Global Economy Matters

Q1-08 Eurozone GDP - A Last Salute from Germany?

2008-05-15T13:01:00.000-07:00

By Claus Vistesen Copenhagen

The preliminary and 'non-broken up' GDP figures for the Eurozone economy are now out for the first quarter of 2008. In many ways, I have been in a bit of GDP mode this week as I both made a sneak peek to the Eurozone release as well as I concluded that the Baltics have now entered a recession (a post which even made it to the front page of Moneyweek.com; thanks for that plug.) From a market perspective such ardent attention is surely not warranted. I hardly think markets moved more than a few digits on today's news most likely because the result was already priced in albeit not the 1.5% from Germany I imagine. Yet, what did we get from today's Eurozone GDP release? Well, let us visualize the figures.

As can be immediately confirmed today's release is all about Germany which posted an unprecedented expansion of 1.5% q-o-q. Also interesting was Spain's obvious slowdown and Italy's continuing absence from the data (we are supposed to get figures from the stats offices the 23rd of May). However, let us have a look at what happended in Germany and where that hefty 1.5% reading comes from. As Edward detailed back in March the first two months of January and February were very strong in Germany before momentum levelled off considerably in March and now as well in April and quite possibly May. So far we don't have a detailed break up of the figures but it is safe to say that the expansion in Germany was driven primarily by corporate capex and specifically construction. Moreover, this strong showing of corporate investment is also a derivative of strong external demand which is also sure to have contributed favorably to today's figure. This is not to say that domestic demand and consumption were not significant but given the level of the figure I am very confident when I say that the main driver was not consumption expenditures. Having said that 1.5% still seems to be an almost extreme number. I have been busy talking with my colleagues about this and one of the reasons we have settled is the seasonal factor.

Basically, the mild weather which is widely cited means that a lot of work would have been advanced. Also, my colleagues made the point that the y-o-y figure at 2.6%, albeit strong, was not strong enough to merit 1.5% q-o-q. So, this is merely to say that before you go out talking about annualised figures of 6% you would be wise to consider the underlying momentum.

Turning to the other big four Eurozone countries we observed, as expected, a significant slowdown in Spain where the global credit turmoil has now decisively spilled over into a slump in construction and housing hitherto the hallmarks of the Spanish growth spurt. A contraction in domestic demand is consequently cited as the main culprit in Spain's case. Germany should of course be looking more than careful here since Spain is one of the 10 biggest customers of German exporters. In many ways, the sub-par Spanish showing is also historical since it marks the first time in a considerable number of years that Spain is trailing the Eurozone average. Based on the correction which now seems to be materialising this could very well mark a structural break as Spain is now set to position itself on a lower growth plateau.

In France, GDP continued to muddle along quite nicely at 0.6% and in many ways France seems to have taken its newly found label (branded her here among other places) as the Eurozone's Mme Average. Undoubtedly, France will slow too but I don't think we will see an actual contraction here. A relatively buoyant domestic consumption factor will prevent this as Edward tries to explain here. The last economy amongst the big four is Italy which again opted not to release its figure. Presumably we are going to get figures for both Q4 07 and Q1 08 later this month as noted above. Meanwhile we are left guessing. Most economists agree that Italy may have already tumbled into a recession in Q4 2007. As for the current figure it is difficult to say. Clearly, Spain's lacklustre performance cannot in itself have dragged down Germany's 1.5% to 0.7% as was the aggregate figure.

If we look across the rest of the Eurozone edifice the result was mixed which indicates that a marked slowdown here is not the explanation either. This pretty much leaves Italy (and Ireland from whom we did not get figures either) to explain why Germany's impressive showing did not push the aggregate figure into the +1% territory. Back of the envelope calculations suggest (see below) that Italy was probably very close to flat in Q1 assuming that the 0.7% figure includes any implied Italian weight at all. At this point it is very difficult to say but can be inferred with some certainty is that Italy was the first Eurozone economy, together with Ireland and Spain of course, to be tussled into the ropes and very likely onto the canvass as a result of the global slowdown. As I have explained again and again this is no coincidence and Italy's situation can consequently be explained through a mixture of unfavorable demographics and institutions where I tend to look more closely at the former than the latter. If we peer across the rest of the Eurozone edifice a couple of things should be noted. Most prominently the Netherlands, who after all account for some 6% of the aggregate economy, slowed considerably posting 0.2% q-o-q. Greece continued to expand at 1.1% while Portugal contracted -0.2%.

So, where does it go from here?

To answer this question we could do a lot worse than visit the recent monthly ECB bulletin out today. In words and graphs it paints a picture of a slowing economy across the board noting in passing the factors such as mild weather and strong external demand in the context of Germany which provided to deliver the impressive Q1 figure. In particular, industrial production as well a the leading indicators in the form of new orders are mentioned to have contributed strongly. The ECB's researchers also emphasise that the construction rebound is likely to be short lived. In Spain and Ireland in particular we have seen a sharp correction but also construction confidence indicators have fallen throughout the beginning of 2008. More worryingly in terms of the general economic outlook business activity and leading PMI indicators in the context of the service industries show a decisive downward trend. Services as we know account for just shy of two thirds of the Eurozone economy.

In the most recent print edition, which I imagine is going through the printer as I type, the Economist is furthermore duly cautious in terms of extrapolating on the basis of today's figure. The failure of domestic demand to take over in a situation where corporate investment loses strength is one of the important points. Of course as the Economist also points out, the reluctance of the ECB to provide stimulans on the interest rate front has straddled up government officials to knit together fiscal stimulus packages. The first of these to be brought into effect will be in Spain where the budget is still - just - fielding a surplus. In Italy and Germany where fiscal balances are much more tight plans are also in the smelter. This however is going to result in more attention from the EU in the context of those Maastricht convergence criteria; especially I imagine in the context of Italy who is already running a rather gung-ho fiscal policy.

In order to summarize on the outlook the Q1 2008 expansion is not likely to last. I am especially looking for a marked slowdown in Germany after the extreme 1.5% reading this quarter. In my opinion Germany may thus very well see a contraction in Q2 on a q-o-q basis. I also think that Spain will continue to trail the sub 0.5% figures and possibly even a contraction in q2 and q3 depending on how far and severe the correction in construction and housing is. This points to considerably lower aggregate figures for the rest of 2008 and possibly even negative numbers at some point. In this light, Italy also needs ardent watching. Evidence suggests that Italy not only may already be in a recession but also that the downturn may be lasting and inelastic. In short, after what can only be seen as a swan song in Q1 2008 the risk and direction is now entirely to the downside. Once Germany slows down which it almost certainly will in Q2 we will see the real effect in the Eurozone.

