monthly oil imports by 43 percent, and oil imports have averaged $7.8 billion a month so far this year, compared with $5.45 billion in 2007.

An additional factor in the upward pressure on the rupee - apart, of course, from the yield advantage which would derive from the anticipated hike in rates following this weeks inflation data - is the fact that the benchmark Sensex share index climbed for a second week, raising optimism overseas investors will scale back sales of local assets. Funds based outside India have sold $7.13 billion more Indian equities than they have bought so far this year, compared with a net purchase of $17.2 billion in 2007, according to the Securities and Exchange Board of India.

Fitch Downgrade

India's Finance Minister Palaniappan Chidambaram has been busy in recent days, trying to downplay the decision by global rating agency Fitch to lower India's local currency credit rating. Chidambaram said the decision was not a cause for concern since the country's economic fundamentals were strong, and stressed that India would grow by around 8 per cent this year. "We must look at fundamentals, which I believe are still strong, but facing difficulties. I do not think we should worry about the outlook,".

While Chidambaram is evidently right here in big picture terms, it is important not to underplay the seriousness of the problem which is being posed by inflation at the present time, nor should he try to deny the significance of the deteriorating fiscal outlook in India, since, as he is indicating, India is far from being in recession, or even in danger of a serious slowdown, so it is important that these twin problems of fiscal deficit and spiralling inflation be gotten under control now.

The decision by Fitch to revise India's local currency outlook to negative from stable is based on a perception by the ratings agency of a worsening fiscal position and rising inflation. The assignment of a negative outlook suggests an increase in the sovereign default rate may follow if the problem is not corrected, and this would affect the flow of funds - and hence investment - into India. The new revised local currency rating will be 'BBB-' with negative outlook as against the earlier 'BBB-' with stable outlook.

James McCormack - Head of Asia Sovereign Ratings for Fitch - is quoted as saying the "the revision to the local currency outlook is based on a considerable deterioration in the central government's fiscal position in 2008-09, combined with a notable increase in government debt issuance to finance subsidies not captured in the budget." The rating agency has revised its economic growth forecast for 2008-09 from just under 9% to 7.7%, and this seems to be not unreasonable.

Fitch did, however, continue to affirm India's long term foreign currency Issuer Default Rating (IDR) at 'BBB-' with stable outlook, its short-term foreign currency IDR at F3 and the country ceiling at 'BBB-'. The assignment of a local currency negative outlook thus means that agency has effectively put India on watch with the implication that is the underlying causes (inflation and the underlying dynamics of the fiscal deficit) are not addressed over the next 12 to 18 months, the rating could be subject to downgrade. Obviously this is a warning shot as much as anything else, and an attempt to put pressure on the Indian government.

India's total central government deficit - including the subsidies to oil companies - may surpass 6.5% of GDP in the current financial. Even the budgeted deficit could rise to 4.5% of GDP from the projected 2.8% of GDP due to higher on-budget subsidies, together with rising interest payments and public sector wages. In addition to this, Fitch argue that bonds issued to oil and fertilizer companies may well reach 2% of GDP in 2008-09.

Higher oil prices have raised India's oil import bill dramatically in last three years, and the goods trade deficit was equivalent to 7.7% of GDP in 2007-08. The current account deficit, however, was much smaller at around 1.5% of GDP, due to high services exports and the strong remittances inflow (estimated by the World Bank at 2.8% of GDP in 2006).

Fitch forecast that the trade deficit will widen further in 2008-09 to 8.2% of GDP, although they suggest the current account deficit may remain broadly unchanged at 1.5%. The IMF do not seem to be so sanguine on this as Fitch, however, (although please note they are using calender and not financial year data) since the April World Economic Outlook forecast was for a CA deficit 2008 of 3% of GDP (they are also forecasting 7.9% GDP growth WY 2008). As can be seen in the chart (below), whichever way you look at it India's external position is certainly deteriorating.

So their is a slight disconnect here, with a deteriorating fiscal side and a comparatively strong external position, which is what is being reflected in the credit rating differential between local and foreign currency.

In the past four years, the three rating agencies have raised India to investment grade on the back of its positive external financial ratios, improving budget deficit and robust GDP growth. The external position remains strong, but analysts are worried that domestic problems and a flight of capital could combine to bring down the country's credit standing.

Earlier this month, Standard and Poor's said the rising cost of subsidies, debt write-offs and public sector wage rises had increased the risk of a downgrade of the BBB-minus domestic debt rating - the lowest investment-grade rating - they assign to India.

