Facebook Blogging

Edward Hugh has a lively and enjoyable Facebook community where he publishes frequent breaking news economics links and short updates. If you would like to receive these updates on a regular basis and join the debate please invite Edward as a friend by clicking the Facebook link at the top of the right sidebar.

Monday, April 20, 2009

A Perspective on Carry Trading

By Claus Vistesen Copenhagen

ARE carry trades back in Vogue? With all the talk about second derivatives, equity rallies, and for my own part spring sensation in the market place this question is, I think, a natural one to ask. And by all means, I am not the only one who is asking it. Actually, I think most serious FX punters out there are considering (or have considered) whether it is time once again to seriously consider moving into carry trades.

Now; it is probably a pretty good bet that if Alpha.Sources start talking about the return of any kind of market trend you are probably bound to have missed the boat on it from an investment point of view. Not that I am lacking the discourse or anything, but it is hard to escape the feeling that if we have, since mid February and up to this point, sustained the longest equity rally and subsequent low point in volatility since the crisis broke out, we seem very close to a turning point. Danish fund manager Steen Jakobsen ended last week on an ominous note talking about the biggest selling point this year, which naturally suggests that whatever juice present in carry trades have been squeezed out by now. Add to this that the two most popular pieces currently on Seeking Alpha both extol the end of the current rally, and it definitely seems that the end is nigh for the bulls. Finally, there is the more technical and wonkish perspective in which John Kicklighter, Currency Strategist at DailyFx points out that risk appetite might be close to its peak.

There have been someone however pointing to the possibility of taking advantage of the benign market conditions to dip its toe in the market for carry trades. Darrel Whitten points to the JPY as the classic funding currency and suggests to invest in high yielders such as the Real, the Lira and the Rand. Also Andy Abraham voices the potential for carry trades as volatility has gone down.

At this point it would probably be a good idea to point out that there are carry trades and then are ... carry trades. Ok, an explanation is needed I think. As most of you probably know, the carry exploits the non-existence of the uncovered interest rate parity which states that an interest differential between two currencies should be offset by the higher yielder depreciating vs. the low yielder. In fact, the carry trade in so far as it is pervasive will persistently disprove the UIP and exacerbate the deviation from the theoretical equilibrium. This is something which some authors have coined as self-reinforcing arbitrage Brière and Drut (2009), Plantin and Shin (2008), and Orléan (1999). This also means that while you can always build your very own carry trade basket or engage in carry trade through money market instruments, there is bound to be a substantial agree of piggy-backing in the spot market. Basically, you only need to realize that low yielders can be modelled as a positive function of volatility Cairns et al. (2007) and negative function of equity returns or as I have shown, that equities can be modelled as negative beta assets to low yielders (see also, Kohler (2007)).

Essentially, it amounts to the same money being made on the same strategy, but the underlying investment narrative is very different. In the case of a pure carry trade, it is a strategic position whereas in the case of spot market piggy-backing, the investment narrative is bound to be more opportunistic and self-perpetuating in both directions. This also underpins the inevitable sharp reversals in this game which is something Brière and Drut (2009) touch on when they show how carry trades tend to perform poorly in the context of crises whereas fundamental strategies (based on PPP) will outperform carry trades. I tend to agree, but I would simply add that for the intra-day trader the correlations and functional relationship are stronger in an environment with sharp volatility reversals (such as the current one). Of course and following once again Brière and Drut (2009), they also cite sources to suggest that in times of rigorous pursuit of carry trades and thus deviation of the UIP, the FX market tends to exhibit disequilibria along the lines of other "fundamentals". This suggests that reversals will be all the more substantial when they arise, but they will also be just that, reversals, and thus not deviations from what we might coin as carry trade fundamentals.

What About the Current Rally Then?

More specifically, what are those carry trade fundamentals? Despite the fact that whatever points we can derive from the current rally do not represent a solid scientific foundation, the ideas expressed above easily give rise to the following expression for the return of a low yielding funding currency.

Rfx = F(vol, (-) Re)

Where Rfx is the return on a low yielding carry trade funder (e.g. USD/JPY quoted directly), vol is a measure of volatility (e.g. the Vix) and Re is the expected return on equities. It is important to note that this functional form only has merit in the context of crises and thus when volatility is relative high on a mean basis. This is to say that when the market experiences volatility above a given period average, the carry trade fundamentals strengthen. In terms of which equity index, it is worthwhile to think about the point I also mention in my paper derived from Zimmerman et al. (2003) that when volatility is high markets tend to be correlated to a higher degree than otherwise which in turn tends to diminish the benefits from diversification in exactly the period where investors need it the most. Moreover, Zimmerman et al. also show that down volatility is larger than up volatility which would further solidfy the relationship noted above.

With this in mind let us get some charts on the table and bearing in mind that we can't really draw any conclusions from we still get a strong indicative result.

Even the untrained eye should be able to spot the proposed connection here (click for better viewing). If we look at the evolution in the market since end February (chosen because this is roughly where the Vix peaked), volatility has declined, the traditional carry crosses (mainly JPY here) have moved to favor the low yielder, and equities have bounced.

Of course, the devil is also very much in the detail here. Especially, the USD is interesting here since it shows us that this is never going to be a one way street. Currencies are thus relative prices and while the USD/JPY still seem, despite the almost equally low yields, to exhibit carry trade fundamentals the USD is also itself beginning to act like a funding currency not least against the Euro as well as against the Rand (and I would presume other EM higher yielders too). Clearly, there could be another explanation here, namely that of safe haven flows in times of a spike in volatility. Yet, I still think we need to consider the effect from the US' credible commitment to inflate its way out of this issue and how Bernanke might be paving the way for, as some has mused, the mother of all carry trades. A colleague of mine pointed the following out recently during a discussion;

So the big issue is really whether all this excess liquidity will work its way out of the US - and into India, Brazil etc etc - as we move forward, especially since, if getting a recovery turns out to be as hard as everyone seems to think it is then the Fed (et al) are likely to be holding interest rates near to zero for quite some time, and all the saving people will be trying to do (with few genuine investment outlets) will mean that the last "savings glut" may turn out to look like very small beer, and "abundant liquidity" will be the name of the game.


Could we steadily see the introduction of a "cheap dollar policy", you know, to keep all those exports flowing out, and keep the cost of servicing the US debt down for a while.

Now, apart from the rather ominous prospect of the US running a current account surplus which would mean a quite severe drainage of aggregate global demand, we need to ponder the effects of a regime of convergence towards QE among the developed economies and what this will mean for the carry trade. Stefan Karlsson had a reasonable go at explaining the link between weaker equities and low yielders a while back, but now the question begs as to what will happen once many of the major G7 economists go for QE. Perhaps it will be like Darrel Whitten noted that the flow of funds will simply move towards the EM to an even higher degree. But I would hold this to be true already in the sense that there will always be those who pursue the juicer trades out there which are bound to be demonstrably more risky than others. It will be interesting in this sense to see whether old relationships will hold regardless of the G7's central banks inclination to go for very low interest rates.

The graphs above cover too short a period to merit any conclusion, but investors should be aware of the proposed relationship, when it reverses and then ultimately to quantify it. In essence the key here is to pin down the extent to which currency movements persistently move contrary to fundamental theories.

Don't get Steamrolled

One of the best conceptualizations of the carry trade is still the Economist's Buttonwood and his narration the instant gratification of carry trades and subsequently how investors were picking up dimes in front of an approaching steamroller. In terms of the immediate prospect of benefiting from carry trade, it is thus important to note that while a crisis such as the one we are experiencing at the moment certainly will tend to intensify many of the links through which carry trades manifest themselves, the reversals will also be more abrupt and unpredictable. Also we should never forget Macro Man and his pink flamingos. I am sure that despite my best efforts to pin down a theoretical and empirical relationship here, pink flamingos will be ever present.

On a more wonkish note, I am doing a thorough re-write of my paper on carry trade (see link below) which is based, in part, on the discussion above. I realize that although the empirical results of the original paper are fairly sound, the theoretical framework is quite poor. I, of course, won't stand for that so will try to tidy this part up significantly as well as I am expanding the empirical investigation especially since the regressions in the full sample suffer from some, erm, statistical issues [1]. Stay Tuned.

List of References (+ some extra inspiration)

As you can see from reading Brière and Drut (2009), I have ripped parts of their list of references.

Bank of International Settlements (2006) - The recent behaviour of financial market volatility, BIS Paper No. 29

Brière and Drut (2009) - The Revenge of Purchasing Power Parity on Carry Trades During Crises, CEB Working Paper No. 09/013 Feb. 2009

Cairns J., Ho C. and McCauley R. (2007) - "Exchange Rates and Global Volatility: Implications for Asia-Pacific Currencies", BIS Quarterly Review, March.

Corcoran, Aidan (2009) - The Determinants of Carry Trade Risk Premia, IIS discussion paper no. 287

Kohler D. (2007) - Carry Trades: Betting Against Safe Haven, University of St.Gallen Discussion Paper no. 2007-12.

Olmo, Jose and Pilbeam, Keith (2008) - The Profitability of Carry Trades, Annals of Finance 5: 231-241

Orléan A. (1999) - Le pouvoir de la finance, Odile Jacob Editions.

