The Eurozone - Mixed Data Suggests a Blurry Outlook

(Update Added Below)

By Claus Vistesen Copenhagen

The biggest news in Europe at the moment could hardly be said to represent the economy which for all intent and purposes is moving along just fine (or is it? we will see below). Rather, the interesting issues at the moment seem to be what Sarkozy, with his recent second-time victory in the national assembly, will do in terms of labour market reforms and the promised fiscal strategy (see latest entries and sources on Eurozone Watch and Eurointelligence for much much more on this). Also and perhaps more important it seems as if the political stage in Europe, after having spent more than 2 years on the canvas following the knock-out from the French and Dutch refusal to the Constitution, is finally read to take up the baton again on the summit starting today in Bruxelles. This time it seems as if the playbook prescribes that the constitution (or whatever we call it) should be stripped for anything which might, oh dear oh horror, lead to a popular referendum in member countries. Once bitten, twice shy it seems. Perhaps though, Europe's political leaders should be less worried this time around as this FT article reports that support for the European Union amongst member states' population is at an all time high mainly on the basis of the strong economic sentiment.

But then again, what is it with that economy?

Let us begin with zone's largest economy Germany. The first thing to note here is that investor confidence declined in June for the first time in several months. This of course should be seen in the context of recent months' buoyant sentiment but it still suggest, as I have noted on several occasions recently, that growth in the Eurozone is waning off going further in 2007. More importantly on Germany is to gauge the perceived inflationary pressures from past and upcoming German wage round negotiations, something which has promted much attention from the ECB as of late regarding the impetus to continue raising rates. First of all we learned that annual wage costs rose by a puny 0.1% in Q1 2007 something which I personally find somewhat surprising even if I did not, in the first place, believe that the German labour market would be the source of much wage push inflation. Another cyclical indicator which was published recently was the German PPI data from industrial production (domestic sales) showing a 1.9% increase y-o-y. This was then noted by Bloomberg as the slowest decline in three years and it further suggests that the inflation bug migh not be as bad as imagined. Remember also here that PPI data is a lagged indicator of wage pressures. Regarding the general inflation data from Germany and the Eurozone the HCIP showed a stable rate of 2% in May just above the Eurozone average of 1.9%. Coupled with recent data on domestic demand operationalized by retail sales which still seem to fall short of this self-sustaining recovery narrative the main issue, I think, still revolves around just how strong domestic demand is in key Eurozone countries. Of course, in Germany we always need to remember the external trade balance and what is still, quite frankly, remarkable performance figures. As such the German statistical office just adjusted the surplus for 2006 to EUR 164.6 billion which signifies that the value of exports exceeded the value of imports by a whopping 22.5%. At the present juncture this of course somewhat backward looking but it still suggests that exports remain very strong in Germany from a general structural perspective.

However, turning to the latest data from the Eurozone as reported by Bloomberg we also see that momentum is still very much present. Consequently, the European services and manufacturing industries expanded in June as measured by the indices from Royal Bank of Scotland Group. However, we need to remember that this is for the entire Europe and not exclusively from the Eurozone. Moreover, especially foreign demand is cited for the continuing impressive demand which once again conforms with my general skepticism towards the sustainability of domestic demand in key member countries. In fact, this quote right at the end of the Bloomberg article paints a rather different picture on the Eurozone economy ...

Rising borrowing costs and the strength of the euro may curb the pace of growth in the second half of the year. The euro has risen almost 7 percent against the dollar in the last 12 months, making European exports more expensive abroad.

Manufacturing orders in Germany fell for the first time in three months in April, and French and Italian industrial production both unexpectedly declined. French consumer spending on manufactured goods fell last month, while the ZEW gauge of German investor confidence unexpectedly dropped in June.

The data still prompted the FT's Ralph Atkins to note how the Eurozone is regaining momentum but as I note above we should think how much of this for foreign demand. In fact, I would argue that the supply/demand dynamics and thus also capacity dynamics here are blisfully unaccounted for in these generalized indices. Note especially here how the Eurozone on aggregate is actually running an external surplus with the rest of the world and has been doing so since Q3 2006. Of course, this masks important cross-country differences but still I think it is an important part of the equation. And then my favorite in terms of future inflation pressures ...

The ECB on June 6 raised its key rate to 4 percent and indicated further moves may be in the pipeline to contain inflation. The measures of input and output prices in today's composite PMI report both increased.

