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Thursday, May 28, 2009

Exports And Investment Drag German GDP Down In First Quarter

By Edward Hugh: Barcelona

German exports and investment spending plunged in the first quarter, dragging Europe’s largest economy into its deepest economic slump on record.

Exports were down 9.7 percent from the fourth quarter and company investment declined 7.9 percent, according to the Federal Statistics Office. The Office reported that gross domestic product fell a seasonally adjusted 3.8 percent from the previous three months, confirming an initial estimate from May 15. That’s the largest drop since quarterly data were first compiled in 1970.

From October to December 2008, the German economy had already contracted by 2.2%, and by 0.5% in each of the the second and third quarters.

According to the statistics office, the decline in economic performance was mainly due to movements in the balance between exports and imports of both goods and services. As in the fourth quarter of 2008, German exports fell much more than German imports in the first three months of this year. While exports declined 9.7 % year on year, imports were down 5.4%, so that the chnaged balance of exports and imports contributed minus 2.2 percentage points to the decline of GDP.

The negative first quarter evolution was also characterised by a notable decline in investments (– 7.9%, quarter on quarter). Capital formation in machinery and equipment, in particular, was much lower than in the last quarter of 2008. Companies invested 16.2% less in machinery, equipment and vehicles than in the last quarter of 2008.

The decline in capital formation in construction was small in comparison with a drop of 2.6% on the quarter. Inventories were also run down considerably during the quarter, thus reducing growth by 0.5 percentage points. Growth was positive only only for household consumption and government consumption, which up by 0.5% and 0.3% respectively.

Year on year, German GDP was down by 6.7% in the first quarter of 2009. After calendar-adjusted, the figure is 6.9% , since there was half a working day more in the first quarter of 2009 than there was in 2008 (easter impact minus the leap year effect).

39.9 million people were employed in Germany during the first quarter, an increase by 48 000 persons (or 0.1%) on a year earlier. The number of unemployed (ILO definition) was just under 3.4 million, 7.8% of the entire economically active population.

The recession in Germany has hit industrial activity (including energy) particularly hard, and output was down 20.2% over the first quarter of 2008. Marked declines in real gross value added were recorded also by construction (– 8.9%) and by trade, transport and communications (– 6.4%). Financial, real estate, renting and business activities fell much less - by 0.9% compared with the first quarter of 2008.

In contrast to the bleak picture for investment, fixed capital formation and German exports, final consumption expenditure was ever so slightly up quarter on quarter - by 0.1% - and even did slightly better than in the last quarter of 2008 (– 0.0%).

On a year on year basis, household consumption was marginally down though - by 0.1% (following a 0.5% drop in the fourth quarter of 2008), but general government consumption expenditure was up by 0.8%.

The Long Term Outlook

The first-quarter drop in GDP marked an unprecedented fourth successive quarterly contraction for Germany’s economy. The government expects the economy to contract 6 percent this year, while ECB council member Axel Weber said earlier that while “rays of light” are positive, there’s “no reliable indication that the global economy is past the worst.” The euro-region economy may only “gradually stabilize during the latter part of 2009.”

The longer term decline in German GDP performance is now pretty clear (see chart below).

According to the Federal Statistics Office:

Measured in terms of gross domestic product changes at 1995 prices, the rates of economic growth in the former territory of the Federal Republic of Germany and - since 1991 - in Germany have continuously declined since 1970. While the average annual change was 2.8% between 1970 and 1980, it amounted to 2.6% between 1980 and 1991 and to 1.5% between 1991 and 2001.

Since 2001 the performance of the German economy has in fact been worse rather than better, much to the consternation of those who hoped that many years of sacrifice in the form of wage deflation and structural reform would lead to a rebirth of the country's former economic prowess. In reality the German economy shrank (0.2%) in 2003, and grew by only around 1% in both 2004 and 2005. And while the German economy picked up notably in 2006 and 2007 (with growth rates of 3.2% and 2.6% respectively) and many talking in terms of such grandiose notions as global uncoupling and "Goldilocks" type sustainable recoveries, the most striking feature of the recent German dynamic has been the way that internal demand failed to respond to the externally driven export stimulus. Of course, all the speculation came to an abrupt end in 2008 when the German economy once more entered recession as world trade expansion slowed and exports collapsed (with GDP only growing by 1% over the year), while 2009 looks set to be a lot worse (with the IMF currently forecasting a contraction somewhere in the region of 5%, and forecasts of up to minus 7% not seeming exaggerated).

What we seem to have here is "engine faliure" rather than mere "magneto problems" (using Claus Vistesen's memorable phrase for a very similar situation in the Japanese economy, and it would be nice if the current crisis could serve as the stimulus for an open, and "in the real world" debate about why this is. So some part of the traditional mechanism of economic transmission seems to have been broken, and the "second leg" of the economic cycle, the domestic consumtion driven one, seems no longer to work. Long term GDP growth rates in the German economy are clearly falling, and the decline looks clearly set to continue. Now falling and ageing population couldn't have anything to do with it, could it?

Seeing is Believing, But Stabilising is NOT Recovering

By Edward Hugh: Barcelona

This is one of the key points I have been hammering here on this blog for some weeks now. There is clear evidence of most economies globally "stabilising" at this point, you could even stretch it to say that the "worst is over" - since I doubt we will go back to the dreadful days of December and January (see German manufacturing PMI chart below) - when it was like someone had given a very sharp knock to the whole industrial sector with a large sledgehammer, and of course ultimately the vibrations settle down even if the damage remains.

But to go from this evident fact to drawing the conclusion that a full recovery is now in the works would be a very fast and loose use of both logic and economic theory. Production is falling less slowly (on an annual basis) and even increasing slightly (on a monthly basis) in some countries as orders can no longer simply be met from what are now very depleted inventories.

But as I suggest in this post, upping output to meet current orders is not a recovery, for the win-win dynamic to move us back into a new cycle investment activity has to increase. And on this front there is precious little actual evidence to back the more positive discourse, and indeed the data we are seeing indicate rather the contrary.

When I last wrote we did not have detailed data for Q1 GDP for the eurozone economies , so I took a look at the evidence from Japan, where investment activity slumped massively between January and March (pointing out that there was no good reason why we should expect the situation to be very different in Europe). Japanese business investment was down a record 10.4 percent year on year in the first three months, and a massive 35.5% over the last quarter.

But now we have detailed German Q1 GDP results from the Federal Statistics Office, and we find a very similar picture. Total investment was strongly down (– 7.9% quarter on quarter), while capital formation in machinery and equipment, was 16.2% lower than in the last quarter of 2008, and 19.6% lower than in the first three months of last year.

But all of that is to some extent history. Much more preoccupying - certainly for the "onward-annd-upward-we-go" thesis - is that German plant and machinery orders declined the most on record in April from a year earlier. Orders dropped an annual 58 percent, the most since data collection started in 1950, after falling an annual 35 percent in March, according to the Frankfurt-based VDMA machine makers association in a statement today. Export orders slumped 60 percent while domestic demand dropped 52 percent. So things actually seem to have deteriorated in April with respect to March. No good news this.

Especially when you read the same day an interview with Hans-Joachim Dübel - CEO of Berlin based FinPolConsult, one of the leading and few relatively independent voices in the German housing finance community - where he says: "My guess is that the Landesbanken alone will cause ultimate losses of 8-10% of German GDP, which is real money. Compare that sum with the 5% of GDP costs for the US S&L crisis".

Devaluation Imminent in the Baltics?

By Claus Vistesen: Copenhagen

Even when liars tell the truth, they are never believed. The liar will lie once, twice, and then perish when he tells the truth.

One thing which is certain at the moment is that the rumour mill is grinding hard and that it is very difficult to get a clear picture of what is going on. It is too cumbersome for me to go into the entire background here (I assume most of you are familiar with the Baltic and CEE situation), but if you want some background try this or this which will give you the opportunity to browse a myriad of articles. The situation is however pretty simple. Ever since it became clear that the Baltics was going to suffer not only a hard landing, but a veritable collapse on the back of the financial crisis one obvious question always was whether these economies could maintain the Euro peg throughout the correction process. So far the peg have held and the countries, as well as the IMF who have been called for aid, have been committed to the peg and thus the future entry in the Eurozone.

But this has come at a price and as international economics 101 tells us, the only way you can correct with a fixed exchange rate and an open external account is through deflation and a very sharp drainage of domestic capacity. And so it has come to pass that particularly in Latvia who has come under the receivership of the IMF the scew has been turned, (and turned and turned) and now the question is how much more can the public and the goverment take. In a recent article in the NYT the situation is well described as the Latvian government scrambles to meet ends on the IMF's pre-condition to continue funding the bailout programme.

One very significant indication that things are near its breaking point came when Central Bank Governor Ilmars Rimsevics launched the idea that, since the liquidity in Lati is being drained in order to keep the peg and because the cuts needed to abide by the IMF rules are immense, public employees might be submitted to receive their pay in "vouchers" in stead of actual Lati. As Edward points out, this is straight out of the vaults of the Argentian crisis' annals. This is one of the things you get with a peg maintained too tightly during a deflationary crisis. It deprives you from liquidity. Now, in some sense this all about the next installment of IMF funds of course and whether Latvia will (can) make the needed budget cuts to please the fund to such an extent that they will continue to slip the bailout checks in the mail.

