The Eurozone - A Structural Assesment

by Claus Vistesen : Copenhagen

2006 was a good year in the Eurozone, there can be no doubt about that. We do not yet have the annualized figures but we are probably hovering around 2.5% growth in GDP which is well above growth rates for 2004 and 2005 which registered 1.4% and 1.5% respectively. As such 2006 will be marked as the year when the Eurozone broke all growth records. Yet, should we be bearish or bullish on the Eurozone going forward? In terms of the general consensus there seems to be no end to the upbeat mood among market commentators and although Q1 of 2007 is likely to put a dampening effect on the optimism the general perception is that fiscal tightening and a process of interest rate normalization at the ECB won't stop the sustainable recovery.

Nevertheless, there is a subtle underlying point to grasp here and, although rarely noted, it reveals itself if you take a closer look at the quarterly GDP figures for 2006. Q1 and Q2 of 2006 saw an impressive expansion of 0.8% and 1% y-o-y respectively. However, as we reached the Q3 growth had slowed considerably to 0.5% a figure which admittedly should be taken with a grain of salt since France apparently in the same period (Q3 2006) recorded a growth rate of 0%. As such, the Q4 figures for the entire zone should be perhaps expected to be a bit over 0.5% if you make the assumption that France will not record a second consecutive quarter of zero growth. Still, the figures indicate with some force that the business cycle had perhaps already turned in the summer of 2006 and if this is the case the question needs to be asked as to why the ECB subsequently became so stubborn in persisting with the continuation of an interest rate normalization process which had become, at least to some extent, pro-cyclical. Another important piece of the puzzle in this regard is to be found by once more reverting back to July 2006 and taking a look at market sentiment at the time, when, partly on the back of the BOJ's ending of ZIRP, it was expected that the three major central banks (the BOJ, ECB and the Fed) would embark on a joint interest rate hike in order to scoop up excess liquidity and normalize rates. Yet, what has happened to this hike process? In Japan the long expected second rate rise keeps on being put off and put off, in the US a housing slump and general slowdown deterred the Fed from making any further increases in the latter part of 2006, whilst in Europe the ECB has solidly stuck to its ground, but now the question arises whether in fact the ECB can continue with this normalization process and indeed, in the interests of prudence, whether in fact it should?

The Eurozone - One Economy?

In the above section I have discussed the general development of the economy in the Eurozone, yet perhaps the most important point about the Eurozone economy is that it comprises 13 different countries. In my opinion this is an important starting point since it essentially outlines how the ECB's endeavors of interest-rate normalization towards a single-interest rate to accommodate all economies are almost bound to cause significant asymmetrical shocks given the important differences which exist at the structural level among these economies. This argument is not new and is often operationalized as the effect on real-exchange rates (see Chart below) which occurs as a result of the transition towards ever tighter monetary cooperation.

1

The divergences in real-exchange rates occur as a result of differences in the domestic inflation rate and varying rates of growth in domestic demand, and those countries experiencing fairly high rates of internal demand growth generally have seen their real exchange rate rise relative to the countries which have been more dependent on leveraging exports in order to grow. In particular Germany - the zone's largest economy - has been enjoying something of a beggar-thy-neighbour relationship with the other Eurozone countries as a result of the notable depreciation of its real-exchange rate since 1990. Germany's export driven growth path is epitomized in the evolution in real GDP between 1999 and 2005 where Germany saw a growth of 1.2% of which two thirds (0.8%) can be attributed to net exports. This is in sharp contrast to, for example, Spain where real GDP growth was 3.6% over the same period, and where an ongoing trade deficit subtracted 1% from a 4.6% growth rate for domestic demand. So there are indeed big imbalances in the Eurozone and they ultimately materialize themselves in important current-account imbalances within the zone, as exemplified by the Germany-Spain comparison, with the former running a whopping surplus and the latter a large deficit. An important additional point here is then to note that the Eurozone hardly can be said to uniformally contribute to either a rebalancing or imbalancing of the global macroeconomic imbalances. Yet, this of course also fundamentally brings into the question the very idea of the Eurozone and the ECB's single-interest rate policy. This is also mirrored in much of the criticism towards the ECB's interest rate policy since while it is clear that Spain (and of course Ireland and Greece) could indeed benefit from a higher interest rate we are left with the problem of what this does to growth in Germany and indeed in Italy? But of course the most interesting question remains; what are the main drivers of these imbalances?

Ageing in Different Tempi

There are indeed many differences between the Eurozone economies but ironically one of the biggest is to be found in something all Euro countries have in common: namely all Eurozone countries are ageing as a result of the double impact of increasing life expectancy and sustained fertility below replacement level (and ineed well below replacement in the case of many countries). One obvious consequence of ageing populations are changing dependency ratios, and indirectly shifting participation rates, and such changes represent a common challenge not only for those within the Eurozone but also across the entire EU27. However, these are merely the stylized facts and the reality is that the process of ageing is taking place at very different rates across the Eurozone countries. Once again, Spain and Germany are illuminating examples since while both countries indeed are ageing, Spain (with a median age of 39.9) unlike Germany, has been able to fuel economic growth partly as a result of a surge in immigration from the late 1990s onwards. Conversly, if we look at Germany, which currently has a median age of 42.6, the migration figures are not very encouraging given the overall trajectory of ageing of the German population. Germany is indeed still experiencing a net increase in its population as a result of net-immigration but the inflows have decreased 22% from 1994 to 2003 and as a result the net-immigration contribution has also decreased significantly on a five year basis measured from the period 1990-1995 and 1995-2000. This last figure is probably biased though as a result of the notable immigration into Germany after re-unification which would then make the 1990-1995 figure stand out. So where I am going with all this? Basically, I have a hypothesis here, and although I would not wish to claim that it can account for the entire story in Eurozone asymmetries, I am convinced that it does constitute one important aspect. Thus I am arguing that at least one of the drivers of Eurozone imbalances is anchored in the divergent demographics of the Eurozone countries. In fact, I don't have any doubt that the fact that Spain is running a relatively large current account deficit and Germany conversely running a large external surplus is to a large extent is driven by the differential demographics. Indeed, looking at Germany in the two graphs below we find evidence of the rapid ageing of Germany's population and given my discouse on Japan we could expect Germany to display some of the same characteristics in terms of being structurally biased towards running a surplus on the external balances as we move along as a function of excess domestic supply over demand.

