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Sunday, January 31, 2010

Greek Bailout News (1)

by Edward Hugh: Barcelona

"British or German taxpayers cannot finance the failures of others," German Economy Minister Rainer Bruederle said at the World Economic Forum in Davos, Switzerland, according to the Associated Press. "Solidarity also means everybody adheres to common rules."

France is not working with Germany or other countries on a support package for Greece which is managing to handle its problems on its own, a French government source said on Thursday. "I am not aware of a support plan. There is not a plan. We're not discussing one (with Germany or others)," the source told Reuters. "They are managing themselves. They are finding financing support on the market. There is no plan for a support plan. We are not working on one. Le Monde newspaper said earlier that euro zone countries were studying ways of helping Greece resolve its budget problems."

The above statements have been widely interpreted in the international press as a "no" from Germany and France to any EU bailout of Greece. But is this interpretation justified? Before going further, I think it should be pointed out that the whole argument depends on what you consider a bailout to be. If you take the view that a bailout involves a restructuring of Greek Sovereign Debt, with the EU itself offering to pay a part, then this is clearly not on the cards, at least at this point, and let's take things a day at a time. But if you consider the "bailout" which is under consideration at the present time to be simply a loan, which in some way shape or form (yet to be determined) would be guaranteed by the EU institutionally, and would thus be available at a cheaper rate of interest than the one the markets are currently charging, then it is hard to see how British or German taxpayers would be having to finance anything, except in the unikely event that Greece were unable to repay (as Moody's point out, Greece's problems are longer term, not short term), and remember, even Latvia and Hungary are likely to repay the loans already made to them, and their underlying economic situation (and competitiveness problem) is a lot worse than that of Greece. So basically the German economy minister is making a speech which generates good headlines, and political enthusiasm, but like Jüergen Starks before him, has little real significance in terms of the options which are really on the table.

On the other hand, statements like the following:

European officials on Friday sought to quell rumors of a pending bailout for Greece, insisting that the financially troubled nation could still manage to avoid a debt crisis on its own. The effort to allay market speculation came as investor confidence in Greek bonds fell this week to levels not seen in a decade, amid concern over the government's ability to close its gaping budget deficit and maintain financial stability.

Can simply be seen as officials doing the job they are paid to do, that is talk down the market pressure. Obviously, if the spread on Greek bonds could be talked back down, then there would be no need for anyone else to make a loan, but at this point in time, and especially following the ill fated proposal of Finance Minister Papconstantinou to mount a fund raising roadshow including a visit to China, this possibility looks very unlikely. After all, why should the Chinese banks risk their money buying bonds the German taxpayer is unwilling to buy? As Yu Yongding, a former adviser to the Chinese central bank said, it just isn't interesting to buy a “large chunk” of Greek government debt in order to help rescue the country simply because their securities "are more risky than U.S. Treasuries". “Let European governments and the European Central Bank rescue Greece", he said. Over to you Herr Bruederle.

And despite the fact that Joaquin Almunia strenuously denied in Davos that any kind of plan "B" existed, really they would be fools not to have a plan "B", and the people involved obviously aren't fools, ergo....

A top European Union official said on Friday there was no risk that Greece would default or leave the euro zone and the country's finance minister said he was not aware of any bailout talks. "No, Greece will not default. Please. In the euro area, the default does not exist because with a single currency the possibility to get funding in your own currency is much bigger," Monetary Affairs Commissioner Joaquin Almunia told Bloomberg TV. "There is no bailout problems."

Asked if its problems could force Greece out of the euro zone, Almunia said: "no chance. Because it is crazy to try to solve the problems the Greek economy has outside the euro zone," he said. Almunia said euro zone ministers had prepared fiscal recommendations for Greece and other countries, to be discussed at a regular meeting at European Commission level next week, but denied there was any special EU plan to rescue Greece. "It is a normal analytical document that is written every month," he said. "We have no plan B. Plan A is on the table. It is fiscal adjustment."

EU Commission "Ups the Ante"

So now lets turn to Plan A, and to that normal analytical document Señor Almunia refers to, which is due to be discussed by the Commission on Wednesday. Fortunately, the Greek web portal Ta Enea have seen the document, and Reuters have provided us with a convenient English language version of what they saw. What the Ta Enea report makes clear, is that the reason Greek Prime Minister Papandreou has not asked the EU for a "bailout loan" is connected to the conditions which would be attached to that loan. According to the reports, the EU Commission plan to go a lot further than simply providing short term funding on the cheap:

The European Union will tell Greece next week to take extra measures by May 15 to shore up its finances and cut a spiralling deficit, Greek newspaper Ta Nea said Saturday, citing a draft of the recommendations. The European Commission's recommendations, due to be made public on February 3, include cutting nominal wages in the public sector and setting a ceiling for high pensions, Ta Nea said.

Under the headline "Urgent measures to be taken by 15 May 2010," the EU document will tell Greece to "cut average nominal wages, including in central government, local governments, state agencies and other public institutions." The EU will also urge Greece to introduce advance tax payments for the self-employed and possibly a tax on luxury goods, according to the document, excerpts of which were printed by Ta Nea. Most other recommendations, as reported in the paper, are already part of the Greek plan.

Reports also mention putting a complete freeze on public sector hiring, and a system of monthly reports to the Commission along the lines of the Latvian programme. What this effectively amounts to is enforcing the implementation of an internal devaluation process along the lines of the ones adopted in Ireland and Latvia, as outlined in the most recent technical report to the commission (see here), in order to restore competitiveness to the economy and make Greek debt sustainable in the long run. It also amounts to an effective surrendering of part of Greece's national sovereignty to the EU Commission, and this is the part that virtually everyone is doubtless baulking at.

IMF Waiting On the Sidelines

Obviously, the EU Commission is not the only institution who could furbish the bailout loan, the IMF would serve just as well, and Marek Belka, Director of the IMF's European Office, has already made it very plain they are ready willing and able to help. And only last Friday John Lipsky, the first deputy managing director of the IMF, said the Fund "stands ready" to help Greece with its debt crisis. According to Lipsky's statement, the fund is in "ongoing contact" with the Greek authorities following a "scoping mission" to assess the possibilities.
"The IMF stands ready to support Greece in any way we can," Mr Lipsky said. "It is a matter for the Greek authorities to decide, in collaboration with the European Union, but we are here to help if we are wanted."

In fact, I personally favour the IMF alternative, given the time scale involved, and the likely programme implementation difficulties, and according to Edmund Conway, economics editor of the UK Daily Telegraph, this view is now shared by many "highly respected" economists:

I understand that in many of the conversations Mr Papandreou had [last week in Davos] with very senior, respected economists this week, he was directly advised to go to the IMF, which would be the 'cleanest solution'..... But an IMF intervention would have potentially to be channelled through European authorities, since Greece is a member of the euro.

But the EU Commission seems to have very strong reservations about going for the IMF route, which is why the "bitter pill" of the EU bailout loan may well need to be swallowed. My fear here is that EU reservations may mean that history sadly repeats itself, the first time in Latvia and then in Greece, as queasiness about taking on board the full implications of what is involved in correcting competitiveness distortions leads to policy-making delays and mistakes of the kind which in Latvia have produced a resession which is far deeper and longer than was actually needed, but which in Greece could easily lead to very serious problems for the entire Eurozone further on down the line.

Yet the door is certainly not closed on an IMF solution, and George Papaconstantinou did meet with IMF Managing Director Dominique Strauss-Kahn on Friday on the sidelines of the WEF in Davos. The possibility of IMF intervention was left open by IMF Managing Director Dominique Strauss-Kahn in an interview with broadcaster France 24 this weekend, although he certainly seemed to suggest that EU support was more likely. "We at the IMF are ready to intervene if asked, but that's not necessarily required," Strauss-Kahn said. "The European authorities, both in Brussels and the central bank, are looking at it and I think they'll handle it properly" ...."solidarity" within the countries sharing the euro could "fix the problem,", he said without elaborating.... "It's the first test of this kind for the euro zone,".

Contagion Danger Concentrating Minds

Perhaps the strongest argument to support the idea of imminent EU support is the level of contagion risk being experienced. Concerns that Athens may not be able to service its debt have put growing pressure on the euro, and even if some would welcome this as an aid to German export competitiveness, the attendent credibility issues hardly make the situation a desireable one. There are also growing worries that the Greek debt crisis could spill over to other weak members of the Eurogroup, such as Spain, Portugal, Ireland and Italy. The German daily Sueddeutsche Zeitung last week quoted an EU draft memorandum as saying the situation in Greece was creating a "big challenge and in the long term risky," and could force other euro-zone countries to pay higher risk premiums on their bonds. The spread between Portuguese and German 10-year government debt rose to 120.5 basis points on Friday - up from 114.9 the day before, and the spread on equivalent Spanish bonds is hovering round the 100 basis points mark. Basically, as one European leader after another stresses, it is hardly desireable to let Greece's problems lead other states to have to pay more to finance their borrowing.