Essentially, under the peg, the central bank has to buy Lati in the open market to maintain the peg since there is, naturally, a pressure on the peg as everybody want's euros. So, the central bank is forced to drain the economy from liquidity to maintain the peg in an environment where the economy is contracting at about 20% over the year. This is not fun and, as it were, not sustainable given the trajectory of these economies. In this sense devaluation is no cure but a simple prerequisite (and necessity) for the healing process to begin.

Even more significant it appears that the the foreign banks, so important in the Baltic story since they basically provided the liquidity inflows to fund the boom, are beginning to accept the basic point I, and others, have made so often before. This is the point that although a devaluation would entail default on a large batch of Euro denominated loans, this default would come in either case as a result of the utterly horrid contraction. In this sense it was very significant that the SEB Chief Executive Annika Falkengren pointed out;

"In total we would have the same size of credit losses, but (if there is no devaluation) they would be a little more regular and over a longer time frame," SEB Chief Executive Annika Falkengren told Swedish radio. "In the case of a devaluation they would be pretty much instantaneous."

This is important because one prerequisite for the peg to hold was always that the foreign banks explicity backed it since they pretty much finance the majority of the credit needed to hold these economies afloat and particularly so Latvia. Essentially, on the Swedish side of things it appears that they are pretty much treating this as over and done.

According to Dagens Industri' Torbjörn Becker, leader of the Eastern European Institute of the School, a devaluation is likely. "The alternative to a devaluation in Latvia is to wait until the reserve is drained and the economy will disappear into a black hole, " he told the DI. Torbjörn Becker believe that neighbors Estonia and Lithuania follow.

Moreover, the Riksbank just recently bolstered its foreign currency reserve with an amount equal to 100 mill SEK which can be interpreted as a precautionary measure to deal with a potential fallout in the Baltics.

The Executive Board of the Riksbank has decided to restore the level of the foreign currency reserve by borrowing the equivalent of SEK 100 billion. This needs to be done because the Riksbank has lent part of the foreign currency reserve to Swedish banks. We have also increased our commitments to other central banks and international organisations. The Riksbank needs to maintain its readiness to supply the Swedish banks with the liquidity required in foreign currency.

Finally, there is Danske Bank, aka Lars Christensen in the context of the CEE, who warns of a serious event risk in the Baltics in today's daily installment on emerging markets.

The event risk has risen sharply in the Baltic markets and we advise outmost caution. Yesterday, the Swedish central bank Riksbanken said it will increase its currency reserve by SEK 100 bn through a loan from the Swedish debt agency. Investors seem to believe that this is a buffer to deal with potential problems arising from the Baltic crisis.


With worries over the Baltic situation on the rise there is a significant risk of negative spill-over to other markets in CEE. Therefore we see clear downside risk on the CEE currencies and a risk of a sharp sell-off in the CEE fixed income markets in the coming days. We especially see value in buying USD/HUF, but potentially also USD/PLN on an escalation of the Baltic crisis.

Basically, the way I see it is that there is only so much the currency boards can do and in Latvia's case, after having already spent over 500 million euros buying lats, I think we are moving steadily towards the end game. Of course, there is an obvious risk that I will perish further down the road with this one, but then again, so be it. It is imperative that investors and stakeholders entertain the possibility of a multiscale Baltic devaluation and, obviously, a sharp CEE sell off in the wake.

Tuesday, May 26, 2009

The New Orthodoxy Is Upon Us

by Edward Hugh: Barcelona

We seem to be witnessing the arrival of some kind of new financial orthodoxy. The IMF put it like this in the Hungary Standby Loan Report (which by chance I was reading last night):

In emerging market countries with debt overhangs, the “Keynesian” effect of fiscal adjustment is likely to be outweighed by “non-Keynesian” effects related to expectations and credibility. Non- Keynesian effects have to do with the offsetting response of private saving to policy-related changes in public saving. In particular, if fiscal adjustment credibly signals improved public sector solvency, a fiscal contraction could turn out to be expansionary, as private consumption rises based on the view that future tax hikes will be smaller than previously envisaged.
IMF - Hungary, Request for Stand-By Arrangement, November 4, 2008

So from Tallinin, to Riga, to Budapest, to Bucharest, the same sonata on a single note is being played, and the message is cut spending and you will expand. Funny how people are not very convinced about this idea in Berlin, London, or Washington.

Monday, May 25, 2009

The Carry Trade and the Global Monetary Credit Transmission

By Claus Vistesen: Copenhagen

Daedalus warned his son not to fly too close to the sun, nor too close to the sea. Overcome by the giddiness that flying lent him, Icarus soared through the sky curiously, but in the process he came too close to the sun, which melted the wax. Icarus kept flapping his wings but soon realized that he had no feathers left and that he was only flapping his bare arms. And so, Icarus fell into the sea. - Wikipedia entry on Icarus

Whether it is merely temporary or a sign of something more durable it is hard to escape the fact that as the discourse on green shoots and second derivatives linger we might be entering a new leg of this crisis. Thus, there should be no mistake. We are very much still stuck in the mire and especially so in the context of the so-called developed OECD economies where it is difficult to see where any speedy recovery is going to come from. On the other hand the world is not made up entirely by the OECD edifice and it is exactly the potential for an asymmetric "recovery" and how global monetary policy might serve to transmit such a recovery which is the topic of this entry. In order to frame the discussion, it is worthwhile to go back to before the crisis where, most notably, the low interest rate environment in Japan was driving carry trading activity across the world with Australia, New Zealand, the Eurozone, the US as notable targets in the developed world edifice where also of course emerging markets were in the spotlight. Whether there are similarities with such historical flashbacks can be debated; but what is abundantly clear is that conditional on the return of some variant of an environment conductive to the carry trade something has also changed.

This change is most clearly expressed through the process by which the US Fed's credible commitment to maintain low rates may become the driving force for a search for yield and return (carry trade) in key emerging economies. In that light, my good friend Edward Hugh recently authored two extraordinarily important pieces and although it is hardly news that I plug Edward at this space I highly recommend you to have a look at these two. Nay, it is imperative that you read them.

The main thrust of the story is that after having observed green shoots throughout since February the carry trade wheel appears to be revving up again. Volatility have come down, risky assets have flown, money market rates in the G3 are beginning to behave, and reports have even come in that a seasoned carry trade veteran Miss Watanabe is once again dipping her toe although people close to the data also suggest that a lot of the effect from Miss Watanabe is clouded by Japanese corporates playing with transfer pricing.

[click on graphs for better viewing]

But, as noted, this time there is a twist. Sure, the BOJ is still running an almost open shop with respect to the provision of funding to play the game but relative to the carry trade of old days, something has changed. Now, it is not the only the BOJ anymore but also the BOE, to a lesser extent the ECB, and most importantly the Fed who are forced to commit to very low levels of nominal interest rates in order to fight off deflation as well as to commit to the support of the restoration of a financial system which has been mortally wounded during the evolving crisis. In a world where uncertainty is high this is a prerequisite to avoid disaster, but in a world where sentiment suddenly shifts to the better it potentially becomes the underpinning factor for what some have dubbed the mother of all carry trades. It is of course this which we have been observing more than passing evidence of in the past weeks.

In a global macroeconomic context, this all goes back to the discussion of re-balancing and decoupling. In the most recent print edition The Economist calls it decoupling 2.0 and although I never liked the idea of decoupling as it was traditionally narrated with Europe or perhaps China taking over as the global supplier of net capacity (demand) it was also always going to be a very true narrative. To put it in other terms; the world decoupled a long time ago and it has long been clear that big emerging economies would rise to the scene to command a much larger relative position.

Besides this common ground, I have mainly had two gripes with the narrative. Firstly, the original idea that Europe and Japan would rise to the occasion to take over from the US was a mirage masked by the simple fact that the Fed reacted more quickly and swiftly to the incoming storm. Secondly, I have also been skeptical about the idea of China (and Russia even) providing demand through a more liberal policy towards the management of its capital account and currency. Essentially, Goldman Sachs' old conceptualization of the BRICs should be allowed to move into the eternal dust bin not only because there is a fundamental difference between China/Russia and Brazil/India, but also because the emerging market edifice is much more diverse and important to be reduced to the whims of the punch line department at the world's biggest and arguably best investment bank.

With these points on the table it is of course worthwhile to ask whether investors and other market participants are responding to this new narrative of vibrant growth in emerging markets and subsequent carry trade opportunities.