Plantin G. and Shin. H.S. (2008) - Carry Trades and Speculative Dynamics, available at
SSRN: http://ssrn.com/abstract=898412.

Vistesen, Claus (2009) - Of Low Yielders and Carry Trading – the JPY and CHF as Market Risk Sentiment Gauges, Working Paper 06-2008


[1] Basically, the regressions suffer from heteroscedasticity in the full sample. This need not be a severe problem for the overall result since the f-stats and standard errors are large and correspondingly small. Also, I am not really interested in the full sample, but in parameter stability across two distinct periods. Pre crisis and post crisis. The problem arises here since the tests we have to check for parameter stability (Chow tests, dummy approach as well as the simple one) are of course sensitive to unequal variances in the chosen period intervals.

Monday, April 13, 2009

Spring Time ?

By Claus Vistesen: Copenhagen

First of all, I hope that our readers have passed a nice couple of days with their families and friends and that they are ready to pick up the baton again here after Easter. One who sadly will not be joining us as we move forward is Greg Newton author of the blog Naked Shorts who passed away recently from a heart attack. I shall immediately confess that I only, on rare occasions, stopped by NS to get a dose of the often very sharp pen wielded by Greg. However, with endorsements and fine obits from the likes of Felix, Cass, and Hempton I am more than convinced that the econsphere has lost a great presence. My thoughts go out to his friends and family.

Meanwhile and here in Denmark things are definitely getting better. After a March of cold and lots of rain April the Easter days have, in particular, blessed us with a fabulous couple of days of sun and (relative) warmth. I doubt that the Spring is more beautiful anywhere else in the world than in the North mostly because the change in scenery is so striking. Judging by a number of recent analyses, comments and data points it is hard to escape the feeling that perhaps, just perhaps, markets are also feeling a bit of spring sensation too even if the signs are most tentative.

Europe, Still not Ready to Take Off

Starting off in Europe, Morgan Stanley's Elga Bartsch recently engaged in bottom fishing where she essentially voiced the sentiment that although the h01 outlook is grim the data is paving the way for a recovery in h02. To support her argument ms. Bartsch fields data on forward looking indicators such as output plans, the so-called Surprise Gap Index, and the (in)famous second derivative which has set in with respect to demand for orders. Generally though, there is plenty of juice for those who carries a more pessimistic approach. A couple of days ago, the Bank of Italy opted to lift the curtains a little bit on what is certain to be an abysmal Q1 GDP reading; as if it was not enough that Italy suffered that dreadful quake over the Easter. Over at Kaiserstrasse, the messages are getting more "interesting" by the day too. Consequently, Nowotny who heads the Austrian central bank noted that although he did personally think the interest rate should go below 1% it was, of course, open to discussion. Bloomberg interprets it as a sign that the council is split which may of course be the case, but on the other hand I also think the ECB is slowly but surely preparing markets for moves which will take the bank into an area where most believed it would not go. For example, Nowotny explicitly noted the option for the ECB to enter the corporate debt market.

“If you’re aiming at intensifying credit supply, measures which focus directly on credit supply are of interest,” Nowotny said. “For example the purchase of commercial paper, corporate bonds and similar things.”

Such moves would mean that the ECB moved in behind the Fed and the BOJ who have both been supporting credit markets through the purchase of commercial paper (A1 grading in the case of the BOJ) for some time.

Also the Dutch representative in Frankfurt Noel Wellink voiced a similar sentiment when he noted that the Eurozone would be likely to experience negative price movements in 2009. Mr. Wellink pointed out that there is room to lower interest rates beyond its current level and that other measures could be deemed necessary too. One can only speculate what such measures would be, but something along the lines suggested by Nowotny is probably not far off.

More generally, the situation in Europe is not only tainted by the obvious crisis in EU-15 and the Eurozone, but also very much so by the lingering mess in Eastern Europe. In real economic terms we need to remember that there is indeed a strong link between the Eurozone and the CEE not least in the context of Germany's obvious dependence of exports to the Eastern European economies. Moving to financial markets we also know that many banks in EU-15 are heavily exposed to the whims of the CEE. Obviously, the new mandate for the IMF in the form of capital injection it was handed at the G20 summit will help in the strides to present a workable solution many of the most exposed countries' trouble.

The US, Tiptoeing Analysts

With regards to the US the second derivative discourse is being advanced much more timidly especially in light of the fact that payrolls once again posted an abysmal showing in March which suggests that the real economic slowdown is intensifying.

Still, some are convinced that the near term at least may indeed bring a bit of spring sensation. Consequently Swiss investment icon Marc Faber was quoted by Bloomberg of saying that the SP500 might rise as much as to reach the 1000 mark within the next three months. If this prediction turns out to be a truism it would mark the biggest so-called sucker rally so far in this crisis and surely one worth pursuing by investors. Faber only, it has to be said, makes a short term forecast based on the fact that since the government (through the new PPIP) essentially is giving away free money and since the Fed seems to committed to reflating the economy companies may have a sound short term earnings horizon. For the equity strategists among you, this is Faber's contention;

“The market very near term has become somewhat overbought and the correction should essentially follow, but I doubt it will go and make new lows in the intermediate future,” Faber said. “The lows in early March at 666 in the S&P will hold and we’ll have another push up into July

With respect to a long term view I attach considerable significance to the report out yesterday that fundraising by US venture capitalists fell by a whopping 39% last quarter as investors understandably chose to shun these investments. The story is pretty straightforward in the sense that startups are literally not finding the same finance opportunities as before and this essentially mean many of them don't make it. Such is of course the darwinian nature of finance, but one wonders whether in fact there wasn't some genuine sound positive NPV projects sacrificed on the altar of the PPIP et al. Whether this is true or not one thing is certain, this kind of investment used to be the hallmark of the US economy and although one can't hardly make any kind of inferences based on this figure alone, seed capital for venture capitalists is probably a part of the macroeconomic investment activity which yields the strongest positive externality with respect to productivity growth (empirical studies anyone?).

As for the overall sweep in terms of a macroeconomic snapshot we can do a lot worse than visit Morgan Stanley's Ted Weiseman and Richard Berner and their respective analyses. If anything Monsieurs Weiseman and Berner seem set to debunk any talk of the second derivate, something which Weiseman addresses specifically when he says;

The key round of early economic figures for March released over the past week was uniformly terrible in absolute terms, though somewhat mixed directionally. A particularly bad employment report stood out, however, against directionally mixed ISM surveys, though with both remaining well below the 50-breakeven level, and some improvement, though to a still-dreadful level, in motor vehicle sales. Weakness in other data, notably in the construction spending and factory orders reports, also pointed to a weaker trajectory for 1Q growth, and we cut our 1Q GDP estimate to -6.0% from -5.1%.

So; Morgan Stanley, for what is worth, is cutting their growth forecasts for the US economy and if you have the stomach for a thorough parsing of the recent US data, Weiseman is the place to go. If Weisman implicitly tried to shy away from the second derivative punt, Berner is very explicit. His main point is consequently that while markets (equities in particular) are embracing the idea of a positive second derivative the recession does not look to be any less sharp and long than it did when we entered 2009. In this respect, I think that the talk of a recovery in early 2010 is largely irrelevant since we need to calibrate first what exactly we mean when we talk about a recovery. If positive or neutral growth is the criteria so be it, but I hardly think that we will be back to normal in any sense of the word.

Asia, a Chinese Conundrum and Japanese Debt Woes

If I am fairly certain that we are not standing before an impending recovery in Europe or the US recent data from China seriously prompts me to consider whether in fact the great tiger is ready to pounce and perhaps save the global economy in the progress. What has caused a lot of commotion was consequently that the Chinese PMI for march actually rose above 50 which indicates expansion. Or did it? As Edward details here there has been considerable confusion over which reading to use, but that did not deter Bloomberg to narrate China (and its recent stimulus package) as the economy to pull its global peers out of the current mire. Add to this that industrial production clocked in a healthy 8.3% increase in March and you get plenty of ammunition on which to build a recovery and even rebalancing story. Of course, this is all a bit of a lame, ermm, Peking duck I think [1] since as Brad Setser eloquently points out with great force, recent trade data indicates that imports are declining more rapidly than exports which makes the fact that exports are not declining more slowly rather innocuous. This is also a point Edward uses to neatly summarize the overall message;

(...) with a growing surplus (at this point, and on a year on year basis) China's economy isn't going to pull the rest of the world anywhere, since essentially it is still draining-off demand from elsewhere.

For more on the recent, mystifying, data from China Pettis' latest tour de force is a fine piece of work and of course Bloomy itself proxied by Kevin Hamlin takes some of the sting off of the bullish China story with today's piece about cooling Chinese growth.