In this light an important question is whether the ECB will react to today's release. Certainly, reduction of interest rates can hardly be justified on the back of this figure. However, given the backdrop which is certain to come in Q2 as well as the much welcome sign that the increase in annual inflation rates are easing you cannot but think that the ECB's bias is about to change. It is not however going to change swiftly. Inflation is still way above the comfort level and even though news of lower global food prices in April rolled in over the wire today I hardly think we are out of the inflation woods yet. The underlying tendencies are too strong I think. For more on this Macro Man's recent invocation of the three axioms of globalization is an excellent place to go. Consequently, I don't quite see the ECB moving its bias in public yet even though the cycle is now certainly turning.

Appendix

The flat growth rate for Italy is found relatively simple but obviously assumes that the 0.7% figure includes Italy at all. As such, if we take the 2007 GDP in current market prices we are able to assign the following weigths ...

Germany - 27.3%

France - 21%

Italy - 17.3 %

Spain - 11%

The Netherlands - 6.3 %

Belgium - 3.7%

Austria - 3.1%

Greece - 2.5%

Portugal - 1.84%

As can be confirmed this amounts to 94% of the entire Eurozone. If we further calculate the weighted average of these countries' growth in Q1 (excluding Italy) we get a growth rate of .644% already for 76% of the Eurozone's countries ex Italy and Ireland. This leaves us with this simple equation where G is the implied growth rate of Italy, Ireland, Slovenia and the rest of the small Eurozone countries.

G = (0.7-0.644)/(1-0.76) = 0.23%.

Now, we know that Slovenia grew smartly which leaves us with Ireland and Italy to share something like 0.15% which is basically flat. Of course, if one of these countries saw a sharp contraction then it means the other must have grown. Especially since Italy accounts for the largest weight by far it cannot have expanded much. I am not sure my method is valid though. In fact, if we include Slovenia it seems as if you hit 0.7% without including Ireland or Italy which may be the way the numbers have been calculated.

A turn to the West in Serbia? Pro-EU parties handily defeat ultra-nationalists

2008-05-11T19:30:00.000-07:00

by Manuel Alvarez-Rivera, Puerto Rico

Sunday's general election in Serbia, which had been widely anticipated to be a tight race between the ultra-nationalist Serbian Radical Party (SRS) and For European Serbia - a coalition of moderate, pro-European Union parties headed by the Democratic Party (DS) - had a completely unexpected outcome, with the pro-EU parties easily prevailing over SRS, according to both estimates published by the Centre for Free Election and Democracy (CeSID) and preliminary results issued by Serbia's Republic Electoral Commission.

The results contradicted findings from opinion polls that suggested the Radicals would top the poll, largely by playing on widespread anger in Serbia over Western backing of the former province of Kosovo's unilateral declaration of independence last February 17. However, the EU's offer of closer ties with Serbia - which included a pre-membership agreement and offers of free visas to Serbs by seventeen European countries - clearly helped the pro-European parties, which repeatedly warned a Radical victory would lead to Serbia's renewed isolation.

The election also dealt a blow to the conservative Democratic Party of Serbia-New Serbia (DSS-NS) alliance of outgoing Prime Minister Vojislav Kostunica, which continued to lose ground and came in a poor third place. Kostunica's center-right coalition government with DS and the right-liberal G-17 (now part of the pro-EU coalition) came apart last March over the issue of suspending ties with the EU in the aftermath of Kosovo's independence, triggering Sunday's parliamentary poll - Serbia's third nationwide vote in fifteen months - three years ahead of schedule. All three ruling parties were (and remain) staunchly opposed to Kosovo's independence, but DSS-NS - along with the opposition SRS - advocated a hard-line stand against Europe over the issue.

While the leftist Socialist Party of Serbia (SPS; originally the party of the late strongman Slobodan Milosevic) and its allies scored significant gains in the election, at the time of writing it remained unclear if the left-of-center Liberal Democratic Party (LDP) - the only party that has accepted the independence of Kosovo - would retain its parliamentary representation by securing at least five percent of the vote. CeSID's projection has the party narrowly crossing the threshold, but LDP stood just below five percent in preliminary election results issued on election night (subsequent official results placed the party above the threshold, as noted under Update).

Irrespective of the LDP result, the pro-EU parties will almost certainly finish well short of an absolute majority in the new National Assembly (Parliament) - whose 250 seats are allocated by proportional representation on a nationwide basis - and SPS could end up holding the balance of power. It was originally expected the party would join forces with SRS and DSS-NS, but according to CeSID's estimate the three groups would have an overall majority of just four seats in the event LDP actually secured parliamentary representation, and the Socialists have not ruled out reaching an agreement with the pro-European parties to form a stronger coalition government.

Update

Serbia's Republic Electoral Commission reports that with 99.6% of the votes tallied, the results of the May 11, 2008 parliamentary elections were as follows:

For European Serbia - 38.4%, 102 seats
Serbian Radical Party (SRS) - 29.4%, 78 seats
Democratic Party of Serbia-New Serbia (DSS-NS) - 11.6%, 30 seats
Socialist Party of Serbia-PUPS-United Serbia (SPS-PUPS-JS) - 7.6%, 20 seats
Liberal Democratic Party (LDP) - 5.2%, 13 seats
Hungarian Coalition - 1.8%, 4 seats
Bosniak List for the European Sandzak - 0.9%, 2 seats
Coalition of the Presevo Valley Albanians - 0.4%, 1 seat

The election had a 61% voter turnout, slightly up from 60.6% in 2007 and just below the 61.4% turnout figure on the first round of voting in last January's presidential election.

Meanwhile, SRS, DSS and SPS, which together command 128 of the National Assembly's 250 seats - an overall majority of six - have announced they have reached an agreement "in principle" over the future administration.

Serbia, Must What Goes Up Really Come Down?

2008-05-11T00:24:00.000-07:00

by Edward Hugh: Barcelona

This post, which is to accompany Manuel's election coverage coming later today, may be considered an update on a previous extensive analysis of Serbia's economic and demographic dilemmas which I carried out at the time of the Presidential election in February (see the post itself for a more details on some of the issues raised here).

The "up" I in the title of this post is, of course, a reference to the recent sudden and dramatic rise in the annual rate of Serbian inflation - which after some years of steady reductions suddenly took off in June 2007, and has been climing sharply since, reaching a high of 15.8% in April 2008.

But it could also be thought of as a reference to the rapid and reasonably spectacular recent rise in the dollar value of Serbia's GDP, or to the rapid rise in consumer demand which has accompanied it.

A key factor in driving these ever higher levels of output and prices has been the ever higher levels of consumption demand produced by the strong acceleration (way beyond productivity improvements) in Serbian wages, which brings us directly on to the "down" part I also refer to, since in true "decline and fall" fashion the rate of real wage increases is now steadily and inexorably heading back to earth, and with it the rate of expansion in Serbian GDP.

As can be seen in the above chart it will now not be too long before the annual rate of increase in real wages hits zero (and in all probability continues its course into negative territory) and naturally in the wake of this sudden deceleration we are now starting to observe a much more general slow-down in Serbian GDP growth as domestic demand begins to weaken.