While Standard and Poor's, like Fitch, rates both India's foreign and domestic debt at BBB-minus, Moody's rates its domestic debt two notches lower than its foreign rating. Foreign funds have already cut their investments in Indian debt and stock markets by $6.3 billion this year to $31.2 billion. Any further downgrade will only serve to speed this outflow.

Friday, July 18, 2008

What Is The Risk Of A Serious Melt-Down In The Spanish Economy?

by Edward Hugh: Barcelona

Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past, the ocean is flat again
John Maynard Keynes

'As far as I am concerned, this is ... the most complex crisis we've ever seen due to the number of factors in play'
Spanish Economy Minister Pedro Solbes speaking this week to Spanish radio station Punto Radio

Jose Luis Borges tells a story about two rascally villains, eternal rivals, who - under sentence of death - are offered one last bet: rather than accepting a conventional execution they can agree to have their throats slit simultaneously, just to see who is a able to run the farthest. Immortality, rather than fame, in an instant. Now I mention this since tale I can readily anticipate the immediate feelings many will have on reading what follows (I am at the end of the day going to argue that it is necessary to inject money - and I do mean rather a lot of money - into a banking and construction system which many will want to argue is largely responsible for Spain's present distress, and indeed, that having made a good deal of money out of the operation, these are the very people who should now be forced to don that sackcloth and ashes costume which so behoves them (actually the way things stand they are much more likely to find themselves reduced to a sporting a loincloth, but still). I understand why many ordinary Spanish people may have such feeling, but I do think this is a time for cool heads, and that what is most needed here is an extreme dose of pragmatism coupled with a lot of emotional intelligence. There is no point in agreeing to have your own throat slit just to see people you don't like have their's slit first.

Martinsa Fadesa The First To Go

This week's filing by the Spanish property developer Martinsa-Fadesa for protection from its creditors has brought Spain's ongoing economic agony back to the headlines. The decision follows a request from Martinsa Fadesa last Friday to its creditor banks for a postponement of the deadline on their requirement that the company obtain a 150 million euro ($235.7 million) loan. The banks refused the request and the rest is now, as they say, history. The failure of Martinsa - Fadesa whose debts are in the region of 5 billion euros - is not only the largest corporate bankruptcy in Spanish history, it is also a reflection of the pain which must now be being felt in Spain's troubled banking and construction sectors, and a harbinger of what is, in all probability, going to be much worse to come.

Spain At Risk

So to come directly to the matter which has provided me with the header to this post, just what is the risk that the present recession in Spain is something a bit more than a mere recession? What is the risk of a real and serious economic melt down just across France's Southern border, a mere stone's throw away (by plane) from Brussels or Frankfurt, yet still on the other side of that intellectual and cultural divide which seems to be formed by that ever so picturesque natural barrier known as the Pyrennees? Well it is a non-negligable one, in my view. Let me explain a bit.

First, as background it would be worth reading my Artemio Cruz Syndrome post, since all the main macroeconomic arguments are presented there (and those who seriously want to know what is going on should definitely read the excellent "Spain:Bubble Bursting - We now expect a full-blown recession" desknote from PNB Paribas).

Secondly, we need a bit of vocabulary clarification, since the terminology being used has become somewhat confusing of late. We could reasonably break things down as follows I think:

i) Soft Landing
ii) Hard Landing
iii) Melt Down

Now, in terms of the available semantic space, why don't we allow that "soft landing" means a recession of the more or less garden variety (as Portugal or Italy have at this moment, or as say France may anticipate, or Denmark) and not consider this to mean avoiding recession completely, which is how some seem to have used the term in recent times (I think it is hard to imagine any EU 15 economy avoiding recession completely between now and Q2 2009). Possibly Hungary up to this point could also be said to have had a comparatively soft landing.

"Hard Landing", on the other hand would be what they are currently experiencing over in the Baltics, what they may well soon experience in Romania, Bulgaria, the UK, and Ireland, and what is now most certainly taking place in Spain. Thus by "hard landing" I mean a very sharp slowdown in growth, a medium sized contraction in consumption, financial distress and bankruptcy in some areas, and a recession which drags itself on for more than a mere two quarters (in and out of negative growth) and probably results in annualised negative growth for a period of at least 12 consecutive months. What happened in Turkey in 2000 was certainly a hard landing in this sense.

iii) "Melt Down", following such definitions, would then be a Hard Landing plus, a Hard Landing plus a shock (or in Hungary's case, where the shock would be a run on the forint, you could imagine what initially is only a Soft Landing being converted into a melt down, but arguably Hungary's case is very special given the very high level of exposure of household balance sheets to CHF denominated forex loans).