Meanwhile, in Japan things continue to look murky. In particular it seems that investors have realized the growing debt burden of the Japanese society at the worst of times since now would really be a nice time for investors to allow Japan to seriously turn on the fiscal stimulus machine. Of course this is not possible and as we learned recently that while observers certainly realize that the proposed stimulus package by PM Aso totalling some $153 billion will mitigate the situation in the short term, it will also serve to make the future debt burden even more unsustainable. Also do note, that the discourse of Japan's ageing population is popping up all over the place in relation to the immediate short term outlook which suggests to me that we may be close to an inflection point. Basically, yields are beginning to climb for the MOF as it attempts to issue paper to pay for the politicians' plan and it appears that yields, at least in part, are driven by the obvious problem Japan will have in servicing the liabilities as we move forward. This means that the BOJ will have to seriously contemplate how to inflate their way out of this one since this is really the only solution, barring of course that everybody else realizes that this is what Japan has to do in order to avoid deflation. It is of course this last part which is the niggle and which will cause much debate as we move forward. My guess is that we will soon see a BOJ not only buying up short term paper, but indeed trying to manage the whole yield curve.

All this is not without consequences for the JPY, and it is difficult not to concur with Macro Man's Easter poetry styling that it may very soon be raining yen. Meanwhile, the spring sensation in markets is not passing by the JPY either as Bloomberg serves up one of those familiar headlines that the JPY is weakening while the AUD, NZD et al. are strengthening on the back of a heightened appetite for risk.

“There’s some optimism in the markets, which supported yen selling,” said Hidetoshi Yanagihara, senior currency trader at Mizuho Corporate Bank in New York.

This sell JPY on optimism punt is something I have dealt with extensively here at Alpha.Sources not least in the context of this working paper. I recently had a look at the paper and realized that it needs a thorough re-write. So this is, in part, what I am working on at the moment. Of particular interest is the fact that I am trying to model the currency pairs (not the stock indices) as a function of the VIX which has so far given me some quite interesting, if of course entirely intuitive, results. In short, stay tuned on this one.

Spring Time?

While there is still plenty of bad news to focus on, it certainly seems as if markets just as well as Denmark may now be entering a more mild season. Spring in Denmark, however, is known to be extremely volatile. If the Easter served up a nice sunny abode the next week may be rainy and even snowy. One has to think that the same reasoning can be applied to the newfound spring sensation in markets. Far be it from me to take away the punch of the bulls out there, but I would simply note that the fundamentals have not changed one bit since the crisis began. Deleveraging is only begun, unemployment is bound to rise further, and all parts of the real sector are stretched to the limit with respect to spending capacity. Add to this that everyone wants someone else to do the spending for them and you end up with a recipe for a long hard walk upwards. Perhaps it is the second derivative punt that is being misunderstood. Evidently, we were always going to see this effect given the almost cataclysmic way in which all economic data points and indices suddenly cratered. However, the point is not so much whether we are still on our way down (which I think we still are), but more so how long we will stay down and how far we will move back up from the mire and indeed who will be able to lift their economies within a reasonable time frame. It is here that I am still fundamentally pessimistic. Consequently, I too am enjoying Spring time, but as a Dane I am well taught not to get my hopes up.


[1] - Sorry

Tuesday, April 7, 2009

Russia's Economy Contracts By 7% In Q1 2009

by Edward Hugh: Barcelona

According to Deputy Economic Development Minister Andrei Klepach last week, Russia's economy shrank by 7 percent year on year in the first quarter of 2009, a staggering turnaround for an economy which has just enjoyed eight years of solid oil-fueled growth.

"These figures are worse than we expected," Klepach said at a press conference in Kiev,citing preliminary figures. Klepach also stated that net capital outflows reached $33 billion in the first quarter of 2009, following record outflows of $130 billion in the second half of last year.

The Russian State Statistics Service have also released official gross domestic product figures for the fourth quarter of 2008. GDP was up 1.2 percent year on year, the worst reading for any quarter since the first quarter of 1999, and down from a revised 6 percent in the previous three months. The World bank are now suggesting that the present slump may be deeper than the one that followed the government debt default and ruble devaluation in 1998.

Certainly the data are bleak. Industrial production contracted for a fourth consecutive month in February - falling by 13.2% year on year - as the credit squeeze and falling incomes eroded demand for metals, cars and consumer goods. Retail sales contracted in February for the first time since February 1999. Unemployment was also up, at 8.5 percent in February, the highest level since January 2005.

Manufacturing output plunged with the collapse in demand in the last two months of 2008, and it is likely to contract further in 2009. According to Rosstat five of 14 major manufacturing industries reported outright output declines in 2008, with electronics, electrical, and optical equipment hardest hit (-7.9 percent), followed by textile and sewing (-4.5 percent) and by chemicals (-4.2 percent). Most of the dislocation took place in November and December 2008, when total manufacturing output respectively fell 10.3 and 13.2 percent (year-on-year). As credit continues to tighten and demand to fall, manufacturing is likely to contract further in 2009. According to recent statistics, manufacturing output dropped 24.1 percent in January 2009, compared with January 2008, and 18.3 percent in February 2009, compared with February 2008. In February 2009 the most significant declines were registered in the production of electro-technical and optical equipment (-46.6%), other non-metal products (-33.3%), and transport and transportation equipment (-31%).

Tighter credit, collapsing global demand, huge global uncertainty, and rising unemployment have hurt both investment and consumption growth in Russia. According to Rosstat, total fixed capital investment grew 9.8 percent in 2008, compared with 21.1 percent growth in 2007. More worrisome is the investment decline by 2.3 percent in the fourth quarter of 2008 (year-on-year), largely reflecting escalating liquidity problems in the banking sector and the resulting credit crunch and a deceleration in consumption growth due to rising unemployment and lower growth. (World Bank Report, April 2009)

GDP Indicator Shows 5.4% Contraction in March

The latest data we have to hand confirm the ongoing character of the contraction. The Russian economy is thought to have declined by 5.4 percent in March compared with March 2008, according to the latest GDP indicator estimate provided by VTB Capital. The VTB GDP indicator also registered an average 4.4 percent contraction for the first three months of 2009, which would be the worst decline since the economy shrank 5.1 percent in the fourth quarter of 1998. The difference between the VTB estimate and the 7% estimate put forward by Klepach would lie in the fact that the VTB indicator does not include contstruction, and construction activity has declined sharply in recent months, so the two pieces of data are consistent with one another.

Purchasing power has been reduced by lower wages and less access to credit, togther with rising unemployment rates. 6.4 million Russians, or 8.5 percent of the economically active population, were unemployed in February, a 5 percent increase over January and a 20 percent increase on February 2008. The World Bank forecast recently that unemployment would rise to 12% in 2009.

The weakening in retail sales and other consumption indicators is not that surprising given the strength of the contraction, and especially since there is now growing evidence that Russia's employers, in order to make cost savings while maintaining staff levels during financial crisis, are more and more resorting to salary reductions or part-time working schedules. This approach is thought to be being used widely and appears to have much more legitimacy under Russian law than simply telling employees to go home and take unpaid leave. Employers are being advised to take special care when unilaterally modifying major terms and conditions in employment contracts, since although under the Labour Code, changing the terms and conditions of an employment contract is permitted only by mutual written agreement of both parties, there is an exemption from this rule – Article 74 of the Code - which specifies that in the event of a change in organizational or technical working conditions which make it impossible for the previously agreed terms of an employment contract to be maintained, an employer is entitled to unilaterally change such terms on his or her own initiative.

As a result of this contraction in output and weakening in the labour market real incomes have declined substantially in Russia since the autumn of 2008. Rising unemployment and worsening enterprise finances (wage arrears have increased considerably) have meant that in the fourth quarter of 2008 alone, real disposable income dropped 5.8 percent year on year, and by 10.2 percent in January 2009 (again year-on-year). And unpaid wages as a share of total enterprise turnover tripled to 0.12 percent in December 2008, compared with August 2008. The stock of wage arrears as of March 1, 2009 (8 billion rubles or about USD 240 million) remains small but is likely to increase as the crisis grows. At the present time such arrears are thought to affect up to 450,000 people, significantly less than 1 percent of total employment. Growth in real wages came to a complete halt in January-February 2009, following double-digit increases in previous years.

Russian Services Contract Less Slowly In March

Activity in Russia’s service sector continued to contracted in March, although the seasonally adjusted headline VTB Services Purchasing Managers Index rose to 43.9 in March from 40.0 in February. Since any readings below 50.0 signals contraction, we can see that while Russia's services are still contracting, they are contracting somewhat less rapidly than in earlier months.

Activity and new business both declined for the sixth consecutive month, however the rate of decline in the volume of new business was at its lowest rate since last October. However a survey-record decline in employment was registered in March, with redundancies at their most severe in hotels and restaurants. Firms raised output prices at a weaker rate in March, as input price inflation moderated and pricing power remained weak due to falling demand for services.

“Surging price competition on the back of weak market demand has urged companiesto tighten their cost cutting programs. Among the measures that have been applied are further redundancies that resulted in the fastest rate of employment contraction in the history of the survey. The input price inflation eased slightly, however, the pressure of utilities charges remains significant,” Svetlana Aslanova, an analyst at VTB Capital, commented on the survey.

As Does Manufacturing

Russian manufacturing contracted at the slowest pace for five months in March as companies reduced their stocks of unsold goods and the decline in new business eased, according to the latest PMI report from VTB Capital. The VTB Purchasing Managers’ Index was at 42 last month after a 40.6 reading in February. Stockpiles of unsold goods fell at the fastest rate since December 2005, according to the survey of 300 purchasing executives.