Where's The Moral Hazard?

Finally, there has been considerable discussion about the dangers of moral hazard in the Greek case. If the EU offer a bailout loan, this will encourage other countries to seek something similar, so the argument goes.
"Moral hazard considerations suggest that the ECB will never openly support a bailout, but we doubt that Greece will be left on its own if the situation were to become critical," UniCredit analysts said. They referred to the danger that a rescue could reinforce ill-considered fiscal practices that have caused serious problems for Greece and others.

But if we look at the realities of the present situation, then it is clear that what is being offered to Greece in return for a possible loan is clearly not enticing, and indeed it may well be that countries would rather not accept the carrot in order to avoid the stick.

But there are other versions of moral hazard at work here. The FT's Martin Wolf put his finger on one of them:
At the same time, a bail-out by the eurozone as a whole would create a monstrous moral hazard for politicians. It would only be possible if the eurozone subsequently exercised a degree of direct control over the fiscal decisions of member states. It would, in short, be the fastest route to the political union that many initially believed was a necessary condition for success.

Indeed, the very creation of a monetary union in the absence of a political will for unification could be seen as having been the biggest moral hazard risk taken on board, and no matter how many clauses you put in Treaties beforehand, this risk cannot be avoided when push comes to shove.

But there is a third, and more dangerous version of moral hazard in play here, and this arises from the fact that the EU Commission may itself fail to adequately identify and diagnose the roots of the problem, with the result that the correction measures prove to be inadequate, sending Greek debt snowballing off into default. At this point, if the Greek leaders had been simply "following orders", then a more substantive form of bailout would become inevitable, and Herr Bruederle's fears that the German taxpayer may end up having to foot part of the bill would be realised. With this in mind, I really suggest that Commission members and Finance Ministers think very carefully about what they are doing before signing and sealing any definitive agreement with Greece. On the other hand, if the nettle is cleanly grasped, and the necessary changes are introduced both in Greece and in the EU's institutional structure, then maybe the most important and most enduring outcome of the current economic crisis will be a Europe which is more unified and effective than ever it was before.

Friday, January 29, 2010

After Greece, and Portugal, Does Spain Come Next?

by Edward Hugh: Barcelona

Well, the Spanish government are due to announce their 2009 fiscal deficit number this morning, together with their adjustment plan for reducing the annual fiscal deficit to below 3% of GDP by 2013. This rather distasteful news will be presented to the Spanish people later in the same day on which they opened their morning newspapers to discover that they were all going to have to work two years longer - no crisis comes free - since the Labour Minister Celestino Corbacho has announced that the retirement age will be raised from 65 to 67 (in two-month-per-year installments) between now and 2025.

Spanish consumer confidence, as measured by the ICO index has been holding up rasonably well of late.

But if we look at why this is the case by breaking the index down into its components, then we will see the main item doing the work (see chart below) is the expectations component, which is actually showing that the Spanish people are in one of their most optimistic moments since the end of 2004, which is, well frankly, just ridiculous given all the problems which are looming this year (rising taxes, reduced services, frozen wages, mortgage payment increases, falling home values, rising unemployment, etc, etc). So I would be worried about a sharp change in sentiment as reality sinks in, and especially as the sort of news they are getting right now takes its toll on the morale of a people who were being told only yesterday that a substantial recovery was just round the corner.

Podcast With Matthew Bennett

Which brings me to my latest podcast with Matthew Bennett (here).

During the podcast we cover four broad areas: demograhpics and the need for exports to take over from internal demand, internal devaluation and how it will affect Spain, Zapatero and ‘solidarity‘ and the need for a structured immigration plan in Spain. In particuar we talk about the recent controvery surrounding immigrant registration in Vic (Catalonia), about how Spain needs immigrants to safeguard the future of its economy, but that it is also important that there be jobs for immigrants to come to - thus returning the economy to growth, attaining employment growth and carrying through the internal devaluation are all interconnected, and relate to the sustainability of Spain's external debt and pensions system in the longer term. Given this it is important the immigration process in Spain be much more structured in the future, and more in harmony with the requirements with Spain's European agreements under the Lisbon Treaty.

We also talk about how a lot of this debate is rather theoretical at this point, since the migrant flows are currently inverting (and thus following the capital flows with a time lag - see chart below). If current trends continue (and Spain doesn't start to create employment soon) the total number of immigrants in Spain will start to decline. Also, young Spanish people will soon start to leave in greater numbers in search of work elsewhere in Europe, or even farther afield. We are thus left with an additional question: would a smaller workforce manage to pay for pensions and ’solidarity’ after internal devaluation if the population drops?

Current Account Deficit Deteriorates Again In November

Spain's current account deficit stood at EUR 4.67 billion in November compared to EUR 4.15 billion in October, but down from the EUR 8.56 billion deficit of a year ago, according to Bank of Spain data out today.

The goods trade balance showed a deficit of EUR 4.40 billion in November, up from EUR 3.4 billion in October, but narrower than the EUR 5.52 billion deficit a year earlier. On the other hand, the services account logged a surplus of EUR 1.36 billion, down from EUR 2.56 billion in October, and down from EUR 1.69 billion a year ago. Basically, as we can see from the chart below, after closing quite dramatically in the first half of the year, the deficit has been opening up again of late.

The reason for this is not hard to understand, it is due to the increase in government spending and debt, which is stepping in and filling a hole left by private demand.

And this spending has been essentially funded by massive lending to Spanish banks from the ECB.

The reason the money is being spent on imports, and the current account is deteriorating is simple: Spanish domestic suppliers are simply not competitive. As we can see in this comparative Real Exchange Rate chart below - provided by BNP Paribas - current virtual exchange rates suggest Ireland and Spain are operating at a higher effective euro rate than Greece, and even more worryingly, the Greek and Spanish rates are continuing to diverge from the German ones. That is, in these two countries, no correction of the accumulated distortions is taking place.

Spain, Latvia and Greece Affirm Their Commitment To The Eurozone

Sometimes images and gestures speak louder than words, and this photo (see below) from yesterday's Davos session of the leaders of three of Europe’s most economically troubled countries stating that the financial crisis had only solidified their commitment to the euro, as they pledged to make budget cuts and other changes in order to ensure their continued membership (or in Latvia's case their possible entry) tells it all. It is evident that Greece and Spain need to stay in the Eurozone, what is not clear at this stage is how far the leaders of France and Germany are going to go to help them do this. A photo of Sarkozy and Merkel with Jean Claude Trichet might be more convincing at this point.

And again, there is what they actually said. Despite the admission by BBVA President Francisco González earlier in the week that the 325 billion euro zombie developer debt presented a major challenge for the Spanish banking system (and that they needed to now take the bull by the horns - this number is around 30% of Spanish GDP) Mr. Zapatero continued to insist to his Davos audience that Spain's banks were among the healthiest in Europe, resting much of his argument that things in Spain aren't as bad as they seem since Spain’s debt to GDP was still comparatively low given that the budget deficit had been kept well within limits set by EU Treaty before the economic crisis. So what was significant was what he didn't say, rather than what he actually said, like what would happen to Spanish debt levels if a major bank bailout did prove necessary.

He did concede however, that “Spain has to improve productivity” (by the 10% mentioned in the recent report to the EU Commission perhaps?, and if so, over what time period) and that the country needed to make its economy more competitive. The example he gave of how his government plans to achieve this - by investing more in research and development - begins to look thinner and thinner with every passing day, and I would say that by this point it is close to threadbare. No wonder that while he is roundly smiling in the photo above, the other three participants (and especially M Trichet) are looking grim, and rather concered. Unfortunately, I doubt many in Spain will be joining Mr Zapatero in his cheer.

Thursday, January 28, 2010

And It's A Bailout.....

by Edward Hugh: Barcelona

Well, it's not fully official yet, and all the fine print certainly isn't written and signed, but the will is now clearly there, and where there's a will, there's a way, especially when you have the global financial markets breathing down your necks. The first one out of the box was the Economist's Charlemagne, earlier this afternoon.

