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Tuesday, February 27, 2007

The Global Capex Debate - Odds and Ends

Claus Vistesen: Copenhagen

The global economy today is surrounded by many vexing questions which are subject to much debate amongst economists. These questions include interesting topics such as global macroeconomic imbalances, the existence of a saving glut, and excess liquidity. Of course all these topics are intimately related and my impetus for this entry is a recent note over at MS GEF entitled the global capex debate (link is down right now, but it is the 19th february issue), where a number of MS analysts engage in a discussion on the topic. So in this entry I am going to address yet another derivative of the global economy, namely that of global capex (investment and capital accumulation), what it is, where it is and is there too little, too much, or just about enough of it, and lastly, but by no means leastly, what drives it?

What is Global Capex?

Generally, capex can be thought of as the investment and/or capital accumulation which accrues as a response to increased capacity needs. As such, there is both a supply and a demand dimension here since global capex can be operationalized as the supply side to capacity which then translates itself further downstream into demand. This conceptualization might seem false since it by-passes the tradtional definition of AD which in itself includes investment as a by-product of savings. However, as I move along here I will make it clear why we need to look at it this way.

But why is global capex important then? To answer this question we need to include the concept of the global capital to labour ratio (K/L ratio) and crucially to ask ourselves what has happened to this ratio in the last decade or so. One of the most notable changes in the global economy over the last 10-20 years has been the massive supply shock to the global economy in terms of how big emerging economies such as China, India, and Brazil have come onstream effectively skewing the K/L ratio in favor of the latter. This supply shock, as it were, has most widely been conceptualized as the so-called China effect which is normally thought to have had two overall effects on the global economy. Firstly, this labour supply shock has often been seen as a positive growth shock to developed economies or perhaps more accurately to their domestic labour and product markets. The point, in its most simple form, is that the emergence of cheap labour has enabled central banks to keep interest rates low without fuelling inflation in many domestic economies. The underlying point is that the abundance of cheap labour in, for example, China has lead to the import of deflation in consumer goods. A further consequence of this is also said to be one of excess global liquidity (a saving glut) as a result of low interest rates. Secondly, we have the global labour arbitrage argument which is used to explain why wages or perhaps more specifically labour compensation has been subdued in developed economies especially in certain sectors. In the US this discussion is for example packaged as a discourse about inequality and how to explain the seeming correlation between productivity growth and income inequality.

So what was global capex again? Well, if we follow the definition advanced in the introduction to the MS' debate we can say as the global K/L ratio has become effectively skewed towards labour, and that the global economy is suffering from a shortage of capital investment or more specifically capex. With this in mind, we should also take note of the point made by Stephen Jen in the above-linked debate (as well as elsewhere) that the whole concept of 'excess' global liquidity is itself a result of the low level of investment relative to the volume of capital available. This effectively means that Jen himself turns the traditional argument (as cited above) upside down when he advances the claim that excess liquidity will continue until global capex has sucked up the 'saving glut.' More specifically, Jen refers to the fact that excess liquidity is 'real' and not nominal which in Jen's own words means that;

Many, such as some ‘old paradigmers’, paint the image that we are standing knee-deep in liquidity flooded by the G10 central banks, with emerging economies as the accomplices through their currency interventions. But I believe it is the low level of global investment that has led to excess savings, which, in turn, have artificially depressed the real long bond yields in the world. This investment (I) and savings (S) framework is a real concept, not a monetary or nominal notion.

What we have above then is more or less what you initially need to juggle around in your head as we venture along. Moreover, it serves to brings us a step further as we can now ask where global capex takes place, what drives it and perhaps also my personal favourite question: where is the capacity (i.e. demand) for this capex?

The Anatomy of Global Capex

Let us begin with the first question in terms of who does the global capex? This is of course a tricky question since everybody obviously does some of it, but as we read along in the discussion over at MS two interesting points emerge. Firstly, we have the point made above that capex is conducted generally to rebalance the global K/L ratio which would then mean that for example China and India with their large share in the positive labour supply shock to the global economy should suck up a substantial and growing component of global capex. China and India are of course a little different in this respect in terms of their respective growth paths (and where they are in the development process) but for the purposes of this note I will simply leave that to one side.

The second important point to be found in their debate is the one forwarded by Robert Alan Feldman, who argues that ageing societies also will demand more capex as the only way they can grow is through increasing their investment shares and their underlying productivity. With this idea in mind, we can now begin to approach a framework from which we may be able to explain the current drivers of global capex. There seems to be two; 1), the skewed K/L ratio translates itself into a demand for capex (too much money chasing too little investment?) to meet the situation of excess liquidity and the saving glut and 2) the ageing process in some key developed economies, which in the most affected economies then acts as a driver for increasing capex as these economies enter a growth path where rising investment shares and an increase in TFP (total factor productivity) become the only viable way to sustain economic growth and living standards in the face of increasingly flat domestic consumption.

However, if we accept this explanation, I still think that we are missing a crucial part of the picture and this is also why, although I do sincerely believe that the Morgan Stanley Team and Brad Setser are right on cue with many of the points the make about the current conjuncture in the global economy, I am going to argue that we still need to adequately factor in one last aspect here, and I do not think it should comes as any sort of surprise to many readers, that I am once again going to invoke the importance of demographics.

In fact, as I have also argued before here at GEM, Robert Alan Feldman over at MS has already contributed markedly to the discourse by suggesting that the ageing process, via the consequent structural decline in consumption, will tend to transit economies onto a growth path driven by investment and productivity gains. However, what seems to be missing here is an account of the flipside to all this talk about the need for more capex, or more specifically an account of where the capacity is going to come from? In order to grind down to the core here it might serve us well to re-call the classic identity which makes up the GDP in an economy.

Y = C+I+G-(X-M)

Now, if we lock-in (growth in) Y at a constant nominal value and imagine a given country X with a median age of around 35 years we could imagine a composition of GDP where C (consumption) equals 70% of GDP. Then, and this follows from Feldman's point as well as arguments advanced a number of times by Edward and I, we should expect this figure to gradually decline as the populations steadily age, coming down around 60% of GDP as media age approaches the 45 mark due to the life cycle component of consumption and saving patterns (empirical evidence for this estimate can be currently found in places like Germany, Japan and Switzerland).

Now, if we hold the share of G (government speding) constant, we could begin to think about this transition by arguing that what gradual population ageing means is a relative shift from a consumption-driven growth path to one driven by saving/investment dynamics (i.e. capital accumulation). However, since we are dealing with open economies we can also expect that this transition also is a transition from one where the economy (perhaps) runs a trade deficit (i.e. domestic excess demand) to one where the economy runs a trade surplus (i.e. domestic excess supply). In fact, it is difficult to argue against this argument I think since the decline in consumption is a proxy for a shrinking demand side in the economy and as such the extent to which investment (capex) can propel domestic growth relies on the extent to which this investment is a countpart to foreign demand or capacity.

We need to remember here the argument that capital accumulation or growth through capital deepening runs into decreasing returns over time and this is exactly what would happen in a closed economy where the population ages and consumption declines accordingly; in such a case investment will enjoy ever decreasing returns relative to the decline in domestic capacity to absorb the capex. So all this is simply to say although I agree with Feldman we need to consider that this also means that ageing societies will be structurally prone to running trade surpluses (Germany and Japan are important test cases here).

This, I would argue, is the only way that these countries can, in Feldman's words, 'fight off' the structural effects of ageing'. In general, of course, consumption still constitutes the lion's share of GDP in all countries, but I would argue that there is structural limit as to how far this number can decline without having consequences for absolute real GDP growth and in the meantime this structural push will only increase the economy's reliance on exports. This is also the link to my initial comment on the supply and demand made in the introduction since whereas the demand for capex can be operationalized as a function of the skewed K/L ratio we also need to think about the demand for capex in terms of what the capex is used for, that is to say that an ageing population will (in real terms) demand fewer goods and thus require less domestically-oriented capex. Of course a theoretical end limit point here might entail what some have coined as 'rapid' dissaving process further on down the line, but we need to think about what happens between now and then even if we firmly believe this may well finally happen.

Too Much, Too Little or Just About Enough?

Leaving this theoretical example for a moment and going back to idea of the global K/L ratio it seems to me that although there are a lot indications which point to too little capex relative to an increase in global labour we might end up with too much! Why you ask? Well, let me explain ...

While we have indeed experienced an immense positive supply shock to the global economy in terms of the emergence of China, India, and Brazil (etc) there is another factor pushing in the other direction and that is quite simply ageing and we need I think to consider this a global phenomenon. We then get an inverse effect. As such, if capex needs to rise to accomodate a growing global labour force (or global supply shock) we also need to realize that the global labour supply might begin to fall at some point. This of course is not yet a reality but ageing and the demographic transition are not synchronously occuring on a global scale from the one and the same point of departure. In fact, as I have been arguing, some countries, such as Germany and Japan are now ageing rapidly, while the whole process of population ageing is nowhere near as advanced in many other develped economies. So, I am sketching a rather different scenario here than the one forwarded by the discussion over at MS. Consequently, we might end up having too much global capex and ageing can help us explain why. Consequently, if ageing pushes economies towards growth paths driven by investment and productivity gains we also need to take into account the likelihood that this growth path will be driven by the need to export. As such, if ageing is a global phenomenon, it also means that as countries join the club of 'demographic decliners' as Feldman has aptly put it, we are left with a long reaching situation where too much capex will need to be absorbed by too few importers of capital.