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So if demographics are important here, how might we further show this in relation to the framework outlined above which shows real exchange rate divergences as a result of the difference in transmission mechanism between the single-interest rate regime and the individual country economies. The figure below which plots changes in real exchange rates and domestic demand is illuminating, especially in terms of the Spanish and German case where the former has seen (between 1999-2005) a notable appreciation in its real-exchange rate coupled with an increase in domestic demand whereas the latter displays the opposite trend. It is of course not possible to speak of a clear correlation but given my argument of how demographics affect the growth path of a country the German and Spanish characteristics are in line with theory in the sense that it seems as if an important life cycle component is in play here.

4

Also, if we take the development between real exchange rates and gross exports the same picture reveals itself with for example Germany displaying a decisive growth path where excess domestic supply over demand has kept inflation lower that the Eurozone average. The decline in German domestic demand relative to the Eurozone average could as such be seen as a proxy for the relatively rapid and ongoing process of ageing that is taking place in Germany. In Spain, on the other hand, the real exchange rate appreciation and decline in exports have, as was argued above, been offset by a growth path driven by domestic demand. It is thus my that this increase in domestic demand largely should be ascribed to the favorable immigration influx to Spain from notably Latin America, Africa, and also Eastern Europe (e.g. Romania).

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Circumstantial Evidence?

In conclusion, I am sure that most people would agree with me that all countries in the Eurozone, as indeed in the entire Europe Union 27, face notable challenges with ageing populations and as such underlying the process there is a region-wide structural phenomenon. However, as I have tried to argue, using Spain and Germany as examples, it is way too simple to lump the whole Eurozone together, especially in the light of the global imbalance discussion. The Eurozone countries will not contribute symmetrically to either a rebalancing or further imbalancing and this is indeed one of the main lessons here. However, as I try to argue above, the importance of demographics and the divergent nature of population developments in the Eurozone also have implications for the whole structural fit and governance of the Eurozone as an economic entity. Yours truly is a great fan of the Eurozone and the idea which is behind the creation of a tight monetary cooperation but as an economist and given my belief in the importance of demographics in macroeconomic analysis the Eurozone markup, with its single interest-rate policy and the macroeconomic demands of covergence, quite simply misses the bullseye by a mile in terms of addressing the real differences between the Eurozone countries. As a result, I am genuinely worried that for example Italy with its rapidly ageing population and mounting public debt at some point will have to surrender to the pressure and leave the Eurozone. I am also not very optimistic on the immediate outlook for Germany precisely because the demographic outlook for this country will cause its growth path to be even more biased towards exports and thus foreign demand. In fact, this has already I believe become rather evident with,for example, the recent persistently dissapointing figures on domestic consumer spending. This is also why I am going into 2007 with some concern that the ECB's interest-rate normalization obsession anchored in future inflation expectations and the money supply could have severe consequences for Germany.

In the end however, I realize that my argument hinges on circumstantial evidence. Yet, I do not think it is wholly unreasonable to argue as I am, and crucially I believe that for example the ECB's inability to see the complexity of this will represent an issue as we move along.

References for figures ...

1, 4, and 5 - Bruegel Policy Brief (2006) - The Euro: Only for the Agile. (PDF)

2 and 3 - Deutche Bank Research - The Demographic Challenge. (PDF)

A Property Bubble in India?

by Edward Hugh: Barcelona

The issue as to whether or not the present rise in property prices in India constitutes a bubble has been getting a lot of coverage in recent days. On the India Economy Blog we had a considerable discussion some weeks back (and the comments really are a very good read).

More recently Indiblogger Debashish Chakrabarty asked me a series of questions about the Indian situation for inclusion in the Hindi blogzine Nirantar (full confession: my hindi isn't really all it should be, so I can't offer any pointers here). Anyway the questions were:

1) Why you disagree that this is a bubble? How do you see the price-war?
2) Do you think that Indian real-estate prices are not pumped up and don't need any correction?
3) Indian Real-Estate doesn't have any regulatory body. Is this the scene worldwide?

To avoid unnecessarily consuming space my answers - for what they are worth - are online in English here.

But the question simply refuses to go away, and in today's FT there is an article about the opinions of Deepak Parekh, chairman of the Indian Housing Development Finance Corporation, who takes the view that a significant market correction may now be looming.

In part one's view of this situation is conditioned by one's expectations for Indian growth potential during the coming years, and in particular much hangs on the issue as to what exactly trend growth is in India at the present time. Both Nanubhai and I have taken quite a strong view on this, and argue that trend growth may in fact be higher - and even far higher - than many (yes, we are talking in particular about the Economist here) imagine. Nanubhai has this fairly impressive post on IEB which explains in some detail just why the Economist and others may well be getting this wrong, and I myself had a crack at the topic here (and here).

So generally I think Deepak Parekh may well be overdoing it, and this view is only reinforced by the kinds of arguments to be found on this post (and this one, and this one). In a nutshell, the whole concept of risk just isn't what it used to be right now. There may be some sort of local correction within the Indian market, but, as I argue in my reply to Debashish's questions, this is hardly likely to derail the Indian economy in any serious way. Anyway, in order to take a second opinion ands to try and get a better purchase on the issue I mailed Envenkat - GEM's Mumbai-based India country specialist - to see what sort of a take he had. The brief note he sent back to me can be found below.