Even a modest glance over the recent news bulletins suggests almost a feeding frenzy as investors and their advisors scramble to exploit whatever window of opportunity that may have opened to make some easy money in an otherwise extraordinarily difficult environment. One notable example was in the context of the CEE economies where Deutche Bank recently suggested that investors borrow in Euros to buy the Ruble and the Forint. Of course, there are carry trades and then there is; well Russian roulette, and of all the potential punts out there this one would seem, to me, the equivalent of a trip to Las Vegas, playing on horses or another derivative of gambling. Apart from DB, Barclays have also picked up the baton with analyst Andrea Kiguel providing the main points that the Brazilian Real and Turkish Lira be the preferred targets of choice;

Brazil’s real, South Africa’s rand and Turkey’s lira offer the “largest upside” as investors return to the so-called carry trade, Barclays Plc said. A global pickup in investor demand for higher-yielding assets and signs the worst of the global recession is over “bode very well for the comeback of the emerging-market carry trade,” analysts including Andrea Kiguel in New York wrote in a report. The carry trade refers to the practice where investors borrow funds in a country with lower interest rates and then invest the money in nations where returns are higher.

Brazil’s real has gained 18 percent in the past three months against the U.S. dollar while Turkey’s lira has advanced 10 percent. South Africa’s rand is up 22 percent, the best performing emerging-market currency in the past three months. “As the decline of global risk aversion gives way to the re-pricing of U.S. dollar, we see potential for emerging-market foreign exchange to continue rallying,” analysts including Andrea Kiguel in New York wrote in a report.

The American Banks want to play ball too and emphasising the unusual and lingering low interest rate environment in Europe, Japan, and the US; JPMorgan and Goldman Sachs are hailing all systems go.

The carry trade is making a comeback after its longest losing streak in three decades.

Stimulus plans and near-zero interest rates in developed economies are boosting investor confidence in emerging markets and commodity-rich nations with interest rates as much as 12.9 percentage points higher. Using dollars, euros and yen to buy the currencies of Brazil, Hungary, Indonesia, South Africa, New Zealand and Australia earned 8 percent from March 20 to April 10, that trade’s biggest three-week gain since at least 1999, data compiled by Bloomberg show.

Goldman Sachs Group Inc., Insight Investment Management and Fischer Francis Trees & Watts have begun recommending carry trades, which lost favor last year as the worst financial crisis since the Great Depression drove investors to the relative safety of Treasuries. Now efforts to end the first global recession since World War II are sending money into stocks, emerging markets and commodities.

Speaking a language most investors can understand Bloomberg reports that a composite index constructed by ABN Ambro where the Euro, Yen, and USD are used to buy Turkish Lira, Brazilian Real, the Forint etc has so far earned an annualized 196 percent from March 2 to April 10. Such kind of rapid reversal of fundamentals can only be underpinned by a very strong dose of positive sentiment as the one we have been witnessing with all the talk about green shoots and second derivatives. As Macro Man points out the most recent survey on Global Funds Managers from Bank of America and Merril Lynch sported the biggest degree of optimism since 2004 and, naturally, a substantial re-allocation of assets towards emerging markets.

Now, this is of course all well and good but the underlying economic dynamics here are not as straight forward as they may seem. There are particularly two issues worth noting.

On the one hand there is the simple issue of where all the liquidity provided by the BOJ, the ECB and the Fed is going. Only recently, the vice chairman of the Federal Reserve Donald Kohn pointed out that after getting a one trillion dollar boost from the Fed's purchase of treasuries and asset backed securities (most notably the MBS) the economy appeared to be on the mend. Leaving aside the question of whether the economy is actually on the mend or not the more fundamental question is the extent to which the Fed, the ECB and the BOJ can govern where exactly this "boost" is going and, of course, subject to what leverage multiple. This, I think, was what made Paul Krugman ever so timidly to venture the idea the perhaps some form of buy American/protectionism wasn't as bad as it was meant out to be. In a European context we can ask a similar question about whether all the liquidity provided by the ECB will simply move into the CEE to play the carry there and consequently further exacerbate the imbalances which have not been unwound yet.

On the other hand there is the receiving end where some emerging markets are already reeling under the prospects of sucking up the inflows. The first proverbial shot across the bow was fired by Henrique Meirelles who is in charge of the Brazilian central bank. Recently, he consequently pointed out that the central bank is standing ready to increase the purchases of USD in order to stem the unduly appreciation of the Real on the back of carry trade optimism and a resurgence of the upward trend in commodities which is a core driving force in the Brazilian case. But this runs much deeper than Meirelles recent comments. Going back to the last time, before the crisis, many emerging markets and commodity linked economies also squirmed under the pressure of inflows. Of course and undoubtedly much to the chagrin of many central bankers, raising rates to quell the inevitable inflation which comes on the back of hot money inflows only serves to worsen the problem. Thus, and with a number of central banks stuck at near 0 % in nominal interest rate, raising rates only intensifies the pressure. This was abundantly clear in economies such as Brazil, India, New Zealand, Australia, and most importantly in the CEE where many economies actually depegged with respect to the Euro because it was believed that the carry flows would lead to nominal appreciation which would choke off the inflation. The most ardent example of an attempt to halt the carry pressure was of course Thailand where capital controls on inflows were installed, not in order to to stem an outflow as originally described in the literature, but rather to avoid to much money coming in.

The key to understand this process is the nature of global monetary policy and the so-called credit channel. This is one of the reasons why I demand that you read Edward's posts linked above, but you could also go right to the source in the form of a paper by Danish economist Carsten Valgreen as well as my own account of said paper. The point is simply the extent to which economies can loose control over monetary policy and what this means. There is ample evidence I think that in a world where interest rate differentials of the current magnitude represent an inbuilt part of the edifice, there exist notable externalities from monetary policy. One aspect of this is created by the fact that some central banks basically have committed to a prolonged period of quantitative easing and another aspect is created by the fact that as the crisis ripples through, the world will be saddled with more economies than before dependent on exports to grow. These two facts taken together suggest that the pressure on those brave souls out there willing to stand up and run a deficit will also face what I have come to call a "turret ride" since when times are good the inflows may seem excessive only to retreat if the mood turns sour. As noted, following traditional convention hot money inflows can create investment bubbles and inflationary pressures (if you don't have the capacity) and the answer would be to raise rates, but if the low risk environment persists such policy measures will only intensify the pressure. I think that this aspect of the global economy is very important to take aboard.

Into the Light with Wings of Wax?

This may of course be much ado about nothing since in the current environment wreckers of havoc to the carry trade and any other kind of risk prone activity potentially lies around every corner. In this sense I agree with people closer to the market than myself. However, it is still worth paying attention to the way markets and investors are reacting and then to think about the consequences of the joint commitment by the big central banks to keep rates low. Clearly, such commitments are always subject to withdrawal if and when the respective central banks see it fit to suck back the liquidity, but so far that point is far into the horizon. This means that we are about to see just how much capacity there is to absorb the carry flows and where the money ultimately will flow. Some investors will certainly be flying equipped only with similar wings as Icarus while some again will be sporting a set of more durable wings. Whatever the future days and weeks will bring, I for one think it is fascinating to watch.

Europe’s Economic Activity Looks Up (a bit) In May

by Edward Hugh: Barcelona

Well the eurozone outlook is certainly deteriorating less rapidly at this point than it was, at least this is the impression given by the May flash Purchasing Managers Indexes (PMIs) - which show the pace of economic contraction slowing markedly from April. PMI readings for the 16-country euro area rose significantly this month, and hit their highest level for the last eight. It is, however, important to bear in mind that the index still registered contracting economic activity, even if the rate of decline fell for a third consecutive month. Chris Williamson, chief economist at Markit, who compile the indexes, said the latest readings were consistent with second quarter GDP falling about 0.5 per cent quarter on quarter (or by a 2% annual rate), well down from the 2.5% quarter on quarter GDP outcome (or 10% annual rate) in the first three months of the year. That being said, we are still in the realm of contraction, and organisations such as the International Monetary Fund, the European Commission and European Central Bank continue forecast a return to positive growth only in 2010.

In fact, May’s eurozone “composite” index, covering manufacturing and services, stood at 43.9 in May, up from 41.1 in April, the highest since September.

The eurozone economies, especially the export-led German one, showed themselves to be particularly vulnerable to the collapse in global demand after the failure of the Lehman Brothers investment bank. Most hopes for short term recovery are based on the idea that since companies have now substantially reduced inventories they will need to step up production to meet future orders. And this, it is true, will give a short-term uplift to output (which is what we are seeing). But for this short term uplift to translate into a full-blown expansion, the demand for inventory renewal has to provoke an increase in investment to fuel an anticipated future increase in demand, and it is far from clear that we are seeing this at this stage.

We do not have detailed data for Q1 GDP for the eurozone economies yet, so evidence for investment behaviour is scanty, but if we look at the evidence from Japan, investment activity slumped massively in between January and March, and there is no reason why the situation should be very different in Europe. Japanese business investment was down a record 10.4 percent year on year in the first three months, and a massive 35.5% over the last quarter.

On the other hand, eurozone economic activity will continue to come under pressure in the months to come as the impact of the sharp contraction in activity feeds through into the labour market. And companies are likely to keep cutting spending because the decline in external demand has left factories operating well below capacity level, and semi-idle workforces can only be retained for so long. Markit said that the pace of job losses had eased this month – but only slightly compared with the record pace reported in April.