Such a shock could be a banking crisis, a run on the currency, a sovereign default (this is where Italy's series of perpetual soft landings could move decisively into meltdown mode one of these fine days if something isn't done to correct the low growth/high sovereign debt to GDP dynamic while there is still time).

Now in this sense, Spain's economy is at some significant level in danger of having a melt down - lets define this as more than two years of negative GDP growth with a magnitude of more than one percentage point, coupled with (in the case of countries which have their own currency) very sharp devaluations, and in the case of those that don't severe and extended price deflation (ie a mini version of what happened in the USA in 1930).

Now the recession in Spain is, I think, more or less most certainly already served. The Spanish press were talking earlier in the week about a quarter on quarter contraction of 0.3% in Q2, and it is hard to see any acceleration of the economy in Q3. Pedro Solbes, when questioned explicitly by Punto Radio on the possibility that whole year growth for 2008 could turn negative replied diplomatically "It's not my feeling at the moment", which means basically that it might well turn out to be the case.

If this expectation if fulfilled then Paribas may have to revise their latest forecast slightly (see above link) since - in what is really an excellent general analysis - they pencil-in the recession to start in Q3 2008 and then move on to anticipate a contraction in the Spanish economy of 0.75% in 2009 (although as they freely admit all the risks here are skewed to the downside). My own personal call at this point is that the recession may well have started in Q2 (we will soon know) and that the contraction in whole year 2009 will be over 1 percentage point. Further than that I am not willing to go at this stage, since it all depends, and in particular it depends on whether or not we get a nasty "event" or series of events which send the economy hurtling out of the "hard landing" bracket and into the "melt down" one. It is because I strongly believe we be should doing everything we possibly can to avoid that eventuality that (and not continue to languish under our blankets with a heavy dose of the Artemio Cruz syndrome) that I am writing this post now.

Before continuing, however, I should point out that even the Paribas idea of negative growth in 2009 is still very nonconsensual, despite the widespread pessimism which currently surrounds the Spanish economy. The consensus economic survey for June gives a median 2009 growth forecast of 1.5%. The lowest forecast in the survey is 0.4% but most are grouped in the range 1.0-1.8%. Maybe the consensus will catch up with the curve in due course.

Structural Unwind

So what would be my justification for making such an apparently gloomy forecast? Well as I argue in my Artemio Cruz piece, and as Paribas re-iterate in their study, this is no ordinary crisis. It is taking place against a background of a severe credit crunch which affects the entire financial sector, in a country with an enormous external deficit (CA deficit over 1o% of GDP and rising), which has a strong external energy dependence, and at a time when food and energy prices have been rising sharply. All of this is bound to exert a very strong downward pressure on internal consumer demand, and as a knock-on impact on investment spending. At the same time slowing growth globally, and in the EU and eurozone economies in particular, makes for a very difficult external environment where increasing exports (even assuming Spanish export prices were currently competitive, which they aren't) becomes difficult, if not well nigh impossible.

Serious Structural Distortions

So let's take a quick look at some of the underlying structural issues. In the first place both Spanish households and corporates are extremely highly leveraged at this point in terms of their outstanding debt obligations. The levels of debt to GDP are really extraordinarily high when compared with their eurozone peers.

So how did Spain get into this rather precarious situation? Well I don't think you need to look too far to discover the answer. As can be seen in the chart below, Spain effectively had negative interest rates throughout the entire period between the start of 2002 and the autumn of 2006. That this state of affairs was produced in the very earliest years of the history of the eurozone was indeed, in my opinion, truly unfortunate, since it meant that inflation expectations had not had time to be "steered down" by a central bank track record. Thus a very widespread reaction on the part of ordinary Spaniards to what were generally perceived to be derisory interest rates for savers was to withdraw money from longer term deposit accounts and to place it in what was considered to be the safest of safe inflation hedges: property. Thus began what may well turn out to have been one of the most serious property bubbles in recent history.