In Brussels policy circles, the question asked about a bailout of Greece used to be: are European Union governments willing to do this? Now, I can report, the question among top EU officials has changed to: how do we do this?

Twice in the past 48 hours I have heard very senior figures - both speaking on deep background - ponder the political mechanics of how large sums in external aid could be delivered to Greece before it defaults on its debts: a crisis that would have nasty knock-on effects for the 16 countries that share the single currency. One figure said yesterday that heads of government could not wait "forever" to take decision. That means a decision in the next few months, at most.

By sundown the story had gotten a bit more traction, with the FT running an article under the header "EU signals last-resort backing for Greece".

The European Union made clear on Thursday it would not abandon Greece and let Athens’ mounting debt crisis jeopardise the eurozone, even as Germany and France played down suggestions they had already formulated an emergency rescue plan.

“It’s quite clear that economic policies are not just a matter of national concern but European concern,” José Manuel Barroso, European Commission president, told reporters in Brussels. According to high-level EU officials, Greece would in the last resort receive emergency support in an operation involving eurozone governments and the Commission but not the International Monetary Fund.

And by sundown the New York Times were running the story:

France, Germany and other European countries have begun discussing privately how they can come to the aid of fellow euro-zone member Greece, as doubts intensify over the country’s ability to get its budget under control.

Despite public attempts to discourage such expectations, discussions are under way, although the shape or scale of a possible bailout package has yet to be determined, according to officials in several capitals, all speaking on condition of anonymity.

“Greece failing is not an option and lots of people think that we will have to intervene at some stage,” said a euro-zone finance official, who was not permitted to speak publicly because of the sensitivity of the matter. “It doesn’t have to happen, and we hope it won’t, but it would be better than seeing a default.”

Of course, we haven't gotten to the actual bail out yet. Timing will depend very much on what happens in the financial markets over the next few days. The spreads on Greek bonds widened strongly again today - reaching a record 4.1 percentage points over German bunds, while Credit- default swaps on Greece jumped 28 basis points to 402, according to CMA DataVision prices. As the Economist puts it in another piece:

The bond market’s skittishness puts more pressure on the Greek government to come up with a credible plan for fiscal retrenchment. A pledge to follow Ireland’s example in making substantial cuts to public-sector wages may now be necessary to ensure Greece can fund itself at reasonable cost. Having raised €8 billion this week the Greeks probably have enough money to see them through until May, when a chunk of their long-term borrowing falls due. The danger now is that market sentiment spirals out of control. If that happens, only the most radical measures, or a euro-zone bail-out, will turn things around.

The bail-out will now surely come, but first it would be better to have the EU Finance Ministers meeting on February 9 and 10, and the national leaders summit on 11 February. The key now will be to see the conditions imposed, and whether they are realistic enough to bring about a return to economic growth and debt sustainability over a reasonable horizon.

Basically all these reports today only confirm the contents of my January 21 piece - The EU Is Reportedly Exploring Making a Loan To Greece - contents which were based on a report in European Voice, a report which, despite all the denials at the time, now seems to have been accurate. The decision also means that the Commission remains adamant not to let Greece go to the IMF. In this case, I do really hope they know what they are at, since failure in the Greek case would immediately expose Portugal, and more importantly Spain to massive market pressure.

Finally, having started this piece with a quote from Charlemagne, I will close it with another one. This time, though, there is a difference, in that in this extract it he who is citing me, rather than I who am citing him:

The bloggers over at A Fistful of Euros offer a view of the Spiegel leak that puts the report neatly in context:

"there would seem to be an underlying transition going on here, one which in EU terms is quite rapid. The EU’s own analysis of the problems in the Eurozone is coming nearer and nearer to that of both the IMF and the credit rating agencies. We are moving beyond short term fiscal deficit issues, and immediate liquidity issues, towards problems like competitiveness, and what was previously a taboo subject - the issue of Eurozone imbalances"

Rumours, Rumours, But No Greek Bond Sales To China

by Edward Hugh:Barcelona

Well there certainly is a lot happening out there at the moment. And Monday's successful bond sale which left the Greek government triumphally proclaiming they could comfortably meet their 2010 borrowing program now seems to belong to a lifetime ago. The sale raised 8 billion euros over a 5-year syndicated bond which attracted total bids of EUR25 billion, well above the EUR 3 billion to EUR5 billion initially targeted by the government, who immediately declared a major victory.

That was before yesterday, and the Financial Times announcement that Athens was wooing Beijing to buy up to €25bn of government bonds in a deal being negotiated using Goldman Sachs as intermediary. China had not agreed to such a purchase, according to the FT at the time. In the wake of this announcement - as the FT put it - "Greece’s debt crisis returned to financial markets with a vengeance as agitated investors demanded the highest premiums to buy its government bonds since the launch of European monetary union over a decade ago".

In fact, the yield spread between 10-year Greek bonds and benchmark German Bunds widened dramatically, and were up by almost 0.7 percentage points at one stage, as a general panic set in among sellers who were rattled by doubts about Greece’s ability to refinance its debt - or their willingness to make the reforms which would make their debt sustainable in the longer term. If they were so keen to make all the necessary changes, why were they talking to the Chinese, and not the ECB and the EU Commission, who can, of course, easily guarantee funding for such a small quantity of money?

But the biggest impetus to the debacle actually came not from the FT announcement itself, but from the Greek government's clumsy attempts to deny they had asked for help from Goldman Sachs in order to sell government debt to China. In the end Greek 10-year bond yields closed at 6.70 per cent, up 0.48 percentage points up on the day. In fact, the lid was virtually sealed on the Greek fate by statements reported in Bloomberg from Yu Yongding, a former adviser to the Chinese central bank, who is quoted as saying that China shouldn’t buy a “large chunk” of Greek government debt to help rescue the country because their securities "are more risky than U.S. Treasuries". “Let European governments and the European Central Bank rescue Greece", he said. Exactly. This is the point.

The Greek finance ministry reacted by coming out with an attempt to deny that any such negotiations were taking place: "The Finance Ministry categorically denies that there is any deal to sell Greek bonds to China.......The Finance Ministry has not mandated Goldman Sachs to negotiate any deal with China." Fine, but wording here is important. Evidently there is no deal, and Goldman Sachs were given no "mandate" - but that doesn't mean they weren't in Beijing, negotiating on Greece's behalf. In fact, as the FT notes, this issue has a relatively long historyand goes back to at least last autumn:

Greece’s attempt to attract Chinese investors to buy a slice of its sovereign debt took shape last November at a lunch attended by George Papandreou, the prime minister, and Gary Cohn, chief operating officer of Goldman Sachs, the US investment bank. Faced by a soaring budget deficit and record public debt, the newly installed socialist government was eager for ideas about how to finance this year’s €55bn ($77.5bn, £48bn) borrowing requirement, the FT has learnt.

Goldman was keen to promote a Greek bond sale to the Chinese government and the State Administration of Foreign Exchange, which manages the country’s foreign exchange reserves – increasing at a rate of $50bn (€35bn, £31bn) monthly in recent months.

Goldman Sachs has close involvement with the struggling Greek government. The investment bank – along with Deutsche Bank – last month organised the government’s first roadshow to London, led by George Papaconstantinou, the finance minister. It was also one of four foreign banks – the others were Deutsche Bank, Credit Suisse and Morgan Stanley – that arranged Monday’s successful bond offering, along with two Greek banks.

The Greek press has long been rife with speculation about possible Chinese investments in the country, and some of the earliest stories go back to 2008, when Chinese port operator Cosco Pacific signed a 3.4 billion euro deal to run and upgrade facilities at Piraeus Port, which is Greece's biggest, although none of the deals mentioned ever fully materialised, since the Chinese have been unable to operationalise their Piraeus asset following a dockworkers strike last October which lead all concerned to have second thoughts.

This time the rumour mill had it that the Greek government were willing to cede some control over one of their strategic assets - National Bank of Greece - in return for the funding. Analysts in Athens saw the government’s appointment of Vassilis Constantacopoulos, a senior Greek shipowner, as a non-executive director of NBG earlier this month as a signal that a deal with a Chinese investor might be in the offing. Mr Constantacopoulos’s shipping company charters container vessels to China’s Cosco shipping and ports group, and it was he who facilitated the above mentioned €4bn concession for Cosco to operate a container terminal at Piraeus port.

The Greek Prime Minister George Papandreou has vigourously denied all these reports - although again, watch the wording. Speaking at Davos today he said that recent media reports that China would buy up to E25 billion worth of Greek sovereign bonds are "wrong," and that Greece has "not asked for money anywhere else." He added: "We are in a jittery time" in which "rumors can create problems." Greece's Finance Minister George Papaconstantinou also reiterated the same points: "We have not talked to China and no investment bank has a mandate from us to talk to China," he said in an interview with The Wall Street Journal.