``This could be of concern to the ECB, which had highlighted the risk of high capacity utilization boosting inflation,'' said Sandra Petcov, an economist at Lehman Brothers in London.

I have no time at this point to go into this but reading through Edward's recent posts here at GEM you should get an idea. I mean, just who knows why capacity is declining at this point? And what happens on the flipside of this cycle if capacity in key economies is inelastic to the stimulants offered by monetary policy? I will tell you what, deflation! Ok this might be a scare monger scenario but I do feel as if we are playing into something here which is not very well understood.

To substantiate the after all mixed recent data, we get the recent evidence from Italy where consumer confidence dropped to a one year low in June. Given the relative sluggishness of the Italian economy in the Eurozone this does not at all make me happy given the perceived trajectory of the ECB in the rest of 2007. My guess is that the Italian economy might slow further and with the annualised growth rate from Q1 of 1.2% (0.3% in Q1) there is just not much slack to draw upon! Also, in France the signs from the hitherto strong French consumer dissapointed with consumer spending dropping in May; see original INSEE note here (in French). And please note the political sub-current here ...

``France has a purchasing-power problem,'' Sarkozy told lawmakers yesterday in Paris. ``Salaries are too low and prices are too high.''

(...)

The decline last month may reflect higher interest rates, said Jean-Christophe Caffet, an economist at Paris-based Ixis. ``We're seeing a slowdown in credit,'' he said. The European Central Bank this month lifted its benchmark rate to a six-year high of 4 percent.

My guess is that we will, very soon, see the ECB taking heat as many times before from various political angles. Of course, this has not and should deter the central bank but it does tend to make things more complicated.

The last thing I want to comment on in this note on the Eurozone is the recent data on construction output. On a seasonally adjusted basis output fell in April from March by 0.9%. On an annual basis growth was positive but significnantly lower in April than it was in March. It is of course difficult ot discern a general trend from this but we need to hold this together with the data showing a slowdown in mortgage lending in the Eurozone. As such, at some point the ECB's hiking campaign is going to bite and one of the areas is of course regarding home mortgages and as such also construction activity. I am not saying that the construction industry in Spain for example is crashing; it clearly is not. But to the extent that the housing market in many Eurozone members have been very hot lately (e.g. in Spain, Ireland, Greecen and France) this is clearly going to come off the its high ground now even if it is not in any sense of the word crashing. All this is difficult to say without digging much deeper into the specifics but still it is something to watch out.

In Summary

The only thing missing here is of course an interest call on the future course of the ECB in 2007. In many ways, I have already dealt with this in my previous notes on the ECB decision to take the refi rate to 4% a few weeks back. For all intent and purposes it is very difficult, at this point, not to expect the ECB to take it to 4.25% at some point in 2007. Both the recent remarks from the ECB, the Euribor futures markets as well as forecasts from Morgan Stanley indicate this. I remain skeptical on this and I clearly do not agree with Morgan Stanley when they open the door to a refi rate as high as 4.75%; this I think is highly unlikely. What I think is important is that the ECB from here on quite simply have to become more data dependant as it clear that restrictive territory is moving ever close if the threshold has not been passed already, at least in Italy's case. In that respect, the data fielded above paints a less favorable picture than the ECB had expected or at least, this would be my guess. Also, at some point it will be interesting to see whether the ECB can keep on maintaining its cyclops eye fixed on aggregate inflation and monetary measures. As for my official interest rate call I have nudged it up to 4.25% based more on what I think will happen than I think should happen. One thing I think however to be crucial is the incoming real data on domestic demand in Germany and Italy.

Update

Today adds a couple of new interesting data points which conform with the headline of a mixed outlook for the Eurozone. Firstly, it seems as of business confidence in Germany may have finally topped although we need to remember that sentiment on a relative basis is still on an all time high.

German business confidence fell more than economists forecast in June after a rebound in oil prices and higher borrowing costs raised concern growth in Europe's largest economy may have peaked.

The Ifo institute's sentiment index, based on responses from 7,000 executives, fell to 107 from 108.6 in May, the Munich-based research institute said today. Economists predicted a decline to 108.4, the median of 43 forecasts in a Bloomberg survey showed.

More evidence of a relative easing of momentum in the Eurozone comes from industrial orders which fell in April. I do think we need however to be cautious here since the number after all is from April and with the latest news from the US about how Q2 growth might even pick up we should perhaps expect a reverse in this in the months to come?

European industrial orders fell in April as the higher euro damped exports of the region's textiles and machinery.