Inflation Rising Again

Russia’s inflation rate rose to a five-month high in March as the weaker ruble boosted import prices. The rate rose to 14 percent from 13.9 percent in February, while consumer prices grew 1.3 percent month on month, compared with 1.7 percent in February.

Inflation was spurred at the start of the year by the weakening ruble, which pushed up import prices, helping the annual rate jump to 13.9 percent in February from 13.4 the month before. The ruble has now lost 29 percent against the dollar since August. The most recent spike in inflation is evidently producing quite a headache for the Central Bank, since chairman Sergei Ignatiev last week that if April's inflation is “significantly less” than it was a year ago, the central bank may consider cutting interest rates for the first time since 2007, giving some kind of monetary relief to an economy which is badly in need of it. Russia’s inflation rate went as high as 15.1 percent last June, and has since come down somewhat from that peak, but really the record of the central bank in containing inflation has been pretty abysmal.

Bank Rossii has been forced to raise its refinancing rate twice since last November, to the current level of 13 percent, in an attempt to limit the amount of rubles available to banks and companies and to slow the decline of the ruble against the dollar. On the other hand the central bank may be in danger of excessive optimism at this point, with Ignatiev telling journalists that his expectation was that the economy may pick up within “several months,” thus trying to offer hope that Russia's banks won’t suffer that “second wave” of crisis that Finance Minister Alexei Kudrin said may hit as bad loans eat up capital. I am of the opinion that Kudrin is right to be cautious here.

Rising delinquency “is a serious problem, but I don’t share the opinion that a second phase of the crisis is unavoidable,” is Ignatiev's view. Overdue retail loans rose to 4.4 percent as of 1 March from 3.2 percent on 1 September. “I believe the most serious phase of the economic crisis is over," Ignatiev told journalists. Would that he were right, unfortunately I think he is wrong, the worst is still ahead.

Obviously the continuing inflation is a problem for Russia's central bank since they would obviously like to offer monetary easing to the economy, just as the U.S. Federal Reserve, the European Central Bank and the Bank of England are doing by bringing their benchmark rates close to zero to bolster banks and pull their economies out of recessions. Bank Rossii last cut the refinancing rate in June 2007, and it has now increased the repurchase rate charged on central bank loans four times since November.

The refinancing rate, seen as a ceiling for borrowing money and a benchmark for calculating tax payments, is currently at 13 percent after being raised in November and December. The central bank increased the repo rate charged on central bank loans twice in February.

Ignatiev admitted that problems with dealing with non-performing loans “could arise", and that he did not "think this is just empty talk,” although he stressed Bank Rossii would seek a solution should the banks be forced to increase reserves to deal with possible losses on loans. Bad loans are still a very low proportion of total debt, nut they are rising. NPLs held by OAO Sberbank, Russia’s largest lender, now make up about 2.8 percent of the bank’s loan portfolio, Chief Executive Officer German Gref last week.

Also, on the general economic front the pessimists more or less balance out the optimists. The latest in the pessimist camp, Vladimir Yakunin, head of OAO Russian Railways, said this week that the slowing in the decline of cargo shipments in March doesn’t seem to him to indicate that the country is pulling out of its economic crisis.

“We are only at the beginning of the crisis and we should wait for better and
more solid indications,” Yakunin, chief executive officer at the Russian state
rail monopoly which operates the world’s longest rail network, said in a
Bloomberg Television interview in his Moscow office today. “We didn’t yet pass
the middle point of the crisis.”

Railway cargo turnover fell by 15.8 percent in March from a year earlier, compared with a 32 percent fall in January and a 26 percent decline in February. The data is a “leading indicator of the trend in Russian industry,” according to VTB analysts in their GDP indicator. Yakunin said Russian Railways is “fighting” to limit this year’s cargo turnover drop to 19 percent as it is forced to slow down its development amid falling investment.

We also learn this week that Siberian Services, an oil-drilling company among whose clients are to be found OAO Rosneft, has defaulted on $100 million of bonds, thus becoming the first Russian borrower to fail to repay its foreign debt this year. Siberian Services didn’t redeem the 13.75 percent notes due 2010 by an April 3 deadline after bond holders exercised a so- called put option, according to Bloomberg news, citing some of the investors involved.

State-owned Finance Leasing skipped an interest payment on $250 million of securities in December, according to Bloomberg. Russian borrowers are struggling to refinance about $100 billion in foreign notes maturing this year as banks reduce lending following $1.3 trillion of losses and writedowns since the start of 2007.

Conflicting Futures?

While the Organization for Economic Cooperation and Development and the World Bank are forecasting that the Russian economy will decline by 5.6 percent and a 4.5 percent, respectively, in 2009, the Russian government is still stubbornly holding fast to its official forecast of a 2.2 percent fall. Publicly government officials are sticking to their view, and diiging in around the idea that they expect a recovery in the final quarter. Deputy Economic Development Minister Klepach said that the government forecast takes into account a package of anti-crisis measures currently being debated by lawmakers that should bolster domestic demand and help boost GDP. Without it, the economy could contract by 4 percent to 5 percent, Klepach noted.

The Central Bank, on the other hand, continues to forecast a 4.5 percent contraction for the current year.

The Russian Cabinet approved last month a revised budget containing the first deficit in 10 years. The budget anticipates a deficit of 7.4 percent of projected gross domestic product, but since the current forecast is for a GDP contraction of only 2.2%, the final deficit may be considerably larger. The Finance Ministry is now transfering money from the Reserve Fund to cover the deficit, and anticipates using some 2.7 trillion rubles this year to help fund the budget gap.

The Ministry of Finance has released the main parameters of its revised federal budget for 2009 which is based on lower oil prices (USD 41 a barrel, Urals) and a drop in budget revenues from the original 21.2 percent of GDP (under the old assumption of USD 95 a barrel) to 16.6 percent, or RUB 6.72 trillion. At the same time, expenditures will be increased by RUB 667.3 billion to RUB 9.69 trillion, to produce a deficit of RUB 2.98 trillion (about 7.4 percent of GDP), a massive reversal of the fiscal position from the 4.1 percent surplus in 2008.

The total consolidated general government deficit is expected to be around 8 percent in 2009 deficit and will be financed largely from the Reserve Fund (7 percent of GDP) with modest domestic borrowing (up to 1 percent of GDP). With a large fiscal deficit, however, and the need to preserve some reserve fund resources for the uncertainty likely to extend into 2010, the space for more fiscal stimulus this year appears limited.

So the level of the contraction which the Russian economy undergoes in 2009 really is rather big beer, since it will condition the size of the eventual fiscal deficit, and the percentage of the Reserve Fund which will need to be used this year. If there is no rebound in oil prices in 2010 then Russia's position can complicate on a number of fronts, since the Central Bank Reserves will be significantly depleted, the Reserve fund also, and there may be less room for fiscal easing in the face of potential credit rating downgrades, while monetary easing may also prove difficult given the need to support the currency, and protect Central Bank Reserves. Which brings is back to that “second wave” of crisis that Finance Minister Alexei Kudrin said may hit as bad loans eat up capital. Russian overdue bank loans are increasing by 20 percent a month, according to OAO Sberbank Chief Executive Officer German Gref this week. He also stated that about 3.7 percent of Russian bank loans are currently delinquent, a figure which compares with the 40 percent level hit at the peak of the 1998 crisis. The IMF are already predicting a 10% loan default rate, but at this pace we will hit that level in the autumn, while the 40% rate looms in the spring of 2010, unless there is significant upward movement in oil prices. All in all, 2010 could be a very hard year for Russia and its citizens.

Friday, April 3, 2009

Spain's Unemployment Continues Its Sharp Upward Surge

by Edward Hugh: Barcelona

The number of unemployed in Spain was up again in March - by "only" 123,543. I say "only" since it is evidently less than the 154,508 increase registered in February, or the 198,538 registered in January. And indeed many of the newspaper stories have been full of arguments from Employment Minister Maravillas Rojo (would that she could work "Maravillas") about how Spain registered the weakest unemployment gain in six months in March (when compared to the previous month). However, as those who look into the economic analysis side of this a bit more (and who don't believe in either wonders or "miracles) point out, taking seasonal factors into account the monthly 3.55% rise in March shows a more or less steady trend, and no special sign of improvement, despite the large stimulus programme. Last March, for example, unemployment fell by 0.62%.

So when we come to look at the year on year situation (which more or less eliminates the seasonal variation) we find that the year on year rate of increase of 56.69% was the highest so far, and if we look at the chart we will see there is no sign of a softening in the curve.

So the overall jobless total rose to 3,605,402 the highest since 1996, and the 3.5 percent or 123,543 March increase was the highest number since 1996 when the current method of calculation was introduced, according to the ministry statement. This was the 12th straight monthly increase and the sixth consecutive montly rise of more than 100,000 registered unemployed in Spain.

Which brings us to the forecast. Basically we could now take two scenarios, a moderate and a worse case one. On the moderate scenario, total unemployment will now hit 4.5 million by December, and 6 million by December 2010. On the worst case scenario we will already be at 5 million by christmas, and be pushing 7 million by the end of 2010. It all depends.