As can be seen from the solid line in the above chart, the Serbian economy has in fact been slowing since the first quarter of 2007. The components which lie behind this slowdown are also interesting. Agriculture turned negative (partly a result of last years drought I imagine), and construction and services both slowed notably, while the section headed "taxes minus subsidies" - which effectively means the government input (and thus the fiscal deficit) - was up significantly during the year. We thus had by December 2007 an economy which was much less dependent on domestic consumption and much more dependent on government spending than it had been back in January.

Really though a significant part of the reason for the slowdown can be clearly seen in the wages chart. The situation basically became "unsustainable", and starting in June 2007 the rate of real wage increases started to decline. Basically as you head on upwards towards the stratosphere you simply lose momentum - especially if monetary conditions cease to be "accommodative" -and under pressure from the economic equivalent of Newton's law of gravity (which some, especially in Russia, seem stubbornly set to do their darndest to try and prove wrong, although in the Baltics they have now reluctantly had to accept) you eventually, and in time honoured fashion, start to head back to earth. If the current trend continues, and it seems very likely since it will since the central bank has been raising interest rates sharply in recent months (see below), then real wages growth could turn negative (year on year) in, say, June or July. The big question is then going to be will we have a "crash landing" in Serbia, or can this somehow be avoided?

The Demographic Backdrop

It is, however, impossible to understand what is currently happening in Serbia, and adequately assess what may be about to happen next, if you lose sight of the underlying demographics, which are so special, and indeed historically almost unique, and of the fact that Serbia's population, like that of many other countries in central and Eastern Europe, is both ageing rapidly and declining. The official population of the Republic of Serbia - as monitored by the Serbian statistics office - has now been falling since the late 1990s. Of course there is quite a jolt downwards after 2001, but the general trend is clear enough even without this and the natural increase of the Serbian population (births minus deaths) has been negative for many years now (in 2006 it was 31,000) even before taking out-migration into account, and last year the number of live births was the lowest since at least 1970 (which is the earliest date for which I have data).

As well as declining Serbia's population is ageing, and the median age has been rising quite rapidly, pushing onwards and upwards beyond the economically sensitive 40-year-old barrier. The rapidity of the rise in median age in Serbia is undoubtedly the combined product of a low birth rate, a steady increase in life expectancy and the migration abroad of people in the younger age groups. 40 can be regarded as a sensitive population median age since it seems to mark the difference (following life cycle saving and spending dynamics) between an economy which can structurally be driven by internal demand and one which becomes increasingly dependent on exports.

What our experience to date of this relatively new phenomenon of population ageing tends to show us is that as median ages move up beyond 40 the momentum of internal demand starts to slacken, and recent experience seems to be showing (Germany, Italy, Japan) that a country's economy comes to depend increasingly on exports for growth. This is significant, of course, in Serbia's case, since Serbia currently runs a sizeable trade deficit. As a result it is quite probable that the "leaner-meaner" Serbian economy which must eventually emerge from the present downturn will be a structurally very different beast from the one it has been of late, although unfortunately there may well be quite a long hard road ahead in order to get there.

Russia, Ukraine and Bulgaria

Before going further into the current situation in Serbia I would just like at this point to draw attention to one other interesting feature of the present situation, and that is the extraordinary similarity which exists between what is happening (economically speaking) in Serbia, and what is taking place among what might be termed her "cultural half cousins" in Russia, Ukraine and Bulgaria.

Inflation as we all know is now a problem in many countries, due to the pressure from global food and energy prices (see this post for a much longer explanation of all this), and Central and Eastern Europe were particularly hard-hit by a drought last year, but still, other countries in what might be considered to be similar conditions have seen their inflation rate rise, but few have seen it rise in anything like the dramatic way it has been moving in the above mentioned quartet (in Vietnam perhaps, but I will just throw that one out as a little teaser, what on earth might the connection be here?).

Bulgaria's inflation rate rose to a 10 year high of 14.2 percent in March, up from a previous 10-year high of 13.2 percent in February.

Ukraine's inflation rate rose to 26.2 percent in March, in this case the fastest rate in eight years, as global food prices surged, while domestic demand increased as the Ukraine government repaid people who lost savings when the Soviet Union collapsed, and Ukranian workers were out busying themselves all over Eastern Europe filling gaps in local labour markets and sending remittances home. Inflation accelerated from 21.9 percent in February, which had already been the fastest pace in Europe for that month and the quickest in Ukraine since 2001. So rapid is the pace in Ukraine that consumer prices rose 3.8 percent in March from February - basically achieving what many would consider a high annual rate in the space of a single month.

Meanwhile Russia's inflation rate rose to an annual 14.3 percent in April, the highest since April 2003, led by rising food costs. The inflation rate rose from 13.3 percent in March, while prices rose 1.4 percent in the month, compared with 1.2 percent in March, the Moscow-based Federal Statistics Service reported last week. Prices have already increased by 6.3 percent so far this year (January - April).

And Russia's inflation continues to accelerate alarmingly, in the week April 29 and May 5, 2008, Russia's inflation was 0.3 percent (or an annual rate of 15.6%). This meant that in May, inflation amounted to 0.2 percent for the month to date (only 5 days), nudging up the toatl to 6.5 percent for the year to date, compared to 0.2 and 4.2 percent respectively for the equivalent periods in 2007, according to the Federal State Statistics Service (Rosstat).

But if I am singling these four countries out for common consideration it is due to the fact that they have more than a high and rising inflation rate in common. Most obvious of all the underlying similarities which can be identified among these countries is one which is all to often ignored in the economics "to do" hitlist drawn up by multilateral agencies like the EU commission, the IMF or the OECD and involves what might be termed the highly "destructured" state of their population dynamics. In all four cases fertility is now extremely low (with Bulgaria's the lowest in all Europe at 1.14), male life expectancy is very low, the population is declining and basically we don't really know how many people there are in the country in all cases: for Bulgaria, Ukraine and Serbia since we have no accurate numbers for those who have actually left (thus we can surmise that working age population and potential labour forces are declining, but we have no idea at all of by how much) while in Russia's case we do know that working age population is falling, but we don't have any accurate information about the number of permanent migrants living and working inside the country (although again, and just to complicate things even further, we do know that many of these come from Ukraine and Serbia). We thus cannot possibly hope to accurately measure the potential labour force in any of these cases.

And this is not an unimportant issue when it comes to inflation, since in order to try to assess potential growth capacity you need to make an estimate of the non-inflationary unemployment rate, but if you really have little idea of how many people you are actually dealing with this becomes well nigh impossible. So when people tell you that, for example, the current Serbian growth is perfectly sustainable, you might just like to scratch your head and ask how it is that they could possibly know this. Unless, of course, they think that population structure, labour force size, and potential consumers are not important areas in economics.

Employment in Serbia

As I say, in Serbia's case it is evident that there are a lot less people around than there are officially supposed to be, and this becomes doubly clear when you look at the decline in total employment numbers we have witnessed in recent years (see chart below), and when you start to GDP think about this employment decline in connection with the 6 percent or so average growth rate of the last few years. Not only has Serbia been having a "jobless" recovery, it has been having a "job-negative" one, even while unemployment has been actually falling. This is what having such weird and unprecedented (at least in peacetime) demographic dynamics actually means in practice. Serbia may not, in practice, be able to turn the world of Newtonian mechanics upside down, but has certainly been having a good try, especially in the context of all our traditional concepts of economic development and "catch up" growth.