Response to Deepak Parekh, a note from Mumbai

by Envenkat

Yes I did see this view expressed by Mr Deepak Parekh in other media in India. He has been on this theme for many months. I do agree that the economics of affordability has not changed yet. But we maybe seeing the emergence of a new consuming class, and hence views based on the traditional consuming class may seem to be out of sync with the market. I guess what I mean is, the new consumer sees the property price as an Mortgage payment/ EMI not as the capital cost of purchasing the property ! This has already happened in the auto industry, and one can see the top-end models being sold more than the entry-level models. More than 75% of the vehicles are now sold on loans. Comparatively only about 30% of the property is sold on loans. However the ticket size for a car, and its loan duration (usually 3 years) is far different from that of a house (loan tenors of 15 years)

What amazes me is that the industry is going ahead full-blast in building deluxe and super-deluxe properties (as opposed to mass/ affordable housing or integrated townships). When I speak to people in the industry - the investment flows into the sector (at project level and company level) is very high. Construction companies who could have had difficulty in mobilising USD 2 mn a year or so ago, are now raising USD 100+ mn from listings on AIM - London, or private equity funds in India or getting themselves listed on the stock exchanges in India. That would give you an idea of the liquidity flowing into the sector. Yes it would be easy to use the traditional India story hooks - like low penetration of mortgages to GDP, low number of built-up houses to families, demand from the corporate/ IT sector to justify the mobilisation of these funds. The servicing of the equity funds mobilised, is going to be something else.

One sunrise sector - IT, has only now been able to justify its valuations based on the sustained growth (in revenues and profits) over the last 5 years. Retailing and Construction are two others which have shown a lot of promise, but can they show the sustained growth path ? From my experience this is usually one wherein the customer is also happy. And with with the sky-high real-estate prices, and housing purchased on loans, the affordability test is usually when there is a downcycle in the incomes. Nobody is forecasting a slowdown in the GDP growth rates for India. Hence everyone is saying - there is a party going on now, enjoy, we will worry about the hangover when it is nearing midnight ! (or we have to go home !)

Commodity-financed time delay fields

by Marcelo Rinesi: Buenos Aires


While Argentina and Venezuela are, like China, among a number of developing countries that have been adding to their reserves (Arg., Ven.) thanks to growing trade surpluses (Arg., Ven.), the drivers of these trends in Latin America are fundamentally different.

China's surge in the world economy has been driven, besides the effects of scale involved, by its quick and through gearing up as a manufacturing base for increasingly sophisticated products. The country's population, political and even cultural dynamics had to shift in order to make this possible. Internal Chinese politics -not to mention banking policies, education, etc- can be seen as the attempt by the Chinese government to "ride the tiger" they let free.

By contrast, the "success cases" of Argentina and Venezuela are mostly due to high prices for key commodities, and little if any internal reconversion was needed for the country, mostly the governments, to cash in the windfall. The countries' fiscal situation, and even the political viability of their governments, wasn't predicated on any improvement to economic processes, methods or tools, but rather on external factors.

In fact, contemporary politics in both countries are, at the level of discourse, ideologically conservative, in the sense that they hark back to questions and issues from decades ago. Much of the Argentinean government's public activities, for example, seem to be related to legal proceedings related to the so-called "Dirty War" of the '70s (although a morally praiseworthy cause, an economic non-issue), and in a weakly nationalistic conflict against Uruguay over the paper plants in construction over the shore of the Uruguay river.

In this they seem in tune with their populations. Argentina's taste of economic re-engineering in the '90s was neither painless nor unambigously successful, and the government's basic strategy of using the windfall from commodity exports to finance a sort of "societal stabilization" via price controls, politically-driven unemployment benefits, etc, has given the Kirchner administration a near complete political hegemony, as well as being the main enabler of Chavez' policies.

It's interesting, and disquieting, to note that this has also been essentially the political strategy of oil-rich countries in the Middle East; if their example is relevant at all, the long-term results of this policy is the growth of increasingly restless, alienated groups that find it hard to meaningfully interact with the international economy. Which shouldn't be a surprise, as their governments have kept them in a time delay field -an expensive one, for sure- for so long.

Of course, long-term alarmism over the prospects of Argentina and Venezuela is at this point unwarranted; neither Chavez nor Kirchner have had yet time to radically affect the societal and economic makeup of their countries (the former not for lack of trying). But it's also true that, were commodity prices to drop tomorrow, neither Argentina nor Venezuela would find themselves with better tools (in technology, infrastructure or management) that they had six or seven years ago.

In a world like ours, that's a long time to sit still.

Iran versus Saudi Arabia Equals a Short-Term Geopolitical Risk Discount and Comfortably Numb Prices

by Artim: New York



Everyone is unambiguously familiar with the concept of the “Geo-Political Risk Premium” in oil markets. More or less a catchphrase for political troubles in the Middle East and a consequent extra price (premium) that then gets added on to the market price of oil, due to the chronic fear of a serious supply disruption.

Anyone heard of a “Geopolitical Risk Discount?” Probably not; yet, that is a phenomenon we are increasingly likely to see in the short-term --due to a snowballing Shia-Sunni divide across the Mid-East (& especially in Iraq), that is on its way to deeply splitting the OPEC -- after prices have already come down in the last few weeks at its fastest pace ever, since the invasion of Iraq. I think this growing new source of regional conflict (particularly Saudi Arabia versus Iran), for once, provides a short window of lower prices that has some interesting implications for investors and policy makers.