In terms of unemployment rate, the latest quarterly estimate we have from the national statistics agency (INE) was 13.9 percent for the fourth quarter of 2008. However according to European Union statistics agency Eurostat, Spain's unemployment rate rose to 15.5 percent in February, the highest level in the whole 27-nation bloc. (The EU average was 7.9 percent). Spain's unemployment rate has now risen each quarter since it dipped to 7.95 percent in the second quarter of 2007, its lowest level since 1978. The government currently expects unemployment to rise to 15.9 percent by the end of the year, but this is obviously hopelessly unrealistic, since we are nearly at that level now, and even the European Commission, which is normally fairly conservative with downside estimates, is more pessimistic, since it forecasts Spain's jobless rate continuing to rise in Spain to 16.1 percent in 2010 and 18.7 percent in 2011.

My own forcasts would be on the moderate forecast around 20% by the end of 2009 and 25% by end 2010, and on the worst case scenario possibly 22% by the end of this year, and 27% to 30% by the end of 2010. These latter numbers look horrific, and seem hard to believe, but we are currently set on a path (especially now with the "breakages" in the banking system - today there is growing and informed specultion here in Catalonia that Caixa Penedes, and Caixa Catalunya may be the next to go) where it is hard to see how we won't get to that horrible place if no one does anything. And since at this moment the entire European leadership seems to be in denial that there is any special problem in Spain nothing looks likely to be done. (Jean Claude Trichet simply said what he had to to the Spanish journalist who questioned him on the Spanish banking system in yesterdays press conference - "I have every confidence in the strength of the Spanish banking system). Even that G20 meeting that is hitting the headlines seems to have had little to offer for countries like Spain, there were plenty of ideas about how to avoid falling into another bubble situation in - say - 2020, but virtually none about how to drag us out of the one we are currently stuck in.

Consumer Confidence Rebounds Slightly

Due you believe in the "earthquake" theory of probability? You know, the one which goes that if you didn't have an earthquake yesterday, and you didn't have an earthquake today, then the probability of having one today must be higher, right? Well something like this seems to be the theory of probability that Spanish consumers inherently believe in.

Why? Because Spanish consumer confidence rose again this month, to 53.7 points, up from 48.6 points in February, The Confidence Index which is provided by Spain's Official Credit Institute (ICO ) was at 73.1 in March last year, hit a record low of 46.3 in July as oil prices soared and European Central Bank interest rates hit 4.25 percent, and has since oscillated around the 50 point level amid easing commodity prices and following ECB decisions to sharply reduce interets rates.

But if we look at the breakdown in the individual components, we will see that the current conditions, employment and state of the country readings have long been trawling the bottom. The only component which gas really not hit lows (yet) is the expectations one. The Spanish are ever optimistic (until they get really pessimistic that is) and this component has been rising in recent months, even as conditions have continued to deteriorate. Which is why I say they must believe something like the "earthquake" theory of probability, the more days that pass with things getting worse must mean that tomorrow they are likely to get better, right?

Industrial Contraction Continues Unabated

The JPMorgan Global Manufacturing PMI – which provides a single figure snapshot of operating conditions across the planet – was out earlier this week and posted 37.2 in March. Although substantially below the no-change mark of 50.0, the PMI was up for the third month in row and at its highest level since last October. The vast majority of the national manufacturing PMIs rose in March, including the US, Russia, Japan, China, most Eurozone nations and the UK.

This is however the most sustained period of contraction in the series history, and it still remains very unclear where we go from here. In general the drop in output reflects weak demand, with new orders declining for the twelfth month in a row. The trouble is, it is not at all clear where the rebound in demand that is needed for a recovery is actually going to come from.

The Markit Eurozone Final Manufacturing PMI for March rose from February's all-time low, up to 33.9 from 33.5. Thus the PMI signalled a marginal easing in the rate of decline from the previous month's record pace. Output showed the weakest decline for five months, and a smaller fall than the Flash estimate, although the rate of decline remained well above that seen prior to last October. With the exception of Italy, Austria and Greece, rates of contraction eased in each of the eight countries surveyed.

The Netherlands saw the smallest (though still steep) drop in production, while Spain saw the sharpest decline for the eleventh straight month. By product, investment goods producers reported the steepest fall in production for the third successive month, closely followed by intermediate goods producers. Consumer goods firms meanwhile reported the weakest rate of decline for the seventh consecutive month. Stocks of both raw materials and finished goods fell at record rates, as companies focused on lowering their operating capacity and controlling costs. The reduction in unsold goods stock was especially steep in Ireland, Germany and France.


The pace of decline in Spanish manufacturing slowed in March but remained at the steepest contraction rate of any eurozone country. The PMI rose in March to 32.9 from 31.8 in February and thus further off from December's record low of 28.5. All the survey's main indicators remain far below the 50 level that divides growth from contraction. Output and new orders continued to contract sharply in March but at slower rates than recorded in the last six months, with panellists blaming falling demand as the principal cause as clients cut back on spending.

"The March PMI data suggests that the pace of decline in the Spanish manufacturing sector has slowed," said economist Andrew Harker at Markit Economics, adding that new orders and output indices are well above record lows posted late last year.

But Harker was at pains to stress that the March figures should not be interpreted as any sort of sign of a turnaround in the Spanish economy. Unemployment in the sector continued to rise in line with falling output requirements as joblessness in the wider Spanish economy stood at 15 percent, the highest rate in the European Union. More than 34 percent of those surveyed by Markit said they had noted reduced employment levels at the end of the first quarter. Staffing levels have shrunken continuously since September 2007, according to the survey.

Slumping demand also hit input and output costs, which both dropped to series lows in March. Input costs fell as firms negotiated better prices from suppliers, while output prices fell as these savings were passed on to customers and as scarce business fuelled greater pricing competition.

Spain's preliminary harmonised inflation fell to -0.1 percent in March, according to government data on Monday, the first negative result for over 45 years as the deepening recession weighed on price gains.

Thursday, April 2, 2009

JPMorgan March Global PMI Report Shows (Slightly) Slowing Contraction

by Edward Hugh: Barcelona

Data from the JPMorgan March Global PMI provide solid evidence that the speed of contraction in global manufacturing is lessening at the present time. Indexes tracking trends in output and new orders generally continued to rise across the globe, and are in general now up significantly from the series lows registered at the end of 2008. However, both the output and the new orders indexes remained at very low levels, all still signalling continuing contraction and well below those consistent with anything resembling a recovery in either component.

The JPMorgan Global Manufacturing PMI – which provides a single figure snapshot of operating conditions across the planet – posted 37.2 in March. Although substantially below the no-change mark of 50.0, the PMI was up for the third month in row and at its highest level since last October. The vast majority of the national manufacturing PMIs rose in March, including the US, Russia, Japan, China, most Eurozone nations and the UK.

This is however the most sustained period of contraction in the series history, and it still remains very unclear where we go from here. In general the drop in output reflects weak demand, with new orders declining for the twelfth month in a row. The trouble is, it is not at all clear where the rebound in demand that is needed for a recovery is actually going to come from.

Only last week the World Trade Organisation forecast a drop of 9% in the volume of international trade in 2009, and it is clear that in most economies output volumes continue to be hit by global as well as by local factors. That is what globalisation means, in effect, we are all interlocked.The rate of contraction in new export orders was severe, and in line with that seen for total order books.

When assesing the present situation, I think we need to keep three factors in mind: employment, inventories, and the massive stimulus packages which are being implemented.

On the employment front, the March data pointed to further job losses, as staffing levels were cut for the eleventh successive month, pointing to weakening consumer demand further along the road. The rate of decline moderated but remained historically high. All of the national manufacturing surveys for which March data were available reported reductions in employment. Denmark, the US and Czech Republic registered the fastest rates of decline.

As far as stocks go Global manufacturers continued to unwind their inventory positions in March. Stocks of purchases declined at the fastest pace in the series history. Among the national manufacturing sectors covered, only India reported a gain in input inventories. Even here, the rate of growth was marginal. So one of the reasons why output levels may bounce back slighly in the next few months is that inventory levels must now be quite low in many cases, and to some extent new orders will need to be met from production rather than from stocks. In addition, we are in the middle of the stimulus programmes, and it would be surprising if we didn't see some impact on manufacturing output from all that money being spent. Another question altogether would be whether any of this spending is capable of gaining traction. With consumers all over the developed world battening down the hatches for a long winter, and saving as hard as they can to put some order back in their balance sheets, it would be surprising if the stimulus packages on the scale we are seeing them were actually sufficient to turn all this round at this point. So the outlook is, a few months of easing in the contraction, and then more of the same.



Sweden's seasonally adjusted manufacturing purchasing managers' index rose to 36.7 in March from 33.9 in February, but the index remained below the threshold level for the ninth consecutive month in March, although this was the third consecutive month of improvement. In March, the production index rose to 38.8 from 34, while new orders index moved up to 35.1 from 28.8. The employment index increased to 31.1 from 30.1 and the inventories index rose 3 points to 39.6. Meanwhile, the prices index fell to 27.7 from 30.4.


The Markit Eurozone Final Manufacturing PMI for March rose from February's all-time low, up to 33.9 from 33.5. Thus the PMI signalled a marginal easing in the rate of decline from the previous month's record pace. Output showed the weakest decline for five months, and a smaller fall than the Flash estimate, although the rate of decline remained well above that seen prior to last October. With the exception of Italy, Austria and Greece, rates of contraction eased in each of the eight countries surveyed.