As we can see in the chart above total employment has been heading steadily downwards, while unemployment has been stuck somewhere over the 20% mark. If we think about this, and about the high level of wage increases Serbia has seen over the last couple of years, then something here simply doesn't add up. Among the many various possibilities to explain this rather strange situation is the idea that some at least of the people concerned are not in Serbian employment, and are remaining on the unemployment register, simply because they are no longer in the country. Whatever the explanation, total registered unemployment was at 785.1 thousand in December, down by 131.1 thousand or 14.0% over 2007, and this decline - according to the central bank - is not the result of new job creation, but is largely attributable to the re-registration of around 90 thousand people from the records of the National Employment Service to the records of the Republic Health Insurance Bureau - ie the registers were being "cleaned up". I wonder why?

Total employment in December 2007 was around 2.44 million, which was down 60,000 from the 2.50 million which had been recorded in September. While employment fell sharply in the majority of areas of economic activity in the fourth quarter, it rose in financial mediation, real estate and in some parts of the public sector (education and culture, healthcare and social work).

In the course of 2007, the sharpest drop in employment was recorded in the processing industries (down by around 24 thousand jobs), and there was also notable drop in employment in the construction industry, and in the electricity and gas industries.

Despite the fall in employment the official estimated unemployment rate (Serbian emthodology) was 24.3% in December, down by 2.4 percentage points from the same period a year earlier.

Central Bank Monetary Policy

Serbia's central bank raised its benchmark two-week repurchase rate by three quarters of a percentage point to 15.25 percent on April 24. This was the fourth increase since the start of February, according to central bank Governor Radovan Jelasic in order to ward off inflation in the absence of stable and determined government.

``Two weeks ago we had a collapse of the government, a drop in the credit rating, an increase oil and agricultural product prices and accelerating inflation,'' Jelasic said, in an interview in Belgrade on April 1. ``As we now have a caretaker government, we cannot count on their support in combating inflation in the next three to six months.''

The credit rating decision Jelasic was referring to was the one take in March by Standard and Poor's to lower their outlook for Serbia's credit rating to "negative'' from "stable.'' based on the growing uncertainty about reforms associated with the current election.

The Narodna Banka Srbije has now lifted its benchmark rate a total of 5.25 percentage points since 1 January 2008 (see chart above). This is strong tightening indeed, and taking into consideration the fact that the economy was already slowing substantially in Q4 2007 we should expect to see a rather dramatic additional slowdown in Serbia over the coming months.

Appreciation in the Dinar

Bank Governor Jelasic has also said he is prepared to spend the bank's reserves and raise interest rates further if need be to support the dinar until stability returns to the political system. Jelasic added that the central bank has 9.6 billion euros ($15 billion) in available reserves to shore up the dinar, which lost as much as 1.5 percent against the euro following Kosovo's declaration of independence. Since the March 13 rate increase, the currency has gained 2.5 percent.

On March 31, the bank changed foreign currency reserve requirements to boost the use of the dinar. As of May 17, 10 percent of the mandatory 45 percent minimum deposit requirement for commercial banks will have to be in dinars.

``Most banks look at dealing with dinars as a nuisance, but the dinar is our national currency,'' Jelasic said. ``We expect that these measures will increase the dinar's share in bank balance sheets, show borrowing costs more realistically
and boost dinar deposits in commercial banks"

This assertion by Jelasic to the effect that the dinar is, after all, "our national currency" may seem strange until you take into account the degree of euroisation in the Serbian economy, which, as can be seen from the chart below which compares the levels of household indebtedness in euros, is - at around 80% and along with Latvia and Estonia - among the highest in the whole CEE .

In Q4 2007 the dinar/euro exchange rate moved within a very broad band of RSD/EUR 76.81 to 84.75, with exceptionally high daily oscillations in November and December reaching as much as 3% on some occasions. In October the dinar continued its steady long term appreciation against the euro (see chart below) and reached a record high since November 2004 (RSD/EUR 76.8). November and December, however, saw far more volatile exchange rate movements and two episodes of sharp depreciation. The appreciation of the dinar was the result of the high foreign exchange inflow and the intensified demand for dinars which followed the announcement of another round of privatization. On the other hand, the sharp weakening in the dinar which took place in late November and early December can be attributed primarily to the impact of global developments and simmering internal political instability, while the depreciation in late December was basically triggered by a mismatch in foreign exchange supply and demand.

Since August of last year the ECB has, of course, kept its basic policy rate unchanged while the FED has embraked on a significant loosening in interest rates. As a result the U.S. dollar has tended to depreciate against the euro, and as consequence, the dinar has appreciated significantly against the U.S. dollar - by somewhere in the region of 10% in nominal terms (see chart).

Thus during Q4 2007 the dinar depreciated by 0.5% against the euro and appreciated by 3.6% against the U.S. dollar. As these two currencies make up the basket of currencies used by the Bank of serbia for calculating the effective exchange rate, the nominal effective exchange rate for the dinar strengthened by 0.8% over Q4.

Serbia has continued to benefit from substantial capital inflows and official foreign exchange reserves have more than tripled since 2004, reaching USD 14 billion or 7.5 months of imports in 2007 — one of the highest levels in the CEE region. However, it is important to bear in mind that this rapid reserve accumulation has in part been the result of the yield differential created by the significant monetary policy tightening carried out by the Serbian central bank and the increased reserve requirements placed on commercial banks’ foreign exchange liabilities by the central bank in 2006. The combined effects of these tow factors has boosted the commercial banks’ foreign currency deposits to about USD 5 billion. But it is important to keep in mind that these deposits represent commercial banks’ obligations to the domestic and foreign private sectors, and thus the central bank cannot fully rely on them in times of distress. That is to say, those 7.5 months of imports cover are not as substantial a cushion as may appear at first sight.

Serbia's Trade Balance

As I have been suggesting, the very high credit euroization which has evolved in Serbia and the accompanying significant external vulnerabilities suggest that — even after allowing for the low debt to GDP ratios — a rather lower debt-carrying capacity for Serbia’s households when compared to regional neighbours. The share of forexdenominated and forex-indexed domestic credit exceeds 70 percent and is among the highest in emerging Europe and is exposing borrowers in Serbia to undesireably large currency risks. Which is another way of saying that while it is not so difficult for the Bank of Serbia to raise the base interest rate, the need to avoid a significant subsequent depreciation in the currency may well make it very difficult to bring this rate down again as the need to revive the domestic economy becomes more pressing. Yet another case of something which easily goes up, but has more difficulty in coming down.