But it is strange to here Mr Papconstantinou saying this, since if we go back just to last Tuesday - the day before the current rumpus broke out - Mr Papaconstantinou gave an earlier interview to the Wall Street Journal, but this time the Greek Finance Minister was there to detail a diversified global borrowing plan to plug government fiscal gaps - including, he mentioed, aspirations to raise up to $10 billion from Chinese and other Asian investors.
Papaconstantinou will lead a delegation next month to the U.S. and Asia to market Greek debt valued at at least $1.5 billion to $2 billion denominated in euros, dollars and possibly yen. But Greek officials hope that the bond tour, which will include stops in Beijing, Shanghai and Hong Kong, could bring in five times that amount if Chinese investors are attracted to the deal. "There is a lot of liquidity in China. There are big funds in China. This is why China is going to be part of the road show," he said, adding that if Chinese investors are to get involved the bond size has to be "significant... possibly $5 billion to $10 billion." A person familiar with the situation has told Dow Jones that Greece is trying to place as much as EUR20 billion to EUR25 billion overall with Chinese investors.

Indeed the Greek government have not gone so far as to deny the roadshow ever exitsed, but Reuters today do report that they have backtracked somewhat, since while they had previously announced they were going to stage the roadshow sometime in the near future, the head of the Greek debt agency (PDMA) is now stressing that no date has in fact yet been set: "Finance ministry officials said the roadshow might take place at the end of February or in March, depending on Greece's borrowing plan, which has not been finalised."

Really, this is all a very, very sorry story, and the main issue facing the Greek authorities at this point is one of credibility since, as the Financial Times says: "at the heart of Greece’s problems is a lack of confidence in its trustworthiness". Such confidence has been lost in the course of a decade of "incidents" with the EU Commission and the Eurostat statistics office, and it is just this loss of confidence which the recent handling by the Greek administration of the China bond issue will have done little to restore. Is the Greek government batting with us or against us at this point?

Tuesday, January 26, 2010

The EU Does Have The Legal Power To Organise Bailouts

By Edward Hugh: Barcelona

Sometimes I am surprised by what some people consider to be news. Tony Barber points out today in the FT Brussels blog that the EU has the power to mount bailouts of any member country under "exceptional circumstances". As Tony rightly points out, under Article 122 of the EU’s Lisbon treaty, which came into effect last December, when a member-state is:

"in difficulties or is seriously threatened with severe difficulties caused by natural disasters or exceptional occurrences beyond its control, the Council [of national governments], on a proposal from the Commission, may grant, under certain conditions, Union financial assistance to the member-state concerned.”

So there it is, as he says, "in black and white", whatever the propaganda smokescreen some widely quoted but anonymous "EU Officials" have been mounting for the press in recent days.

What Tony omitted to mention is that Article 122 of the Lisbon Treaty is simply another version of article 119 of the [Foundation] Treaty of the EU (which was presumeably incorporated directly into the Lisbon Treaty. Article 122 stated the following:

Where a Member State is in difficulties or is seriously threatened with difficulties as regards its balance of payments either as a result of an overall disequilibrium in its balance of payments, or as a result of the type of currency at its disposal, and where such difficulties are liable in particular to jeopardise the functioning of the common market or the progressive implementation of the common commercial policy, the Commission shall immediately investigate the position of the State in question and the action which, making use of all the means at its disposal, that State has taken or may take in accordance with the provisions of this Treaty

This was the article cited in justification for the assistance to Latvia and Hungary, and as I pointed out in February last year, give the grounds to justify the issue of EU Bonds (as was in fact done). Now some recent statements of EU Officials point to the fact that help was given to Hungary and Latvia was only given as a result of the fact they were suffering from a "Balance of Payments" crisis, since the crisis those countries (Latvia and Hungary) was described in this way, and that this help would not be available to members of what is now being called the EuroGroup of countries. They say this, correctly, since these countries can't (almost by definition) suffer a Balance of Payments crisis, since the Eurosystem funds trade and current account deficits almost automatically. Precisely, there "danger signal" problems can't arise. But what can arise are funding problems for the government debt which eventually arises in their wake, which is where we are now in the cases of Greece, Ireland, Portugal and Spain.

So we move on to the second line of defence, which is "as a result of the type of currency at its disposal". This wording was no doubt adopted to cover cases of those countries with so called "vulnerable currencies", but when you stop and think about it, it perfectly describes the predicament of those countries, who given the lack of an adequate (red light flashing) warning mechanism on balance of payments and reserves issues, now find themselves in a much deeper problem and with no currency of their own to devalue. The definition fits the case like a glove.

The thing is, as Tony Barber points out:
Article 122 stresses it would be EU national governments, acting on advice from the Commission, that would take the decision to rescue Greece - or Ireland, Portugal and so on. There is nothing in the treaty requiring the ECB to state its opinion one way or the other. So, on this question, it is important to listen to eurozone political leaders, above all Chancellor Angela Merkel of Germany and President Nicolas Sarkozy of France, as well as Commission president José Manuel Barroso.

So look tot he statements of national leaders and EU Commission Officials for road maps on how this particular topic will develop.

The ECB Is Here To Help

But there is another area we need to think about, and that is liquidity provision. Here the ECB can be of enormous help. Basically, as I outlined in my Debt Snowball post, the critical debt to GDP ratio depends on two factors: growth in nominal GDP and the interest rate spread on government bonds. Now, EU Bonds (or whatever) can help with nominal GDP, since they can be used for fiscal support, and to provide domestic demand to an economy during the correction, but the ECB liquidity provision to the banks can also help to keep spreads under control, and thus reduce the cost of borrowing for national governments.

If we are all Europeans, and all in this together, isn't this what our leaders should be doing - for those countries willing to make sacrifices and trying to put their house in order - providing fiscal and demand support via the powers of the Commission, and liquidity support via the spreads. Is this not what M. Trichet meant when he said "we are here to help" - it would be a strange form of Union wheree the main collective institutions were working against the interests of the individual members.

Surely it is this sense that we should read yesterday's statement by ECB council member Axel Weber (one of the leading pretenders to M Trichet's thrown) that the bank will discuss reverting to long-term refinancing auctions after March,according to a report in the German newspaper Boersen-Zeitung.
After the end of the first quarter, “we will talk about returning to the auction process in the refinancing operations with longer maturities,” Weber said, according to the newspaper.

This makes perfect sense, as any other approach would be near suicidal, given the difficulties we are now all facing. Flexibility is the word.

And it is in this sense we should be looking at another piece of news that has generated considerable interest today. According to reports, investors placed about €20bn in orders for the new Greek five-year, fixed-rate bond - four times more than the government had reckoned on offering. A sign of success? Hardly, since if you look at the interest spread they needed to offer, it is clear that Greece is being made to pay dearly for all those years of fiscal profligacy, with the bond carring a record high interest rate spread relative to the rate for German bonds, the eurozone’s benchmark. The terms were described by Bloomberg as "generous".

Greece sold 8 billion euros ($11.3 billion) of bonds at premium yields to ensure the country’s first debt issue since being downgraded was a success. The five-year securities yield 6.2 percent, the Greek ministry of finance said late yesterday in an e-mailed statement. The ministry said it received 25 billion euros in orders, after offering 0.3 percentage point more yield than on the nation’s existing debt with similar maturities. The new bonds yield 3.5 percentage points more than the benchmark mid-swap rate, after being first offered at 3.75 percentage points. That compares with 3.2 percentage points on Greece’s 3.7 percent notes due July 2015, according to ING Groep NV prices on Bloomberg. The yield on Greece’s existing five-year bonds declined 7 basis points yesterday to 5.88 percent. That narrowed the difference with comparable German debt, the European benchmark, to 358 basis points, from 365 basis points last week, the widest since Greece joined the euro in 2001.

“It showed we have the ability to raise funds that we need,” according to Spyros Papanicolaou, head of the Greek debt agency. “We expect the spread to start to tighten after the sale, because Greece has been misread and misjudged.”