The flash reading only gives details for two of the euro area's big four. The rate of decline in Germany's private sector eased to its slowest in seven months in May, and the composite index rose to 44.4 from 40.1 in April, suggesting the contraction in the second quarter will be much slower than the 3.8% slump (15.2% annualised) in the first. Markit estimated that we may be looking at something like a 0.6 decline (-2.4% annualised). The outcome may be a bit worse than this, but still a significant improvement seem certain.

The German manufacturing PMI index rose to 39.1 from 35.4 in April, while the services sector index rose to 46.0 from 43.8. The manufacturing index was dragged down by major job losses in the sector, and according to Markit "Manufacturing employment in Germany is falling at a far, far faster rate still than services...Manufacturing has really been hammered even though there was some easing in the rate of job losses in May."

The French services PMI was up at 47.6 in May from 46.5 in April, while the manufacturing sector also rose to an above expected level of 43.1 from 40.1.

So it would be very premature to draw the conclusion that we are out of the woods yet. The euro hit 1:40 to the dollar on Friday, and with this level it is hard to see how German exports are going to stage a recovery with currencies like the Swedish Krona and the UK pound down something like 20% over the last year. And remember, with Italy and Spain themselves in deep recessions German companies are now going to have to look well beyond the eurozone to find those much needed customers.

Saturday, May 23, 2009

Don't Get Carried Away Now!

by Edward Hugh: Barcelona

As Paul Krugman recently pointed out, one of the central points they made in the latest IMF World Economic Outlook was that recessions caused by financial crises tend to get resolved on the back of export-lead booms, with countries normally emerging from the crisis with a positive trade balance of over 3 percent of GDP. The reason for this is simple, since consumers are so laden-down with debt from the boom period, they are naturally more obsessed with saving than borrowing during the initial crisis aftermath. So much then for the typical crisis, and the typical exit. But musing on this point lead Krugman to an additional, rather disturbing, conclusion: since the present financial crisis is truly global in its reach, the habitual exit route to recovery will only work after we are able to identify another planet to send all those exports to (shades of Startreck IV). The joke may seem a rather exaggerated one, in poor taste even, but behind it there lies a little bit more than a grain of truth.

But not everywhere is gloom and doom at the moment, and on the other side of the world they woke up reeling from different kind of bounce last Monday morning, on learning that India’s outgoing government had been not only been re-elected, but had been thrust back into power on a much more stable basis. And that was not the only pleasant surprise in store for those reading their morning newspapers in London, Madrid or New York, since India's main stock index - the Sensex - shot up as much as 17% during early trading on receiving the news, while the rupee also surged sharply. So just one more time we find ourselves faced with the prospect of living in a rather divided world, where on one side we have growing and deepening pessimism, while on the other we see a burst of optimism, with someone, somewhere, getting a massive dose of that "let a thousand green shoots bloom" kinda feeling. Perhaps we should ask ourselves whether there is any connection?

Well, and to cut the long story short, yes there is, and the connection has a name, and it's called sentiment. Indeed sentiment is precisely why the recent (and highly controversial) US bank stress tests were so important. Their real significance was not for any relevance they may have from a US banking point of view (which was, of course, highly contested), but for the reassurance they can give market participants that there will not be another financial explosion in the United States (as opposed to a protracted recession, and long slow recovery), or put another way, to show the days of "safe haven" investing are now over. Risk is about to make a comeback, and the only question is where?

Which brings us straight back to all that earlier talk of coupling, recoupling, decoupling, and uncoupling which we saw so much of a year or so ago (or to Decoupling 2.0, as the Economist calls it). And to the world as we knew it before the the demise of Lehmann brothers, where commodity prices were booming like there was no tomorrow on the one hand, while credit- and housing-markets markets were steadily melting down in the developed economies on the other, where growth was being clocked up in many emerging economies at ever accelerating rates, while the only "shoots" we could see on the horizon in the US, Europe and Japan were those of burgeoining recessions.

The point to note here is not just that a significant group of investors and their fund managers spent the better part of 2008 busily adapting their behaviour to changed conditions in the US, Europe and Japan, but rather that a very novel set of conditions began to emerge, as the credit crunch worked its way forward and property markets drifted off into stagnation in one OECD economy after another. Just as they were finally announcing closing time in the gardens of the West almost overnight it started "raining money" in one emerging economy after another - as foreign exchange came flooding in, and the really hard problem for governments and central banks to solve seemed to be not how to attract funding, but rather how to avoid receiving an excess of it. Thailand even attained a certain notoriety by imposing capital controls with the explicit objective of discouraging funds not from leaving but from entering the country.

Then suddenly things moved on, and day became night just as quickly as night had become day as one fund flow after another reversed course, and the money disappeared just as quickly as it had arrived. Behind this second credit crunch lay an ongoing wave of emerging-market central bank tightening (during which Banco Central do Brasil deservedly earned its spurs as the Bundesbank of Latin America) with the consequence that one emerging economy after another began to wilt under the twin strain of stringent monetary policy and sharply rising inflation. Thus the boom "peaked" in July (when oil prices were at their highest), and momentum was already disapearing when the hammer blow was finally dealt by the decision to let Lehman Brothers fall in late September. By November all those previous positive expectations were being sharply revised down, with the IMF making an initial cut in its global growth estimate for 2009 - to 2.2 percent from the 3.7 percent projected for 2008. The World Bank went even further, and by early December was projecting that world trade would fall in 2009 for the first time since 1982, with capital flows to developing countries being expected to plunge by around 50 percent. By March 2009 they were estimating that the volume of world trade, which had grown by 9.8 percent in 2006 and by 6.2 percent in 2007, was even likely to fall by 9 percent this year.

Having said this, and while fully recognising that the future is never an exact rerun of the past - and especially not the most recent past - given that emerging economies have been the key engines of global growth over the last five years, is there any really compelling reason for believing they won't continue to be over the next five? Could we not draw the conclusion that what was "unsustainable" was not the solid trend growth which we were observing between 2002 and 2007, but rather the excess pressure and overheating to which the key EM economies were subjected after the summer of 2007? And if that is the case, might it not be that the "planet" we need to find to do all that much needed exporting to isn't so far away after all, but right here on this earth, and directly under our noses, in the shape of a growing band of successful emerging economies.

According to IMF data, the so called BRIC countries actually accounted for nearly half of global growth in 2008 - China alone accounted for a quarter, and Brazil, India and Russia were responsible for another quarter. All-in-all, the emerging and developing countries combined accounted for about two-thirds of global growth (as measured using PPP adjusted exchange rates) . Furthermore, and most significantly, the IMF notes that these economies “account for more than 90 per cent of the rise in consumption of oil products and metals and 80 per cent of the rise in consumption of grains since 2002”.

But behind the recent emerging market phenomenon what we have is not only a newly emerging growth rate differential, since alongside this there is also alarge scale and ongoing currency re-alignment taking place, a realignment driven, as it happens, by those very same growth rate differentials. The consequential rapid and dramatic rise in dollar GDP values (produced by the combination of strong growth and a declining dollar) has meant that a slow but steady convergence in global living standards - at least in the cases of those economies who have been experiencing the strongest acceleration - has been taking place, and at a much more rapid pace than anyone could possibly have dreamed of back in the 1990s, even if the long term strategic importance of this has been masked by the recent collapse in commodity prices and the downward slide in emerging stocks and currencies associated with the post-Lehman risk appetite hangover. Which is why, yet one more time, that simple issue of sentiment is all important, or using the expession popularised by Keynes "animal spirits".

Carry On Trading

But now we have a new factor entering the scene. The US Federal Reserve, along with many of the world's key central banks, has so reduced interest rates that they are now running only marginally above the zero percent "lower bound", and the Fed is far more concerned with boosting money supply growth to fend of deflation than it is with restraining it to combat inflation. Not only that, Chairman Ben Bernanke looks set to commit the bank to maintain rates at the current level for a considerable period of time.

In this situation, and given the extremely limited rates of annual GDP growth we are likely to see in the US and other advanced economies in the coming years, all that liquidity provision is very likely to exit the first world looking for better yield prospects, and where better to go than to to look for it than those "high yield" emerging market economies.

The Federal Reserve could thus easily find itself in the rather unusual situation of underwriting the nascent recovery in emergent economies like India and Brazil , just as Japan pumped massive liquidity straight into countries like New Zealand and Australia during its experiment with quantitative easing between 2001 and 2006. And the mechanisms through which the money will arrive? Well, they are several, but perhaps the best known and easiest to understand of them is the so called carry trade, which basically works as follows.

Stimulus plans and near-zero interest rates in developed economies boost investor confidence in emerging markets and commodity-rich nations whose interest rates are often in double figures. Using dollars, euros and yen these investors then buy instruments denominated in currencies from countries like India, Brazil, Hungary, Indonesia, South Africa, Turkey, Chile and Peru - which collectively rose around 8% from March 20 to April 10, the biggest three-week gain for such trades since at least 1999 . A straightforward and simple carry-trade transaction would run like this: you borrow U.S. dollars at the three-month London interbank offered rate of (say) 1.13% and use the proceeds to simply buy Brazilian real, leaving the proceeds in a bank to earn Brazil’s three-month deposit rate of 10.51%. That would net anannualized 9.38% - under the assumption that the exchange rate between the two currencies remains stable, but the real, of course, is appreciating against the dollar.