In addition, low exports, rapidly growing euroized liabilities in the corporate sector, and other external vulnerabilities discussed above are closely linked to the financial sector. In these circumstances, even moderate disturbances may eventually lead to changes in the household sector’s balance sheets and could quickly spill over to the rest of the economy. These considerations suggest that on balance, the current rapid growth of household credit is making the country more vulnerable.

Similar conclusions about the enhanced vulnerability of Serbian households over and above those of regional neighbours can be derived from examining the Emerging Market Bonds Index (EMBI) for six Central and East European countries. As indicated by the chart below, the increase in EMBI spread is much higher for non-EU member states (except Bulgaria) than for the EU member countries. In addition, the increase in the spread is higher for countries running high inflation and balance of payments deficits, i.e. countries more vulnerable to external shocks. The largest increase in the EMBI spread from June 2007 to January 2008 was recorded for Kazakhstan and Bulgaria (140%), followed by Serbia (118%) and Ukraine (106%). Far lower increase was recorded for more developed Central European countries and EU member states - Poland (67%) and Hungary (49%).

Serbia's current account deficit hit an all-time high in Q4 2007, as did its share in GDP (18.9%). Relative to Q4 2006, it widened by 58.4% as a result of a rising deficit on trade in goods and services (51.9%). The shares of the current account deficit and the deficit on trade in goods and services in GDP rose by 3.4 and 3.3 structural points, respectively. The deficit on trade in goods and services widened as exports growth slackened and growth in imports picked up.

The decline in the year-on-year growth rate of exports which we have been seeing for some time continued into Q4 2007. This slowdown in post July 2007 export dynamics was partly the result of a drop in the export of cereals (due to the drought and a temporary ban on exports), and non-ferrous metals and iron and steel (due to the autumn overhaul in US-Steel). The value of exports of these products decreased from a record level of EUR 176 million in July to EUR 99 million in December.

If movements in these three sections of the Standard International Trade Classification (SITC) are excluded from calculations, the dynamics of export growth in the fouth quarter remained stable at around 30%, in euro terms. Commodity exports in dollar terms hit record highs (USD 2,515.8 million), but declined on a quarter on quarter basis in euro terms. This was the first time since 2002 that exports in Q4 did not rise on a quarter earlier.

The composition of exports also saw positive changes, as the share of machinery and transport equipment almost equalled that of food and live animals and miscellaneous manufactured articles, and seems set to become the second most significant section of exports in 2008 (after manufactured goods).

However, the year-on-year growth in imports, and consequently the trade deficit, was higher in the second half of 2007, as rising domestic aggregate demand spilled over into higher imports.

Migration and Remittances

Some indication of the extent of Serbian out-migration can be obtained from the remittances flows, which were estimated by the World Bank to be running at a rate of 17.7% of GDP in 2006. Now this is a very large share in GDP value, and has lead people to use the expression "labour export" driven development in the case of countries like Moldova and Serbia. But this view misses one important feature of the situation, and that is that - unlike high fertility socities like Pakistan or the Philippines - Serbia is not resource rich in labour, Serbia's current fertility is 1.4 and not three point something. Labour is a precious and potentially scarce resource in a low fertility society, and far from exporting, Serbia needs to hang onto what it has, and even attract back many of those who have left.

Back in 2002, according to the statistics office, there were roughly half a million Serbs working abroad, about 100,000 of those being in Germany. In that year there were 2 billion dollars worth of remittances coming back. In 2006 there were roughly 4.7 billion dollars coming in, so we could estimate that the number of those working abroad has more or less doubled to near the million mark over these years. In a country with a labour force in the 3 to 4 million region, this is a lot of people.

Slowdown or Hard Landing?

Returning now to the immediate short term dynamics of the Serbian economy, it is worth noting that the real growth rate of household demand was 3.8% year on year in Q4 2007. However the sharp quarterly decline over Q3 (10.7%) was the result of both a slowdown in the nominal growth rate (from 18% in Q3 to 13% in Q4) and the strong surge in inflation. As can be seen in the chart the transformation is remarkable. GDP gowth is no longer being driven by household demand, and the dangers of a very rapid slowdown (Baltic style) are now evident. Given the added financial vulnerability which exists in the Serbian case, and the ongoing political uncertainty this situation is certainly a cause for concern.

Higher wages have been increasing both consumption and imports, and thus fuelling the increase in the current account deficit. They have also contributed to the increase in inflation in the non tradable sector and have made the job of the National Bank much more difficult.

Looked at in this way Serbia seems to be caught in some kind of trap, one where out-migration has been producing substantial remittances and an increase in consumer and foreign exchange loan demand, and this increase in demand has been fueling a wage price spiral which seemed at one point to be hurtling out of control (remember that euro denominated loans carry a much lower rate of interest than dinar denominated ones, and they have thus effectively been circumventing the central banks monetary tightening), but which now appears to be in danger of imploding in on istelf, especially as the global credit crunch steadily bites and makes it more and more difficult to keep expanding the credit. And all of this has been taking place while unemployment - according to official data - has been running at over 20%. So what happens next? This is very hard to say, since no-one really has ever been here before, but it does appear that a vice is tightening around Serbian, and this time it is an economic and not a political encirclement that is taking place. The Bank of Serbia will certainly now find it hard to loosen monetary policy without provoking a rout for the dinar, and meantime the Serbian economy effectively looks set to all but wilt on the vine.

And meantime no one in any position of responsibility mentions even in the faintest of whispers that most dreaded of of all the dreaded words: fertility.

Some further explanation of the theorectical logic that lies behind the argument advanced in this post can be found in:

Inflation in Russia: Too Much Money Chasing Too Few People?

and

Catch Up Growth and Demographics - Evidence from Eastern Europe

Jitters In The Eurozone?

2008-05-05T06:03:00.001-07:00

by Edward Hugh: Barcelona

Economic confidence across the eurozone has now started eroding steadily, with increasing signs that the growth slowdown is hitting the region’s manufacturing output and labour market, according to a number of indicators we have been seeing in recent days.

The European Commission’s eurozone “economic sentiment” index fell notably last month, dropping from 99.6 in March to 97.1 in April – the lowest level since August 2005. With the indicator regarded as good guide to growth trends, the reasonably steep decline pointed to a marked deceleration in economic activity, a deterioration which we are also seeing on other fronts like retail sales. If we look at the overall confidence indicator chart we can see that things have now been deteriorating steadily since last summer.

The latest data will undoubtedly add to speculation that the European Central Bank will cut interest rates later this year (although they are virtually certain to leave things untouched this week). This will be doubly the case since eurozone inflation shows signs of slowing, and Eurostat reported in a flash estimate at the end of last week that eurozone prices rose at an annual rate of 3.3 per cent in April – down from 3.6 per cent in March – suggesting that the worse may be over in terms of price pressures.

The picture, however, is a mixed one. The german economy - despite some recent evidence of weakening in the labour market dynamic - has been holding its head above water, as has the French while, as can be seen from the above chart, Italy's economy continues - like Venice - to sink steadily, and the two eurozone economies which had the strongest housing booms - Spain and Ireland - head steadily off the cliff, with Spain occupying poll position, and by quite a long margin.