The situation was also doubly unfortunate, since the ECB along with other central banks had lowered interest rates in an attempt to support economic weakness produced by a drop in stock market values following the collapse of the internet boom. In Spain's case however, the excesses caused by the internet boom never really had the opportunity to unwind, since as one boom ended, another one simply got going in its place. This effect can be clearly seen in the chart for long term quarterly GDP growth produced below, where we can see that following the 1992/93 recession (and up to Q2 2008) Spain simply hasn't had one single quarter of negative growth - that is during 15 years. Hence the legend of the Spanish economic miracle was born. But as with all legends, we should also really be asking ourselves what the reality was which lay behind it, since as we can now see, the absence of recession - and in particular the absence of recession in 2002/03 - simply means that we now have a lot of extra "distortion" lying out there and waiting to be "corrected" (the waste-pipes were effectively never flushed, which is why we are now faced with such a peculiar smell emmanating from the sewage system). This would be the main reason why I would argue that what we cannot now expect is a relatively smooth "return to trend" in 12 to 18 months time, since Spain has effectively been "off trend" for some six or seven years now, and the magnitude of the excesses (10%+ CA deficit, 5 million immigrants in eight years, corporate indebtedness pushing the 120% of GDP mark etc etc) is prima facie evidence for this. So even in the best of cases we are almost certainly now facing a significant period of negative and then very low headline GDP growth. But we may not be lucky enough to get away from all this with a simple best case scenario.

The last piece of structural evidence I would offer in this post refers to the CA deficit situation. Since I deal with that reasonably exhaustively in the Artemio Cruz piece, I will only refer to one item here: the deteriorating balance on the income account.

Now this is important in my opinion. It is important since obviously any of the remedies to Spain's short term financing problems imply borrowing money (in some way, shape or form via the support which is offered by belonging to the eurosystem). Spain needs one of those proverbial "bailouts", even though since Spain does not have its own idependent currency this position is somewhat masked by the fact that everything is denominated in euros. But debts incur interest, and the more you borrow, the more you effectively have to pay, not only in capital, but also in interest. And if Spain country risk rises sharply in any way - as some analysts are suggesting it may have to - well then what is already a serious problem is only going to become a more serious one.

Land Prices

So where are the risks? Well I think it is no simple accident that Martinsa-Fadesa has been the first major developer to go, since a very large part of their portfolio is composed of land. According to press reports Martinsa Fadesa had land totalling 28.67 million square metres, 41 percent of which is outside Spain (and 50% of which is not "zoned", that is it is without the necessary premission to build). They also have a stock of more than 173,000 newly-built and unsold properties (again by no means all of these are in Spain). Now land is going to be a very important component in this whole "correction", since a lot of land (as we can see) has been accumulated with intent to build, and much of this land may now become virtually worthless. And land prices are already falling faster than house prices. Data from the Ministry of Housing shows that land for building fell to 251 Euros/m2 in March, a 7.7% drop when compared with March 2007. Land prices had fallen for 3 consecutive months by March with the average cost of land in Spain now being back somewhere around where it was at the end of 2004.

So I would say this is one of the first issues the Spanish government needs to tackle, and quite urgently. Frankly I can see little alternative to having the government intervene and take this land off the books of those who are holding it - not at market prices, they can handle some sort of "haircut" - but I don't think the government should be sitting idly back and watch one developer after another simply fold, since the end result of this is that the problem then moves over into an already overstretched banking sector.

Which brings me to my exhibit one: Japan land prices.

One of the key features in Japan's ongoing battle against deflation has been the way in which land prices were simply allowed to fall after the property bubble burst in 1991. The above chart shows the sharp rise in Japanese land prices from 1986 to 1990 - a period during which they more than doubled - and how they subsequently fell - albeit more gradually — by roughly two thirds from 1990-91 to 2005. Although urban land prices started to turn up slightly post 2006, land prices still continue to fall elsewhere, and of course we still haven't seen how the latest construction "bust" in Japan is going to leave things. Unsurprisingly, residential construction has remained virtually dormant in Japan over this entire deflationary period.So the question is, what is to stop this happening in Spain. I would be grateful to anyone who can present me with a reasoned argument as to why what happened in Japan won't happen here. Meanwhile the risk is evidently there.