The Netherlands saw the smallest (though still steep) drop in production, while Spain saw the sharpest decline for the eleventh straight month. By product, investment goods producers reported the steepest fall in production for the third successive month, closely followed by intermediate goods producers. Consumer goods firms meanwhile reported the weakest rate of decline for the seventh consecutive month. Stocks of both raw materials and finished goods fell at record rates, as companies focused on lowering their operating capacity and controlling costs. The reduction in unsold goods stock was especially steep in Ireland, Germany and France.


Declines in German manufacturing activity continued to slow in March, however, activity in the sector continues to contract at a sharp pace, the research firm added.

The German manufacturing purchasing managers index rose to 32.4 in March, up one point from February's figure and in line with both preliminary estimates and expectations. March's increase marks the second consecutive month of improvement after PMI reached a 12-year low in January of 32.0. Nevertheless, the figure remains well in contraction territory, with the average taken across Q1 as a whole notably lower than the previous quarter's figure. According to the PMI report, manufacturing output and new orders continued to contract, albeit at a reduced pace, while employment fell at a record pace over the month. "The sector's performance in Q1 was at least as bad as Q4 and therefore points to another heavy fall in GDP," Markit senior economist Paul Smith said.


The pace of decline in Spanish manufacturing slowed in March but remained at the steepest contraction rate of any eurozone country. The PMI rose in March to 32.9 from 31.8 in February and thus further off from December's record low of 28.5. All the survey's main indicators remain far below the 50 level that divides growth from contraction. Output and new orders continued to contract sharply in March but at slower rates than recorded in the last six months, with panellists blaming falling demand as the principal cause as clients cut back on spending.

"The March PMI data suggests that the pace of decline in the Spanish
manufacturing sector has slowed," said economist Andrew Harker at Markit
Economics, adding that new orders and output indices are well above record lows
posted late last year.

But Harker was at pains to stress that the March figures should not be interpreted as any sort of sign of a turnaround in the Spanish economy. Unemployment in the sector continued to rise in line with falling output requirements as joblessness in the wider Spanish economy stood at 15 percent, the highest rate in the European Union. More than 34 percent of those surveyed by Markit said they had noted reduced employment levels at the end of the first quarter. Staffing levels have shrunken continuously since September 2007, according to the survey.

Slumping demand also hit input and output costs, which both dropped to series lows in March. Input costs fell as firms negotiated better prices from suppliers, while output prices fell as these savings were passed on to customers and as scarce business fuelled greater pricing competition.

Spain's preliminary harmonised inflation fell to -0.1 percent in March, according to government data on Monday, the first negative result for over 45 years as the deepening recession weighed on price gains.


Italy once again goes against the stream, since manufacturing activity fell in Italy at its fastest pace on record in March, with the manufacturing purchasing managers index falling to a record low of 34.6, down from February's 35.0 and suggesting an unprecedented contraction in activity for the sector. Weakness was widespread, Markit said in their report. Staffing levels were cut at a record pace as firms were forced to adapt to falling workloads and declining new orders. Backlogs of work also declined at their sharpest pace in the history of the PMI as falling demand meant firms to were increasingly able to complete outstanding projects.


French manufacturing output fell at a slower pace in March than in February, but but the outlook remained highly fragile as demand continued to suffer and firms stepped up job cuts. The Markit/CDAF manufacturing purchasing managers' index came in at 36.5 , well still below the 50 mark separating growth from contraction. The reading was, however, better than the record series low of 34.8 seen in February.

"Although output and new orders fell at slower rates in March, the latest PMI
data still point to severe weakness in the French manufacturing sector as the
slump in demand continues," said Jack Kennedy, an economist with Markit

Again, in a picture we get from one country after another, there was a sharp fall in inventories of finished goods. This suggests the overhang of unsold stock is diminishing, and once the destocking phase is complete, falls in production should ease for a bit, although I doubt such upticks will be enough to retart the economy given the depth of the current recession/depression. On the investment side, it was notable that those taking part in the survey said consumers and businesses were reluctant to commit to new spending.

The new orders index hit 34.3 in March from 30.1 in February, but remained deep in negative territory, marking its 10th consecutive month of contraction, according to the survey. Faced with dwindling levels of new business, firms worked through backlogs at a rapid pace, and slashed jobs to trim excess capacity, pushing the factory employment index to its second-lowest level in the series history, at 36.2.


The Greek Purchasing Managers’ Index fell to a new record low of 38.2 in March, reflecting a sharp drop in production, new orders, employment and inventories during the month. The markit economics monthly report said factory prices fell more rapidly in March, while import prices fell at a slower rate, a sign of further pressure in companies’ profits. The employment rate in the Greek manufacturing sector fell to a record low in the same month.

Eastern Europe


Hungary's manufacturing purchasing manager index eased by 0.2 percentage points to 39.5 in March picking up from an all-time low in February, according to the Hungarian Association of Logistics, Purchasing and Inventory Management (HALPIM). The contraction of the manufacturing sector that started last October has continued, and its rate has even increased as compared to February.


In Poland, the index rose to 42.2 points, the highest in five months, from 40.8 in February. The decline in Polish industry decelerated for the third month in a row and was the least weakest rate since November. Markit said both new orders overall and new export orders continued to contract rapidly, reflecting weakening demand from western Europe, while employment fell to a new record low for the fastest rate of decline since the survey began in July 2001.

Roderick Ngotho, a strategist at UBS, pointed to German PMI data also released on Wednesday, which he said did not reflect a collapse in Germany factory orders and it was possible sentiment was "adapting to bad news". "Hence though still quite poor, it could be looking for a base in the poor side of the scale. This is different from sentiment being outright optimistic due to a positive change in global macro indicators," he said. "Without global demand picking up and with domestic demand generally weak, it is difficult to envisage a positive environment for industrial orders/output to pick up meaningfully in the near term."
The Czech Republic

The Czech Purchasing Managers' Index inched up to 34.0 in March from 32.6 in February and from the record low set in January. The Czech decline was also the least extreme in five months, but the first quarter as a whole still pointed to a much steeper rate of decline than the second half of 2008, said Markit, which compiles the PMIs.

The slower rate of contraction in March could, of course, be linked to the effects of the car-scrapping subsidies introduced in some 10 EU countries in January. Carmakers are the main drivers of economies like those in the Czech Republic and Slovakia, where leading global manufacturers have set up factories this decade. Both countries have seen their sharp declines in output ease in recent weeks. Some firms, including the Volkswagen unit Skoda, have recently hired additional workers and resumed full working weeks to handle the resulting surge in orders, the problem for these economies is that the subsidy effect may only last for several months.


Russian manufacturing contracted at the slowest pace for five months in March as companies reduced their stocks of unsold goods and the decline in new business eased, according to the latest PMI report from VTB Capital. The VTB Purchasing Managers’ Index was at 42 last month after a 40.6 reading in February. Stockpiles of unsold goods fell at the fastest rate since December 2005.

“Stocks of unsold goods declined which, combined with a sluggish contraction of the new business sub-index, suggest that the headline index may keep rising into the second quarter,” Dmitri Fedotkin, a VTB economist, said in the statement. Still, “no sharp recovery” in the index is to be expected.
The index showed contraction for the eighth straight month, a longer period of decline than the one registered in 1998, when the government devalued the ruble and defaulted on $40 billion of debt.

The manufacturing workforce shed jobs for the 11th month in a row, the longest period of contraction in the survey’s history, VTB said. “Firms reported that the redundancies resulted from lower workloads and the subsequent need to cut spare capacity,” it said in the statement.



China’s manufacturing industry shrank for an eighth straight month in March as collapsing global trade cut exports and growth across Asia. The CLSA China Purchasing Managers’ Index dropped to a seasonally adjusted 44.8 last month from 45.1 in February. So again, while the stimulus programme is slowing the rate of contraction, there is no sign of any expansion in China.

The manufacturing component of the index continued to increase, rising for a fourth month from a record low of 40.9 in November. The export orders index rose to 41.4 from 39.5 in February. New orders climbed to 43.6 from 44.2. Output gained to 44.3 from 43.9, while the employment index rose to 47.1 from 46.6, its second increase in eight months.

“A worsening of domestic manufacturing orders lies behind the drop in the PMI and accords with what we are seeing on the ground in the steel industry,” said Eric Fishwick, head of economic research at CLSA in Hong Kong. “Expect the production index to show softness in April......More encouragingly, export orders continue to improve,” he added “They are still falling but at the most moderate pace since October.”


Indian manufacturing activity contracted for a fifth straight month in March as demand remained depressed by the global economic downturn, although there were some signs of improvement, according to the report which accompanied the ABN AMRO Bank purchasing managers' index. The index rose to a seasonally adjusted 49.5 in February from January's 47.0, indicating slight signs of slight improvement after hitting a 44.4 trough in December, getting now very close to the reading of over 50 which signals economic expansion. "On the whole, it appears that business conditions in the manufacturing sector are gradually improving," said Gaurav Kapur, senior economist at ABN Amro Bank. Perhaps India's is the only manufacturing sector in the global economy which gives some indication of moving out of contraction and into recovery at this point.