But Mr Papanicolaou needs to read the Credit Rating Reports (and paricularly Moodys) more carefully (or alternately he could read my blog). In fact Moodys (who stand apart from the other agencies on this one) argued only last month that investors' fears that the Greek government may be exposed to a liquidity crisis in the short term are totally misplaced. As they said in their press release "the risk that the Greek government cannot roll over its existing debt or finance its deficit over the next few years is not materially different from that faced by several other euro area member states". And they took this view since it is obvious, as a member state of the EuroGroup they can receive liquidity via the ECB (one of the strongest liquidity providers in the world), and if they implement an EU Commission approved correction programme, then the ECB is obliged to help them. It makes no sense at all, for any of us, to make this correction process more difficult.

And Spain Will Need All the Help It Can Get, From Both The EU Commission and the ECB

Now finally, one piece of news few seem interested in. Santos Gonzalez, President of AHE (Spain’s Mortgage Association) has come out today and warned that Spain's banks do not have the financial capacity to assume the outstanding debt of property developers, which amounts to around 325 billion Euros, This he says "gravely endangers the viability of the Spanish property sector as well as Spain’s financial industry".

The problem is growing, according to Gonzalez, since the need to refinance 15,000 million euros worth of interest payments annually against assets which are continuously losing value becomes insustainable. The numbers are not so much what matters here as the growing number of people who are coming out and talking publicly about the problem.

As Mark Stucklin editor of Spain Property Insight says, "You can see how bad the situation is just driving down the Spanish coast. Vast quantities of capital have been sunk into unsold developments and abandoned building sites, the result of deranged lending during the boom. Debts have will have to be written down further to get the market going again. The longer it takes the more painful it will be. Spain needs to grab the bull by the horns".

Unfortunately the links are in Spanish, but the gist of the problem is that the number mentioned is around 30% of Spanish GDP, and if the government have to mount a bailout of this order (as I have long been arguing they will need to, and this is only for the developers) then Spanish sovereign spreads are going bo be in for a very bumpy ride. Maybe English language journalists should broaden their horizons a little.

Eurozone Imbalances Weaken Trust in The Euro and Undermine Euro Area Cohesion

by Edward Hugh: Barcelona

This is the conclusion drawn - rather surprisingly - not by some bank analyst, or by a Credit Ratings Agency, but by the European Commission itself, according to the contents of a report "leaked" to the German magazine Der Spiegel at the end of last week. "(The imbalances) weaken trust in the euro and endanger the cohesion of the monetary union,".

Here is a rough translation of the Der Spiegel report:
The EU Commission Sees Monetary Union At Risk

The EU Commission is concerned about the survival of monetary union. The differences in competitiveness between member countries and the resulting imbalances give "cause for serious concern for the eurozone as a whole", according to a presentation given by the Directorate General for Economy and Finance to the finance ministers of the Eurogroup.

The experts who advise the Finnish Commissioner-designate Olli Rehn fear that the differential development of the economies in the various Member States undermine confidence in the euro and may ultimately threaten the cohesiveness of the monetary union. Of particular concern to the Brussels officials is the economic condition of those countries who in the past ran huge deficits in their current account balances, because they lived for many years thanks to ample credit which was avaialable due to the low interest rates prevailing. Now these countries are suffering, especially Spain, Greece and Ireland, under the weight of escalating government deficits. "The combination of declining competitiveness and excessive accumulation of public debt worrying in this context," the experts say.

As a way out of trouble, the EU officials first propose that the countries concerned put their own houses in order and introduce the necessary reforms. Wage levels need to be set with due consideration to falling productivity and the loss of competitiveness. In plain language: workers ambitions should be modest, with low wage settlements. "The adjustment will be accompanied by a marked increase in unemployment."

The Commission officials also recommend that the deficit countries employ a strategy which was used by Germany in its recent efforts to exit from many years of weak growth. At the same time the German federal government does not escape criticism in the report, since Germany and other relatively successful countries such as Austria and the Netherlands need to tackle the chronic weakness in their domestic demand.

To achieve this the Brussels experts recommend enabling more competition in the services sector, the intriduction of tax reforms and the elimination of credit hurdles. The longer the countries concerned delay introducing the necessary measures, the higher the social costs which will be incurred. The Commission believes the euro countries have no choice: "These adjustments are vital for the long-term functioning of monetary union."

As far as can be seen from this Spiegel report, while it is the case that some of the wording used is similar to things we have seen before, there would seem to be an underlying transition going on here, one which in EU terms is quite rapid. The EU's own analysis of the problems in the Eurozone is coming nearer and nearer to that of both the IMF and the credit rating agencies. We are moving beyond short term fiscal deficit issues, and immediate liquidity issues, towards problems like competitiveness, and what was previously a taboo subject - the issue of Eurozone imbalances. These were, in fact, supposed to disappear with the passage of time, so it was expected that they would have diminished rather than increased. In that sense there is now an implicit admission that the institutional environment in which the common currency has been operated was severely deficient and badly needs to be improved. In my view this change in approach is already a big improvement, as is the fact that people are begining to face up to the reality that the Euro has exacerbated the imbalances, rather than reducing them.

In particular the Commission seem to be starting recognising that countries like Spain whose main export became pieces of paper (or IOUs on their future) which were securitised against assets which we can now see didn't have the value they were thought to have (the housing stock, or should I say glut) entered a dynamic which was seriously unstable. Now we need to see the measures which can be applied for correcting these distortions.

Juergen Stark, member of the Executive Council of the ECB was out with another interview more or less along the same lines on Saturday:
Stark told the Welt am Sonntag newspaper that Greece, which is battling to get its budget under control, must make comprehensive consolidation a priority but also reform its economy to stop producing deficits. "Countries like Greece must not only bring their deficits under control, but also enact a fundamental reorientation of their economic policy," Stark said. "Some countries have even managed to accept falling wages -- there is no alternative for economies in a difficult situation," he added in the interview, which had been held on Thursday.

The reference in the Spiegel report to the earlier German expience is to the earlier "internal devaluation" Germany carried out between 2001 and 2005 in an attempt to restore competitiveness after having entered the common currency at an exchange rate which was later discovered to have been too high. The thing is, the German devaluation was quite limited and quite slow. Greece and Spain have large devaluations to carry out, and the time scale is likely to need to be short, since it is urgentto restore growth to these economies to avoid the debt to GDP percentages snowballing upwards.

Another aspect to this whole problem is the new emphasis on correcting the imbalances as a shared process, one which, as Mr Zapatero would have it, involves "solidarity", and joint responsibility. That is to say the surplus countries are going to be expected to play their part: no wonder the German economy minister became so angry with Mr Zapatero's 2020 strategy initiative.

Of course, it is not really posible to present the problem in quite this way, since one set of economies are competitive, and another set are not, so it is hard for the Greeks and the Spanish to really blame the Germans and the Dutch for their present situation, although everyone, both centre and periphery, will have to play a part in the search for solutions. I tend to put it this way: the South must make sacrifices, and then the centre must help. Thus talk of no "financial bailout being possible", or, as M Trichet would have it, simply stating that the "external surpluses of some member countries (in the balance of payments) finance the external deficits of some others" without recognising that the presence of these very same surpluses form a problematic part of the internal Eurozone imbalances is hardly helpful at this point.

As Martin Wolf said recently:
What people do not seem to understand is that peripheral European countries cannot escape from their trap because they are caught in a game of competitive deflation with Germany (and the Netherlands). So long as the eurozone has an external balance (roughly) and Germany has a vast surplus, the rest of the zone MUST be running aggregate deficits. That is a subtraction from their domestic demand. This then means that either the private sector runs deficits (spends more than its income) or the public sector does. If the latter is pushed towards balance, by eurozone pressure, GDP must contract enough to force the private sector finally back into deficit and so towards bankruptcy. Ultimately, the only way out of the trap is for nominal wages and costs in peripheral Europe to fall so much that it forces core Europe into depression . That also means a depression in peripheral Europe. No advanced polity can cope with a permanent depression. Anything can then happen. I have always feared that the euro could break the EU. I believe this is quite possible.

"Alternatively, demand must start to rise substantially in core Europe. Is that possible? The other alternative would be for the eurozone as a whole to move into surplus - but how, given the weakness of external demand and the strong euro?"

No easy answers yet awhile, but lots of interesting problems to talk about, and plenty of food for thought.

Sunday, January 24, 2010

Chile votes for the (center-)right

by Manuel Alvarez-Rivera, Puerto Rico

Back in October 2008, I noted on Chile's democratic restoration, two decades on that "President [Michelle] Bachelet is constitutionally barred from running for re-election in 2009, and opinion polls have her 2006 runoff rival, Sebastián Piñera of National Renewal as the early favorite." Well, fifteen months later this has come to pass: in a closely fought runoff presidential election last January 17, billionaire businessman Sebastián Piñera of the right-of-center Coalición por el Cambio (Coalition for Change; formerly the Alianza por Chile or Alliance for Chile) narrowly prevailed over former president Eduardo Frei-Ruiz Tagle, the candidate of the ruling, center-left Concertación alliance.