The Builders In General

Obviously even if the most immediate and pressing problem in Spain is arising in the area of land prices, the rest of the housing related construction sector will not be far behind. This is a problem that is simply waiting to happen. According to the latest data from the Spanish housing ministry, average Spanish property prices fell by 0.3% in the 3 months to the end of June, but they were still 2% up on prices in Q2 2007, a factor which is leading many to question the reliability of the Spanish data (one more time Artemio Cruz strikes, since Spanish institutions are far from swift in responding to problems, and would seem to prefer denying that they exist). One explanation for the present situation may be that prices are being measured in terms of the initial asking price and not the final selling price. Whatever the explanation prices are certainly set to tumble, and even the the G-14 developers’ association, traditionally a staunch upholder of the immobility of property values, has had to admit that new-build prices have fallen by 15% in the last 6 months alone, while Cue Mariano Miguel, ex-president and present board member of the much troubled developer Colonial, is already predicting a fall in the region of 25% to 30% over the next two years. And new property in Barcelona (which is where I live) is now taking ten times longer to sell than it was only a year ago, according to real estate consultancy Aguirre Newman.

Meanwhile we learn from Jose Luis Malo de Molina, director general at the Bank of Spain (speaking at a recent conference in Valencia) that the number of new homes which will be completed in Spain in 2008 will beat all previous records (I said this was a system which was slow to react), simply piling one more house after another in order to add to that glut of newly completed homes that is already idly languishing and casting its long shadow over the Spanish property market. Muñoz's explanation for this phenomenon is simply that “the real estate sector can’t turn around quickly, it works in the medium and long term, so this year the properties started at the end of 2005 and beginning of 2006 will be completed, which means the number of new properties on the market will hit an all time high.” As I say, "just in time" may be an idea that has entered the heads of the more agile companies like the textile consortium Inditex, but most of Spain is a very, very long way from being able to offer an agile response. On the anecdotal front, a friend of mine recently went to visit family homes in the North West of Spain. In Vigo he spoke to the owner of a brick factory, and in Leon someone who had a quarry. In both cases production was continuing (there is simply no on/off switch here) but the inventory already had piled up to the extent of being now prepared to satisfy normal requirements for the whole of 2009 (in both cases), and of course, in 2009 requirements will not be normal, since housing starts in 2008 have collapsed to a forecast of below 200,000 (down from 600,000 plus in 2007).

At this point estimating the volume of unsold housing in Spain is really a question of "its anyone's guess" rather than a matter of scientific fact. The number 1 million is popular, but I suspect this is more a question of serving up an easily managed factoid than one of accurately measuring empty houses one by one. The same applies to the estimates for the size of the likely fall in property values. All we can safely say at this point, I think, is that the number in both cases is large.

The big question for our current concerns is who is exposed to the risk on all this, and the answer to that question is a lot simpler: Spain's already cash-strapped banking system.

One common estimate of the exposure of the banks to the builders would be somthing of the order of 300 billion euros - this is the opinion of Spanish analyst Inigo Vega at Iberian Securities (and it is one I more or less share). So we could say we have something in the region of 20% to 25% (or more) of Spanish annual GDP in play here.

Bank Exposure Through Mortgage Backed Securites

To this second order exposure of the banking system to the construction sector alone (and remember, through the negative impact of all this on the real economy, we should never lose sight of those non-construction corporates, you remember, the ones who had all that indebtedness we saw in the first chart) we need to add the exposure of the banks to the cedulas hipotecarias, which alone run to something in the 250 to 300 billion euro range (to which we need to add, of course, other classes of more conventional mortgage backed-securities ). If we add these two together - the builders and the cedulas - then we are obviously talking about a potential injection into something of over half of one years GDP in Spain.

According to Celine Choulet of PNB Paribas mortgage-backed securities in the broader sense of the term (ie including cedulas and MBS) now add up to around 37% of outstanding mortgage loans in Spain. She also estimates that asset backed securities held by non-residents may amount to as much as 81% of the total securities issued.

Outstanding home loans (for purchases and refis) represent a substantial percentage of the Spanish banking institutions’ balance sheets (21.5% of total assets and 35.6% of total loans to the non-financial private sector in the second quarter of 2007). In the second quarter of 2007, outstanding home loans amounted to 589 billion euros, 56.4% of which were distributed by cajas (29.8% of their assets), 37.2% by commercial banks (15.4%) and 6.4% by mutual institutions (30.9%).

If we add together home loans and the financing of real estate sector (construction and property services), the overall exposure of Spanish credit institutions has increased significantly over the last decade (37% of assets in the second quarter of 2007, 61.5% of total loans to the non-financial private sector). Exposure of Spanish banks to the real estate sector has exceeded, both in level and in growth rate, that of US, Japanese and British banks. In total, in the second quarter of 2007, cajas (49.7% of assets, 70.5% of loans) and mutual institutions (46% and 56.3% respectively) were almost twice as exposed as commercial banks (28% and 55.2% respectively).