Other options which immediately spring to mind are Turkey, where the key interest rate is currently 9.25 percent, Hungary (9.5 percent) or Russia (12 percent). And the cost of borrowing is steadily falling - overnight euro denominated inter-bank loans hit 0.56 percent last week, down from 3.05 percent six months ago after recent moves by the European Central Bank to cut interest rates and pump liquidity into the banking system. The London interbank offered rate, or Libor, for overnight loans in dollars is thus down to 0.22 percent from 0.4 percent in November. And while the ECB provides the liquidity, the EU Commission and the IMF provide the institutional guarantees which - in the cases of countries like Hungary or Romania - mean that even is such lending is not completely free from default risk, they are at least very well hedged.

Indeed Deustche Bank last week specifically recommended buying Hungarian forint denominated assets, and according to the bank the Russian ruble, the Hungarian forint and the Turkish lira are among the trades which offeri investors the best returns over the next two to three months. Deutsche Bank recommends investors sell the euro against the forint on bets the rate difference will help the Hungarian currency gain around 10 percent over the next three months (rising to 260 from around 285 to the euro when they wrote). Investors should also sell the dollar against the Turkish lira and buy the ruble against the dollar-euro basket, according to their recommendations.

And it isn't only Deutsche Bank who are actively promoting the trade at the moment, at the start of April Goldman Sachs also recommended investors to use euros, dollars and yen to buy Mexican pesos, real, rupiah, rand and Russia rubles. John Normand, head of global currency strategy at JPMorgan, is forecasting a strong surge in long term carry trading as the recovery gains traction. Long trading, he says, is decidedly "underweight" at this point. Long carry trade positions held by Japanese margin traders, betting on gains in the higher-yielding currencies, peaked at $60 billion last July, according to Normand. They were liquidated completely by February, and have subsequently increased to around one third of the previous value (or $20 billion). “Only Japanese margin traders and dedicated currency managers appear to have reinstated longs in carry,” Normand says. “Their exposures are only near long-term averages.”

And Barclays joined the pack this week stating that Brazil’s real, South Africa’s rand and Turkey’s lira offer the “largest upside” for investors returning to the carry trade. A global pickup in investor demand for higher-yielding assets and signs the worst of the global recession is over “bode very well for the comeback of the emerging-market carry trade,” according to analyst Anfrea Kiguel in a recent report from New York. In part as a result of the surge in carry activity the US dollar declined beyond $1.40 against the euro on Friday for the first time since January. Evidently the USD may now be headed down a path which is already well-trodden by the Japanese yen.

India on The Up and Up.

But some of these trades are much riskier than others. Many of the countries in Eastern Europe who currently offer the highest yields are also subject to IMF bailout programmes, so they are with good reason called "risky assets". But others look a lot safer. Take India for example. As Reserve Bank of Indian Governor Duvvuri Subbarao stressed only last week, India’s “modest” dependence on exports will certainly help the economy weather the current global recession and even stage a modest recovery later this year. Of course, "modest" is a relative term, since even during the depths of the crisis India managed to maintain a year on year growth rate of 5.3 percent (Q4 2008), and indeed as Duvvuri stresses, apart from the limited export dependence, India's financial system had virtually no exposure to any kind of "toxic asset".

As mentioned above, the rupee rose 4.9 percent this week to 47.125 per dollar in Mumbai, its biggest weekly advance since March 1996, while the Sensex index rallied 14 percent for its biggest weekly gain since 1992.

And, just to add to the collective joy, even as Indian Prime Minister Manmohan Singh began his second term, and stock markets soared, analysts were busy rubbing their hands with enthusiasm at the prospect that the new government might set a record for selling off state assets, and thus begin to address what everyone is agreed is now India's outsanding challenge: reducing the fiscal deficit.

Singh, it seems, could sell-off anything up to $20 billion of state assets over the next five years as he tries to reduce the central govenment budget shortfall which is currently running at more than double the government target - it reached 6 percent of gross domestic product in the year ended March 31, well beyond the 2.5 percent government target. The prospect of a wider budget gap prompted Standard & Poor’s to say in February that India’s spending plans were “not sustainable” and threaten that the country's credit rating could be cut again if finances worsen. But just by raising 100 billion rupees from share sales and initial public offerings in the current financial year would reduce the fiscal deficit by an estimated quarter-point, at the stroke of a pen, as it were. And there is evidently plenty more to come from this department.

As a result of the changed perception that the new Indian government will now - and especially with the elections and the worst of the global crisis behind it - seriously start to address the fiscal deficit situation, both S&P and Moody’s Investors Service, have busied themselves emphasising just how the outcome gives India's government a chance to improve its fiscal situation. The poll result gives the government more “political space” to sell stakes in state-run companies and improve revenue, according to Moody’s senior analyst Aninda Mitra, while S&P’s director of sovereign ratings Takahira Ogawa commented that the result means “there is a possibility for the government to implement various measures to reform for further expansion of the economy and for the fiscal consolidation.”

So off and up we go, towards that ever so virtuous circle of better credit ratings, lower interest rates, rising currency values, and ever higher headline GDP growth, which of course helps bring down the fiscal deficit, which helps improve the credit rateing outlook, which helps... oh, well, you know.

And it isn't only India which is exciting investors at the moment. Brazil's central bank President Henrique Meirelles went so far as to warn this week against an “excess of euphoria” in the currency market, implicitly suggesting the bank may engage in renewed dollar purchases to try to slow down the latest three-month rally in the real. The central bank began buying dollars on May 8, and Meirelles’s latest are evidently upping the level of verbal intervention. The real has now climbed 20.5 percent since March 2, the biggest advance among the six most-traded currencies in Latin America, as prices on the country’s commodity exports rebounded and investor demand for emerging-market assets has grown. The currency is up 14 percent this year, more than any other of the 16 major currencies except for South Africa’s rand, reversing the 33 percent drop in the last five months of 2008.

Carry Me Home

Despite a number of outsanding worries about the emerging economies in Eastern Europe, the general idea that countries like India, Brazil, Turkey, Chile, Peru etc are firmly at the top of the list of the economies where current growth conditions are generally favorable seems essentially sound. Additionally, if this sort of argument has any validity at all it is bound to have implications for what is sure to be one of the key problems we will face during the next global upturn: what to do with the financial architecture which we have inherited from the original Bretton Woods agreement (or Bretton Woods II as some like to call it).

The limitations of the current financial architecture have become only too apparent during the present recession, since with both the Eurozone and the US economies contracting at the same time, the currency see-saw between the dollar and the euro has failed to provide any adequate form of automatic stabiliser. And since Japan's economy is in an even more parlous state -deep in recession, and desperate for exports - having to live with a yen-dollar parity which is at levels not seen since the mid 1990s can hardly be fun. This has lead some analysts to start to talk of a new and enhanced role for China's currency, the yuan, in any architectural reform we may initiate. But obviously, beyond the yuan we should also be thinking about the real and the rupee. However,I would like to suggest the problem we now face is a much broader one than simply deciding which currencies should be in the central bank reserve basket, and it concerns the central issue of how to conduct monetary policy in an age of global capital flows. During the last boom, comparatively small open economies like Iceland and New Zealand were on this receiving end, but this time round we face the truly daunting prospect of having global giants thrust into the same position, while the USD gets pinned to the floor, just as the Japanese yen was previously.

The problem is evidenty a structural one. The euro hit 1:40 to the USD on Friday (at a time when Europe's economies are in deeper recession than the US one is), while - as I said - the Brazilian central bank President felt the need to come out and warn against an “excess of euphoria” in the local currency market following an 18% rise in the real over 3 months. Officially, the euro surged as a result of news that the US might receive a downgrade on its AAA credit rating, but this justification hardly bears examination, given that around half of the eurozone economies could be in the same situation. Obviously currency traders live in a world where the most important thing is to "best guess" what the guy next to you is liable to do next, and in this sense the rumour could have played its part, but the real underlying reason for the sudden shift in parities is the return in sentiment we have been seeing since early May, and the massive and cheap liquidity which is on offer in New York.

Of course, the impact spreads far beyond Delhi and Rio. Turkey’s lira is also well up - and has now advanced 10 percent over the last three months - while South Africa’s rand is up 22 percent, making it the best performing emerging-market currency during the same period.

All good "carry" punts these, with Turkey’s benchmark interest rate standing at 9.25 percent, and Brazil’s rate of 10.25 percent. Even the ruble is up sharply, just as Russia's economy struggles to handle the rapidly growing loan default rates. The currency climbed to a four-month high against the dollar on Friday, making for its longest run of weekly gains in almost two years, hitting 31.0887 per dollar at one point, its strongest level since Jan. 12. The ruble was up 3.2 percent on the week - closing with its sixth weekly advance and extending its longest rally since September 2007 - and has risen 16 percent since the end of January. Russia's central bank has cut base interest rates twice since April 24 in an attempt to revive the economy, but the refinancing rate is still 12 percent - well above rates in the EU, the U.S., Japan and even quite attractive in comparison with those on offer in other emerging markets. The basic point here is that carry trade players can leverage interest rate differentials and benefit from the changes in currency valuation that these very trades (along with those made by other participants) produce. So all of this is truly win-win for those who play the game, until, that is, it isn't.