Investment is Bad then?

I would not want to walk away from this one leaving the impression that I am advocating saving/investment dynamics to be a bad and un-wanted thing for the the global economy since this would make me a pretty poor macroeconomist. Indeed, there have been many profound empirical economic studies which show how long term growth to a great extent is correlated with the savings rate. In this regard I also think it is important to note the point made by Stephen Jen (linked above) about saving rates and investments rates in Asia ...

'Exhibit 2 shows that in Asia, one of the fastest-growing regions in the world, while the savings rates for NE and SE Asia have not changed that much in the past 15 years, their investment rates have collapsed, even including the massive investment that has taken place in China in recent years.'

This clearly suggests that, at this point at least, there is indeed a shortage of investment relative to savings. Moreover we also have the US economy which is increasingly driven by consumption rather than capex. This of course conversely to my argument above indicates, at least in theory, that current growth is being traded for future growth. Indeed, some are hard at work predicting a recession in US which of course would have marked consequences for the rest of the world. So we also need to look at the imbalances here and crucially how demographics affect economies' growth paths and thus saving investment dynamics.

However, what I ultimately propose is that ageing and its impact on the economy might turn around the short term/long term view in the sense that we need to think about long term growth driven by for example technology and investment relative to a given level of consumption to GDP. In essence, we need to think about the idea of a balanced growth path and what happens when consumption as a share of GDP decreases to below 60%? Of course offloading your goods abroad might provide a brief asylum, especially if you are good at it, but in the end this is not structurally viable since many countries also have debt to pay and expensive welfare systems which after all depend on growth rates in the absolute level of GDP and not simply on changes in GDP per working member of the population (productivity).

Ending on the remarks made by MS I am not at all at odds with the general analysis that the skewed K/L ratio demands capex from a theoretical point of view. I am also much intrigued by the proposed relationship between this and the concept of excess liquidity and a savings glut. I like the idea that the world might, in fact, be in the 'early stages' of a whole capex cycle. I don't diasgree with much here but I think other structural forces are at play here in the long run which are important to consider when we discuss the global economy, macroeconomic imbalances and other related topics.

The Least Bad is the Enemy of the Good - Thoughts on Education in Finland

By Aapo Markkanen: Tampere

Finnish education system has often been subject to considerable praise, in large part because of its ability to deliver decent results for relatively modest investments. Finland normally, for example, is found to shine in the OECD's PISA surveys, even though educational expenditure per capita is pretty much around the OECD average. I don't deny this; the country has after all moved up the value ladder rather painlessly, and has thus faced globalisation without too much angst and frustration. The title of PISA 2003, Learning for the Tomorrow's World, says it all -so when it comes to harnessing skill and talent, the Finnish way has certainly got at least some things right. But do not fool yourself into think that everything's perfect. The PISA studies have in fact focused on school pupils at the age of 16, but in what follows I'm to try to explain just how the system starts to fail from that point onwards.

Finnish kids go to school when they're six, though the first year, the pre-school one, is voluntary and it is left up to the parents to decide for themselves. Compulsory education starts when you're seven, and lasts until the end of the primary school -at the age of sixteen, that is. This can be extended by one additional year, and if you're past the tenth grade and you still don't have the primary diploma (as is the case for about one per cent of each cohort) then you're free to quit. Schools are run by municipalities and are largely autonomous; the ministry drafts the curricular framework but gives free hands otherwise -all the way down to the individual teachers, who are quite independent in their work. To some extent, the same idea goes for pupils too, as the subjects that are learnt in the upper classes contain a high degree of optionality.

After the universal primary level the system branches into two secondary ones: upper secondary school, historically considered as the door to university, and vocational training, after which you are usually supposed to start working. About 55% of young people go to the former, 35% to the latter, and the rest don't go anywhere or go somewhere a year or two later -so at the end of the day there are only about 6% that actually quit school completely after the compulsory level, and if you count those who drop out from the next one you have almost twenty per cent of each cohort who don't obtain any secondary diploma.

The tertiary level is divided in two as well: universities are responsible for academic education, whereas the so called "universities of applied sciences" try to provide something more practical and more based on the needs of employers. Here the data on who goes where gets to be a bit blurred - since many students can't make up their mind, or get the place they want, right after the secondary graduation - but the data I did manage to dig out has it that the former host some 174.000 and the latter approx 130.000 students. Both are free, and are supposed to take five (the academic) and four (the applied) years; the EU's Bologna Process (3+2) has, however, brought some changes, and for example the academic unis now require you to finish the Bachelor degree before starting your Master.

Applied unis are more school-like institutions, with narrower structures and curricula, whereas the students within the academic branch of higher education tend to enjoy much wider freedom over what courses to pick and how many years to study -as there are virtually no time limits for graduation, or even for the number of degrees you can complete. Taking into account also the generous student benefits, covering six years as a minimum, and the fact that in Finland you're seven times more likely (according to this OECD PDF, for instance) to be pursuing an academic degree if either of your parents have one than if they have none, your contributor's own perception is that Finnish university-goers are benefiting from a pretty dubious and heritable upper and middle class privileges. Just don't except them to admit it.

It's nevertheless the troubled secondary level to which I'd like to highlight, as I believe that the worst failures -regarding both the allocation of human capital and equality of opportunities - can be found there.

The problem - somewhat ironically, since it is in fact the most indispensable of our national assets - is that Finns overvalue education. Or, in fact, that their image of education is alarmingly elitist and narrow-minded. Our economy and working lives have surely changed but it's the people's attitudes that are still stuck in the past. Finns love to brag about their egalitarian society and the ideal of lifelong learning, but refuse to acknowledge what those mean in practice. Ask them about education and the information society, and it's most likely mobile phones, R&D and, of all things, those free universities that they'll mention. Good education, however, is about so much more than that.

It's about being able to do things better, and differently, when your premises and resources change. When cars get more complex and sophisticated, a car mechanic must learn how to deal with such challenges; as must a metalworks that wants to buy new machinery - and if it's to reap all the productivity gains possible it must be able to count on the employees' ability, and willingness, to use that machinery. The same logic, that the best kind of management today is self-management, applies basically in every field you examine. This means naturally that the best things that education systems can deliver are adaptability and flexibility; and since you shouldn't define your skills for good when you learn them, you shouldn't be made to define where you learn them either.

The root of the problem is a tradition that values academic education too highly and questions its intrinsic value far too rarely; Finnish universities are islands of complacency and self-justification, having always granted themselves the right to define their place in society without paying attention to the demands of the other subjects, and thus the whole education system has been built according to their own demands. The unis have tended to argue that the education they provide needs to be all-round educative, and as a consequence the rest of the system must focus on that objective and ensure that all tertiary candidates get such a basis. Simple semantics tell it well: ylioppilas means both the upper secondary graduate and the university-goer, and derives from the word yliopisto -university, or "higher institute". As well, when the other branch, formerly known as polytechnics in English, changed their names to universities of applied sciences, just guess which institutes (and which students) were kicking the biggest fuss?

The road to both of the tertiary branches is open also after vocational training, yet this possibility is insufficiently put to use. And by the same token, there are far too many upper secondary graduates who don't study further and try to get jobs instead, with their overly theoretic education -thus ending up in some training program, or vocational school, for the next couple of years. This leads to skill wastage and bottlenecks within the labour market, as youngsters spend too much time trying to decide what to do with their lives.

But, besides globalisation, this where the demographic imperative will step in. As age groups turn smaller, it'll become harder and harder for schools to arrange their teaching in a way that meets the standards of both quality and cost-effectiveness. Finnish authorities have always played with the idea of the "youth school", or nuorisokoulu, that would lump the whole secondary level into one and teach not only theoretic subjects but practical ones too. Although different lobbies have so far managed to continually shoot this idea down, I believe that labour shortages and the new constraints on public finances will soon make this a reality. And recognition should go where it belongs, for this is the reform mainly promoted by the blue-collar trade unions.

It won't be a silver bullet, but might well cure many of the biggest problems. Personally I would, by no means make everybody study everything, but rather leave it for the parents and the students themselves to decide, possibly assisted by teachers and student advisors -this could work as a kind of buffet table, and naturally include lots of variety for different kinds of learners. In this way, if you feel after the first year that you've made the wrong choice you could still correct this. Fewer teens would pass their 19th birthday with neither professional training nor plans of studying further, and the lane taking you to tertiary level would finally get to widen enough. Schools that are still perceived as "the loser's choice" by many would disappear, which would result in better motivation and fewer drop-outs. To cut it short, youth school would smoothen our labour market and create more social mobility. And, at the very end of the day, perhaps, images and attitudes concerning concepts such as education, expertise and knowledge could change as well.

It is not only socially questionable to force young people to choose their path so early, but in a time of flux and great change it is also very stupid. Good schools must be places where you learn good basic skills for your future; when you need to specialise and learn more, you'll do it in the next level -and through your life.