Having emerged well ahead of Frei - but short of an absolute majority - in a first round of voting last December 13, Piñera was generally expected to prevail in the runoff vote, although opinion polls accurately forecast a tightening race. While the Communist Party-led Juntos Podemos Más (Together We Can Do More) alliance - which came in fourth place in the first round - quickly endorsed Frei, the Concertación eagerly sought a clear endorsement from deputy Marco Enríquez-Ominami, an erstwhile Socialist who ran as an independent in the first round, coming in a strong third place with twenty percent of the vote.

However, in the end Enríquez-Ominami - popularly known by his initials ME-O - only gave Frei a half-hearted, personal endorsement in which he didn't even mention the latter by name. Consequently, Piñera remained ahead of Frei all the way to runoff day, when he prevailed with 51.6% of the vote to Frei's 48.4%, largely by winning over many first round ME-O voters who wanted change after two decades of back-to-back Concertación governments.

Piñera's triumph is the first by a center-right presidential candidate in Chile since 1958. It constitutes a heavy blow to the Concertación parties, which will be out of office for the first time in two decades, and could conceivably part ways in the not-too-distant future. It is also significant because during the course of the past two decades Chilean voters had repeatedly rejected right-wing parties at the polls, as these had strongly supported Gen. Augusto Pinochet's 1973-90 dictatorial regime. However, Piñera - who stood behind the "No" option in the 1988 referendum on the extension of Pinochet's mandate for a further nine years - ran successfully as a moderate.

In addition, the Concertación lost its majority in the Chamber of Deputies for the first time since 1989: the Coalición won the largest number of seats, even though the Concertación (running in a joint ticket with Juntos Podemos Más) narrowly outpolled the Coalición and won the most votes in 35 of the 60 two-member Chamber districts (to 24 for the Coalición).

This peculiar outcome was due to the fact that unlike in past elections, the Concertación failed to secure majorities of two-to-one (or more) to win both seats in any district, whereas the Coalición prevailed by more than two-to-one in one district - Santiago's upscale District 23 (Las Condes-Vitacura-Lo Barnechea). Thus, the Coalición won 23 first-place seats, both seats in District 23, and 33 second-place seats, for a total of 58 seats, while the Concertación had 35 first-place seats in as many districts, plus 22 seats in twenty-three districts where it came in second place (the exception being District 23) for a total of 57 seats (including three Communist deputies, the first elected under the party ticket since 1973); the remaining five seats went to independents and regionalist independents.

Meanwhile, the election in nine of the Senate's nineteen two-member constituencies brought no changes to the composition of the upper house, with the Concertación and the Coalición winning nine seats apiece - exactly the same result as in the preceding 2001 Senate poll in these constituencies. Presidential and Legislative Elections in Chile has detailed results of Chile's recent election, along with election results since 1989.

Given that neither the Concertación nor the Coalición will have an overall majority in the Senate or the Chamber of Deputies, it shouldn't be surprising that Piñera has suggested a government of national unity; indeed, he may try to attract centrist Concertación supporters - mainly from Frei's Christian Democratic Party (PDC) as well as the smaller Social Democratic Radical Party (PRSD). From a historical perspective, it would not be at all unprecedented: PDC has joined forces with the right in the past, most notably during the presidency of Salvador Allende, to oppose his left-wing Popular Unity government. Thus, the Christian Democrats may go the way of Chile's old middle-of-the-road Radical Party - the predecessor of PRSD - which emerged as the kingmaker of Chilean politics during the early-to-mid-20th century by alternately forming alliances with the right and the left.

Moreover, President-elect Piñera's National Renewal (RN) holds far fewer seats in the Chamber of Deputies than its coalition partner, the Independent Democratic Union (UDI), which stands to the right of RN. From that perspective, seeking centrist support from PDC and PRSD (which appears set to jump ship) may be a way to not only attain a clear legislative majority, but perhaps to secure a counterweight to the right-wing UDI as well. That said, the old Radical Party's repeated change of allegiances eventually led to a damaging split from which it never recovered (its right wing broke away when the party backed Salvador Allende in 1970); PRSD is a shadow of its former self, and its much diminished political presence nowadays should serve as a cautionary tale for the Christian Democrats.

The recent general election in Chile is already notable for having introduced the first alternation in power between center-right and center-left alliances since the restoration of democratic governance, a development that until now had been conspicuously absent from post-Pinochet Chilean party politics. It remains to be seen if Chile's turn to the right will also pave the way for a major realignment of political forces in the South American country.

Friday, January 22, 2010

A Detailed Look at Savings in Japan

By Claus Vistesen: Copenhagen

In short, if the world economy is to get through this crisis in reasonable shape, credit worthy surplus countries must expand domestic demand relative to potential output. How they achieve this outcome is up to them. But only in this way can the deficit countries realistically hope to avoid spending themselves into bankruptcy.

Martin Wolf (2008)

It is not the first time that I am using this quote by the FT's chief economics commentator and I don't suspect that it will be the last. Of all the attempts by pundits and analysts to pinpoint the crux of the current crisis the observation above is the most important aspect in my opinion and I have argued as such several times (see also Rogoff and Obstfeld (2009) and Baldwin and Daria (2009)). However, I disagree with Mr. Wolf in one critical aspect. Specifically, I don't think that this is simply a question of it being up to them, as it were, in terms of how export dependent/oriented economies may succeed in pushing their growth path onto one increasingly driven by domestic demand. In this way, I believe that the export dependency of Germany and Japan (and a whole batch of economies which will now join them) are ultimately rooted in their demographic profiles where decades of below replacement fertility and rising life expectancy have now condemned them to an economic structure where the growth generated by domestic demand is virtually zero leaving external demand as the only meaningful way to create growth.

This does not mean that the combined external surpluses of these economies do not represent an important and potentially negative externality to the global economic system, but it does crucially mean that we cannot expect Japan, Germany et al to simply revert, through e.g. structural reforms, to a growth path driven by domestic demand that would allow them to suck up excess global capacity through an external deficit.

In order to focus the attention in this ongoing debate I will home in on Japan and concretely, a recent piece in which Martin Wolf actually fleshes out a specific way in which Japan would potentially be able to raise domestic demand to benefit of herself and the global economy. Martin Wolf's piece is worth pondering in its entirety, but in this context I am going to focus on the notion of high corporate savings and whether its release from corporate balance sheets holds the potential for spurring domestic demand in Japan.

My own view is that the underlying structural problem has been the combination of excessive corporate savings (retained earnings) and diminished investment opportunities, once catch-up growth was over. As Andrew Smithers of London-based Smithers & Co notes, Japan’s private non-residential fixed investment was 20 per cent of GDP in 1990, close to double the US share. This has fallen to 13 per cent after a modest resurgence in the 2000s. But no comparable decline has occurred in corporate retained earnings. In the 1980s, the challenge of absorbing these savings was met by monetary policy, which drove the cost of borrowing to zero and sustained wasteful investment. In the 2000s, the challenge was met by an export and investment boom, driven largely by trade with China (see chart).


Japan’s aim now must be to achieve domestically driven growth. The most important requirement is a big reduction in corporate saving. Mr Smithers argues that this will happen naturally, since savings are largely capital consumption, itself the product of the history of excessive investment. I would add that if ever an economy needed a market in corporate control, to shift cash out of the hands of sleepy managements, Japan is it. Not being beholden to Japan’s corporate establishment, the new government should adopt policies that would change corporate behaviour, at last.

What follows is my take on this argument seen through the lens of a detailed look at the savings behavior of households and corporates in Japan.

Household Savings - (Dis)saving in Japan?

Standard life cycle theory states that consumers run down their assets into old age (dissave) and thus that a rapidly ageing society at some point should move into a state of perpetual dissaving with the consequence in an open economy context being an external deficit (eventually). However, both in theory and in practice this is not so simple and Japan is a good example here. In this way and while the household savings rate (out of labour income) has indeed plummeted in Japan, the economy still has a large and persistent external surplus. Since we know that the government is mired in both current and future debt this has, by definition, to reflect a high level of corporate savings. Thus and with a low savings rate in the household sector the reduction in corporate savings holds perhaps the biggest potential for releasing domestic demand in Japan or so at least is the crux of Martin Wolf' argument as I see it [1].