Not all of this is preoccupying - far from it, since the issues arising are in many ways related to the problem I started this article with: namely, who it is who will run the trade and current account deficits and do the necessary consuming, to make all those export-lead recoveries (even in China, please note) possible. Evidently the core problem generated during the last business cycle was associated with the size of the imbalances it threw up, and the impact on liquidity and asset prices that these imbalances had. If I am right in the analysis presented here, then we are all on the point of generating a further, and certainly much larger, set of such imbalances as we let the process rip in the uncordinated and unrestrained fashion we are doing. As you set the problem up, so it will fall. Floating Brazil and India is a very attractive and very desireable proposition. Consumers in those countries can certainly take on and sustain more leveraging. The two countries can even to some extent support external deficits as they develop. But they need to do this in a balanced way, an they do not need distortions. The world does not need more Latvias, Estonias, Irelands or Spains (let alone Icelands, and let alone of the size of a Brazil or an India). So policy decisions are now urgently needed to impose measures and structures which help avoid a repeat of the same in what is now a very imminent future. And despite all the talk of reform, very little has been done in practice. Talk of "tax havens" and the like sounds nice, and is attractive to voters, but all this is on the margin of things. What we need is global architectural reform, and policy coordination at the central bank, and bank regulation level, not to stop the capital flows, but to find a more sophistocated way of managing them.

Thursday, May 21, 2009

Japan's Economy Contracts At An Annualised 15.2% In The First Three Months Of 2009

by Edward Hugh: Barcelona

Japan’s economy shrank at a record rate last quarter as exports collapsed and businesses drastically cut back on investment spending. Gross domestic product fell by an annualized 15.2 percent in the three months ended March 31, following a revised fourth- quarter drop of 14.4 percent, according to the Japanese Cabinet Office. The economy contracted 3.5 percent in the year ended March 31, the most since records began in 1955.

Japan's economy is exports dependent, and exports fell by an unprecedented 26 percent during the last quarter, forcing most companies to drastically cut production. In fact industrial output was down 18.1% on the previos quarter and 34.5% year on year.

GDP fell 4 percent on a seasonally adjusted basis, more than double the 1.6 percent drop in the US, and well above Europe’s record 2.5 percent contraction. Due to the impact of deflation, without adjusting for price changes Japan's economy actually shrank 2.9 percent in nominal (current price) terms in the quarter.

Weaker domestic demand was the biggest contributor to the decline, reducing GDP by 2.6 percentage points, the most since 1974. But this was unevenly distributed between consumer demand and investment. Consumer spending held up reasonably well - and only dropped by 1.1 percent (see chart above) while business investment was down a record annual 10.4 percent, and a massive 35.5% over the last quarter. And companies are likely to keep cutting spending because the decline in external demand has left factories operating well below capacity level, and semi idle workforces can only be retained for so long.

“There is a huge problem of over-capacity,” said Hiromichi Shirakawa, chief economist at Credit Suisse Group AG in Tokyo. “That means capital spending is not likely to pick up.”

The slump in housebuilding has also deepened, and home construction was down by 25% quarter on quarter.

Shrinking More Slowly?

A number of reports over the past month suggest that the contraction in what is still the world’s second-largest economy may slow (second derivative decrease) for the first time in a year this quarter) as exports begin to stabilise (albeit at a low level) and Prime Minister Taro Aso’s 15.4 trillion yen stimulus plan, announced in April, has some effect.

The most recent Nomura/JMMA Japan Manufacturing Purchasing Managers Index reading rose to a seasonally adjusted 41.4 in April from 33.8 in March, the steepest gain since data were first compiled in October 2001. However the index remained below the 50 threshold that separates contraction from expansion for the 14th straight month.

The Economy Watchers index, a survey of barbers, taxi drivers and others who deal with consumers, climbed to 28.4 in March from 19.4 in February, the second-biggest jump on record, according to the Japanese Cabinet Office.

Japan’s consumer sentiment alos rose - to a five-month high - in March, and the confidence index climbed to 28.9 from 26.7 in February. The index has now advanced for three consecutive months since after plunging to 26.2 in December, its lowest level since the government began compiling the figures in 1982.

Exports also increased in March from a month earlier, as firms across the globe who had run down stocks started to rebuild them.

Still, the failure of export demand to do more than simply stabilize will probably limit the scope of Japan’s recovery. Toyota, Hitachi, and Panasonic have all recently forecast continued production and job losses in the current business year. Panasonic said only last week it plans to close about 20 factories this year and proceed with the 15,000 job cuts announced in February.

Paul Krugman, speaking as far as I can see at a seminar in Ho Chi Minh city, had the following to say, which I pretty much agree with.

“Just about all of the economic indicators out there are suggesting that the free-fall has come to an end, that we’ve stabilized,”

“Probably the worst in terms of shocks to the system is over.....The acute stress that we had last fall after the failure of Lehman has been reduced,” he said. “Interest-rate spreads on commercial paper are way down, interest-rate spreads on corporate debt are down a little bit. The spread on interbank lending is down....“I don’t think we’ve hit bottom, but the bottom is not too much further below us,” he said. “My big concern is that we don’t hit the bottom and bounce, we hit the bottom and stay there. It’s not obvious where recovery comes from.”

It's like someone hit a very sensitive mechanical device with a large sledgehammer, this sent the device reeling under the impact smashing a lot of the works in the process, and now the shock absorbers have done their work and the vibrations are slowing we will be able to assess the true extent of the damage.

He also seems to be warning the US dollar can experience a "Japan-style carry" effect.

“The U.S. dollar is going to fall quite a lot, or at least significantly,” he said. “The demand for dollars has been temporarily inflated by the crisis. Good news is actually bad news for the dollar. If things stabilize, then the safe-haven demand for dollars falls off.”

So the second derivitive is falling. We should not see more 15.2% annual contractions in Japan, but this does not mean GDP will not keep on falling -for how long? This is the part we still don't know.

Wednesday, May 20, 2009

Is Hungary Set To Become The New Iceland?

by Edward Hugh: Barcelona

Iceland, why on earth Iceland? Well, the issue I have in mind concerns the independence and viability of central bank monetary policy (especially in a small open economy like Hungary's) and the role interest rates, and investor sentiment, and yield differentials, and oh yes, I almost forgot, that notorious vehicle so beloved by investors the "carry trade" in producing a situation where financial dynamics get really out of hand.

In a visionary paper given at the International Conference of Commercial Bank Economists (held in Madrid, July 2007) - entitled The Global Financial Accelerator and the role of International Credit Agencies - the Danish economist Carsten Valgreen argued the following:
The choice major countries have made in the classical trilemma: ie, Free movements of capital and floating exchange rates – has left room for independent monetary policy. But will it continue to be so? This is not as obvious as it may seem. Legally central banks have monopolies on the issuance of money in a territory. However, as international capital flows are freed, as assets are becoming easier to use as collateral for creating new money and as money is inherently intangible, monetary transactions with important implications for the real economy in a territory can increasingly take place beyond the control of the central bank. This implies that central banks are losing control over monetary conditions in a broad sense. The new thing – this paper will argue – is that we are increasingly starting to see the loss of monetary control in economies with stable non-inflationary monetary policies. This is especially the case in small open advanced – or semi-advanced – economies. And it is happening in fixed exchange rate regimes and floating regimes alike.
Interestingly enough, Valgreen chose as his paradigmatic examples of central bank loss of control over monetary policy the cases of Iceland and Latvia. Equally today we could add the name of Hungary to our list. As Valgreen argued (and this remember, before the sub prime blow-out):
It is no accident that the two examples are small open economies with liberalised financial markets. Being small makes the global financial markets matter more. A country such as Iceland will be the first to notice that the agenda for monetary policy has changed, as the current and capital accounts are naturally very large and important for the economy. However, this is more of a reason to study its experiences carefully, as they might show something of what is in store for larger economies over the next decade.
So the issue really is, does the Hungarian National Bank continue to control monetary policy in any meaningful sense, or is it reduced to responding to events elsewhere? And does the Hungarian government have any effective tool left with which to fight this crisis? But getting ahead of ourselves and going too far into all this, let's step back a bit, and take a longer look at the Hungarian economy, just to set the scene.

The IMF and the EU Agree To A Larger Deficit

The International Monetary Fund and the European Union has now approved Hungary's request for a larger budget deficit this year, thus giving the government marginally more room for manoeuvre in the face of the very severe contraction in GDP. The government is now going to be authorised to aim for a 3.9 percent of gross domestic product shortfall, as compared with the earlier 2.9 percent objective, according to Finance Minister Peter Oszko. The government have also revised their forecasts, and expects the Hungarian economy to shrink by 6.7 percent this year, the most since 1991, a revision from the earlier 6 percent forecast. Hungary was the first EU member to arrange a 20 billion IMF-led bailout last year, lining up 20 billion euros in a bid to avert a default after investment and credit to eastern Europe dried up. The country then pledged to keep its budget deficit under control to qualify for the loan.