Thursday, February 22, 2007

Italy's Economic Problems Under The Spotlight

by Edward Hugh: Barcelona

As Manuel points out in his accompanying note, Romano Prodi's resignation as Italy's Prime Minister is a rather sudden and dramatic, but scarcely unexpected, development. The immediate political crisis may be resolved as rapidly as it appeared, but again as Manuel indicates it may only serve as a prelude for further things to come, and the fragility of any government coalition which may be put together only underlines the difficulties Italy will almost certainly have in addressing what are important ongoing economic problems. This brief note will simply attempt to outline some of the main problems, in order to contextualize the political problem a little.

The Deficit

First and foremost among Italy's immediate economic problems is the question of the government deficit. The debt to GDP ratio in Italy - which is currently somewhere in the region of 107% of GDP - is second only to Japan in magnitude, and the short term position has only been deteriorating of late, with estimates for the 2006 deficit being around the 5% GDP level.

All of this has, of course, placed Italy in somewhat bad odor in Brussels, and lead to the opening of an ongoing excess-deficit procedure from EU Economics and Finance Commissioner Joaquin Almunia under the terms of the revised Stability and Growth Pact. The seriousness of the situation hit the headlines last October when the credit rating agency Standard and Poor's downgraded Italy's credit rating from AA to AA-. All of this would come to have an even more ominous dimension if the situation continued and Italy's credit deteriorated further as the ECB has already indicated that should the grade drop below A, then they would cease to accept Italian paper as part of their reserves.

The upshot of all this is that the Prodi government adopted a fairly restrictive budget in fiscal terms for 2007 in an attempt to bring the deficit for this year down to within the 3% limit set by the EU SGP. Now this budget has been extensively criticised for it's shortcomings (and here, and again see the OECD view here), especially for the emphasis it places on tax increases and one-off measures over structural adjustments in expenditure as a way of addressing what are, after all, long term issues (shades of the German VAT hike here, except that in this case it is personal taxation for higher income earners which bears the brunt rather than consumer taxes), nevertheless it is obviously a step in the right direction, and what matters now is the follow-up, and especially the need for a major attempt to put some sort of order into the long run problems with the pensions system which in the context of the rapid ageing of Italian society (and here) is evidently not sustainable as it is.

And it is in this follow-up process that is precisely the issue in the current crisis, since there is no consensus at all on the need for these kind of reforms among the components of the Prodi coalition (which is why I feel the best outcome which could be expected from the crisis is the incorporation of the old Christian Democrats in the coalition, but again as Manuel indicates, it is far from clear that the left can tolerate this).

As Morgan Stanley's Vladimir Pillonca noted in a useful summary of Italy's current economic situation on the GEF back in January, the very good economic performance (at least by Italian standards, around 2.0% y-o-y, which was a significant increase on the lackluster average of 0.6% achieved during the years 2000-2005, but was still well below the eurozone average of 2.7% for 2006 ) attained during 2006 has had a positive impact on the short term debt dynamic. The trouble is that with most forecasts indicating a mild slowdown in global and eurozone growth this year, and lingering doubts persisting about the short term sustainability of momentum in Germany (Italy's chief export market) it is hard to see this dynamic being sustained across 2007, and any faltering of Italian growth will immediately begin put pressure on the underlying fiscal deficit situation and will once more raise the spectre of a further credit downgrade from Standard and Poor's.

Human Capital

Another preoccupying feature of Italy's forward looking situation is the net human capital balance that the country is sustaining. I have written extensively on this topic here (and here). The heart of the problem is that Italy has a substantial outflow of young educated people (as exemplified by the fact that the percentage of university graduates leaving the country in search of a brighter future is now running at some 4% of the total, up from 1% at the start of the 1990s). This situation takes on added importance in the light of the fact that Italy now has relatively few children (a Tfr of around 1.3) and in fact the Italian population stopped reproducing itself back in the early 1990s. To some extent this situation is offset by a large and steady inflow of migrants into Italy (which is to some extent responsible for the continuing buoyancy of the Italian economy) but I think it is important to think here about the human capital implications of what is happening. I think there is a general consensus among those who study the ageing societies problem that public finances are only sustainable in some of the worst affected societies if their economies manage to achieve a substantial move up the value chain into higher-value-added economic activities. Attracting migrants in substantial numbers to carry out low value work may help short term GDP numbers (as well as the government revenue position) and may indeed help correct some of the structural deficiencies in the population pyramid, but this alone will not turn Italy's welfare system and the associated funding issues from a unsustainable to a sustainable one. To achieve this target Italy needs to retain its talented young people, and put them to work in economic activities which are commensurate with their abilities. Hence the need for major reforms in the labour market, in the ease of setting up businesses (reducing red tape) and in the cost structure associated with the initiation of new types of economic activity.

And here again is another difficulty with Prodi's coalition, since one part of the coalition may well resist such changes ferociously.

Growth Weakness

As has been suggested above, Italy's growth problem is not a new one, and has been persisting for many years now. As can be seen from the chart below Italy's performance has substantially lagged behind that of the other main EU economies since the start of the nineties.

Indeed, as Italian economist Francesco Daveri points out in an extremely interesting podcast (Productivity Growth in Europe), Italy's growth rate has been steadily declining at about the rate of 1% a decade since the 1960s. Again this decline in trend growth has been associated with a steady stagnation in the rate of productivity growth, as Daveri outlines in this paper. Such is the downward secular tendency in Italian growth that it has really become impossible to clearly identify what trend growth is now in Italy, and thus it is hard to determine what part of 2006 growth is simply a temporary 'spurt' and what part is a real improvement in the underlying situation. Only 2007 will begin to make this point clearer. However it is obvious that if any real and lasting progress is to be made on this front, then substantial structural reforms are urgent.

Ageing and Saving?

Part of the issue with the immediate outlook for the Italian economy is the question of just what will be the propensity to save of Italian consumers and wage-earners from any forthcoming increase in income stemming from the recent comparatively good times and the apparent tightening in the Italian labour market (a tightening which is, remember, in part produced - as in the German and Japanese - and here - by the ageing process itself, since the larger number of workers to be found in the retiring older generations are not matched by equivalent numbers in the younger ones that replace them, although this tendency is in part offset by raised participation levels from young women in comparison with their older counterparts, but at the same time it is negatively affected by the increasing number of years spent in education before entering the labour market).

Claus Vistesen and I have already been addressing this ongoing weakness in domestic consumption in Germany and Japan, but it is worth pointing out that while the Italian State may be extraordinarily profligate, Italian citizens are not, and have a comparatively high level of personal saving (there is little in the way of a proerty boom to be found in Italy) as this report from McKinsey and Co outlines. So the most likely scenario is one of mid-term continuing weakness in consumption, and the best possibility for growth would seem to come from structural reform and growing export dependence.

The Outlook Going forward

As mentioned above Vladimir Pillonca offers a pretty balanced assessment of the immediate outlook for the Italian economy. Recent data for both consumer confidence and business confidence are certainly better than many (myself included) actually anticipated, and the Italian consumer appears to be remaining surprisingly robust (although we still need to see some real hard data for 2007, and we also need to see how the political crisis impacts on the confidence mood).

Also Italy seems to have begun to wake itself up to the advantages of a Japan/German style export-lead growth model, and there are serious moves afoot from Italian companies to try and leverage the opportunities which India seems to be offering (here, in Italian unfortunately). Confirmation of this tendency is already to be found to some extent in the recent data, which show that industrial orders have been moving up sharply on the back of significant rise in orders from abroad - 13.4% y-o-y in December, following a 6% m-o-m jump in November alone. So whilst there are evident downside risks (such as the impact of the VAT hike on consumption in Germany, the relatively high value of the euro, the fiscal tightening implicit in the 2007 budget, and the interest rate raising policy of the ECB), and while it is still impossible to see at this stage whether or not Italy will have a brush with recession in 2007 (due in part to difficulties in assessing capacity and trend growth movements at this early stage), there are evidently some significant positive elements at work - in particular those coming from corporate restructuring and the growing global export mentality of a core section of Italian higher-value-added industry (with the Fiat group notably taking the lead here), as well as from the growing numbers of migrants now working in Italy, who, as well as being employees remember, will also be customers and taxpayers.

Clearly the rapid rise of a number of the key developing economies (a process which, ironically, is significantly facilitated by the cheap interest rate environment produced by the presence of the "carry trade") offers important opportunities for Italy, Germany and Japan to thrive in the short term on export growth, it only remains to be seen (and to hope) whether or not these possibilities will be thrust asunder in the Italian case by a return of the old enemies of political instability, cynicism and pessimism.

A crisis is born in Italy

by Manuel Alvarez Rivera: San Juan de Puerto Rico

After only nine months in office, and just over two weeks after it lost a foreign policy vote in the Senate, Italy's center-left coalition government went into crisis when Prime Minister Romano Prodi presented his resignation to President Giorgio Napolitano, following a further foreign policy vote setback in the Senate.

At the time of writing, Napolitano has yet to decide if he will accept Prodi's resignation, pending the outcome of consultations with political leaders. Following these consultations, he may request the government to continue in office - provided it wins a vote of confidence in both houses of Parliament. However, if that doesn't happen, the cabinet would have to resign and a new government would have to be put together, either by Prodi himself, another member of the center-left coalition, or by non-party technocrats. Even then, it may not be possible to form a new government capable of commanding majority support in both the Senate and the Chamber of Deputies, in whose case early elections would have to be called, for both the Senate and the Chamber, or just for the Senate only.