Orders in the euro area fell 0.4 percent from the previous month, the European Union statistics office in Luxembourg said today. Economists had forecast a decline of 0.8 percent, according to the median of 15 estimates in a Bloomberg News survey. From a year earlier, orders increased 12.2 percent, compared with an 8.1 percent rise in March.

And finally some good news albeit the fact that it is not really in the bank yet. Still, the French statisitical office revised its growth forecast upwards today for the last two quarters of 2007 (to 0.7%). All in all, if the INSEE predictions for the Q2-Q4 07 come through France will be looking at an annualised growth rate of 2.5% which is not bad at all.

French economic growth will accelerate in the second half of the year as consumer spending picks up, according to Insee, the national statistics office.

Paris-based Insee predicted Europe's third-largest economy will grow 0.7 percent in each of the next two quarters from the previous three-month period after 0.6 percent in the current quarter and 0.5 percent in the first three months of the year.

Structural Aspects of German Export Dependene: Part II

by Edward Hugh: Barcelona


This is the continuation of a post which begins here, and which has simply broken into two for purposes of manageability.

Population and labour participation in Germany


(Click on the chart for a better view).

Throughout this post I have spoken continuously about demographically driven labour market tightening in Germany, but what exactly is the current position in this regard? Well let's start by looking at the above chart which comes from the Federal Statistical Office. The first thing to note is that the German population actually peaked in 2003, and has since been declining. The same also goes for the economically active population. The key point to grasp here is that the potential unemployed population now has a natural tendency to decline in Germany, even with zero economic growth. Obviously, and in particular during 2006 and the first quarter of 2007, the German economy has been growing at what is - by German standards - a pretty high rate, so the natural decline is also accompanied by a real decline produced by increased employment.

The second thing to note about the table is that these are unadjusted data, so to get a real idea of what is happening you need to compare the same quarter from one year to another. Now if we compare, as an example, data for the first quarter, we can see that between Q1 2005 and Q1 2006, the economically active population dropped by some 425 thousand, while unemployment dropped over the same period by some 440 thousand, so effectively there was a only a small decline in effective unemployment (or, if you like a small rise in employment of 20,000 people), despite the sharp fall in the unemployment rate. Now if we come to Q1 2007, we can see that - when compared with Q1 2006 - the economically active population dropped by some 120,000 people (less than in the previous year, presumably reflecting the fact that with the improved labour market conditions more people proportionately remained economically active) while unemployment dropped by nearly 700,000, showing that there was in fact a real and substantial increase in employment in 2006.

The point I want to make here is that while the improvement in employment in Germany in 2006 was real and substantial, with population numbers ticking-on downwards, and hence the economically active population trending down, the "natural unemployment rate" outside of substantial recessions will do so too, regardless of real economic conditions.

Which leaves us with the question as to where the labour force will come from to fuel future economic expansions. This becomes doubly important when you take into account - as I explain in this post over on Demography Matters - that migration flows are now more or less neutral, that is, almost as many people leave each year as enter. Presumably Germany will at some point have to change its immigration policy, but it will be interesting to watch and see just how and when.


German Consumption

Now since I have asserted repeatedly throughout this post that consumption has long been structurally weak in Germany, it would perhaps be interesting to also flesh this part out a bit more (and in doing so I am going to freely draw on work which Claus Vistesen did for this post here).

Now as Claus argues, one of the most striking features of the German economy over the last 25 years - with the exception of the post-reunification boom that is - has been the secular decline in the rate of household consumption growth.




The above figure comes from a paper by Adam S. Posen (summarized here by Wolfgang Munchau) and shows the evolution of German household consumtion from 1991 to 2001 - with the exception of the early 1990s re-unification years which are left out in the figure.

Since the time series used ends in 2001 we also need to look at the data from 2001 to date to try and get a more complete picture. For this I rely on calculations and estimates made by Claus Vistesen.

my rough calculations on price adjusted private consumption expenditure figures from 2002 through 2006(Q1-Q3) show an average increase in private consumption in percentage change of previous year of 0.14%. However, if we exclude the first three quarters of 2006, during the years 2002 through 2005 Germany actually recorded a slight average decline in private consumption of -0.68% y-o-y. This should perhaps indicate that the impressive year in 2006 needs to be explained by other factors, like forward purchasing as a result of the VAT hike perhaps?