Most analyses on household saving rates in Japan do not move beyond the representation above which plots net savings as a share of net income. And indeed, this paints an unequivocal picture. The quarterly figure is highly volatile and subject to notable seasonality, but smoothed through a 12 quarter moving average shows us that since 2000 the savings rate of Japanese households have not exceeded 5%. More interestingly is of course is relentless downward trend which shows, more than anything, that the real economic conditions for Japanese households have changed significantly. This perspective which looks at the flow of savings is strongly underpinned by many empirical studies on the savings behavior of Japanese households. The most recent study is Horioka (2009) who presents a timely overview of the literature on the dissaving of the eldery in Japan. The evidence strongly suggests that Japanese consumers dissave into old age and as Mr Horioka ends his article, this is likely to have important ramifications on global imbalances assuming, I guess, that as Japanese consumers steadily move into a state of negative saving the economy will move into a current account deficit. I assume further that this is what Martin Wolf expect would happen if corporate savings were released to the benefit of Japanese households since otherwise Japan would not do much to correct global imbalances.

Now, I cannot refute the amount of evidence presented by Horioka and thus the conclusion in the main. What I can do however is to respectfully take Mr. Horioka to task on the definition of savings and thus what is defined here as dissavings. In this way, Horioka notes that the main source of dissaving by elderly take the form of declining social security benefits, increase in taxes and social insurance premiums, and increasing consumption expenditures. Let us quickly dispense with the last one and agree that Japan has not experienced any meaningful consumption boom in a long time which suggest that dissaving is not likely to take the form of a surge in consumption in any meaningful way (I don't suspect this is what Horioka wants to argue, but it is important for me to point this out).

Since 1997 the growth rate in GDP and private consumption expenditures have languished at a depressing mean reverting trend around the zero percentage annual growth mark. This indicates quite clearly that whatever the extent to which ageing households in Japan have dissaved through increasing consumption expenditures it has not been any meaningful driving force of consumption.

But what about the other two (increase in taxes and social insurance premiums). Are these really dissaving? I don't think so. Rather, these represent a transfer of saving from households to the government and thus an attempt by part of the government to reduce the future cost of age related liabilities and thus to compensate for a strongly negative net asset position by part of the government both in a current but more importantly, in a future perspective. In an ageing economy this is exactly why we would expect the dissaving hypothesis to be in need of significant adjustment since there will be forced savings through the inevitable attempt by the government to stabilize the deteriorating fiscal situation.

As such, the representation above does not paint an adequate picture of household savings in Japan and while this initially may be explained in light of the fact that we should look at the savings of the entire Japananese consumer base and not only the elderly (retired) consumers the rapid and ongoing process of ageing in Japan means that these two argument will inevitably converge over time, a point Horioka (2009) also makes.

Specifically, the account of dissaving above fail to take into account, at least, two important missing links. The first is the simple fact that the rate of savings out of total income is closely related to the annual growth in income which, in Japan's case, has exactly declined significantly in the same period in part because of the deflationary environment but also, I would argue, to reflect the changing productivity structure of the Japanese labour market with an ageing work force.

Between 1998 and 2005 the change in the annual income flow to Japanese households was persistently negative and suddenly; a consistent savings rate in the same period of about 3-5% does not exactly come off as rapid dissaving. In fact, at no point in the graph above has the savings rate been below the annual growth in income which provides a very important qualifying perspective to the idea that the release of corporate savings either as a lump sum transfer or through a steady trickle of dividends would immediately be channeled into discretionary spending. I find this very difficult to believe, but in effect this will be subject to easy falsification if and when corporate savings in Japan became an important policy variable in terms of stimulating domestic demand.

The second missing link relates to the idea that savings may be defined in two overall ways, the first which is a flow perspective is described above and the second is a stock perspective. The best example of the latter is the asset meltdown hypothesis that envisions a sharp decline in asset prices as aged households grind down their stock of assets by selling them to a smaller and shrinking base of working age households who will not be numerous or wealthy enough to support asset prices at the given level.

In the context of Japan, I have argued before how there is no meaningful destocking of assets even if the growth of households' total assets have stalled significantly.

Despite the obvious drawback of only having data from 1997 and onwards the picture is quite clear. Between 1997 and 2009 the overall household balance sheet in Japan has remained pretty "stable" rising from trn 1285 JPY in 1997 to about trn 1440 in 2009 JPY (current prices). I choose to put stable in quotations mark here since the real thing to notice is the lack of expansion (i.e. debt driven asset expansions) by part of Japanese households to reflect the fact that there was no housing bubble let alone any other kind of bubble in Japan in the period in question. The main point is of course that despite a continuing decline in the rate of savings from a flow perspective, Japanese households are not (yet!) engaged in any meaningful de-stocking towards what ever end point the economy would reach if ageing households and indeed the society as a whole began to run down its stock of savings.

In terms of composition, we find evidence of the often cited fact that Japanse households are quite risk averse Nakagawa and Shimizu (2000) holding between 50% and 55% of their total assets in either deposits or currency. In comparison, and while direct holdings of shares and investment trusts have indeed risen over the period, this entry still makes up only about 11% of the total balance sheet in 2009. Naturally, there is some cyclical effect here as the total share (value) of risky assets held directly in portfolio of Japanse households peaked in the years 2005 to 2007 at about 16-17%. Moreover, it is safe to conclude that if we include indirect holdings of risky assets through pension and insurance holdings, the picture becomes more balanced.

Looking at direct evidence of dissaving, we find none in the aggregate. Over the period in question the stock value of time, savings, and transferable deposits have gone up by 11% (i.e. a net addition of savings by the Japanese household) from some bn 665 JPY in 1997 to bn 742 JPY in 2009. Moreover, it is remarkable to see that the amount of currency held by Japanese households have increased by 40% in the same period. This suggests, more than anything, the risk aversion of Japanese households. Finally, I think it is worth to mention that although the amount of bonds held directly by Japanese households is next to none, Japanese households are naturally doing a substantial part of the heavy lifting in terms of financing the ongoing and almost perpetual deficit spending by part of Japan's governments. In this way, the large bulk of deposits as well as insurance and pension funds are very likely to be substantially invested (de-facto) in Japanese government bonds.

As an interim conclusion ans while a first glance suggests that Japan indeed is dissaving through its household sector it is an argument which does not hold entirely up to scrutiny. It is important for me to emphasize two things. Firstly, I don't dispute the analysis in Horioka (2009) and thus the wide range of previous studies that have shown how the life cycle model of savings is well calibrated to a Japanese context. However, I do think it is important to differentiate it with the points above and particularly the notion that Japanese households, as a whole, do not seem to be rapidly dissaving to the extent that many claim. Secondly, I want to reiterate the point that I am not arguing that dissaving will never occur in the aggregate. What I am saying however is that looking at the dissaving of the elderly and concluding that this will lead Japan towards an external current account deficit misses the current and real effect from ageing in Japan. Consequently, the picture of Japan at the present time running an almost perpetual external surplus is one of an economy fighting like hell to avoid obvious end point that would occur in the event of rapid de-stocking/dissaving.

Corporate Savings - Restraining Consumption through Retained Earnings?

Traditionally, economic models such as e.g. an OLG model set in an open economy context does not discriminate between the savings of corporates and households Rogoff and Obstfeld (1996) and Mason (1988) which is often because our economic models are set-up in a representative agent framework where the representative consumer is the sole shareholder of the representative firm and thus must be the sole beneficiary of whatever earnings (retained or otherwise) the company has. In a widely cited study Friend (1985) concludes that there is a moderate degree of substitutability between household and corporate savings which sounds about right to me.

In practice though and although principal agent problems and a thick corporate veil may make the direct link very sluggish, once foreign ownership of the domestic market cap is accounted for (about 20% in Japan's case I would say) there should no problem substituting corporate for private savings. In any case and to the extent that there is indeed a very long way from the dividends of Japanese corporates to the pockets of households it is, I assume, exactly here that Martin Wolf inserts his main argument.

As should be immediately clear here, it is not as if Martin Wolf is shooting blanks here although I don't suspect anyone really suspected that. Consequently, both the nominal value of retained earnings (manufacturers and non-manufacturers excl finance and insurance) as well as its share of total company assets have increased markedly since the mid 1970s. Since the second quarter of 1975 the nominal value of the stock of retained earnings has increased by a little over 270% while the corresponding figure for total assets is 163%. In terms of the share of total assets, the graph above does not tell the whole story as retained earnings as a share of total assets actually reached its low in the mid 1970s at around 5% declining from the mid 20s% in the 1950s. The average quarterly share of retained earnings relative to total assets in a post 1990 context is 14.14% with a steady upward trend throughout the 1990s and 2000s.