Prodi's predicament is somewhat unusual in that his coalition government enjoys a comfortable majority in the Chamber of Deputies - courtesy of the majority-prize electoral system introduced in 2005 by Prodi's arch-rival (and then-Prime Minister) Silvio Berlusconi - but it only commands a very narrow lead in the Senate, even with the support of seven lifetime members.

In last April's election, Berlusconi's center-right House of Freedoms coalition actually won a majority of votes in the Italian Senate - chosen by a somewhat more restrictive franchise that excludes citizens aged 18-24 - but majority prizes in the upper house are awarded on a regional basis, and in the election they cancelled each other out. Meanwhile, Italian expatriates, who were given separate parliamentary representation by Berlusconi's government, ended up supporting Prodi, and in the process handed him a one-seat edge among elected Senate members. Under these circumstances, a Senate-only poll - which would be Italy's first such vote and would have to be held under the existing majority-prize electoral law - would be even riskier than a full legislative election, since it could bring about a complete parliamentary deadlock if the center-right were to secure an upper house majority.

At any rate, the likelihood of fresh elections appears to be minimal at this juncture. Recent opinion polls have the center-left and center-right coalitions in a statistical dead heat (with the latter holding a very narrow lead), and it is far more likely that President Napolitano - a prominent former Communist who was chosen head of state last year over the objections of opposition right-of-center parties - would seek to exhaust all other alternatives before calling an early poll under an unchanged electoral law that could well bring Berlusconi back to power.

In some ways, this crisis has been somewhat blown out of proportion, since none of the parties in Prodi's coalition have withdrawn their support from the government: on the contrary, the center-left parties have rallied behind Prodi. Nevertheless, while Prodi may yet survive, the government's defeat in the Senate, brought about by two far-left parliamentarians who abstained from voting, underscores the fragility of its upper house majority.

As I have noted before, the government may eventually end up broadening its political base by bringing on board the Union of Christian and Center Democrats (UdC) - which broke with the House of Freedoms late last year - but that move could prove very difficult to sell to the far-left parties, which already find the more conservative elements within Prodi's coalition (read Clemente Mastella and his right-of-center UDEUR) just barely tolerable - and Prodi can't afford to lose the far left either.

While the current crisis is certainly reminiscent of the events of October 1998, which brought down Prodi's first government by a single vote in a Chamber of Deputies confidence vote, a more apt comparison may be with the crisis that took place a year earlier, when Italy's Communist Refoundation Party (PRC), who had sustained Prodi's first government without being part of it, suddenly withdrew its parliamentary support, leaving Prodi (who at the time had been in power for less than a year-and-a-half) with no choice but to submit his resignation. However, the whole thing was over within a week, and Prodi withdrew his resignation, remaining in office for another year.

Thus, the events of the last few days may not bring down Romano Prodi; nonetheless, they may turn out to be the prelude of a greater crisis further down the road.


Romano Prodi will remain in office after his center-left coalition government narrowly won a vote of confidence in the Italian Senate on Wednesday, February 28. The vote in the Senate was held after President Giorgio Napolitano rejected Prodi's resignation last Saturday and asked him to remain as prime minister.

Prodi won the Senate vote by a 162-157 margin. Four life senators voted for the government, as did former UdC leader Marco Follini, now sitting as an independent centrist. Subsequently, Prodi's government prevailed in a Friday, March 2 Chamber of Deputies confidence motion by 342 to 253 - a widely anticipated outcome, since the ruling center-left coalition holds a commanding majority in Italy's lower house of Parliament.

While this sudden crisis has died out in just a week - as was the case in 1997 - the long-term outlook for Prodi's government remains uncertain at best, in the absence of a strong Senate majority. Although Prodi's center-left allies have agreed to a "non-negotiable" 12-point program, it's far from certain the deal will be sufficient to overcome policy differences among coalition partners on a variety of issues, including among them a reform of the existing electoral system.

Moreover, if the events that took place after the October 1997 crisis are any indication of what lies ahead, things don't look very promising for Prodi: after that crisis was overcome, he only managed to last one more year in office before his cabinet finally lost the confidence of Parliament. While history may not necessarily repeat itself, the fact that this crisis has come much sooner than ten years ago - back then, the center-left had been in power for seventeen months, as opposed to just nine this time around - makes it difficult to escape the conclusion that Romano Prodi's troubles are far from over.

Mergers & Acquisitions in India 2007

by Envenkat: Mumbai

The Indian media, has found a new bandwagon – M&A. Corus, Vodafone – Hutchison India, Novelis, Daewoo Electronics, Sinvest, REPower have already been announced. More than USD 25bn would change hands if all the above are consummated, and the first quarter has not even ended! Who knows how many more are in the works ? This set me to thinking about what it is that has really changed in the IndianEconomy, why are we currently seeing so many more of these announcements?

Global flows of Capital into the Country

Pre 1990s, this type of inflow was largely represented by Multilateral and bi-lateral agencies (World Bank, IMF, ADB, JICA…). During the late 90s, with the stock market liberalization and the advent of electronic trading, the FII vehicle became a convenient and efficient channel for such flows. It is estimated there is now over USD 100b of FII money in Indian capital markets. With such a large positive investor experience, the FDI investors could not be far behind. In 2006, FDI in fact overtook FII as a source of funding. However in 2007 it is likely that Outward FDI become greater than Inward FDI.

To put this in another perspective the deals so far announced have a transaction value of more than USD 25 bn, and include around USD 20 bn in acquisition funding! This is close to the External Commercial Borrowing limit, of USD 22bn, set by RBI for the entire country in FY07. So global capital markets are willing to almost double the capital available to Indian Corporates for financing their global acquisitions.

This increase in capital availability is against a global backdrop of rising interest rates and a commodity outlook which is stable or trending downward. Not the kind of scenario in which Risk Managers would recommend increasing allocations for an Emerging Market. Or is it that, India is different this time ?

Investment Grade rating for India

S&P completed its review and in Jan 2007 upgraded India to Investment grade, and hence now all the major credit rating agencies, agree that India is investment Grade. So maybe the Acquisition Funding opportunities were able to capitalize on this very rapidly. We have started hearing about many non-banks wanting to increase their deployment into Indian opportunities.

In the INR/ USD outlook markets have started discussing the possibility of an appreciation. Many of the Indian Corporates have become Net Foreign Exchange Earners, and thus have a natural hedge, if the INR depreciates.

Maybe somethings have changed. But how has the fundamental risk profile of the Indian Corporate undertaking these kind of transactions changed ?

Risk Profile

FII’s, as a shareholder class, are now a significant group in both the Corporates listed on the Stock market, and in Private Equity Funds seeking to invest in unlisted sectors/entitites. FII’s don’t have voting rights in the listed entities, hence would typically walk in case their perceptions concerning a given business change. This has also led to the need to maintain a Quarter On Quarter (QoQ) performance view. Maybe this is making Corporates view M&A opportunities as another option by which to meet their QoQ expectations.

Regulatory Issues, too are contributing – Custom duties are now down to the teens, and the Government has even started talking about single digit custom duty levels. This is now coming close to global levels. If Indian Corporates have to survive and thrive they have to operate at global scale. And M&A is definitely a more rapid way to achieve this! Another development which has significant bearing is the USD 180 bn which is sitting in the country’s foreign exchange reserves. People are concerned about getting better returns than those available from US treasury . Hence the Government too is supportive about using the reserves for Outward FDI, and getting National Pride up into the bargain!

The Managerial profile too is changing – In the early 90s, promoter holding was low, and levels of Debt in the Company were high. With the good corporate performance we have seen in the last few years, debt levels in companies have significantly reduced, and the promoter holding in many companies has now gone up. There are many Companies where the promoter holding is in excess of 50%. This along with the comparatively low gearing, has put the Promoter back in the driving seat of the Corporate strategy.

Maybe that is why we are seeing a rash of M&A transactions in 2007.

What will be the impact of these M&A transactions on Corporate performance/ Strategy – watch out for my next post on this.

Wednesday, February 21, 2007

Japan In The Front View Mirror

by Edward Hugh: Barcelona

This week the Japanese economy has suddenly become the centre of everyone's attention, and just today we have the news that the Bank of Japan has finally bitten the bullet, and gone for a further 0.25% increase in its overnight lending rate. However I cannot help having the unfortunate feeling that everyone is so busy eagerly looking forward (to the recovery, the end of the carry trade, or whatever) that they are making the glaring and rather irresponsible error of forgetting to check on what has been happening behind, and in the only all too recent past.

The G7, as everyone by now probably knows, has just reasserted it's faith in the view that the Japanese economy is well on course to recovery. According to the official statement:

“Japan’s recovery is on track and is expected to continue. We are confident that the implications of these developments will be recognized by market participants”

Now this is a strange statement, since there are plenty of indications coming out of Japan that there are subtsantial doubts about this, and particular there are doubts about the resilience of domestic consumption in the current recovery, as Claus has already ably explained in two excellent posts (here and here). Since Claus will comment further on the details of the current decision, what I would like to do in this note is step back a bit, and reflect upon some aspects of the situation which should give us all cause for serious thought.