Before progressing further let me also emphasize up front that –from a long-term demand perspective-- not much has changed around the world. In that, I subscribe to the view that, within broadly unchanged technological attributes and environmental conservation standards, the structural forces that are almost bound to drive prices higher (than they are now), in future years, are definitely out there. However, from a short-term demand perspective, a couple of odd things have conspired to lower oil prices. First is the freakishly warm winter weather pattern in the U.S. and in Europe. Then there is the lack of any lingering Y/Y hurricane related impacts that last year (at this time) caused higher prices. And last but not least, the combination of these 2 referenced factors have also enabled an improvement of inventory positions around the world and strengthened the case for lower prices in the coming 3-6 months (and possibly longer).

In the remainder of this article –which is premised on growing Saudi-Iran tensions- I try to develop a very rudimentary framework for: establishing intent that forms the basis for conflict; assessing capability that is likely to lead to usage of oil as the main weapon; guesstimating ST outcomes that I think will be characterized by prices operating within a narrow range; and, lastly, highlighting implications for investors and policymakers.

Intent:

The Saudi perspective:





There has been an enormous increase in concern within Saudi Arabia and in the rest of the Sunni-dominated Mid-East about the implications of a Shia dominated Iraq that is closely aligned to a nuclear armed Iran. A thorough analysis of the causes of tension would of course need to be politically intricate and historically nuanced –neither of which I am seeking to accomplish in this web-blog. But, what is clear, is that, as the growth in political power of one protagonist (Iran) becomes an ever growing reality --amidst an emasculated balancing role of a chastened or even demoralized U.S.-- the prospects for the other protagonist (Saudi Arabia) becomes increasingly less secure from almost every single strategic vantage point. In other words, if Iran’s power were to rise unchecked in the region, Saudi Arabia would: 1) have to deal with a substantially powerful partner (& combined with direct or indirect control of Iraqi oil, another potential swing producer) within OPEC; 2) could see its religious domination of the Islamic faith challenged by an alternate religious power, a quasi-politically united Iraqi-Iranian Shi’ite clergy, centered in Qom or Kerbala; and 4) face the prospect of seeing its vast political and moral influence in almost all Islamic and regional multilateral frameworks – OIC, Arab League, GCC, Mid-East peace processes- be challenged, if not outright threatened. And last, but not least, Saudi Arabia (& other gulf states) could face a direct internal challenge if the Iraqi/Iranian Shi’ites were to decide- someday- to incite their co-religionists (a large minority) within the oil rich kingdom(s).

The Iranian perspective:





Iran finds itself at a historical cross-road; on the verge of establishing an enduring socio-political influence on its predominantly Shi’a, but traditionally Sunni dominated, western neighbor and is only a few years away from nuclear capability. This is a historical opportunity in that, not since the days of the Safavid empire, or in even earlier –pre-Islamic- centuries of Persian hegemony over the rest of the region, has Iran faced a clear and present opportunity to establish its political, military and economic security and pre-eminence across the entire region. For so long have the Iranians (especially its Shi’a self-identity) been the underdog in a region dominated either by Arab Sunnis or, subsequently, by western powers, that its popular culture is dominated by the cults of martyrdom and belief in the return of the Mahdi (the mythical 12th Imam, who will redeem mankind). Thus, the prospect of: 1) a weakened West, as exemplified by the lack of the U.S.’ practical or sustainable military/political options in Iraq, coupled with 2) long-term structural demand pressures on oil, and 3) ongoing nuclear enrichment -- all provide it with the building blocks for securing the political and military basis for establishing regional security; if not outright dominance.

Taken together, Saudi Arabia and Iran, the region’s two pre-eminent Islamic and oil –producing heavy weights are unambiguously locked in a struggle for power in a growing political vacuum that is Iraq. So far Iran has exercised its power through its proxies in the region – Hezbollah in Lebanon, and the (Moqtada-led) Mahdi army in Iraq. Saudi Arabia has not really done much in response, in light of the heavy U.S. involvement, thus far, in Iraq. But clearly, the demographic and religious tide within Iraq favors its Iranian competitor. The question that then arises is can the ongoing U.S. “Surge” negate everything that the Iranians have gained in Iraq since 2003? My answer would be probably not, short of a limited U.S. war against Iran itself. But even limited coercive action against Iran will be subject to profound U.S. congressional objections and adverse world opinion. So it is for the Saudis to take up the gauntlet themselves.


For now --short of backing Sunni insurgent terror groups, which the Saudi’s are extremely cautious about (for risking association with Al Qaeda type elements)-- the only effective weapon that the Saudi’s can realistically employ is their enormous oil production ability to keep oil prices low in order to try and constrain Iran’s ability to finance further conflict in the region (be it in Iraq or Lebanon or in the West Bank/Gaza areas). Yet another reason for the Saudis to actively employ the oil weapon at this juncture, has to do with the recent deterioration in the health of the Iranian economy on account of poor management by the Ahmadinejad administration. This fact is evident, in the recent losses suffered by the supporters of the Iranian President, in local elections due to popular frustration with high inflation, and joblessness. This under-appreciated fact could be critical, as the structural fiscal framework of Iran is increasingly encumbered with handouts to Hezbollah, Mahdi army and various other domestic constituents on the basis of ideology (not entirely unlike Chavez’ shenanigans) – thereby leaving it more vulnerable to a dip in oil prices. On the other hand, the Saudis and their Gulf Arab neighbors have either built up large net external creditor positions or are paying down their stocks of public debt. Additionally, the recent tightening of U.S. sanctions on Iran, with the support of the E.U. and (more reluctantly) China and Russia has left Iran relatively bereft of financing sources which makes either internal fiscal adjustment more critical or higher oil prices more necessary.