The question is, is this good news or bad news? Evidently the decision not to strangle the government budget is welcome (we are in danger of a contraction that feed on itself here, since with external demand at very low levels, applying 9.5% interest rates and fiscal tightening means the economy can simply fall into a downward spiral). But in the braoder context the news is not good. The IMF and the EU have cut Hungary some more slack simply because the ferocity of the slump in output is worse then any previously imagined, and things are now going to get worse, not better. Which made it rather strange to read in Bloomberg this morning that Finance Minister Peter Oszko has announced the government is to consider selling foreign-currency denominated bonds this year in order to take advantage of rising investor confidence. We are on very dangerous gound indeed here gentlemen! I mean, whatever happened to once bitten twice shy. According to Bloomberg:
Foreign-currency borrowing, along with slower growth, a wider budget deficit and higher government debt than elsewhere in eastern Europeraised concern about Hungary’s ability to repay its debt lastyear......IMF and EU officials this week approved Hungary’s plan torun a wider budget deficit this year and next than earlier targeted....
So what exactly has changed? According to the latest data growth is now even slower than before (or rather the contraction is sharper), the budget deficit and gross government debt are both pointing up again, and the only (vaguely) "good" news is that living standards are falling so fast that the trade balance is improving, and with it the current account deficit. But the government debt dynamics are not the same as the external trade one, and things are getting worse, not better, which makes you wonder what all the optimisim is about? In their recent stress testing exercise the Hungarian Government Debt Management Agency suggested the debt path was sustainable (see much more below on this), but in order to offer this assurance they assumed an average growth rate of GDP of 3% 2013 - 2020 even in their worst case scenario! . My estimate is a much more sobre one, and that is, with declining and ageing population to think about - the Hungarian ecenomy will be lucky to average 1% growth over the above time horizon (more justification on this below). So as far as I can see Hungary's public debt dynamics are still set on a clearly unsustainable path.

Then you need to take into account how you have a 9.5% central bank benchmark interest rate going into a 6% percent plus GDPcontraction (with inflation around 3%), so what are people thinking about? This policy mix doesn't work, and it won't. If you lower the interest rates to support the economy, the forint crashes, and with it the balance sheet of all those households still holding CHF denominated mortgages in their portfolio. Hungary is clearly caught between the proverbial rock and the hard place.

And what's more, this policy mix is leading to all sorts of distortions. Hence the reference in the title of this post to Iceland, since Iceland's problems precisely got out of hand, due to the "juiciness" of the trade their domestic interest rate yield differential offered. Viz a recent Deustche Bank report which specifically recommended buying HUF denominated assets, due to the yield differential.
Currency deals that profit from the difference in interest rates globally are returning to favor on speculation the worst of the creditcrisis may be over, spurring investors to buy eastern European assets,Deutsche Bank AG said.The Russian ruble, Hungarian forint and Turkish lira offer investorsthe best returns in the next two to three months thanks to the highestrates in the region, said Angus Halkett, a strategist at Deutsche Bankin London.The so-called carry trade, in which investors borrow in currencieswith low interest rates to buy higher-yielding assets, helped theforint and lira surge to record highs last year before the collapse of Lehman Brothers Holdings Inc. prompted investors to sell riskier assets.
Perhaps people should reflect a little more on the significance of those final few words: "before the collapse of Lehman Brothers Holdings Inc. prompted investors to sell riskier assets".

This is what is known as the "carry" trade, and it works like this. Stimulus plans and near-zero interest rates in developed economies boost investor confidence in emerging markets and commodity-rich nations with interest rates which are often in double figures.Using dollars, euros and yen these investors then buy instruments denominated in currencies from countries like Brazil, Hungary,Indonesia, South Africa, New Zealand and Australia which collectively rosee around 8% from March 20 to April 10, the biggest three-week gain since atleast 1999 for such carry trades, according to data compiled by Bloomberg . A straightforward carry-trade transaction would be to borrow U.S. dollars at the three-month London interbank offered rate of 1.13% and use the proceeds to buy Brazilian real and earn Brazil’s three-month deposit rate of 10.51%. That would net anannualized 9.38% - as long as both currencies remain stable, but the real, of course, is appreciating. Now all of this can present a big problem for a number of CEE economies, because:

Turkey’s key interest rate is 9.25 percent, Hungary’s is 9.5 percent and Russia’s 12 percent. The cost of borrowing in euros overnightbetween banks reached 0.56 percent yesterday from 3.05 percent sixmonths ago as the European Central Bank began cutting interest rates and pledges of international aid allayed concern the global slowdownwould worsen. The London interbank offered rate, or Libor, forovernight loans in dollars fell to 0.22 percent from 0.4 percent inNovember as the U.S. government and the Federal Reserve spent, lentorcommitted $12.8 trillion to stem the longest recession since the1930s.

So basically, "Big Ben's" US bailout is fuelling specualtion on Hungarian debt!

And don't miss this point from the Bloomberg article:
Deutsche Bank recommends investors sell the euro against the forint on bets the rate difference will help the Hungarian currency gain 10 percent to 260 per euro in two to three months from 286.55 today. Investors should also sell the dollar against the lira and buy the ruble against the dollar-euro basket, the bank said.
And it isn't only Deutsche Bank, Goldman Sachs recommended on April 3 that investors use euros, dollars and yen to buy Mexican pesos, real, rupiah, rand and Russia rubles.

We can see some of this impact in the German ZEW investor sentiment index. As can be seen, something interesting is happening somewhere, even if it is not immediately evident where. As Solow would have said, "I can see evidence for improved investor sentiment everywhere, except in the real economies".

So, come on everyone, off you go to Monte Carlo, and place your bets. But meanwhile, remember, in Hungary at least, the most notable phenomena are the growing unemployment and the way the bad loans pile up, even as the Hungarian economy tanks! Basically, the all the evidence now points to the fact that IMF and the EU urgently need a rethink about how they are going about things, but this is beyond the scope of the present post.

"Hungarian lenders face an increase in non-performing loans, which will contribute to “substantially deteriorating” profits for the country’s financial system, central bank Vice President Julia Kiraly said. The whole banking system, which is stable with adequate liquidity, may end up with “negative profit” this year and some lenders need to strengthen their capacity to resist shocks, Kiraly said at a conference in Budapest today."

The Fundamentals, All The Fundamentals, And Only The Fundamentals

Horrid GDP Data

The decision to widen the deficit allowance slightly is not that surprising when you take into account that Hungary's gross domestic product dropped by 5.8% year on year in the first quarter of 2009. The figure was announced by the statistics office last Friday and followed a decline of 2.6% in the last three months of 2008.

Quarter on quarter there was a 2.3% GDP decline, (down from 1.5% contraction in the fourth quarter) which means the economy was shrinking at a 9.2 percent annualised rate, quite sharp, but far from being one of the worst cases in the EU. What makes the Hungarian recession rather different is the way it has been lingering in the air since the initial "correction" in 2006, and is now becoming protracted since this was the fourth consecutive quarter when quarter on quarter growth was negative, and it is hardly likely to be the last.

Household consumption is in continuos decline (see retail sales data below), real wages are falling, and the lack of internal and external demand growth means that investment remains weak. Further, this dynamic is not likely to change rapidly. Exports have plunged - even though since imports have slumped even further we have the ironic detail that net trade is still mildly positive for GDP. However, with interest rates at such a high level and fiscal policy being continually tightened there is little chance of a 'V' shaped recovery in Hungary, and the recession has all the hallmarks of becoming an 'L' shaped" one.

Even the agricultural sector due to the high base effect of last years bumper harvest. So basically, it's back and back in time we go at the moment.

Retail Sales In Continuous Decline

Hungarian retail sales fell for the 25th consecutive month in February as rising unemployment falling wages and a generally deepening recession sapped consumer spending. Retail sales were down an annual 3.2 percent following a 2.8 percent decline in January, according to national statistics office data. Prime Minister Gordon Bajnai, who replaced Ferenc Gyurcsany last month as differences over how to handle the recession boiled over, has indicated he plans to raise the value-added tax as the recession cuts into budget revenue. This will surely push sales down even lower, and household consumption is now expected to decline by as much as 8 percent this year, according to the most recent government estimates.

Consumers started finding themselves with less to spend following the introduction of the government austerity programme in 2006 which raised taxes and utility prices.

Unemployment On the Up and Up

Hungary's jobless rate rose to 9.7% in March, up sharply from the 8% level recorded in December. Hungary's unemployment rate has been howevering continuously in the 7%-8% range for more or les 4 years now, so the current spike (with the prospect of more to come) suggests something important has changed. Between Q4 2008 and Q1 2009, unemployment claims rose by 66,000.