According to Choulet - and just to take one example - in 2006 total new funding to the Spanish mortgage market reached 201.3 billion euros, of which 88.3 billion took the form of covered bonds (representing 43.9% of the total of mortgage securities market) and 113 billion was in mortgage-backed securities (56.1%).

And remember the cedulas all need to be "rolled over" in the next few years (with a big chunk coming up between now and 2012). And the problem starts this autumn. According to an article in the Spanish daily El Pais at the end of June the Spanish banking sector needs to raise 62 billion Euros before the end of this year just to rollover what they have coming up on the immediate horizon.

So what does all this add up to? Well, to do some simple rule of thumb arithmetic, just to soak up the builders debts and handle the cedulas mess, we are talking of quantities in the region of 500 to 600 billion euros, or more than half of one years Spanish GDP. Of course, not every builder is going to go bust, and not every cedula cannot be refinanced, but the weight of all this on the Spanish banking system is going to be enormous. Banco Popular is the most visible sign of the pressure, and their shares have already dropped by 44% this year, and by 7.9% on Tuesday alone (they were the listed bank which was most exposed to Mrtinsa Fadesa).

So it is either inject a lot of money now - more than Spain itslelf can afford alone - or have several percentage points of GDP contraction over several years and very large price deflation - ie a rather big slump - in my very humble opinion. And it is just at this point that we hit a major structural, and hitherto I think, unforeseen problem in the eurosystem (although Marty Feldstein was scratching around in the right area from the start). The question really we need an answer to is this one: if there is to be a massive cash injection into Spain's economy, who is going to do the injecting? Spain alone will surely simply crumble under the weight, and it is evident that the problem has arisen not as the result of bad decisions on the part of the Spanish government, but as a result of institutional policies administered in Brussels and monetary policy formulated over at the ECB. And yet, the Commission and the ECB are not the United States Treasury and the Federal Reserve, no amount of talk about European countries being similar to Florida and Nebraska is going to get us out of this one: and it is going to be step up to the plate and put your money where your mouth is time soon enough. Yet, cor blimey, we are still busying ourselves arguing about the small print on the Lisbon Treaty.

Demographics and Construction

The third major area of risk I would like to highlight today relates to the problem of demographics and their impact on the construction outlook. PNB Paribas (see initial link) see demography as one of the principal downside risks to their forecast. They put it like this:

"With United Nations population projections pointing to growth of only 300k per year on a ‘high-population’ variant for 2010-15, housing starts could fall considerably further. Hence the risks to our central forecast of 30% off housing investment by end-2009 are to the downside. The correction could be more rapid than expected. If not, it is likely to persist into 2010. ...........Our forecast has housing investment converging to levels consistent with relatively strong population growth. A weaker population assumption or some undershoot of the ‘equilibrium’ level would lead to a worse outcome."

Basically, I think the big topic in this context is the coming rate of new household formation. And here it is worth remembering that while the countries most affected by the property-driven credit crunch in the EU would appear to be Spain, Ireland and the UK, the UK is rather different from the other two, since while housebuilding grew by 187% in Spain between 1996 and 2006 (and by 177% in Ireland), the equivalent increase in the UK was just 12%. Planning restrictions in Britain meant fewer homes were built and the resulting relative scarcity may provide one part of the explanation for why house prices have almost doubled, in real terms, in the UK since 1999 despite the comparatively low percentage of new builds (this would bring us back to the huge zoned and un-zoned lang overhang in Spain, and what the dynamics are that produced it). That is, while the UK can to some extent offset the impact of the crisis in the longer term by increasing homebuilding (to house, for example, all those extra people from Poland and other parts of Eastern Europe), in Spain and Ireland the problem is going to be very different, since they both have to sharply reduce housebuilding capacity.

So what are the main sources of new household formation in Spain? Well basically they are threefold: natural population development, migration, and second homeowners from the north of Europe. Now if we start with the question of natural population evolution in Spain, ex-migration the Spanish population is virtually stationary at this point - with an average annual increase of a mere 30,000. But what matters in housing terms is not so much the size of the population as its age structure, and here we don't need to go to the level of refinement involved in looking at longer term UN population projections (high, median or otherwise) because in terms of Spanish property from now to 2020 (at least in terms of natural population drift) the deal is now done (or rather the goose is now cooked), and a quick glance at the US Census Bureau IDB population pyramid for 2000 should make this abundantly clear (see below).