Manufacturing PMIs

European manufacturing growth slowed for a third month in April as cooling global demand and a stronger euro took their toll on export orders. Royal Bank of Scotland Group Plc's manufacturing index fell to 50.7 from 52 in March, according to NTC Economics Ltd., which carries out the survey of purchasing managers. That's less than an initial April 23 estimate of 50.8 and the lowest since August 2005. A reading above 50 indicates growth.

The final RBS/NTC Eurozone Manufacturing PMI came in at 50.7 in April, down from 52.0 in March and slightly below the earlier flash estimate of 50.8. The fall in the PMI was the largest for six months and took the index to its lowest since August 2005.

German PMI

German manufacturing activity weakened to its slowest pace in four months in April, but held above its long-term average thanks to robust expansion in output. A dip in new orders growth, however, suggested pressure on output may increase in coming months and the pace of job creation slowed to the weakest since October.

The NTC/BME Purchasing Managers' Index (PMI), based on a survey of 400 firms, slipped to 53.6, adjusted for seasonal swings, from March's seven-month high of 55.1, NTC said.

"The manufacturing sector remained on a healthy footing at the start of the second quarter, with production rising at a robust and above-trend rate," said NTC economist Tim Moore. "However, output growth was again slower than the peak of the current growth cycle and will likely come under pressure in the months ahead following the relatively subdued improvements in new order volumes recorded on average in 2008."

A measure of output rose to 55.3 in April from 54.7, NTC said. By contrast, a gauge of employment fell to 54.2 from 56.5 and a measure of new orders dropped to 52.5 from 54.9.

An NTC gauge of new export orders signalled the second-weakest increase for around three years, falling to 51.8 from 54.0.

"There were reports that the strong euro and deteriorating economic conditions in the United States had both weighed on export demand," the group said. NTC chief economist Chris Williamson said the impact of the strong euro was most discernible in the consumer goods sector in April's survey. "Whether that's down to the euro or just general easing of consumer sentiment in key trading partners like Britain and the United States remains to be seen," Williamson said. "There are problems in competitiveness creeping in because of that strong euro on a broadbased scale," he added. On prices, Moore said a surge in steel and energy costs had underpinned a sharp increase in average cost burdens last month, with the rate of inflation only just below March's eight-month high. "April data suggest that the spike in pipeline inflationary pressure has begun to make its way to the factory gate, as output prices rose at the third-strongest pace in the series history," Moore added

France

Shrinking orders and slowing output caused French manufacturing growth to fall to its weakest level in six months in April.
The NTC/CDAF Purchasing Managers' Index (PMI), came in at 51.1, below March's 51.9 and under the flash estimate and economists' forecasts of 51.5. The index reading added weight to recent data showing a French economy was slowing, even if not as rapidly at this point as some of the other members of the eurozone.

"It looks increasingly possible manufacturing could contract... It all very much depends on factors like the strength of the euro and global demand," said Chief Economist Chris Williamson at data compiler NTC. "We could see some negative figures this autumn... consumers just aren't buying, and the consumer goods industries already reported output contraction in April."

New work placed with French manufacturers contracted for the first time since last September, with the new orders index falling to 48.6 from 50.1 in March.
Output growth slowed, slipping from 53.4 in March to 53.1, well below the long-run average of 54.9. Rising prices led French consumers to cut back in March, and monthly spending fell by its sharpest rate in a year and a half. In April, household confidence dropped to its lowest level in over two decades.

NTC's Chris Williamson said fading demand could affect unemployment, which has been on a downward trend since 2005.

"I think we'll see some modest cuts in employment and net job losses, like we saw at the end of last year, going through to the third quarter," Williamson said. "But French manufacturers have been very conservative in their hiring, especially compared to German and Spanish manufacturers... so that suggests they're lean already and may not need to focus so much on reducing staff costs," he added

This basically slowing but "neutral" call on France can be observed in the EU economic sentiment indicator, which is still holding up tolerably well under the circumstances.

Italy

Italy's manufacturing sector contracted for a second month in April, posting its weakest performance since May 2005 and casting a deepening shadow over growth prospects, accoring to the NTC/ADACI PMI survey.

The NTC Purchasing Managers Index fell to 48.2 from March's 49.4, sinking further below the 50 divide between growth and contraction. The survey is the latest in a string of negative data for the euro zone's third largest economy, underscoring the tough task awaiting incoming Prime Minister Silvio Berlusconi after his victory in last month's general election.

"There are really no indications of a turnaround, with backlogs of work still falling and new orders the weakest since December 2001," said Chris Williamson, chief economist at NTC Research which compiles the data.
"The big area of weakness in Italy is in the domestic economy, and within that the consumer sector where things are going form bad to worse."

The International Monetary Fund forecasts the Italian economy will grow just 0.3 percent this year, and Williamson said the PMI data pointed to a contraction of gross domestic product in the first and second quarters, and possibly beyond.

"These PMI figures are very much signs of recession," he said, forecasting that the rate of job losses is likely to pick up, hitting consumer confidence further. Italy's 1.5 percent 2007 growth rate was little more than half the euro zone average, maintaining a trend of Italian underperformance that has persisted for at least a decade.

The survey showed employment levels fell for the third month running and the manufacturing output sub-index pointed to a fall in output for the first time since May 2005. Input price inflation eased significantly to a four-month low but, with an index level of 64.2, remained at a high level by historical standards.

Spain

Spain's manufacturing sector shrank at its fastest rate in more than six years in April and more hardship seems to be on its way as orders continued to dry up. Spanish economic growth is expected to halve this year from last year's rate of 3.8 percent as property sales plunge, the construction sector shrinks, loan defaults rise, and unemployment surges.

The NTC Purchasing Managers Index (PMI) showed the gloom had settled firmly over the manufacturing sector which shrank for the third month in a row, dropping from 46.4 in March to 45.2 in April, its lowest in 76 months and well below the 50-mark that separates growth and contraction.

The new orders index dropped to 42.0 from 45.3, which NTC put down to weaker demand from the building sector and foreign buyers put off by the strength of the euro. Export orders dropped at the fastest rate in almost five years.

"The continuing strength of the euro and worsening global economic conditions suggest external demand is unlikely to fill the void left by the end of the construction boom." said Nathan Carroll, an economist at NTC.

Employment slipped for the eighth month running and at the sharpest rate for three years at 47.7 as manufacturers tried to cut costs and make up for lower orders.
That might put in doubt government predictions that industry can provide new jobs for those who have been laid off from the construction sector.

"I suspect that these numbers will provide some worrying reading for anyone thinking that the manufacturing sector can absorb jobs from construction ... employment is falling for the eighth month running and the indications are that companies are going to cut back further," said Chris Williamson, chief economist at NTC. "The long term trend in employment is difficult to say ... but would we expect to be seeing job losses in industry in the INE survey in coming quarters? Yes."

So What Happens Next?