It is also worth bearing in mind here that the OECD private consumption index shows for the same period (02-05) an effective stagnation in private consumption relative to 2000 PPP figures (indeed if we take the readings for 2001 to 2006 inclusive there is precisely 2% growth in real personal consumption over 6 years, or 0.33% growth per year).

Another issue which arises in this context is the contribution of of domestic consumer demand to GDP growth. This needs to be looked at from two points of view. In the first place there is the contribution made by domestic consumer demand to real GDP growth, and secondly there is the total share of domestic demand (private consumption) in nominal GDP. In terms of the former the IMF paper referred to above offers interesting and relevant data on Germany's export share in GDP growth. In the first place it is important to note that one more time the reunification boom stands out as something of an irregularity in the general trend. This being said, if we examine the chart below we can see that post re-unification, growth in domestic demand has been making a smaller and smaller contribution to overall GDP growth.




As can see from the chart the contribution of demand to real GDP growth has been pretty volatile over the entire time series, but if we factor out the reunification boom domestic demand's contribution to real GDP growth has steadily declined since 1994, and this decline becomes especially noteworthy from 1999 and onwards. In this sense we should be able to see that the emergence of an export driven growth path has become pretty clear. Moreover if we look at calculations provided in the paper from the German national account figures, we find that the total share of private consumption in nominal GDP has fallen to around 60%. In fact Claus's back of the envelope calculations show a 59% share of private consumption in nominal GDP between 2002 and 2006 - a figure which is relatively stable y-o-y; that is to say, the decline is so slight (yet steady) you have to go into decimals in order to track it. This figure is of course in striking contrast to younger societies such as India for example where private consumption accounts for about 70% of GDP but also with economies such as the UK and the US where the consumption share of GDP is much higher than in Germany.

German Trade Evolution

The following chart shows the evolution in German trade from 1995 to 2006. It is extracted from data supplied by the German Federal Statistical Office. The first column shows exports, the second one imports, the third shows the trade balance (exports minus imports), the fourth the % increase in imports from the previous year, and the fifth the % increase in exports.

(Please click over chart to read clearly)



What can be seen from the chart is that the rate of increase in German exports hit a peak in 2000 (coinciding with the internet boom year), crashed and only really started to gather pace again in 2005 and 2006. It should also be noted that in the strong growth years, rates of export growth have been very rapid indeed, hence the 21% growth in 2000, the 9% growth in 2005, and the 16.5% growth in 2006. The interesting question arises, however, as to just how sustainable this growth is in the longer term, in particular given, as we shall see below, the significant impact of exports to the Eastern European countries, and continuing doubts as to just how long the rapid rates of growth being seen there can continue, given the labour supply constraints they are about to face.


Main Destinations For German Exports


The following chart shows the principal destinations for German exports (by percentage share), and the evolution of each destination over the 1995 to 2005 period.


(Please click over chart to read clearly)



The above chart is, in fact, really interesting, since, for all the talk in the press about the growth in exports to China and other third world emerging markets (and these of course have been growing very rapidly of late) due to the low base from which such exports start, the real impact on German growth is limited. Exports to the US, other old EU countries AND to the new Eastern Europe Accession countries, on the other hand, are all comparatively important. Exports to the new EU countries in 2005, for example, represented 8.6% of all German exports, which compares with a figure of 11% for ALL Asia.

Now if we look at the chart below, which shows the top twenty sources of German imports and destinations for exports in 2006 (in value terms, millions of euros) we can also find some surprises. Like, for example, the fact that exports to the Czech Republic alone were not that far short of exports to China despite the huge difference in the relative sizes of the countries. Exports to Poland were in fact greater than exports to China. So I think this chart really gives us a much clearer perspective on things, and enables us to see just how Germany might be sensitive to a growth slowdown in Eastern Europe.

(Please click over chart to read clearly)



Some indication of the scale of importance of Eastern Europe can be found from the latest edition of the BIS quarterly review (summarised here by Bloomberg), which informs us that:

"Investment and lending have boomed in eastern Europe, pushing up wages and spurring consumer spending, as eight nations joined the European Union in 2004 and a further two followed this year. More than 60 percent of new credit to emerging markets went to European countries in the last three months of 2006, the BIS said today in a quarterly report."

Now a phenomenon which is accounting for 60% of new emerging market credit seems to me to be a pretty important one, and Eastern Europe as such seems to form a relatively important part of the current momentum in global growth, all of which leads us to ask what the impact on Germany will be when all of this eventually slows. Clearly India and others are now coming, so there will be new opportunities, but will German exports be able to retain their relative hegemony in these new markets? This, I think, is an important question.