Capability:

A simple look at the at the attached table (Table 1, below), which is taken from the IEA (Int’l Energy Assoc) website shows that, per November ’06 data, Saudi Arabia and its regional OPEC allies (Persian Gulf based kingdoms/Emirates – Kuwait, UAE, Qatar), are producing something in the region of 14.8 millions of barrel of oil per day (mbd), and have a vast advantage over Iran and its most proximate OPEC ally – Venezuela- both of whom together produce roughly 6.2 mbd. Note that the Saudi coalition can bring upwards of 2.2 mbd into world markets on short notice – this amount is the difference between current production and spare capacity. Note also, that Iran + Venezuela are, as of Nov ’06, already producing 1.2 mbd below their production targets (either because of production constraints or due to more strenuous ongoing efforts to hold down prices). In other words, given a starting point of oil prices at roughly $50/barrel, and the Saudi coalition poised to throw in another 2.2mbd (approximately 3% of total estimated 2006 world demand) and the Iranians and Venezuelans either already doing their utmost to prop up prices or being hampered by ST production difficulties – oil prices have little place else to go but hover around the $48 - $55/barrel range (based on the ST ebb/flow of global demand and timing of Saudi+Gulf overproduction). I think the Saudis will stick to this strategy, as evidenced by their pointed shrugging off of the recent decline in oil prices, rejection of calls –at the behest of the Iranians- for another OPEC (production cut) meeting. Moreover, the Gulf Arab countries have expressed support for the U.S. surge in Iraq, and they too remain painfully aware of the limitations of their ability to influence political events in the region with the exception of modulating oil production and pricing trends.






A caveat of all of this analysis is that it ignores other OPEC, as well as non-OPEC, production trends, capabilities, and actions. Barring Saudi, Kuwait, Qatar, UAE, Iran and Venezuela, all other OPEC members collectively account for just 30% of total OPEC production. Moreover, as again can be seen from the graphs, barring Iraq, such (non-heavy-weight) OPEC members –taken together- are more or less producing at the level of their production quotas, with an additional spare capacity of a modest 0.6mbd. From such levels, these OPEC members could –collectively- very well decide to cut production to put some upward pressure on prices. But, I do not think this will be a viable policy choice since ongoing capacity problems in Indonesia and political issues in Nigeria are the main drivers of most of the compliance (of small OPEC states) with production quotas. If the Saudi alliance were to decide on a sustained course of high production and low prices, such countries as Algeria and Libya really do not have the market wherewithal to counter the low price trend; or they risk facing much lower market share (which then becomes a long-term revenue problem).



As far as Non-OPEC countries are concerned, I think there are indeed some production slippage risks with Pemex in Mexico; we could probably also see a slowdown in Russian production (because of the government’s interventionist stance in oil projects and contract negotiations); though, offsetting these potential setbacks could be higher production in such countries as Azerbaijan, China and Kazakhstan.

In all, in the context of current global demand of roughly 84 mbd yes there are some production slippage risks; though, I do not feel they are either too great or imminent enough to temper my overall ST market call on global oil prices as noted below.

Short-term Outcomes:

Crude oil prices will probably fluctuate in the $48 to $55 range; a “comfortably numb” range from a producer perspective. I.e., a price-range that ensures growth but not enough revenues for ambitious fiscal outlays by populist (or politically aggressive) oil producers. A return of colder weather, stronger than expected global growth, and further geo-political problems say in Lebanon or Nigeria could fuel the risk premium concept and temporarily take prices above $55. But, I think –in the coming few months- the Saudi-Iran conflict potential is compelling and well grounded in political and economic strategic theory to warrant an oil production-based response from Saudi Arabia that will tend to hold back ST prices from rising too much on a sustained basis.

I will concede that there is at least one substantial risk to the comfortable numbness (of oil prices). And this has to do with the likelihood of an Israeli strike on Iranian nuclear installations, with or without the backing/connivance of the Americans and the Saudis. Here too, I do not think the Israelis will countenance such a drastic step until a few regional events (or some combination thereof) have run their course, such as: 1) the impact of the U.S. surge and its recent “jaw-boning” of Iran (a process that could take at least 3-6 months to play out) and/or 2) the Saudi oil-price war to financially strap Iran and restrain its ideological and proxy-driven aggression in the region (an economic tactic, whose success, or lack thereof, should also become more evident in the next few months). Moreover, the risks of an Israeli strike are not lost upon Iran either. To suffer such a strike and not respond “befittingly” would result in a loss of face. And to react befittingly would raise the outright risk of a broader war, and the concomitant risks of damage to (if not shut down of) the Hormuz straits. At this juncture, even as its growing influence in Iraq and Lebanon unsettles the West + Sunni Arabs, Iran’s future political maneuvering room is narrowing and its international isolation is growing.


Given its narrower international diplomatic position, Iran’s foreign policy establishment is already facing a clear fork in its path. It will soon have to choose between either foregoing greater influence in Iraq or put its nuclear enrichment on the back-burner for now. Put differently: given its growing diplomatic isolation + the sheer military and economic pressure arrayed against it (amidst oil prices at 3-year lows) it may soon become objectively inconceivable for the Iranians to simultaneously dominate a future Iraqi government and also continue developing its nuclear options. In this regard, the Saudi driven oil price pressure could serve as a critical (& not just a rhetorical) reminder to the Iranians of the real limitations of the current course of their policies. There already is considerable anecdotal evidence of a deep debate within Iran of the need to avoid further provocation of America in Iraq and elsewhere, and also considerable domestic alarm at the state of the Iranian economy. If such domestic disgruntlement grows noisy –as might very well be the case- I suspect the West will give this internal debate some more time to play out, before making any hasty moves whose political and military trajectories could become far less predictable or even less controllable.

So, in all, I stand by the expectation of a short-term equilibrium crude oil price of $48-$55/barrel; while recognizing the “blow out” risks of some sort of a limited strike in Iran (though, I feel they remain far from certain and will take more time to crystallize).