In particular there is the issue of deflation, and the danger that Japan may once more fall back into the deflation trap. I say once more, since at the present time I am already getting a strange feeling of deja vu, since few seem to remember that the current approach was tried and found wanting once before, back in 2000. Paul Krugman writing at the time had this to say:

So what if last Friday the Bank of Japan finally ended its "zero interest rate policy" (yes, ZIRP)? After all, it's only a quarter-point rise, in a faraway country that doesn't interest most Americans now that it no longer seems a dangerous competitor. And yet I would not be surprised if future economic historians look back at Friday's move as the beginning of the end for an era, and not just in Japan.

For one thing, this move by the Bank of Japan is a much bigger deal than you might think, because of its potential impact on expectations. By raising interest rates, even slightly, when the economy is still depressed, the B.O.J. in effect signals anyone in Japan who might be feeling stirrings of exuberance that it is likely to step on the brakes in earnest if the economy actually shows any signs of booming, or if consumer prices start to rise even slightly.

All of this is now of course simply history, but it is the sort of history for which many market participants - as opposed to academic economists who follow the Japan problem - seem to have remarkably short memories, and yet the consequences of that history remain, and are it seems, once more coming back to haunt us. As is well known the BoJ subsequently had to back away from the premature 2000 attempt to 'normalise' interest rates, but it seems that little has been learned from that experience. In fact, as is even less-well remembered, this failure constituted the second dent in the BoJs credibility as a deflation fighter. I say the second dent, since it is important to keep in mind that there was an earlier one, and this dent wasn't produced by the the failure to prevent the rise in asset prices that took place in Japan in the late 1980s and which gave rise to the eventual bubble. No, I am talking here about an episode which too place during the years between 1990 and 1995, during which period, according to a later consensus, the BoJ consistenly failed to act swiftly and decisively enough in lowering rates in order to try to prevent deflation occuring in the first place.

The locus classicus of this consensus is a short but influential paper by Ahearne et al (Preventing Deflation: Lessons from Japan's Experience in the 1990s. Alan Ahearne; Joseph Gagnon; Jane Haltmaier; Steve Kamin, Federal reserve Board, International Finance Discussion Papers, June 2002), which was widely read and quoted upon (and notably in the present context by Stephen Roach himself) during the the 2002-03 'deflation watch' period in the US, since it was seen as a central piece of acquired doctrine. Given the importance of all this I will now take the liberty of quoting the paper abstract in full (although reading the paper itself is strongly recommended):

This paper examines Japan’s experience in the first half of the 1990s to shed some light on several issues that arise as inflation declines toward zero. Is it possible to recognize when an economy is moving into a phase of sustained deflation? How quickly should monetary policy respond to sharp declines in inflation? Are there factors that inhibit the monetary transmission mechanism as interest rates approach zero? What is the role for fiscal policy in warding off a deflationary episode? We conclude that Japan’s sustained deflationary slump was very much unanticipated by Japanese policymakers and observers alike, and that this was a key factor in the authorities’ failure to provide sufficient stimulus to maintain growth and positive inflation. Once inflation turned negative and short-term interest rates approached the zero-lower-bound, it became much more difficult for monetary policy to reactivate the economy. We found little compelling evidence that in the lead up to deflation in the first half of the 1990s, the ability of either monetary or fiscal policy to help support the economy fell off significantly. Based on all these considerations, we draw the general lesson from Japan’s experience that when inflation and interest rates have fallen close to zero, and the risk of deflation is high, stimulus, both monetary and fiscal, should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity.

Note the last sentence in particular: when the risk of deflation is high "stimulus, both monetary and fiscal, should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity". And where exactly are we right now? Well it is hard to be certain, but certainly there is a widely held view that the risk of Japan falling back into deflation is not a negligable one.

Now one of the key episodes in the whole lamentable Japan deflation affair took place in the period between May 1994 and January 1995. As Ahearne et al note, the BoJ was at the time busying itself selling the idea that the worst of the long recession was over and that a new phase of economic recovery was on the point of opening up:

The BOJ maintained this (the low interest rate) policy stance unchanged through 1994, as hints of recovery began to emerge. In May 1994, the BOJ observed in its Quarterly Bulletin (pp. 32-33) that “Japan’s economic growth appears to have stopped weakening, against the background of progress in capital stock adjustment as well as the permeation of stimulative effects of monetary and fiscal policies to date.” By November, the BOJ noted that the economy was “recovering gradually,” with all categories of spending showing strength, and long-term interest rates moving up in apparent response.

Ring any bells anyone?

The anticipated recovery, of course, did not materialise as envisioned, there was a sharp slump in equity values and the BoJ was forced to respond by reducing its official discount rate to 0.25% in September 2005, at which level it remained until being lowered essentially to zero in 1999.

There is another difficulty which is also associated with the current consensus narrative on Japan, and that is associated with the current value of the yen. In a useful piece in the Financial Times yesterday, David Pilling (who is generally an excellent Japan watcher) drew attention to the way in which many would seek to put pressure on the Japanese authorities to do something to facilitate an upward movement in the value of the Yen:

There is one more element to add to this potent mix. In the past few weeks, Tokyo has come under pressure from European – though not US – officials over the weak yen which, in trade-weighted terms, is at 20-year lows. Some European finance ministers have linked the issue to Japanese interest rates being 5 percentage points below those in the US and the UK. As well as making Japan’s exports “unfairly” competitive, the criticism goes, the wide differential has fuelled the so-called carry trade, encouraging people to convert cheap yen into higher-yielding foreign assets.

Now let's just think about all this for a moment. Japan is being encouraged to raise rates, not primarily because of the internal needs of the Japanese economy, but in order to address possible problems being caused by the very low (some would say undervalued) level of the yen, and to help ease concerns about the impact of the ensuing carry trade. Fine. But what I ask if this tightening (or as some would say 'normalising') process only serves to send Japan back into deflation again? Well at the very least we would be back with ZIRP, and with it would come another prolonged period of carry-trade activity, with the likely additional consequence that the yen would be lead to weaken even further, as confidence in the BoJ and the Japanese economy suddenly ebbed, and as a further outflow of funds from Japan occured.

And just in case all this isn't enough, we might like to think about the work of Lars Svensson. Lars is Professor of Economics at Princeton University, and is one of the experts on that strange phenomenon known as the liquidity trap, which is of course intimately related with the deflation question, and about which much heart searching has been going on in recent years. So what does Lars have to say about possible policy methodologies for exiting from a liquidity trap (which is of course one of the problems which has been ailing Japan):

"In an open economy, the Foolproof Way (consisting of a price-level target path, currency depreciation and commitment to a currency peg and a zero interest rate until the price-level target path has been reached) is likely to be the most effective policy to raise expectations of the future price level, stimulate the economy, and escape from a liquidity trap. It is the first-best policy to end stagnation and deflation in Japan."
From the abstract of the paper Monetary Policy and Japan's Liquidity Trap (January, 2006).

Now let's leave aside at this point the throny question of whether the 'foolproof path' is as foolproof as it actually seems in the absence of any convincing analysis as to why the problem is such a protracted one in Japan (as well as the associated issue of just who exactly the 'fools' are that Lars would seek to protect us against in framing the idea in this way), the important point to note here is that the best advice one of the world's leading experts on how to handle Japan's problems can give is that they should systematically depreciate the currency, and then hold it down with some sort of peg. He is absolutely clear, allowing a rise in the value of the yen would simply raise expectations of a continuing weakness in prices (and remember this was also Krugman's point back in 2000) and hold Japan firmly in the grip of deflation. So those who now talk about the yen being currently 'undervalued' would do well to bear this in mind. Simply egging the yen upwards will only perpetuate deflation and send Japan careering back towards the re-introduction of ZIRP, which would of course only fuel the carry trade even more, and so on, and so on.

In closing, just three simple points. The first comes from David Pilling's piece mentioned above:

On one side of the debate, many academic economists argue that it is ludicrous even to consider raising rates now. Stripped of energy costs – the normal practice in other advanced economies – Japanese prices are still falling. Few textbooks, to put it mildly, advocate tightening at such a juncture.

Rarely has the distinction been more stark, there is a complete disparity between the advice and thinking of theoretical macroeconomists, and that of policy makers, central bankers, and market analysts. We are, of course, about to get to see who is in fact right (economics has the virtue of being a science which refers to a real world, so spin can only go so far), and my only hope is that one way or another the consequences of any error being committed at the present time are not too serious.

Secondly, lurking behind all this, as I have been indicating, lies the mirky question of why precisely deflation has been plagueing Japan for so long now. Only yesterday Stephen Roach served us up what must still be the consensus view on the situation:

The difficulty Japan is having in extricating itself from a post-bubble deflation may well be emblematic of deeper problems that continue to afflict the world’s second-largest economy. This same difficulty may also be having an important bearing on Japan’s competitive prowess. The damage from the bubble may well have been so wrenching and so fundamental to the system that it simply may be asking too much of Corporate Japan to rise quickly from the ashes and hold its own against the rapid emergence of China, the intense determination of Germany, and the solid gains evident by exporters elsewhere in the developing world.