My basic guess is that the mechanism for the biggest chunk of the slowdown in the eurozone will come from events in central and eastern europe, and in one of those peculiar but fascinating circular causality processes the crunch in Eastern Europe will come via a slowdown in Germany. Basically the German economy is very heavily dependent on exports (see numerous posts on this blog), and German GDP growth is now very sensitive to export volume growth. The slowdown in the UK, Italy and Spain - which are all important German customers will in all likelihood have a significant negative impact on the German industrial output dynamic, and we saw an indication of this in the relatively weak employment growth in April in Germany. Since most of the CEE is locked into the German economy quite strongly this loss of momentum in the German economy will be felt across the zone, and in a sort of negative lose-lose dynamic this impact on output in the CEE will work its way back home to Germany again. That is to say I would be expecting to see quite a significant slowdown in Germany in the second hallf of 2008. And when we get a big slowdown in Germany the last leg will fall from under this current wave of expansion in the eurozone, in my humble opinion.

Inflation Returns to Japan - Tightroping Between a Slowdown and Recession

2008-05-03T01:54:00.000-07:00

Claus Vistesen Copenhagen

In this note, I am going to have a look at the recent slew of economic data for the month of March as well as other relevant information. Last time I did my monthly review of Japan the data had not budged much. This time is different. As per usual my analysis will progress by looking at Japan's economy from five angles which should subsequently yield a full picture of the current important yardsticks for assessing just where Japan might be heading. Consequently, I will have a look at price developments, domestic demand (also the labour market), domestic investment (and as a derivative here external demand) as well as the Yen. Immediately, there are two important questions which should be stated up front. One is whether I still see the BOJ cutting in Q2? I don't think so. As we shall see below derivatives trading implying future rate movements by the BOJ have, during the past month, moved from a dovish to hawkish and now back to a medium position where most investors and observers expect the BOJ to stay pat for the rest of 2008. The second question is whether Japan is heading for a recession. Upbeat data in the beginning of this month and the (most welcome) reluctance of the data to turn decidedly for the worse recently prompted Morgan Stanley's Takehiro Sato to somewhat retreat from his call that the global economy would see a dual-recession with the second unlucky economy being the US in this case. Since I have also been musing ominously about a potential recession in Japan am I about to retreat to? Not exactly, but I do concede that we are far, at this point, from an actual contraction in Japan. However, this also quickly turns into a alphabetic soup of just what kind of national accounts we are looking and how we 'deflate' the numbers. In Japan's case it e.g. depends on how we treat production vs. income. Basically, the current environment of stagflation means that traditional headline activity numbers need to be taken with a pinch of salt.

A lot of ground to cover then it seems. Let us commence.

If we begin with the development in prices the biggest news from the data was without a doubt how inflation has now returned to the shores of Japan. This was epitomized in the fact that even the price index stripped from food and energy managed to wring out a slight increase in prices at 0.1% y-o-y.

Yet, this is a far cry from the kind of 'escape' that was originally expected in the context of interest rate normalization in Japan and a positive spill-over effect as activity in the corporate sector as well as a tight labour market would lead to a recovery in Japan's hitherto slumbering domestic economy. Of course, the return of positive figures for Japanese inflation has prompted all kinds of knee-jerk reactions from commentators. Even the normally cool David Pilling from the FT was carried away I think as he featured a story noting how Japan may now finally have 'shaken' off more than a decade of deflation. I remain very skeptical of this and I completely agree with Edward when he says that the argument of Japan escaping deflation would carry much more weight if we were standing on the brink of a recovery rather than in the middle of the worst global financial crisis for many years, a subsequent slowdown in global trade, and a resulting slowdown in Japan's economic edifice. The fact consequently remains that the domestic economy is still slumbering and in this light the passage of strong headline inflation to core prices has not have been an easy one. Most commentators and observers are now beginning to latch on to the narrative I, among others, have been pushing in the context of how Japanese inflation is driven by cost-push rather than demand-pull inflation. Reports are thus coming in about how rising raw materials now represent a paramount risk to the Japanese economy. Ken Worsley furthermore has a timely analysis on the recent data from the inflation front reiterating the point that inflation is coming from all the 'wrong' sources. Japanese consumers are thus still very pessimistic on future income expectations and obviously the current bout of inflation naturally weighs heavily here since it erodes real income. We should also understand that the passage of prices down through the value chain is not occurring without collateral damage. This is the whole point about cost-push inflation without the subsequent demand effect. A significant sign of this came with the reports that the amount of small-cap companies, who constitute 70% of the Japanese workforce, filing for bankruptcies rose 18% in the year ending March. To be slain by the sword or the axe seems to be the nasty dilemma for many companies as they are finding themselves in a double bind with no real ability to pass on the rising costs over to their customers. The inflation figures above thus suggest that inflation is now finding its way to consumers in other goods than energy and food. This could in principle be a good sign in the sense that if inflation expectations were to persistently move upward it could pave the way for that much allured interest rate normalisation in Japan. Moreover, recent news that wages were climbing on the back of changing regulation prompting companies to regularize part time workers is a very welcome structural change in terms of labour market dynamics. Yet, I think it is unlikely that this constitutes a lingering trend or at least I remain skeptical that what we have now is the beginning of a virtuous circle. On the contrary it seems as if the current price dynamics in Japan could now constitute more of a vicious circle.

As for the immediate future the current momentum seems likely to keep all three inflation indices in the positive for the next couple of months. However, core prices in Tokyo for April actually moved from a 0.1% increase to a flat reading of 0%. Given that this figure is a leading indicator for the price indices above (to some extent at least) I would not be surprised to see a return to deflation for April in core prices.

If we move over to the development in domestic demand the situation is obviously closely related to the analysis of prices above. The first months of 2008 saw a surprisingly strong showing from Japanese consumers but as I also noted there might be a distortionary bias in the numbers. Quite simply, with a situation resembling stagflation (driven by price increases in food and energy) consumers cannot but take on the increase in prices in the context of consumption of 'non-luxury' goods (i.e. for which demand elasticity is low.)

The first figure above shows, as per usual, the main data as reported by the media. As can be observed the decline in y-o-y consumption of -1.6% means that the initial strong showing at the end of 2007 and in the beginning of 2008 now has been somewhat paired . In fact, the average of the last four months slots in nicely with my general rule of thumb that we should not expect domestic consumption to grow by more than 1% in a Japanese context. For a fuller analysis of this headline consumption figure Ken Worsley provides the relevant information. Especially, the sharp decline in durable goods (i.e. the lacking demand effect again) seems to be a decisive factor in explaining the March figure. A look at the more long term tendencies for the recent two months indicates that we are moving on nicely around reversion to a declining mean over time. The reason as to why we have a mean with 'trend' here as we put it in econometric lingo is, I think, to be found in the context of Japan's demographic profile where an ever declining size of the working and income earning cohorts relative to the total population coupled with endogenous changes in life cycle behaviour (at least I think so) exert a structural pressure on domestic consumption. The future cyclical tendencies in domestic consumption are very difficult to gauge I think. One thing which casts a cloud over the next months' reading is the flurry over the gasoline tax which was not re-approved by the DPJ and may thus be reinstated which would increase gasoline prices and thus potentially push up consumption expenditures (or even divert resources consequently pushing down consumption). The main point is that monthly consumption figures tend to be clouded in a stagflationary environment. What would perhaps be more pertinent, and Ken Worsley's analyses are usually very much to the point, is to look at traditional strong demand components such as durable goods, semi-durables, furniture etc (household investment), auto sales, etc. in order to gauge what the real domestic demand effect is.