Implications:

From a trading perspective, it would make sense to put on “straddles” in the short-term to buy into any oil price dips below $48/barrel or sell on any increases over $55/barrel; with a long-bias beyond a 6 month time horizon

From a policy perspective: the next few months may seem like a good time for monetary authorities around the world to relax their guard against a critical source of headline inflation, but –in my view- it might be more prudent to leave rates alone and let lower CA deficits (at oil importing countries) work their way through releasing more liquidity and assisting the growth contribution from the external sector. A quick monetary loosening impetus may subject country specific asset markets to excessive liquidity, and leave inflation fundamentals ultimately vulnerable to either the medium term structural risks of a climb up in oil prices or the less probable, but high impact, risk of a price “blow out.” The latter risk could come to the fore if the principal protagonists – against the noted odds- act too hastily or irrationally.

The Impact of Oil Prices and the Rise of China on US and Global Imbalances

by Nanubhai Desai: New York

There are many theories out there about what the actual causes of global economic and financial imbalances are. In differing degrees, analysts point the finger at a profligate US, or a lack of domestic demand (i.e. or excess savings) in East Asia and parts of the EU. Others point to the structural drivers of imbalances. ICT innovation and the expansion of international trade and finance are both deemed as being responsible (at least partially) for the current state of affairs. The consensus is that these imbalances cannot persist and that some corrections are in order – a rise in the value of the yuan, a fall in the dollar, a reduction in available liquidity, etc. In general, there is a prevailing view that, on account of the massive size of the US current account deficit (estimated as reaching -6.7% of GDP in 2006), what is happening now is unprecedented and a direct consequence of globalization.

However, over the past few years, another more-familiar and sinister force has been exacerbating the impact of all the factors listed above: namely, rising oil prices. Driven by increasing geopolitical angst in the Middle East, sporadic capacity constraints, but mostly by the increasing demand in fast-growing Asia – energy prices have increased almost 2.5 times between 2002 and 2006. In the US, where the average American consumes the equivalent of 25 barrels of oil each year (total consumption is about 7.5 billion barrels per year), this has meant an increase in the trade balance for oil – a major component of the US current account. On the other side of this equation, oil exporting states have by-in-large enjoyed large trade surpluses, and the petrodollars they have ‘earned’ have been invested largely in dollar-denominated assets. (Of course, sizable chunks have also been used to finance domestic real estate development, and sadly, the radical Islamists fighting America.)

Almost simultaneously, China has been on a mercantilist tear – constantly increasing its dominance of the global manufacturing industry. Large US dollar purchases have allowed China to keep the yuan low and exporting industries competitive. The dollar purchases have fueled low interest rates and consequent high consumption growth in the US, resulting in a rapidly increasing bilateral trade deficit.

These two factors alone are responsible for the majority of the deterioration in US current account deficit between 2002 and 2006 – 77% of it to be precise. The chart below breaks down the current account deficit into three components:

1. The bilateral trade balance with China
2. The trade balance in crude oil – estimated by multiplying annual net imports of crude by the average oil price for the year
3. Everything else

Over the period, the US current account deficit went from 4.5% of GDP to 6.6% (2006 numbers have been estimated using data up till Q3 2006) – a deterioration of about 2%. What we can see clearly in the chart above is that oil prices were responsible for more than half of that – or about 1.1% of GDP. We can safely assume that prices alone were responsible because oil consumption did not increase much over the period – only about 1% annually. We can also see in the chart that the trade deficit with China worsened by about 0.8% of GDP – from about $100 billion in 2002 to $235 billion today (2006 number estimated using data up till November 2006). When we net out these two components of the current account, we can see that the balance on all other items worsened by only ~0.2% of GDP over the period. Clearly, the additional money that Americans have borrowed from abroad over the last few years has been used mostly to fund purchases of two things: more expensive gasoline, and more cheap goods from China.

There are also good reasons to believe that on both fronts, we may soon see a moderation in the impact on the current account. Oil prices have eased to about $55 a gallon - $5 lower than their 2006 average. Assuming stable growth in consumption (1% CAGR) and net imports, and using the conservative assumption of 5% nominal GDP growth, we can say that for every $10 reduction in the average annual price of oil, we will see a 0.35% (of GDP) improvement in the current account deficit. To put this in perspective, other things staying the same, an oil price of $40 would imply a current account deficit less than 6% of GDP. While it might be optimistic to think this achievable this year, it seems plausible (though, in my opinion, not as yet probable) that this level can be achieved in the near future – given the recent boom in alternative energy and the push towards consolidating gasoline consumption. (This push can be seen most recently in last night’s State of the Union address with President Bush calling for a 20% reduction in gasoline consumption over the next decade.)

The trade balance with China, of course, is far more complex and unpredictable. The yuan edged up a tiny bit against the dollar last year. In the short term, this raises the cost of imports and exacerbates the deficit. However, over time, it raises the relative competitiveness of American goods and the bilateral imbalance should decrease. This year is sure to include some rumblings from the Department of Treasury about China revaluing up or moving to a managed float. And we might see some token moves from the PBOC – most likely in advance of high profile political events. However, in the end, it might be China’s own domestic imperatives that lead it towards stemming its dollar purchases and the resultant currency peg. Having acknowledged the need for a greater role of domestic demand in economic growth, Chinese leaders should now move gradually towards loosening domestic capital controls – which will mean a slower flow from the ‘savings glut’ into dollar-based securities. The yuan will rise, albeit slowly.

To be sure, recent productivity gains and continued foreign interest will keep Chinese manufacturing competitive – and the impact on the US-China trade balance will be neither immediate nor dramatic. But it seems reasonable to assume that when combined with slowing consumption in the US, we might see it stabilize, and perhaps even drop down a couple of notches.