Co-variation of German Balance of Payments Surplus and GDP Growth

The graphs below - which show the evolution of GDP growth and balance of payments surplus as a % of GDP over the years between 1990 and 2004 - offer us some more evidence for what export dependence means. While the correlation is far from exact, a certain relation can clearly be observed, with GDP expressing a lagged drop subsequent to declines in the level of the BoP surplus (thanks to Claus Vistesen for this). So someone somewhere should be able to develop a "sensitivity index" from all of this.





GDP and Exports Co-Variance

Reinforcing the above the next graph below shows % changes in both GDP and exports on an annual basis between 1995 and 2006 (thanks again to Claus Vistesen). Again (and with a lag) GDP growth seems to follow movements in the growth in exports. It is also worthy of note how the rapid decline in the rate of export growth following the bust in the internet in 2001 is followed by a protracted period of low GDP growth.



I think what both the above graphs clearly suggest is a susceptibility of the German economy to any slowdown in the rate of growth in global trade, and this simple fact alone should help us put some sort of perspective on those claims that the current German recovery may become self sustaining.


Bazaar Economy Hypothesis

Finally I would just like to touch on the so called "Bazaar Economy" hypothesis. This hypothesis is evidently also associated with Dalia Marin's idea of the operation of a reverse Maquiladoras effect in the creation of new product chains. As such it is associated with a growing value - and skill - component in outsourced intermediate activities. The following chart - which shows the evolution of domestic value added and imported inputs for the export sector since 1995 - shows the process at work:

(Please click over chart to read clearly)


As the authors of the IMF study argue that such a picture, together with the econometric results they obtain, constitute an "intuitively appealing" initial confirmation of the Bazaar thesis, and at the very least suggest that this is an area in need of continuing research:

An important contribution of the paper is its attempt to test whether Germany’s export growth was linked to the emergence of new production chains (Marin 2005). Following a well known literature (e.g. Sinn 2005, 2006) the paper argued that the fall of value added in Germany’s export sector reflects a growing share of traded intermediate inputs in the production process. From this perspective, the empirical link between value added and export growth can be viewed as evidence for a more decentralized production process. This interpretation also helps explain why the recent surge in exports did not translate into a significant employment growth in German industry (Becker and others 2005). While this finding is intuitively appealing, the empirical evidence is only indirect and further research is needed to confirm this result.

Summing Up


In this post I have examined some of the structural characteristics of the German economy in the light of certain stylised facts about the recent wave of global growth and the apparent structural dependence of elderly economies (median age 41+) on exports for growth. We have been able to see how growth in German GDP is somehow structurally linked to growth in world trade thanks to export dependence, and that in this whole picture the new EU Accession economies play an important strategic role. We have also seen how weaknesses in the volume of human capital entering the German labour market may well have been decisive in determining a high skill component in the outsourcing practices of German firms, with a consequent long term impact on the aggregate levels of German wages and salaries. We have also noted that this latter effect becomes rather preoccupying when it is considered that for a proportionately smaller workforce to support a proportionately larger elderly dependent population what is needed is more (and not less) value added per worker.


Sources

What Explains Germany’s Rebounding Export Market Share?
Stephan Danninger and Fred Joutz
IMF working paper WP/07/24

Overall Development in Foreign Trade 1950 - 2006. German Statistical Office.

Order of Rank of Germany's Trading Partners. German Statistical Office.

German exports in April 2007: +13.1% on April 2006,German Statistical Office, 8 June, 2007.

Labour costs in the first quarter of 2007 and in an EU-comparison for 2006, German Statistical Office, 8 June, 2007.

Is Human Capital Losing from Outsourcing? Evidence for Austria and Poland
Andzelika Lorentowicz,Dalia Marin, Alexander Raubold: University of Munich, Department of Economics, Discusion Paper

A New International Division of Labor in Europe: Outsourcing and Offshoring to Eastern Europe Dalia Marin GESY Discussion Paper 80, September 2005

Impacts of outsourcing on Germany and Austria's human capital, Alexander Raubold. Phd Thesis. Munich.

‘A Nation of Poets and Thinkers’ - Less So with Eastern Enlargement? Austria and Germany, Delia Marin, University of Munich, Department of Economics, Discussion Paper 2004-06.

Location Choice and Employment Decisions: A Comparison of German and Swedish Multinationals
Sascha O. Becker and Karolina Ekholm, Working Paper August 2005