So the problem stems, on this account, from the difficulties being encountered in extricating Japan from post bubble headaches. But this bubble burst some 18 years ago now. Really I fail to find this a very plausible account, and especially in the light of the fact that in recent years Japan has introduced wide reaching and extensive structural reforms (so yes, the centrality of structural reforms hypothesis is also under test here). As is by now well known to all our regular readers, Claus and I have been advancing another hypothesis, related to demography, Japan's ageing population, and the secular downward trend in the internal consumption GDP share. There is a hypothesis, it seems to fit much of the data reasonably well, and yet there is a a remarkable lack of enthusiasm for even considering this possibility. One notable exception here is MS's Robert Alan Feldman, who as Claus has been noting (and here), has been struggling with the 'something funny' feeling about the Japan consumption pattern. Methinks he is on the point of getting to the heart of the matter. Keep on scratching Robert!

Finally, there is the issue of what will happen to BoJ credibility if they have actually gotten this all wrong. Here I can do no better than cite Hidenao Nakagawa, secretary general of the Liberal Democratic Party (as quoted in this Bloomberg article)

The government's ``chilly, tacit acceptance of the move was based on the reasoning that the BOJ would be left accountable for any subsequent slowing of the economy,'' said Shinichi Ichikawa, chief strategist at Credit Suisse Group in Tokyo.

So the BoJ will remain accountable. Be warned! You are all playing with fire here, and I hope you realise it, since the livelihood and well-being of many millions of people depends on getting this one right.

Tuesday, February 20, 2007

4th Quarter to the Rescue?

By Claus Vistesen: Copenhagen

Earlier last week figures for Q4 growth in Japan and the Eurozone came out and by and large the reports make for very comforting reading accentuating the notion of 2006 as a very good year for economic growth in both the Eurozone and Japan. In my initial notes here at GEM I have maintained a rather pessimitic tone towards growth prospects in the Eurozone pointing most notably to long term structural factors, but also looking forward to 2007 I see the potential signals for a marked slowdown in key member states in the Eurozone itself and in Japan. Yet, as the Q4 figures have rolled in this week and the commentaries have appeared, we find ourselves right smack into the same old optimistic discourse. In the Eurozone the commissioner for monetary affairs Joaquin Almunia was quick to up the forecast for 2007 Eurozone growth pointing simultaneously to the robust and Eurozone wide recovery. You could even hear amongst some commentators mention of the illusive concept of a goldilocks recovery resurfacing. In Japan, the optimism amongst market watchers was also almost uncontainable although some still recognise that domestic consumption constitues an ever enduring weak spot for this proclaimed sustainable Japanese recovery.

So what do the numbers say and what should we expect going forward?

Eurozone - Enough Honey in the Pot?

The 4th quarter figures for the Eurozone were an overall comforting read. Relative to the Q3 figures of 2006 where the Eurozone grew 0.5% q-o-q growth rebounded somewhat to 0.9% q-o-q. So what happended? First of all, and quite surprisingly I have to say no one seems to link this rebound in Q4, at least to some extent, to the French economy where, as we might remember, there was a quite surprising 0% q-o-q growth rate in Q3. In Q4 France grew by 0.6% over the previous quarter, which translates into a 2006 growth clip at an annualised rate of 2.2%. Obviously, the 4th quarter is not all about France since Germany and Italy also reported strong growth rates above the earlier consensus forecast. In Germany, growth increased sligthly from Q3 (0.8%) to 0.9%. The reason for this is widely cited to be a pick up in domestic consumption as consumers chose to bring forward purchasing to avoid the three percentage VAT hike which came into effect on the 1st January 2007. I have not had time to consult the figures in terms of composition but generally the commentaries also confirm the picture of a German growth path which remains driven by strong export growth contributing significantly to Q4 growth too. This phenomenon of forward purchasing, especially of durable and capital goods, is also emphasized by MS's Eric Chaney in his note on the Q4 growth figures in the Eurozone. Actually, the German growth rate does not surprise me that much but Italy's does I have to admit. In Q4 the Italian economy raced ahead reporting a 1.1% growth rate q-o-q and here also the break-down of the growth components has not yet been given in the official data. However, intra-trade dynamics within the Eurozone and especially the sustained pace shown by Germany are noted as major contributors. However, as Eric Chaney also notes, external demand cannot be the sole driver for such impressive numbers for the 4th quarter. Lastly, we have Spain where growth also maintained a lively pace reporting 1.1% q-o-q which also translates into a very strong annualized growth rate of 3.8% (annualized quaterly figures) and close to 3.8% in y-o-y terms too.

So, all in all, there should be plenty of grounds for optimism and as such also grounds for the revival of the goldilocks recovery idea. However, the question remains, will there be enough honey to go around as we venture further into 2007? Well, both Eric Chaney's note as well as this analysis by Eurointelligence pretty much beats me to it in terms of calling and essentially maintaining my pessimism. There are at least two things which we all seem to agree on. First of all, as I have also persistantly been arguing since last summer, fiscal tightening is on the menu in 2007 in both Italy and Germany and given the nature of this tightening process which essentially is a proxy for personal savings I am weary for the outlook for consumer spending and ultimately the evolution in aggregate domestic demand in 2007. Secondly, there is the evolution of the US economy to think about, and although recent data continues to point to a 'soft landing' for the US economy on the back of a housing slowdown in Q3 and Q4 of 2006, the US economy is by no means out of the woods yet. Eurointelligence points to a recent note by Brad Setser in which the December Treasury International Capital report is scrutinized. The worrying data point is that private capìtal inflows have turned negative (at least temporarily) which of course brings into question the sustainability of the mounting US current account deficit. Stephen Roach from MS also has more on this in one of his recent notes. Yet, we also, of course, have commentators like Nouriel Roubini who has been busy pointing us to the possibility of impending credit crunch in the US. Lastly, I should also note that Eurointelligence seems to agree with me (or I with them) in terms of the questionability of the continued presence of inflationary pressures and whether or not the ECB really does need to remain so vigilant, at least on inflation grounds.

In this context we need to keep well in mind that liquidity/monetary measures such as, for example, M3 are not necessarily an accurate measure of inflationary pressures especially in the light of carry trading. Secondly, fiscal tightening is key member countries is also likely to have a deflationary effect on Eurozone aggregate inflation rates.

In the end I also need to point to the inability or reluctance of commetators to factor-in the sustained process of ageing in the Eurozone and especially Italy and Germany. As the ECB continues to pursue an ideal Eurozone-wide interest rate I fear that imbalances within the Eurozone itself might very well grow to become even bigger and as such the strutural growth path of key member countries may be pushed even more towards export dependancy. This is why I am so interested in consumer spending figures from especially Italy and Germany which provide an important test case for the hypothesis.

Japan - Expecting a Hike by the BOJ?

Turning over to Japan the Q4 also reported a healthy growth clip. From the third quarter the economy grew 1.2% which translates into an annual growth rate based on annualised quarterly figures of 2.2%. Of course the interesting thing here is consumer spending and here alongside the FT article linked above Takehiro Sato from MS provides the relevant figures in his note on the Q4 figures. The q-o-q figures show an increase in domestic demand in Q4 of 1% after a (-0.3%) decrease in Q3. This translates into an average q-o-q growth in domestic demand of 0.4% (0.35%) in the last two quarters of 2006. Turning to movement on a y-o-y basis, domestic demand grew 4.8% in y-o-y terms in Q4 but declined (-4.2%) in Q3 on a y-o-y basis. This consequently translates into a composite growth rate in the two last quarters of 2006 on y-o-y basis of a 0.3% increase. These figures are of course subject to continous revision and as the main sentiment goes we should perhaps be looking for a downward revision? Sato from MS also notes that consumer spending perhaps declined on a monthly basis in December relative to October and November. Turning to inflation, prices remain subdued and the Q4 did not see any notable move towards sustained inflation; in short, we are still hovering very close to negative price evolution. Sato has the relevant summary:

Among domestic demand deflators, the public and residential investment deflators remained in an upward trajectory, while the capex deflator also bottomed. Above all, the decline in the personal consumption deflator is hurting overall.

So what does this mean for the BOJ and future interest rate expectations? As I have already argued before following one of Takehiro Sato's points, the BOJ should be very careful about raising in March on the back of positive Q4 figures especially when the general trend in consumer spending figures and inflation is still very weak. MS apparently puts the possibility of a March hike at 50% (or marginally at 51%) which is the equivalent, in analyst-speak, of saying ... this could go either way. In the end, I think the BOJ decision should be pretty clear by now and evidently, if the main yardstick is to remain economic fundamentals, I do not see justification for a raise from the BOJ. However, there are other factors in play here, including pressure to unwind the carry trade as well as the perceived need and/or temptation to act on the Q4 figures. In the end I think that inflation will provide the strongest grounds for the BOJ to stay on hold as it is very likely that the first quarter of 2007 will see inflation dropping into negative territory as the headline reading continues to put downward pressure on prices. Finally, Takehiro Sato continued his Japan coverage last week by reporting that MS have recently upped their forecast for the Japanese economy. The above-mentioned reservations do however all remain, and as we stand on the brink of the next BOJ interest rate meeting we have reverted to a 'too close to call' stance by the markets.

4th Quarter to the Rescue?