So far so good then.

However, as with the case of household saving above, once we dig a bit deeper in the analysis it is not certain that retained earnings constitute the magic bullet. First of all, the representation above is one of stocks and not flows and thus if we express it as flows we get the same picture as above with household savings; namely, that while the stock of savings (in the aggregate) is not being drawn down the flow of savings is steadily declining even if the flow of corporate savings is quite volatile.

Still, the flow of corporate savings have been impressive even in a post 1990 context where the average quarterly growth rate (yoy) has been 4.5% (with a correspondingly high SD of 6.7%). Moreovern, the relationship between the total amount of gross fixed invesment on a quarterly basis and the stock of retained earnings is further indicative here. Between 2000 and 2008, Japanese corporates consequently kept an average of 183% worth of retained earnings on their balance sheet relative to the average value of quarterly gross fixed capital formation. As Martin Wolf evidently points out, this is ultimately a question of a secular decline in investment demand to which Japanese corporations only can do two things; dissave to match the decline in investment demand or let those savings flow out in the form of an external surplus. In the context of Japan and in strict sense of national accounting it is the latter route which has been chosen.

The more interesting question in terms of what those retained earnings are financing (i.e. on the asset side) is almost implicitly answered above although it is not as simple as it looks.

Consequently, conventional wisdom has it that the retained earnings of Japanese corporates are merely sitting on the asset side in the form cash and deposits and thus would be readily and easily available for distribution to shareholders. The more I look at the data however, the more this seems to me to be a myth.

The total amount of cash and deposits as a share of total assets held by Japanese corporates peaked in the first quarter of 1990 at 15.5% and has since declined to about 10% in the 2000s. Now, I might be missing an important liquid asset entry here, but it should serve to differentiate the picture somewhat of Japanese companies as cash hoarders.

Yet, the main picture remains in the sense that even if retained earnings have then gone to finance land acquisitions or the build-up of fixed assets the GDP entry of GFC shows with all certainty that investment activities in Japan have been in secular decline for the past 20 years as the nominal value of GFC peaked in the first quarter of 1991.

It is worthwhile to note however that of the main balance sheet entries on the asset side, "investment securities" is the one that has exhibited the strongest growth rate in a post 1990 perspective. This suggests that a large part of the incremental change in retained earnings in this period has been parked in yield bearing instruments be it government bonds or more importantly foreign securities which have helped Japan gain a substantial boost (far bigger than from goods and services exports) from a positive income balance. Since 2005, the stock of investment securities held by Japanese corporates has been approximately equal to 68% of the stock of retained earnings.

More generally, the flow of investment securities onto corporate balance sheets rose steadily until about 1999-2000 after which we observe a discrete bounce and a much more rapid (and volatile) increase hereafter. From Q1-00 to Q1-01 the stock of investment securities rose 25% and has since increased steadily to about trn 181 in 2008.

This last point in particular serves to differentiate the argument by Martin Wolf even if it is unquestionably true that the share of retained earnings used to finance the asset side appears extraordinarily large in the context of Japanese corporates. Moreover, I cannot of course say for certain what would happen in the event that those retained earnings became the subject of political attention as a tool to muster domestic demand.

Is it Optimal to Dissave?

The standard life cycle model tells us that it clearly is, and especially so when set in the context of a representative agent model aggregated to the macroeconomic level. Sure, we may incorporate bequest motives or uncertainty, but in the limit; dissaving on a microeconomic level will transfer itself to the macroeconomic level. Implicitly, this is the argument advanced when it is held that the retained earnings of Japanese companies can meaningfully be deployed to boost domestic demand in Japan and, most importantly, lead Japan towards an external deficit which would go some way to rebalance the global economy.

Let me be clear. I don't dispute the dissaving argument in itself; especially in a context where fertility "never" recovers (which may well be the practical case in Japan). However, and while dissaving certainly would be the fate for a closed economy, it need not be for an open one. In fact, it should take us very little time to agree that dissaving as a function of old age perhaps even to the extent that the economy moves into an external deficit is utterly undesirable from the point of view of the economy as a whole. Thus, it is my contention that ageing societies are not, in the main, characterised by aggregate dissaving but rather by the fight against it. In Japan's case the high level of private savings reflected primarily in the level of corporate savings becomes a vital shield towards spinning further into negative trend growth and deflation.

Apart from this which is really my main observation on a theoretical level I have two additional points.

Even if we assumed that the retained earnings of Japanese corporates could be effectively channeled to the purses of households, would these same households increase spending? Put differently, what is the underlying demand here? Needless to say, I am quite sceptical here and moreover, it is important to remember that the rate of savings closely follow the growth rate in income. Thus, if suddenly income rose either through a lump sum payment or a steady trickle would the savings rate follow?

Finally, the extent to which Japan may become a global provider of spare capacity not only hinges on the trend of dissaving but also, by definition, on investment demand. This makes the whole issue much more complicated since what we are really looking for is a net effect and since both savings and domestic investment demand can be expected to decline with the transition into old age and it is the mutual pace between the two that determines the external balance. Consequently, empirical as well as theoretical studies have spent considerable time to pin down what this net effect is supposed to be. I will not go into the conclusions from this literature (my upcoming thesis will have much more on this), but merely note that we can observe how countries such as Germany, Japan, Finland etc are running external surpluses, why this surplus is critical for their growth prospects and thus why the salient features of an ageing economy is not dissaving but rather the fight against it.

Once you get this point and extrapolate it to the issue of global imbalances and the convergence of the global age transition towards a, so far, unknown end point you should realize the tremendous mess we have to sort out. In fact, why don't I come full circle and finish off with a most recent quote from none other than Martin Wolf writing in his latest column;

Meanwhile, the eurozone as a whole, having lost its erstwhile internal demand engines, must now hope for faster growth of net exports. So do countries hit by the financial shock, such as the UK and US. So, too, does recession-hit Japan. So, not least, does China. Either the rest of the world has a spending binge, or these countries – which make up 70 per cent of the world economy – are going to be disappointed.

This seems self-defeating to me since there is no way that 70% of the world economy can rely on export driven recoveries let alone export driven growth strategies no matter what kind of binge came upon the rest of the world. Still, I completely agree with Martin that this is indeed the issue. And once you overlay this argument with some basic intuition of how demographics affect savings, consumption and investment you end up with the fundamental challenge for the global economy in terms of staging a comeback from the economic crisis.

So yes Virginia, demographics do matter!


[1] - Click on pictures for better viewing

List of References

Data for this piece can be obtained by mailing me and I will ship over my excel sheets. However, for those of you who want to check it out yourself here is the database on the corporate balance sheet data and in terms of household data you can get it from the website of the Bank of Japan (search for "household" and you should be able to dig out the relevant files).

Baldwin, Richard & Taglioni, Daria (2009) – The Illusion of Improving Global Imbalances, VoxEU research article (14.11.09) http://www.voxeu.org/index.php?q=node/4209

Friend, Andrew (1985) - The Policy Options for Stimulating National Savings, Conference on Saving and Capital Formation: The Policy Options Philadelphia (May 1985)

Obstfeld, Maurice & Rogoff, Kenneth (2009) – Global Imbalances and the Financial Crisis: Product of Common Causes, Paper prepared for the Federal Reserve Bank of San Francisco Asia Economic Policy Conference, Santa Barbara, CA, October 18-20, 2009

Horioka Yuji, Charles (2009) - The (Dis)saving Behavior of the Aged in Japan, Discussion Paper no. 763 The institute of Social and Economic Research Osaka University

Mason, Andrew (1988) - Saving, Economic Growth and Demographic Change, Population and Development Review, vol. 14 no 1 pp. 113-114

Nakagawa, Shinobu and Shimizu, Tomoko (2000) - Portfolio Selection of Financial Assets by Japan’s Households, Why Are Japan’s Households Reluctant to Invest in Risky Assets? BOJ Research Paperfff

Nakagawa, Shinobu and Yasui, Yosuke (2009) - A note on Japanese household debt: International comparisons and implications for financial stability, BIS Paper no. 46

Obstfeld, Maurice & Rogoff, Kenneth (1996) – Foundations of International Macroeconomics, MIT Press

Wolf, Martin (2009) - The Greek tragedy deserves a global audience, FT column January 19 2010

Wolf, Martin (2009) - What we can learn from Japan’s decades of trouble, FT column January 12 2010