What we can effectively see is that in 2000 (and please click on the image if you want a better look) Spain's three historically largest 5 year cohorts constituted the 25 to 40 age group. But if we mentally fast forward as far as 2015 we will see that the aggregate size of the cohorts in this age range is very significantly smaller, and if we fast forward again to 2020, we will see that what we have are the three smallest cohorts in the last forty years. And from here on in we only go down and down - talk about absence of sustainability!

So we are left with North Europeans is search of second homes and migrants to offer some support to Spain's rapidly crumbling housing sector in the coming years. Well on the North Europeans front the picture doesn't look exactly promising either, since the bulk of the buyers in recent years have been British (Britons own an estimated 500,000 to 700,000 properties in Spain), and they are already having their own problems, plus the fact that changes in the value of the GBP and interest rates mean that affordability is becoming an issue, an issue to which you have to add the drop in attraction of properties whose prices may now be set to seriously deflate, and over a significant number of years.

Indeed, according to Manuel Gandarias, president of the ‘Live in Spain’ holiday-home developers’ association, sales of holiday homes in Spain are now down by 50% from the peak “In recent years between 120,000 and 125,000 holiday homes were sold each year, this year it will be half that,” he is quoted as saying. And of course it isn't only the cost of buying the home that has been going up, it is also the cost of servicing the debt that buying the home brings with it. Josep Suárez, director at Solbank in London estimates that the combined impact of rising Euribor rates and the appreciation of the Euro against the pound (15% in the last 9 months) means that mortgage payments for Britons with mortgages in Spain are now 25% higher than they were a year ago.

So the outlook on the North European second home market doesn't exactly look bright either, which leaves us with the migrants. As is now generally well known, Spain's population has increased dramatically in recent years - from around 40 million in 2000 to around 45 million in 2008 - and this increase has been almost exclusively (natural increase is no more than a quarter of a million) the result of huge inward migration.

Basically the future of all these migrants is now deeply uncertain. I would even say that losing the migrants constitutes the most important of all the downside risks to the Spanish economic crisis for the impact it will have on urban rents and mortgage delinquency in the short term (since many of the migrants have bought flats), and for the consequences for Spain's housing market and pensions system in the mid term. Evidently, since most of the migrants are economic migrants the inward flow must surely be about to dry up (since there are few if any jobs for them) and thus our attention should be focused on the need to hold onto those we already have.

Is There A Rescue Plan Available?

Basically, and on the basis of all the above, I would like to now put forward a five point "rescue" plan for the Spanish economy. It would look something like this:

1/ Set up a national land agency, to buy up land and to irrevocably convert it to other uses (agriculture wouldn't be a bad bet where possible given present food prices). This to include the proviso that such land could never again be zoned.
2/ Buy out and close down the bankrupt builders as part of a general restructuring programme such as the one which was developed for the shipyards and the mines.
3/ Buy up and burn immediately ALL outstanding cedulas hipotecarias. Well, I'm exaggerating here, but something very decisive needs to be done to take these things out of circulation in the longer term, or we will never ease Spain out from under this.
4/ Establish a programme to help immigrants in difficult circumstances, and offer training etc to prepare for the future. Abasic focus of policy needs to be on trying to persuade migrants to stay.
5/ Restructure all existing mortgage contracts - which will involve every one paying more - in order to put mortgage financing in Spain back on a sound footing. This will obviously require legislative intervention, and will equally obviously involve breaking the direct tie with one year euribor. It has been following euribor up and down which has gotten the Spanish mortgage market into this mess in the first place.

OK, I warned you. I said none of this was going to be popular. And none of these propsals should be consider as carved in stone. Better ones could well, I am sure, be put forward, but in the absence of anything credible in the way of alternatives I am putting them forward now. As I said at the start, there is no point in agreeing to have your own throat slit just to see people you don't like have their's slit first.

It is very, very important that some form of "corta fuegos" (fire break) is put in place, and put in place now, otherwise the whole of Spain could very easily burn down in just the same way the Liceu opera house did here in Barcelona, simply because some chump decided to do on-stage soldering repairs with the safety curtain up! Risk sir, there's no risk here. It's all as safe as houses.