So then, we should not be doomssayers here. Both in the Eurozone and in Japan 4th quarter economic data points to a solid growth towards the end of 2006, but what we are talking about here really is only data for one quarter and we should be looking at the bigger picture too, and also, crucially, the structural components of growth in the economies in question. As such, the fundamentals have not changed I think and ultimately this is why I remain sceptical on the ability of both these key economic regions to display the same kind of vigorous growth in the future that we have seen in the recent past. In fact, given the rather spectacular growth stint we have just been through, and especially in the Eurozone, we really should expect 2007 to be somewhat different. At the end of the day we need to think about just how to describe all of this and,crucially, we need to consider just what a 'sustainable' recovery actually means in the present context in the key economies? In Japan, 2006 was the year which marked (for the time being at least) the official ending of ZIRP was ended, but even exiting 2006, where it is widely recognised that growth was at an unprecedented rate in comparison to recent performance, interest rates have not been pushed up since the initial move which took Japan out of ZIRP in the summer of 2006. So, will 2007 finally be the year when this, after all, hideously slow normalization process really starts to take root? Perhaps, but perhaps not, and as I have stressed so many times on these issues we need to look at the structural components and what they mean. A 4th quarter rebound is indeed good in and of itself but whether it is a sign of maintained and sustainable strength is an entirely different question.

Monday, February 19, 2007

The Hard, Fast and Permanent Rules of Carry Trades

by Artim: New York

A lot has been written, over the past few weeks, about "carry-trades" in both the financial press and the blogosphere; a good illustration of the views being expressed can be found in articles in the Economist, and on the RGEMonitor as can be found here, here, and here. The underlying theme that binds such articles is loud and clear: "…there is too much borrowing using the Japanese Yen (JPY) as a funding currency for investments in risky, high yielding assets. Consequently, if, or when, the JPY (for whatever reason) appreciates in value – and, or, if the BoJ hikes its policy rates - then a sharp reversal of short JPY positions in forward FX markets could wreck financial markets and endanger the global economy."

Detractors’ – of the carry trade - utilize a simple framework of analysis that is eye-catching in that its market and policy implications are alarming. My beef with all of this is that it is perhaps too simplistic, and its conclusions –ultimately- are not only on the outer edges of plausibility, but also predicated (more) on event-risk rather than fundamental economic risk.

Put simply, from an emerging market (EM) investment standpoint, the carry-trade involves an investor borrowing in a low cost funding currency (whose value is expected to remain stable-to-weak) and investing the principal in a high yielding currency (a currency whose value is expected to remain stable-to-strong). So basically, yield differentials and expectations of currency values drive the carry trade.

Though difficult to accurately verify, I do not doubt consensus estimates that JPY and CHF (Swiss Franc) based funding is indeed driving the bulk of the carry trade in most EMs these days; in fact the Economist estimates that up to a Trillion dollars of carry trades maybe built on JPY funding alone. All of this, in turn, appears to be driving down the cost of risk-assets, etc. But I have a problem with the widespread peddling of 2 fear-mongering concepts: first, that a sharp appreciation of such funding currencies could lead to a total reversal of or a breakdown in global carry trades; and, second, that policy tightening at the central banks of funding currency countries could have the same financially wrecking and economically devastating effect.

I assess below the (un)reasonability of these two fear-mongering arguments by exploring their plausibility:

First, let’s say the JPY appreciates sharply on account of surprisingly/persistently good economic news. For such a phenomenon to put an end to carry trades in EMs, it would have to be hard and fast and permanent.

Where, I define:

Hard = JPY appreciation in excess of 12%-15%; wherein such appreciation offsets an assumed average (or median) EM local currency nominal yield of around 7% to 9% and an – expected - average annualized real FX appreciation rate of around 4% to 5%.

Fast = very quickly, as in the referenced [hard] JPY appreciation would have to take place in a matter of days, and certainly within less than a month.

Permanent = a lasting condition wherein the [hard and fast] JPY appreciation is not transitory and stays at an appreciated level for a considerable length of time, say, 6 months or possibly longer.

Maybe I am missing something, but amidst Japan’s structural growth and inflation problems and with the added budget constraint of weak public finances and a deteriorating demographic profile, I can’t conceivably imagine how or why the JPY would meet all the hard-fast-permanent appreciation conditions, referenced above, such that JPY funded global carry trades become suddenly worthless or even incur losses.

To be more specific: I do not disagree that, on a trade or inflation adjusted basis, the JPY is undervalued. Consequently, I do not doubt that the JPY does indeed have appreciation potential – perhaps even to the extent of +15%. However, it remains questionable, whether, from a fundamental standpoint, such a large and rapid extent of JPY appreciation will be permanent or even be, temporarily, tolerated by Japanese authorities on account of its deflationary impact and the loss of external competitiveness that it entails. Japanese growth remains far more dependent on net-exports than its U.S. counterpart, and its fragile inflation fundamentals need far more nurturing on account of its critical importance in setting domestic expectations about wages, prices and interest rates and ultimately affecting the temporal stability of consumption trends. As a result, while I remain sympathetic to the "theoretical" possibility of at least some JPY correction, I doubt if its magnitude, rapidity and permanence can come anywhere close to putting at risk the entire construct of global carry trades.

All told, I do not doubt that occasional strengthening of the JPY may hurt carry positions; it probably already has in mid-Feb, after the release of 4Q06 GDP data showed a strong economic upturn and led to a sizeable JPY strengthening (see Chart: 1). As such, the occasional strengthening –or such expectations therein- do seem to trigger spikes in unsecured overnight call rates ("Mutanpo") in interbank markets as investor demand for hedges on unsecured carry trades rise. As is notable, from chart 1, below: the few moments of uncertainty about BoJ rate hikes (in mid-Jan’07) or JPY appreciation (in early-mid Feb ’07) have hardly caused a "blow-out" in interbank rates, thereby signifying considerable confidence in both Yen stability and/or gradual BoJ rate hikes.

The second fear-mongering argument is that the BoJ is going to raise interest rates which in turn could hurt the cost of carry and cause turmoil in global asset markets. This too is a fallacious line of reasoning; as Claus Vistesen has already strenuously argued, here, Japanese inflation remains as elusive as Yeti "the abominable snowman" (notwithstanding, the recent spurt in growth, as evidenced by Q406 numbers). In light of this, the BoJ remains not only unsure about its policy stance but also highly vulnerable to political criticism for reacting to soon or too fast or in response to the wrong data release (i.e. hiking rates –in a politically unpopular fashion- in response to strong economic growth, rather than strong inflation).

But even if I am wrong, and the BoJ does in fact raise rates (as was much expected in mid-January ’07, including by such experts as Takehiro Sato of Morgan Stanley) – then, in my opinion, not only is a 25 bps rate hike simply too small to offset the juicy yields still on offer in such places as Brazil, Turkey, India, Lithuania, and elsewhere… but JPY funded hedges to protect against carry erosion is eminently possible in Japanese interbank markets at fairly attractive prices (the last 2 major spikes in "Mutanpo" –in mid-Jan ‘07 and mid-Feb ’07- averaged less than 15 bps).

Before I end, I would like to point out that our comfort with carry trades remains subject to two other caveats:

First, is the idea – originally advanced by Nouriel Roubini - that if good economic news out of Japan is accompanied by bad news in the U.S. then the JPY could stand to gain much more. Consequently, carry trades could come under far more pressure. Once again, this is all theoretically correct. But why should the U.S. continue to encounter more and more bad news to begin with? If anything, good economic trends in Japan should – over time - offset internal demand weaknesses in the U.S. (say, if, for instance, the housing downturn in the U.S. were to become prolonged then strong Japanese demand should increase the net-exports contribution to U.S. GDP growth). It’s almost as if Roubini were subjecting the U.S. economy to autarkic assumptions and analyses while using the ensuing outcomes in assessing globally inter-connected risk phenomenon!

Second is the criticism about leverage and margin calls. I agree, here, that carry trades that are put on with entirely borrowed (and un-hedged) funds are dangerous, are subject to mark-to-market losses and subsequent margin calls. The resulting risks to the, largely unregulated, hedge-fund industry are obviously sizeable. While agreeing with the systemic risks, I would still argue that this issue is not a direct outcrop of the "carry-trade" per se, nor is it a result of global imbalances and/or the lack of desired policy coordination. Rather, I would put the blame for such systemic risks on regulatory shortcomings in global capital markets that have been unable to keep up with financial innovation and the opportunities that have cropped up with the recent financial maturation of several emerging markets at once.

So, to conclude, carry trades are here to stay for quite a while. All the talk of structuring such exotic trades as short CNY/long INR are a part of a global trend that seeks to capitalize on new and emerging opportunities which may seem surprising or go against the grain of traditional notions of the creditworthiness of a Brazil or an India or a Turkey. But like it or not, somebody somewhere thinks BRL, INR, TRL assets offer good returns and they are going to find the cheapest way to get their hands on such assets. Currently, the JPY definitely remains a very good bargain!

Wednesday, February 14, 2007

Ageing in Germany ... an Important Impact

by Claus Vistesen: Copenhagen

Update: My calculations below have been revised slighlty to show average y-o-y figures in stead of the previous figures which showed average quarterly changes on a y-o-y basis.

In a previous post I have already made a big point out of not lumping the Eurozone together as one single economy here at GEM. At least, I argued that for analytical purposes we should be aware of the caveats involved in doing so. The damn thing about this, of course, is that it demands we look at all the Eurozone economies individually which can become a pointless and thankless task in and of itself. So we do indeed need to look at the aggregate state of the Eurozone whilst at the same time being able to grind it down to country level specifics and in terms of doing this we might want to start with Germany, the biggest member of the Eurozone which also accounts for a little under 30% of the Eurozone economy.