Manufacturing, however, currently only makes up about 16 percent of India's gross domestic product. "It appears that domestic demand is picking up," Kapur said. "External demand, however, remains weak and contracted in March too, for the sixth consecutive month." The new orders index rose to 49.5 from 45.9 in February.


United States

Manufacturing in the U.S. contracted for a 14th straight month in March as factories kept on cutting production, though a spike in new orders and the lowest inventories since 1982 indicate the industry may be stabilizing to some extent, whether in the short term or the longer term remains to be seen. The Institute for Supply Management’s factory index rose to 36.3 last month from 35.8 in February. Still, the contraction is very pronounced at this point.

The ISM’s gauge of inventories fell to 32.2, the lowest since August 1982, from 37 in February. Even as manufacturers are pushing their inventory levels down ISM representatives stressed “we’re probably two, three months away from seeing significant improvement in new orders that would be driven by customer inventories coming in line.”


March data pointed to yet another weak performance of Brazil’s manufacturing economy despite the fact that the headline seasonally adjusted Banco Santander Purchasing Managers’ Index registered its highest reading since last October (42.2). Despite a slower contraction in output being recorded in March, the pace of decline remained substantial. The trend in production closely followed that of new orders, although another severe depletion in unfinished work prevented it from falling as severely. Stocks of finished goods were also lower than in February, and the latest data are consistent with a modest reduction in inventory holdings, with manufacturers frequently responding that orders had been met directly from existing stocks.

Input and output prices fell at series record rates during March. The drop in purchasing costs was only the second in the survey history, and reflected weak global demand for fuel and raw materials. Manufacturers passed these reductions on to customers, by way of lower charges, in an effort to remain competitive in a difficult market environment

Wednesday, April 1, 2009

How Not To Convince People You Are Capable Of Having An Internal "Devaluation"

by Edward Hugh: Barcelona

The news coming out of Estonia is obviously none too good at the moment. This morning we learnt that both Estonian industrial production and retail sales plunged at the most rapid rate on record in February, giving us very clear evidence that the recession is now deepening. Industrial output (adjusted for working days) fell an annual 30 percent, the biggest drop since 1995, following a 27 percent drop in January, while retail sales, excluding cars and fuel, fell 18 percent, the most since 1994. Month on month, output fell a seasonally adjusted 3.5 percent. And the situation is hardly likely to improve in the short term, since, as Danske Bank point out, all Estonia's main partners are themselves now in deep recessions, so the possibilities of an uptick in activity - even were the economy competitive - are really pretty restricted.

“Industrial production is in freefall, and we expect a continuation of this trend in 2009,” Danske Bank A/S said in a note ahead of the report. “Only an improved outlook for Estonia’s main trading partners, Finland, Sweden, Germany, could change this trend, but this is hardly feasible before the beginning of 2010.”
In fact, while the crisis is a general one, some countries are obviously faring far worse than others, and Estonia’s industrial production dropped the most in the entire 27-nation European Union in December and January. And even if things do start to pick up again elsewhere in 2010, it is hard to see the Estonian economy benefiting that much, since it will still be grappling with price competitiveness issues (see below).

At the present time, as we can see in the index chart below, output is now down around 30% from the 2007 peak, and it continues to fall. Clearly the rate of decline will reduce at some point, and then we may flatten out at quite a low level, but this flattening out will be very different from a rebound, since there is no reason whatsoever to expect a rebound at this point.

Retail sales also fell sharply in February, by 18% when compared with the same month in the previous year. The latest decline dwarfed the 10% fall we saw last month, and may well signal much worse to come. As the statistics office said "In February, the retail sales decreased to their lowest level so far" (see index chart below).

The decline was attributed to the economic slowdown and to deteriorating consumer confidence. According to the Estonian Institute of Economic Research, consumer confidence dropped to a record low of minus 37 in March from minus 35 in February. Compared to the previous month, retail sales declined 7% at constant prices, and after seasonal and calendar adjustments, fell 2%.

New Finance Ministry Forecast

Estonia’s Finance Ministry announced today (Tuesday) that according to their latest estimates the economy will shrink 10 percent this year, if their “worst-case scenario” is realized. This is only in line with what most experts are now saying (although, truth be told, none of us really know) but as recently as last November, the Ministry were forecasting a 3.5 percent contraction for this year and an expansion of 2.6 percent in 2010. Not surprisingly therefore Finance Minister Ivari Padar is having to do his sums again and is now proposing budget cuts of 3 billion krooni ($260 million), as well as a temporary halt to the transfer of pension contributions from workers and employers into the second-pillar pension fund.

But this is now one "chop" on top of the next, since the Estonian Cabinet agreed only last month to cut the fiscal deficit by about 8 billion krooni, or 8 percent of the total budget, in an attempt to ensure the shortfall doesn’t exceed 3 percent of GDP. According to Padar, without further measures the deficit would reach 2.9 percent of GDP this year under the main scenario and but rise to as much 6.1 percent under the worst-case (but possibly more plausible) scenario. Detailed proposals on how to lower the fiscal deficit are to be presented to the government on April 9.

Naturally analysts like myself are rather sceptical about all this. Forecasts have been consistently behind the curve in Estonia, and there is no risen to imagine that this situation won't be repeated across 2009, and 2010, especially looking at the macro data we see coming in. The statistics office announced today that Estonia had a budget deficit of exactly 3 percent of GDP last year, when the economy shrank 3.6 percent. The shortfall was thus precisely equal to the threshold allowed by the EU as one of the conditions for euro entry. Also, when we consider that the country moved from a surplus of more than 2% of GDP in 2007, then it is clear that the rate of deficit creation was very high in the last quarter of 2008.

SEB AB’s Ruta Eier makes the point that with the economy quite probably shrinking by as much as 10 percent this year (or more), the risk of breaching the budget deficit goal is significant. “The chances of meeting the deficit criteria this year seem rather small, especially with the economy shrinking at such rates,” she said in her latest report. Indeed she estimates that first-quarter GDP may shrink by over 15 percent, on an annual basis. Violeta Klyviene, senior Baltic analyst with Danske Bank, is more or less in the same line, and suggests that the budget gap may reach 5 percent of GDP this year unless the government cuts spending further.

So spending cuts are looming, but these will add to unemployment and reduce total domestic demand, so, in effect they will lead to a further contraction in economic activity, which will lead to a higher deficit, which will mean more cuts, and yet more contraction, and so on. This is all a very difficult situation really, which is why I think another approach is needed.

In part bank lending will be another important detail, but bank lending will depend on loan defaults, and these will depend on unemployment, and since even the Finance Ministry are forecasting unemployment at 12.2 percent this year and 15.6 percent in 2010, then defaults are surely set to rise, and with them distress in the banking sector. Indeed, while the Estonian economy at the present time is producing few sellable exports, one thing it is producing are loan defaults: indeed we might say at the present time that the present government strategy is turning Estonia's economy into one huge loan-default assembly line, rocketing backwards as it is with neither steering wheel, nor brakes.

Threat to Euro Membership?

In any event, whatever the eventual size of the deficit, it will need financing, and Estonia’s Finance Ministry is at this very moment seeking a loan for these very purposes, on top of funds already approved by the European Investment Bank.

Of course, one of the reasons that these deficit numbers are so important is that they impinge on Estonia's strategy of seeking Euro membership, and we also learnt today that Estonia’s government has set Jan. 1, 2011, as its new official target. This is an effective abandonment of Prime Minister Andrus Ansip's earlier plan to try to join the euro area on July 1, 2010, although the official position is that this option is still being kept open, despite the fact that European Monetary Affairs Commissioner Joaquin Almunia politely made it clear on March 19 that the plan to join in July 2010 was too ambitious, at least under current criteria.

My feeling is still that Estonia's representatives should be actively working with other East European countries to get these criteria changed, since if we don't achieve that position, the spiraling cycle of contraction, deficit, and economic and political instability may well see eventual euro membership put off into a far distant future.

Are We On The Right Road?

Basically, I feel the whole process of addressing the economic issues presented by the boom-bust cycle are being inadequately - almost incompetently - handled. My own view is that the country urgently needs a devaluation of the kroon, but this is evidently a minority, rather than a majority view. So be it. But then if we are going to go down the internal deflation road, then at least lets do it seriously.

For example, I was horrified to read in the Estonian press that Prime Minister Ansip, is saying that the intended benefits of the new Labour Contract Act may be at risk of being postponed because theSupervisory Board of the Unemployment Insurance Fund did not reach agreement with the Government to raise the unemployment insurance payment rates from January 1.

My impression, as an outsider I know, was that the Labour Contract Act was one of the cornerstones of the labour fexibility process which is so vital to the internal deflation strategy, so how can agreement not have been reached on a key clause in the Act?

"The most important provisions of the Labour Contract Act were agreed between employers and employees. The Government accepted them and asked whether all these benefits fit the unemployment insurance tax rate of 1.5% and the unambiguous response was that they will indeed," said Ansip. He added that the social partners promised back then already that if the benefits would not be covered by the existing payment rates, the benefits would have to be cut.