The current debate about the driving forces behind these imbalances is largely focused on defining the global context under which they have emerged. However, the more important question to consider should be: what is so unique about them now? Because aside from the academic aspect of it, the fundamental question of imbalances is about their sustainability. It is a very fine line, but the operative question to consider should not be ‘Are current imbalances unsustainable?’—but ‘What level of imbalances are, in fact, sustainable?’

The chart below, which examines the current account balances of 150 countries over the past 25 years, paints a conflicting picture. On the one hand, if we look at the average current account balance across all countries, we see that what we are seeing now is nothing new. In the early 80s and 90s, average balances rose to over 8% of GDP – much like today. However, once we weight these individual balances by the countries’ GDPs, we see a different picture. When we look at the sum of the absolute values of these current account balances as a proportion of world GDP, it is quite clear that, this time around, something is quite different. Through most of the late 80s and 90s, this number hovered around 2%. Since 2000, it has risen to over 4% – no doubt powered by the massive deficit in the US, and the concomitant surplus in China.
Though the weighted-measure is undoubtedly a more judicious way to account for imbalances at the global level, it does not mean that average balances are irrelevant. In the chart below, one can see a close correlation between the average level of global imbalances and oil prices (the correlation coefficient is 0.47). Quite clearly, the levels of current account balances worldwide tend to rise and fall with energy prices.
In my view, the driving forces of global imbalances today are a mix of the ‘old’ and the ‘new’ – of the familiar and the unfamiliar – with each having a relatively equal role. High energy prices are the driving force of much of the imbalances today; but they are helped by another seismic structural change – the rise of China. Neither force is likely to be as strong in the next five years as it was in the last five, so it seems plausible that the imbalances could unwind a bit – with the US current account deficit coming down to 4.5%-5.5% of GDP by 2010. The question going forward is whether even that level can be sustained indefinitely. For now though, we should be content in knowing that returning to 2002 levels may be within the realm of possibility.

(Links to related articles are forthcoming)

Migration in Eastern Europe and the CIS - Picking on the World Bank

by Claus Vistesen: Copenhagen


The World Bank has just published a large report on migration in Europe and Central Asia (EAC: in fact Eastern Europe) as well as in the Commonwealth of Independant States. I have already posted a brief note on the topic over at Alpha.Sources but given the scope of the report and its conclusions I thought that I would go into the topic a little deeper for GEM readers. Clearly, this one is all about demographics since migration forms a major part of the discipline and consequently as the world population ages the flow of (and crucially nature of) migration becomes interesting to follow. This is particularly important in the case of Eastern Europe with its demographic profile and its migration relationship with Western Europe. Lastly, we have the more general question of how migration affects the economy of the receiving and sending country. I will return to these questions as I move through the major points of the report (from PDF overview).

Aspects of the Migration Flow

First of all the report highlights the rather substantial nature of migration in the EAC which (excluding movements between industrial countries) amount to one third of the world’s immigration. Looking at the direction of the flows the pattern reveals that a major part of all Eastern European migration (42%) goes to Western Europe where notably Germany and the UK are large recipients. In terms of migration from the CIS it primarily (80%) takes place in an intra-regional context with Russia receiving the lion's share.

Turning to the demographic impact of migration we are given an important initial insight into the general demographic realities in Eastern Europe. The report notes the fact that many countries in the area are experiencing a rather rapid population decline, a decline which is partly driven by net-emigration but also influenced by very low fertility rates which represent a significant trend throughout Eastern Europe. More specifically we are talking about the following countries: Bulgaria, Latvia, Lithuania, Moldova, Poland, Romania, and Ukraine. More interestingly the overview also briefly mentions the crucial point that many countries, despite net immigration, still experience population decline. This importantly also goes for Russia and here I have to say that I am bit disappointed by the report’s balance of points since it is perfectly allright to highlight Russia as a major recipient of immigration but this should be put into the perspective of the general demographic outlook for Russia which is, as has been reported on before on DM, pretty dire. A key issue is the fertility component of intra-regional immigration flows which, given the regional trend, can only add to an already rapid process of ageing. To be fair though the report does indeed note the immense displacement effects of migration internally in Russia and the former Soviet Republic where whole regions and cities are rapidly de-populating.

Another gripe I feel the need to express is the report’s analysis of the drivers of migration. It is not so much that I disagree with the report’s general analysis which notes that migration immediately after the collapse of communism was largely driven by ethnic partisanship as the borders were opened. I also agree that the drivers now to some extent have shifted so that migration today is driven by economic factors and most notably by expectations about future economic evolution as expressed for example in the substantial East-West wage gradient which is to be found. Clearly the substantial flow of east-west migration is also mirrored in the divergent economic outlook and realities of East and West. However, this evolution of migration drivers incites the authors of the report to indicate the emergence of yet another transition in which migration will be driven by demographic factors. What underpins this view is the idea that as Eastern Europe and old Soviet countries age these countries will be less capable of producing emigrants and as such will begin to need replacement immigration from elsewhere. As such they argue that we should expect to see a reversal/change in migration flows in a scenario wherein, for example, the EAC and CIS countries attempt to attract labour from Asia or Africa. In all modesty, I think the authors are dangerously behind the curve here since much as this might seem plausible from a theoretical point of view it is very far from being guaranteed as an automatic process. Where, for example, is all the immigration going to come from? Clearly, the ability to leverage intra-regional immigration will gradually fade, and indeed is already rapidly fading, as fertility continues to decline on a regional scale and if we accept that economic factors and expectations fundamentally drive migration how will many of these countries ever be able to leverage immigration from outside the region? Moreover, the inability of these developing economies to leverage immigration coupled with their internally unsustainable demographics raises important questions about the drivers of longer term economic growth and their ability to push up the value chain. As such, we should be weary of taking this analysis of ‘future trends’ at face value I think. Another related point where I feel the report is jumping to conclusions is in the comparison between the Irish/Southern Europe case and the case of Eastern Europe. What underscores this comparison is the fact that Ireland and Southern Europe have undergone a transition from net-emigration to net-immigration countries in a post-war perspective and as such might we not expect outward migration from Eastern Europe to the EU to decline and perhaps even reverse? It is difficult to gauge just how comparable this effect will be according to the report, and this is perhaps the point where I feel the need to most ardently disagree. It is in fact very unlikely that we can apply the same logic to the two situations and there are several reasons to this. First of all, there is the issue of EU membership and associated with this the flow of structural aid. Many of the sending Eastern European countries are not member states of the EU (although some are) and it is anything but certain that the EU can commit to aid from its structural funds to the same degree as was the case with the so-called cohesion countries (Ireland, Spain and Greece). Moreover the initial demographic and economic point of departure of, for example, Ireland and Spain was very different from that which now exists in the Eastern European countries.