So what is it that is so interesting about Germany? Well, I have already highlighted in my previous post (linked above) that I believe demographics to be important in the sense that the course of Germany's growth will provide an important test case for a hypothesis on how demographics affect the macroeconomic environment. But also more generally the German economy is obviously pretty decisive in terms of overall growth in the Eurozone.

Consequently, as with the Eurozone as a whole in 2006, Germany has also come through the last year quite impressively compared to previous years. In fact, this impressive run in 2006 has lead many commentators to hail the return of Germany towards a sustainable recovery from the recent years of sluggish growth ... some have even talked about a 'goldilocks recovery.' However, I have always been rather reluctant to subscribe to this view and although there can be no denying Germany's impressive performance in 2006 I believe the underlying tale of Germany's growth composition is an important indicator of why we should not perhaps be so optimistic after all. As you might have expected I am going to anchor my analysis in demographics and I really want to stress that I don't do this just because of some sort of fundamentalist view that demographics are destiny to economic growth and performance. I do feel, however, that someone has to talk about this topic and quite frankly I am continuously surprised that noone seems to want to factor this aspect into their economic analysis, especially in Germany where the demographic changes and outlook constitute, after all, fundamental shifts in German society. Essentially, I will argue that the persistently sluggish growth in private consumption coupled with a growth path which is driven more and more by exports are, to a somewhat strong degree, symptoms which are endemic to an economy with a sustained process of ageing such as that which is to be found in Germany.

Consumption in Germany - Sluggishness or Outright Decline?

One of the most striking features of the German economy in the last 25 years with exception of the post-reunification boom is the continuing decline in household consumption growth. Let us scrutinize the facts for a moment.


The figure above from a paper by Adam S. Posen (summarized here by Wolfgang Munchau) shows this development with the exception of 1990 and the re-unification which is excluded in the figure. However, the time series ends in 2001 and I guess that we should also try to account for the period from 2001 onwards in order to try to get a full picture. Now; I should say here that the number crunching gets a whee bit complicated here but I still think we can get a pretty good estimate of the evolution of things. As such, 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? Only yesterday the 4th quarter figures were released and they point to a strong growth stint in Germany and indeed in the entire Eurozone. However, these figures are still subject to revision, and it is worth bearing in mind that the OECD private consumption index (2000=100) shows for the same period (02-05) a stagnation in private consumption relative to 2000 PPP figures. Essentially, it should be quite clear though that private consumption growth in Germany over the past years has not exactly been rampant and the question of course imposes itself ... why is this? Ageing and demographics surely are not the only explanation but let me put it this way. The hypothesis of a strong life-cycle component of economic growth composition is in this case an 'all things equal argument' and in the broader picture sceptical consumers or not it we should only expect the process of ageing to weigh even heavier on the German consumer's propensity to save relative to consume.

Another related issue to the scrutiny of consumption is the contribution of demand to GDP growth. This has two aspects. First of all we have domestic demand's contribution to real GDP growth and secondly we have the total share of demand (private consumption) in nominal GDP. Looking at the former a recent IMF paper on Germany's exports' share in GDP growth which I will return to later provides a telling figure. Once again the reunification boom stands out as somewhat of an irregularity from the general trend.

German.demand.contribution.to GDP.jpg 2

As we can see in the figure the contribution of demand to real GDP is 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 especially from 1999 and onwards we see that the emergence of an export driven growth path has become pretty clear. Moreover if we look at the total share of private consumption relative to nominal GDP calculations from the national account figures we can see that private consumption is now just shy of 60%. My concrete 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, you have to go into decimals in order to track such a slight decline. 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. Why? Well, take a look at the demographic differences between these countries and you should have a pretty good bullseye to go by I would say.

German Exports - Steady as She Goes?

Where Germany's private consumption growth, share of nominal GDP, and contribution to real GDP growth seem on the decline over a more or less extended time series, German exports have, especially since 2000, taken up the baton from domestic consumer demand in contributing to real GDP growth. As I reported in a previous analysis German GDP growth from 1999-2005 averaged 1.2% of which four fifths (0.8%) were due to net exports. By conducting a mirror of the consumption calculations carried out above my calculations show that net exports in Germany averaged a growth rate y-o-y of 1.32% between 2002 and 2006 (Q1-Q3). Between 2004 and 2006 the surplus in trade in goods and services has stood steady at 5-6% of GDP. Another interesting perspective on German exports come from a recent IMF paper (mentioned above) which sets out to explain the rebounding market share of Germany's export sector. The paper is excellently summarised by Wolfgang Munchau over at EuroIntelligence. Essentially, the paper argues that specific ties to fast growing trading partners and the successful exploitation of regionalized production and value chains have been strong contributors to the rebounding market share of Germany's export sector. Interestingly, the paper somewhat goes against the so-called global labour arbitrage theory which argues that wage moderation in developed economies have been necessary in order to compensate for the emergence of especially India and China on the global stage. Indeed, Germany has experienced considerable wage moderation from the mid 1990s and onwards. This is especially evident internally in the Eurozone where the decline in Germany real effective exchange rate has caused many to speak of a beggar-thy-neighbour policy conducted by Germany vis-à-vis its Eurozone colleagues. However, whereas the German exports indeed have been strengthened in an intra-zone perspective the paper dismisses this factor's contribution to the overall increase in Germany's export market share. This is interesting in so far as the general argument on the importance of global labour arbitrage which is also sometimes argued to be the source of exactly sluggish domestic demand in for example Germany and Japan.

Obviously, this remains a very powerful and potent global economic dynamic but we need to look at it alongside another global phenomenon, namely that of ageing and essentially the build-up of demographic imbalances as a result of countries' asymmetric paths through the demographic transition. The thing which stands out in the IMF analysis as the main reason for Germany's growing international export market share are the ties to fast growing trading partners. I don't believe that you need to think long and hard to guess that these trading partners include prominent global players such as India and China, but it is also interesting to note how the petroexporters are singled out by the paper. I find this interesting since some of the very recent news coming out on the Germany tends to suggest that these conditions are changing. As such, exports declined in December 2006 for the second consecutive month but, more importantly, one thing which is highlighted is how, for example, industrial products sold to China are declining as China is moving up the value chain and thus becoming able to produce these goods domestically. Once again, the evidence of another strucutural shift here is just one more reason why we should be very cautious in terms of hailing the sustainable and even goldilocks recovery in Germany.

Conclusion - Once again, strong circumstantial evidence

What I have essentially tried to argue above is once again the attempt to account for a life cycle component of growth in an ageing society. I am duly careful of course and as such the evidence is circumstantial and not conclusive but I do not think it is unreasonable to claim that demographics have somthing to say. In the case of Germany there might indeed be other factors at work holding down consumption but as Germany ages we should only assume that the life cycle consumption component will increase and as such the Germany economy may well become structurally even more biased towards a growth path driven by exports. In the end I am really not a fundamentalist and demographics are not destiny to economic growth but I am pounding away in order to clarify that demographics indeed do matter and that we need to understand how they interact with the macroeconomic environment.

In terms of Germany it is in many ways a good day to address this. The GDP growth figure for 2006 is likely to be upped to 2.7% and as such the proponents of the goldilocks recovery should feel vindicated. However, I am not optimistic about 2007 and the reason is not necessarily that Germany will plunge into recession but rather cautious given that the VAT hike which was in some ways necessary has been coupled with a vigilant ECB whose interest rate hikes may well depress private domestic consumption even more given the already strong structural forces which are in play. In 2006, domestic demand is likely to have contributed strongly to GDP growth but given the very special situation in 2006 where for example consumers have pushed forward purchasing before the VAT hike I just do not expect this rampant pace to be sustainable and I am even a bit pessimistic on the downside too. Also if exports are also set to run into difficulties there is no time for complacency I would say. Generally, the demographic outlook in Germany is of course set to have huge consequences for economic growth going forward and this is epitomized by the figure below taken from a research note from Deutche Bank (linked below). This is of course a model simulation but it should give an idea of what we are talking about.


The last intriguing point I would like to highlight is the angle provided by the paper from Adam S. Posen cited above which actually compares the economic performance of Japan and Germany since the beginning of the 1990s. As Munchau puts it in his summary ...

Japan’s stagnation began with an asset price crash; Germany’s was brought on by unification. In both cases, lousy economic policies made a bad situation worse.

Now, as you will read in the paper or in Munchau's well written summary we should not merely look at demographics and as such the need for structural reforms in both countries and following from Adam S. Posen's main points Munchau makes the following point ...

I have no doubt that Germany will eventually do the right thing, but Japan is currently ahead of Germany in terms of reforms. It is therefore rational to consider Japan’s long-term economic prospects as brighter.

I have no doubt that this is true in the sense that both countries should pursue reforms, but reforms addressing what and why? This is the question I think. In fact, there can many good reasons to compare Japan and Germany and one of them is demographics since these two countries are amongst the oldest societies in the world. This is why I think that if you want to compare Germany and Japan from the beginning of 1990s and onwards you need to incorporate demographics and its impact. Otherwise you won't get the right story ... pure and simple!

References to figures:


2. Stephan Danninger and Fred Joutz - IMF Working Paper, What Explains Germany’s Rebounding Export Market Share?

3. Deutche Bank Research - The demographic challenge Simulations with an overlapping generations model