In this way, and as I have recently emphasised it would serve us more to look at tendencies in corporate capex (e.g. industrial production) and its connection with export growth if we want to assess the Japanese business cycle.

As we see in the figure above it could seems as if the curve is starting to dip. Obviously, the interpretation for cyclical analysis is not straightforward since we are talking about an index but I still think it is beginning to look as a turning point. As Edward notes here industrial production also nudged back on a monthly basis which suggests that economic activity is now clearly firming down. Not surprisingly the relative poor showing from industrial production comes in conjunction with a marked slowdown in the increase of exports. The semantics here are not insignificant since what we need to understand is that absent a recovery in domestic demand Japan needs a high increase in the growth rate in both exports and as a derivative corporate capex in order to keep the economy floating. If this rate of increase slows down significantly (even if it may not dissipate entirely) it also effectively means an erosion of Japan's only shield against a severe slump. In this light specifically, IMF's and WTO's recent warnings of a significant slowdown in global trade are especially worrying from Japan's point of view since she so desperately depends on being able to leverage external hotpots of economic growth in order to keep growth at a minimum sustainable level*. If the slowdown stabilises on the current level of increase which is a bit lower than the high levels seen in the summer/autumn 2007 I think Japan can weather the storm without experiencing a contraction. However, if the slowdown in capex and exports intensify I am unsure as to how much we can expect domestic demand to take up the slack and in any case growth will have to come down to much lower levels.

Finally, I should mention FX markets where the Yen as ever remains an important canary in the coal mine for gauging the overall risk sentiment in the market place. For a more thorough operationalization of this argument I invite you visit my post on the USD/JPY and its correlation with equity markets.

As we can see the Yen has weakened across the board since last time we looked at this chart and even though we are not nearing the soothing pre credit turmoil carry trading days (save in the context of the EUR/JPY cross maybe) it does seem as if risky behavior is returning to the market. Now, as Macro Man notes in the comment section here he finds that this past week has been rather puzzling. This may be so. However, I don't think that our good MM's compass is completely off and in our immediate context he asked this Thursday whether in fact risky assets and carry trade were once again, if perhaps temporary, the game to play.

The SPX broke 1400 just before and after the FOMC announcement, but there was little appetite to follow through; the close must have been disappointing to bulls. Similarly, USD/JPY flirted heavily with resistance around 105 earlier in the day but failed to breach it, thanks in part to reported Golden Week offers from exporters. Watching these two charts in tandem is probably not a bad idea; if both break and hold, it should suggest that the risk trade is "on, baby." However, if they both continue to jiggly about without showing much inclination to break through, it will send a powerful signal that all is not well in Denmark.....or make that risky financial assets.

I completely agree with MM when he notes that we should be watching the USD/JPY in conjunction with the SP500. As such, it could seem as if the bulls were exiting their pens to scour the planes once again. Surely, those with a knack for risky assets could use the recent employment data from the US to underpin their views. Moreover, the USD seems to be staging somewhat of a come back against the Euro as the economy of the latter fiat currency now decisively seems to be heading for choppy waters. On the Yen, it remains calibrated as a very fine thermometer measuring the degree of risk aversion in financial markets. I urge investors in this context to remember that the fundamentals of Japan's economy are next to useless in plotting the path of the Yen and if anything exerts the opposite effect of what the textbooks would claim. Personally, I am surprised to see that the EUR/JPY is back in the +160 territory and from a short term tactical point of view I think that a sell could be warranted here. The USD/JPY is now firmly back in the 100s and we consequently never really got to stay for long in the <100s>

In Conclusion

How should we connect the threads there then? A good place to start would be to revisit the two questions stated in the beginning. Is Japan heading for a recession and pending that question what I am expecting from the BOJ? As regards the first question it is pretty difficult to say I think but what is not difficult to see is that Japan is now set to slow down significantly. Recently, the BOJ noted (see a detailed analysis here) how the economic outlook had worsened in eight out of nine regions. This change in outlook was chiefly driven by the adverse effect of high headline inflation as well as a decline in corporate profit. On the latter the BOJ is expecting that capex will trend down not least seen in the light of a general slowdown in global trade. The charts above support this analysis. The MOF (ministry of finance) also recently reiterated the general point that economic momentum is fading on the back of declining business activity and investment. I don't think this is surprising. However, what comes next will be a big test of what the idea of a recovery actually means in a Japanese context. Many observers have voiced the expectation that as the external economic edifice slows domestic demand would be able to take over the baton providing a cushion for the low levels of business investment as well as consumption would provide a buffer. I remain very skeptical with respect to these claims. At the very least I expect that whatever change of baton we will see the receiving athlete in the form of the Japanese consumer will be moving at a considerably slower pace than we have seen in the past 18 months. In that vein I think that industrial production need to be watched closely from here on, especially in connection with the slowdown in global trade. One important brigth spot in this regard is the reports indicating that companies are beginning to take on more full time employees as per function of recent legislation. We even learned from the data that unemployment declined in March. This could in theory give a structural boost to wages and thus domestic consumption. However, the chains of economic fundamentals have not been broken. A large bout of economic research suggests that the increase in part time jobs in connection with an ageing workforce is driven by productivity effects as well as ageing workers' preference for supplying their labor exclusively in a part time context. As such, wages should not be expected to increase above and beyond labour productivity I think since this is not possible in the context of many Japanese firms exposed to external competition.

Finally, we have the future course of the BOJ. The new governor Masaaki Shirakawa started out on a hawkish note which even had investors expecting a raise in interest rates at some point during the past month. Such expectations have now been paired and at this point we are back to "normal" so to speak with the BOJ in a perpetual holding position. In my mind there is no doubt that the proverbial statement paving the way for a cut in the event of a rapid deterioration of economic fundamentals is made . However, the market discourse has also changed so as to make a weary eye on climbing inflation a higher priority relative to the initial response of massive damage control to counter the effects of the credit turmoil. In this light I want to hammer down that Japan's exposure to the credit turmoil does not come from the liquidity issue itself but rather from the potential adverse effects of a general slowdown in global activity and trade. For the immediate future I am moving in behind the market consensus pointing towards a holding BOJ for the next three months. This position is subject to a revisit should industrial production show further signs of an accelerated slowdown.

*Where of course "sustainable" in the long run here is virtually impossible but if the end point can be postponed it can buy us time to perhaps turn the ship around