Remittances and Their Economic Impact

Another key aspect of the report is its investigation of the scope and effect of remittances on the economy as departing emigrants send back money to their families in their native countries.

According to the report, the significant share of remittances in the GDP of many countries in Eastern Europe and the former Soviet Union means that outward migration contributes significantly to economic growth there. Furthermore, the flows are likely to be even greater than the official figure presented in the report of US $19 billion in 2004. Not surprisingly, the EU is a major source for these remittances. In a general macroeconomic perspective the report also notes that the importance of the remittances for the receiving countries can be very real in the longer term provided that issues such as institutional weakness and weak governance are addressed. Once again, I really do not disagree with the main thrust of the argument and actually I find it very interesting to see just how much remittances can affect the general macroeconomic environment. However, yet again I think that we are lacking a basic sensitivity to the real issue at hand. It seems to me to be decidedly odd that the human capital component of these remittance flows is not considered. What am I talking about here? Well, as we saw above, emigration from the EAC towards the EU is strong, and this of course is also what is behind these major flows of remittance payments. So what we need to think about here is the compositional effect on the sending countries’ demographics in sourcing emigration to EU which is then able to send back remittances. In short, the fact that remittances from EU to Eastern Europe are so great can essentially be seen as a proxy for the fact that the emigration from the sending countries is taken from a pool of human capital (relatively skilled labour) which these countries so desperately need in order to grow but sadly cannot accommodate relative to the job opportunities in domestic economies. This is for example something Edward has been busy following in the context of Hungary.

It is Easy to Cherrypick

Am I being unfair to the World Bank’s researchers here? I mean, it is after all pretty easy for me to write up an article like this pulling out all the weak spots and hammering down on them. However I do think there are some notable weaknesses in this report and they generally have to do with the lack of sensitivity towards demographic realities in Eastern Europe and also the assumptions on future trends in terms of the migration dynamics in the region. This is of course not to say that the report is useless because it clearly is not. It generally fields a very impressive range of data, especially given the notorious difficulties which the statistical material on migration in the salient countries presents, and in this sense I believe the report does a pretty good job. However, as I have articulated, there are in my opinion some things which need to be scrutinized in greater detail if you want to start to get a handle on the full picture.

What 'disruptive technologies' really are

by Marcelo Rinesi: Buenos Aires


Just a tip: It's not iPhones.

Demography might indeed be fate - and the same can be said about ecology - but, as was the case for the Oracle's often elusive pronouncements, it's not always clear how demographic trends should be interpreted. It's not just the hard problem of figuring out what might happen; there's also the often overlooked problem of what it will mean. This isn't always as straightforward as it might seem.

Consider, for example, the case of Japan. It's clearly an ageing society, and a fast-ageing one at that. This is logically expected to lead to lower productivity and consumption levels - in fact, our own Edward Hugh has long promoted the idea that the current state of the Japanese economy can be ascribed in part to demographic factors. There is a good deal of evidence that suggests this indeed is true in the present and, given the trends in Japanese population and the social and practical barriers to migration into the country, it's only natural to expect that these problems will worsen in the future.

One key assumption in this analysis, of course, is that net productivity falls with age. In other words that, all things considered, a more aged Japanese society will be less productive and less willing to consume. This isn't an unfounded assumption. For example, Skirbekk's 2003 literature survey of age an individual productivity found that worker productivity starts falling rather quickly after the age of 50, with skills specially important in our contemporary economy - reasoning and learning - decaying the most. For any economy strongly dependent of human cognitive capital this can be a very bad blow.

But if demography is fate, biology need not be constant. Just as basic natal care and sanitation drastically changed demographic tendencies in the past, current medical research could very well reduce or even eliminate the cognitive decline involved with age. This isn't an isolated discovery. Prompted partly by fast-growing, affluent markets in Europe, the United States and other countries, and partly by our rapidly increasing knowledge about the human nervous system from the molecular to the cognitive scale, there's no doubt that neuromedicine has the potential not only to improve the lives of tens of millions of people, but also of changing some of the biological dynamics that mediate between demography and economics.

While such a development wouldn't turn Japan -or Europe, for that matter- into a young, booming economy, it would drastically change the future path of productivity levels. Fiscal realities would change, too. Suddenly, a bigger population of elderly people need not be a burden on healthcare systems, but rather a boost to the economy.

This isn't to say that this is actually a prediction. It's but an scenario, but it's a possible scenario and, most importantly, an example of how technological change -and not necessarily out-of-the-blue, unexpected technological change- can drastically modify the underlying dynamics, sometimes even the underlying biological facts, that drive the economic interpretation of current trends. There was a time, after all, when oil had no economic significance (and there will be a time, probably in the lifetime of people already living, when it again won't - how's that for a technologically mediated geopolitical change?).