Of the country’s 402,800 registered unemployed, 42.5 percent have been out of work for at least a year, now. The number of Hungarians employed averaged 3.76 million in the first quarter, compared with 3.88 million in the previous three months. It is hard to see a resurgence in the number of Hungarian's employed, even after this recession is past and forgotten, since the working age population is falling steadily, and has been for some time now.

Alongside the increase in unemployment the activity rate has declined even more rapidly. Of the 117,000 laid off during the last quarter some 40,000 chose to remain inactive rather than looking for employment elsewhere. Hungary's already languishing job market received a major blow from the global economic crisis in the form of layoffs and bankruptcies, meanwhile, companies may have been more cautious in hiring new staffers. These job market trends were only to be expected, however downsizing is on a higher scale compared with forecasts. Hungary's economy is in a state of deep recession, with predictable consequences for employment, real wages, and demand.

One consequence of the sharpnesss of the recession has been that Hungarian aggregate wages are falling much more rapidly than anticipated, and this, in turn, has put a major dent in the new government's fiscal adjustment plans. The Finance Ministry had originally anticipated an additional HUF 50 billion in tax revenue. However, the new unemployment figures suggest that the decrease in wage costs may surpass the government's most recent 2% forecast. In a worst-case scenario, the drop in aggregate earnings may be as high as 4%, with a HUF 100 billion-HUF 150 billion negative impact on the budget.

Exports Continue To Fall

Hungary posted a foreign trade surplus of EUR 492.8 million in March, the largest in the past decade, according to the Central Statistics Office (KSH). Still exports were down by nearly 20% year on year, and the improved balance was the result of imports falling even more - by over 23%.

In fact Hungary's exports came in at EUR 5,173 million in March - an 18.2% year on year decline, a considerably slower rate of decline than that registered a month ago (-29.7%). Imports came in at EUR 4,680 million , a staggering 23.4% drop, following a plunge of 32.3% in February.

The gap between export and import growth (5.2 percentage points) has not been as wide as this this wide September 2007 (5.9 percentage points). The March balance shows a record high, a surplus of EUR 492.8 million, which compares with a surplus of EUR 213.9 million in March last year. Exports in the first quarter as a whole amounted to EUR 13,843 million, a decline of 26.3% in annual terms. Imports in Q1 amounted to EUR 13,233 million, down 28.5% year on year. Hungary's Q1 foreign trade balance showed a surplus of EUR 609.3 million, another record, which compares with a surplus of EUR 282.1 million for the same period of 2008.

And Industrial Output Slumps

With exports slumping in this way it is not surprising to find that Hungary's industrial production dropped by 19.6% in March, according to working day adjusted data. Over the first quarter Hungarian industrial output declined by 22.3% year on year, but - although it rose 4.3% month on month, according to data adjusted for calender and working day changes.

And activity in Hungary's manufacturing sector continued to contract in April according to the PMI reading, although the pace of contraction is now down slightly from January's all-time low.

The headline manufacturing PMI stood at a seasonally adjusted 40.4 in April, up slightly from the 39.5 registered in March, according to the release from the Hungarian association of logistics. This was the seventh consecutive month of contraction, following the all-time low of 38.5 hit in January. The Hungarian government currently forecasts that GDP will contract by as much as 6% this year as the German economy, Hungary's chief export market, also faces a similar decline in GDP. Hungarian manufacturing output contracted even more in April than in March, to 37.1 from 37.6. The export index showed a further decline to 35.6 from 36.5 in March. The only positive development came from the new orders index which showed a marginal increase to 37.5 from a reading of 35.0 in March.

Only Inflation Rebounds

Hungary’s inflation rate unexpectedly rose in April for the first time in 11 months, after a weaker forint made imports more expensive, with prices of fuel, medicine, clothing and new cars leading the rise. The annual rate was 3.4 percent, rising from 2.9 percent in March to what is its highest level so far this year. Core inflation, which filters out food and energy prices, was 3.2 percent on the year and 0.5 percent on the month. The annual rate had returned to the central bank’s 3 percent target in February for the first time in more than two years.

The prices of consumer durables, including cars, rose 1.4 percent in a month, while fuel costs climbed 2.9 percent and medicines by 1.9 percent. The price of clothing increased 3.7 percent, the statistics office said. With Hungary’s recession damping demand, consumer prices are set to increase “only moderately,” according to the central bank. Policy makers now expect the inflation rate to average 3.7 percent this year and 2.8 percent next year. The bank raised its estimate from an earlier forecast of between 3.1 percent and 3.4 percent for 2009 and 1.5 to 1.9 percent for 2010.

One factor which will influence future inflation is the new government's decision to raise the main value-added tax rate to 25 percent from 20 percent, as of July 1 in an attempt to offset declines in state revenue and narrow the budget gap. Raising the rate of consumption tax is deeply problematic in the sort of double-bind situation which Hungary faces. Germany raised VAT by 3 percentage points on 1st January 2007, and look what happened to consumption (see chart below) in December 2006, and then subsequently. This is doubly relevant to the Hungarian case since the Hungarian economy is more than likely set on the German path of becoming an export dependent economy. Weakening domestic consumption further could well prove to be a "lethal dose".

Magyar Nemzeti Bank policy makers expect the annual inflation rate to be “near” their 3 percent goal “on the monetary policy horizon” of five to eight months, they said on May 8.

“The NBH would clearly like to cut interest rates, which at 9.5% look far to high for an economy that will contract by 5-6% this year, but this is more dependent on global financial stability and declining risk aversion than the latest CPI release." Nigel Rendell, Royal Bank of Canada

And So The NBH Keeps Rates On Hold

Hungarian monetary policy makers left the benchmark interest rate unchanged at their April meeting for a third month as concern over the forint’s decline outweighed the outlook for slowing inflation and growth. The Magyar Nemzeti Bank kept the two-week deposit rate at 9.5 percent.
Policy makers didn’t consider cutting the interest rate in March based on stability concerns (according to the minutes) and even rejected a proposal, backed by Governor Andreas Simor and his two deputies, to raise the key rate to 10.5 percent. In April the rate-setting Monetary Council considered the recession, the outlook for inflation and economic stability when setting the key rate. The annual inflation rate may be near the bank’s 3 percent target on the 18-month monetary policy horizon, according to the statement.

Much Ado About Debt

Zsuzsa Mosolygó and Lajos Deli, of the Hungarian Government Debt Management Agency recently published what they call " a first a simple model to analyze the impact of the international credit line on debt ratio trends as well as to demonstrate the importance of calibrating reasonable values for decisive macroeconomic parameters".

Read stress tests.

Below you will find the chart showing their basic assumptions, and giving the outcomes for the various scenarios. The whole idea of the process was to show that Hungarian debt to GDP will not necessarily rise in the future as some analysts had been predicting. I don't want to go into all of this in too much, but if you click on the chart and take a look at the assmptions for GDP growth (which is actually the key parameter), you will find that on both the basic and the pessimistic scenarios average growth of 3% is assumed (this is impossible to attain on my view), while the "optimistic" scenario even assumes 4% (incredible). Remember these are average growth rates and over seven years (2013 - 2020). This is like selling Spanish property pre 2007 with a splendid photo of the sun and the beach.

And this comes from two apparently serious analysts, analysts who are supposed to be committed to taking a serious stab at putting the country's longer term finances on a stable footing. All they actually acheive is offering a confirmation of the worst fears of those of us who feel that the debt dynamics in Hungary are totally unstable in the mid term, and illustrate just how out of balance most of Eastern Europe now is as we move forward.

They justify their decision in the following way:

Market analysts tend to assume in their debt models a 2% economic growth for the
Hungarian economy. The National Bank of Hungary estimates currently a 2%
potential GDP growth rate, however, it does not mean necessarily the long-term
economic growth. A few years ago the estimates were higher and it seems to be
possible that adequate reforms to encourage employment would result in a 3-4% or
even higher potential GDP growth rate.

(Please Click On Image For Better Viewing)

In fact the objective of the study was not to seriously stress test Hungarian debt dynamics, but to try to argue that those analysts arguing for unsustainable dynamics have it wrong. The end product isn't very convincing. Not surprsingly the debt to GDP ratio diminishes gradually after 2009 both in the “optimistic" and “basic" version. The authors even underline that debt development does not appear to be unsustainable under very pessimistic macroeconomic conditions, either. In the “pessimistic" scenario debt ratio peaks at about 80% in 2020 and descends slowly afterwards (which is due to the assumed 6% interest rates). Of course, "pessimistic" here means Hungarian GDP rising by 3% a year every year from 2013 to 2020. To put this in perspective, using current Hungarian government forecasts average GDP in the ten years up to 2010 is something like 1.8% per annum. And this has been a pretty good decade by Hungarian standards (see chart for long term growth).

In fact, with a declining and ageing workforce, together with decline domestic consumption (see retail sales chart above), even a 1% per annum growth rate may be optimistic. In any event we won't see 3%, and nothing produced by the Hungarian government to date substantiates the claim that longer term debt is NOT on an unsustainable path. "To sleep, perchance to dream-ay, there's the rub."