According to Postimees Online, Ansip stated in a radio interview that the crisis surrounding the Labour Contract Act is the fault of both employers and employees. Sorry, but isn't the job of government to see that these kind of logjams don't arise, and especially in delicate moments like these. My point, however, would not be to discover who exactly is responsible for the mess, but to ask a more fundamental question: how can it be that people are still bickering about this kind of thing in the face of a national emergency, when the survival of your economy and banking system is at stake?

Gentlemen, this cannot be taken seriously.

"We certainly cannot allow to fail to fulfil the Maastricht criteria due o the eficit of the Unemployment Insurance Board that would exceed the planned levels," emphasised the Prime Minister.

Well quite, but the fact that this is even being discussed like this suggests that the hope of clawing through to the daylight is much slimmer than might have been hoped.

Another question revolves around the issue of what kind of adjustment process Estonia is actually committed to. Certainly we are a little short of precise numbers of the kind the IMF spell out in the Latvian case. And the public statements of leading members of the administration do little to reassure us they know what they are about here. Andres Lipstok, the Governor of the Estonian Central Bank, has, for example (see interview extract below) suggested that Estonia's average salary cannot be lowered sharply. Does this man understand what he is talking about at all, I ask myself when I read a statement like this. I fully accept his right to believe that devaluation would contribute nothing to the Estonian economy, but surely, he must understand that substantial internal price deflation is the only half-way viable alternative, that this will be hard, and that this will mean substantial reductions in wages and prices. Basically he doesn't seem to have grasped that Estonia has a competitiveness problem at all, and that all these arguments about not wanting to be a low wage economy (and hence turning the nose up at lower skilled activities) and Estonian wages being lower than the EU average are how we got in the mess in the first place. With an economy imploding at a 10% per annum rate, you can't afford to be that choosy, you know. All I can say is, what's the weather like on his planet?

“One must emphasize that wages in Estonia are still low compared to EU’s verage. Those entrepreneurs and analysts, who think that Estonia should lower alaries remarkably to remain competitive, are wrong. He added that Estonia can’t and won’t be a country with very low wage level. “Estonia’s wage level keeps rising ogether with economy, after necessary correction,” Lipstok said. Inflation is also lowing down. In past 6 months the prices have not grown, after price adaption that ollowed after Estonia joined EU in 2004. The inflation will likely be negative in 009.

For the competitiveness of the economy are no less important to the slowdown in wage rowth. The fast increase in wages in previous years was in part a response to apidly increasing profits. However, at the beginning of last year, the wage level, hich clearly threatened the competitiveness of Estonia. Approximately 15 per cent short of the increase is clearly too much at a time when output per worker is educed. In its first few months, however, wage growth actually stagnated compared o the previous year.

At the same time, it must be stressed that the wages in Estonia, the European Union verage is still low. Analysts and traders are wrong who think that maintaining the ompetitiveness of the Estonian average wages significantly lower. After the ecessary correction will result in the climb to the wage level in Estonia, together ith the overall development of the economy.

At the same time, wage growth has been delayed to stop the inflation of prices.. After the accession to the European Union, followed by adjustment to the price is not for the general price level increased over the last half of the year. 2009 inflation is likely to be negative.

The Price and Wage Correction Is Too Slow

In order to understand why I am being so critical of the Estonian administration in this post, and to see what is wrong with the path on which Estonia is set at the moment we need to keep permanently in mind the objectives that the country has set itself for the coming months and years, which is to carry out a substantial reduction in wages and prices over the next two years (as an alternative to a one off devaluation). Exact estimates are hard to come by here, but we must surely be talking in terms of a very sharp downward adjustment in prices and wages, something of the order of 20% during 2009 and 2010. And my beef is that we see little evidence of that kind of correction taking place. In fact this view is only reinforced on reading the economic policy formulations from the central bank. In its February 2009 statement Eesti Pank had the following to say:

Inflation has fallen rapidly and will not exceed 2% in 2009. The price level is not projected to rise in 2010, either. Many companies have changed their operating strategies and have brought prices and wages into line with the new market situation. This is also proved by rapid changes in the labour market: employment has started to drop, flexible working contracts are becoming more widespread, and nominal wages have started to decline in some sectors.
Let me be blunt: this is thoroughly unsatisfactory as a policy objective, and completely unrealistic (head in the clouds) about the severity of Estonia's adjustment problems.

The pace of deflation at this point is just far too slow to be convincing. According to Statistics Estonia, the percentage change in the consumer price index in February 2009 compared to January was -0.3%, while compared to February of the previous year it was still a positive 3.4%. However, ss reported by the German Federal Statistical Office, the consumer price index for Germany is expected to rise by only 0.5% in March 2009 over March 2008 (down from February's +1.0% - according to initial results available from six Länder). This is the lowest inflation rate registered in Germany since July 1999. Compared with February, prices are expected to drop by 0.1%.

And if we look at the EU harmonised consumer price index for Germany, the downward trend is even clearer, since year on year prices are only expected to increase by 0.4% from March 2008 to March 2009 (February: +1.0%), while compared with February, the index will be down 0.2%.

And the point about looking at German inflation (or rather deflation) is that Estonia is not carrying out this correction in a vacuum. What is important here is relative prices, and if all your neighbouring countries are aither devaluing their currencies, or having internal price deflation (due to thelarge contractions they are experiencing, Commerzbank estimate the German economy itself may contract by 7% in 2009) then you have to do more, and go that bit further, not do less. Otherwise when the recovery does, finally, come, you will simply be left behind, since you will still be uncompetitive.

Nor is Germany an isolated case, inflation in Italy, the euro region’s third-biggest economy, also slowed to a record low in March, with inflation dropping to an annual 1 percent from a year earlier, compared with 1.5 percent in February. And, of course, over the last three months prices ahve actually fallen. And Spanish consumer prices declined for the first time ever (on an annual basis)in March, highlighting concerns that deflationary pressure will emerge right across the European economy. Consumer prices fell 0.1 percent from a year ago using the European Union’s calculation method after a 0.7 percent increase in February.

Indeed inflation rates across Europe are now falling near to zero, and fell to the lowest on record in March according to the initial estimates, adding to concerns that deflationary pressures are emerging throughout the whole region. Inflation in the euro area slowed to an annual 0.6 percent in March from 1.2 percent in February, the lowest rate since the data were first compiled in 1996

And most of Europe's economies are facing contractions in the 5 percent per annum region, so Estonia has a tough benchmark to work against, one which is even tougher when those who make policy are totally unrealistic about the magnitude of the task facing them. I would remind Estonian policy makers: it is a fairly easy thing to say that those economists who don't agree with you don't know what they are talking about, and quite another thing to establish that you, yourselves, do.

Now, as I say, basically the problem here is to restore competitiveness and, although not everyone will be prepared to agree with me, I would argue that the only solution for Estonia is to export its way out of trouble. Given the problems the banking system is having and is about to have, it would be sheer fantasy-land (and very foolish) to imagine we are going to see a return at any point in the forseeable future to consumer credit driven growth (we are talking everywhere about more, not less, regulation), so as Estonians work hard (once they finally get a job again) to pay off their debts and try to save for their increasingly uncertain old age, the only really valid way to try to go for growth is by exporting. Saying that this is not possible, well... this is simply defeatism before you start, and I don't imagine the Estonian character that way somehow, not after so many years of fighting to gain a hard won independence.

So if you want to export, you have one benchmark to work againt - Germany. And if we look at the chart below, we will see the extent of the competitveness gap which has opened up since 1999. Now Reel Effective Exchange Rates (REERs) are a nice measure of competitiveness, since REERs attempt to assess a country's price or cost competitiveness relative to its principal competitors in international markets. Since changes in cost and price competitiveness depend not only on exchange rate movements but also on cost and price trends the specific REERs used by Eurostat for its Sustainable Development Indicators have been deflated by nominal unit labour costs (total economy) against a panel of 36 countries (= EU27 + 9 other industrial countries: Australia, Canada, United States, Japan, Norway, New Zealand, Mexico, Switzerland, and Turkey). Double export weights are used to calculate REERs, reflecting not only competition in the home markets of the various competitors, but also competition in export markets elsewhere. A rise in the index means a loss of competitiveness, and as we can see Estonia's index has risen sharply against Germany's in recent years.

Well, just in case anyone thinks that the comparison with Germany is not an appropriate one in Estonia's case, here (see below) is the equivalent chart for Finland, which shows an equally strong loss, and let us remember that the worst year in this sense (2008) is still not included, since Eurostat have not processed the data yet.

And of course, I am only looking at eurozone comparisons here, we won't enter at this point into the embarassing fact that Sweden and the UK have both devalued sharply in rcent months, as have Eastern EU rivals, Romania, Poland, Hungary and the Czech Republic, as well as non EU rivals like Ukraine and Russia. Really hanging on to the peg blindly in these circumstances is not only foolish, it is ridiculous, and I hardly see how following a ridiculous policy (which for sure is not working at this point) is going to enhance your credibility, which is what the decision not to devalue was all about in the first place. Even worse, it won't even shield the Nordic banks from the slew of incoming defaults as people lose their jobs and the biggest slice of their income. Estonia needs a viable strategy, and it needs it now!