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Thursday, March 27, 2008

Will Iceland Erupt?

By Claus Vistesen Copenhagen

I am sure that most of my readers are aware that Iceland, to a somewhat greater extent than the rest of us, are subject to the forces of nature. Being severed by the mid-Atlantic ridge which is a constructive tectonic plate margin cutting across the Atlantic ocean is consequently not for the faint of hearts. In modern times the skirmishes of Surtsey 1963 and Heimaey 1973 are omnious cases in point. As far as I am informed the tectonic activity in Iceland is relatively subdued at the moment but that, as we shall see, does not mean Iceland is not faced with a potential eruption. This time only, Iceland is subject to the equally potent forces of global financial markets rather than the whims of mother nature. In many ways, the sudden return by Iceland to the spotlight is not surprising. As early as in the Spring of 2006 we discussed whether Iceland were among the first in line to suffer a blowout on the back of an abyss deep current account deficit driven by a housing and consumer credit boom and a subsequent vulnerable currency. Here at GEM we have, since the credit turmoil began, been looking wearily towards the Eastern European edifice for the first potential macroeconomic fallout in the context of what we could call emerging economies. I still am but given the most recent events it could indeed seem as if Iceland is about to beat the collective of the CEE and Baltic countries to it. At the heart of the debacle in Iceland lies the same kind of imbalance as we are currently observing in the US as well as other countries around the globe. A large current account deficit coupled with high inflation at a time when the housing bubble and consumer credit boom is about to come to a very abrupt standstill are all ingredients which we should be well aware of at this point. As can be expected this has also taken its toll on the financial sector which has played a seminal role in the recent Icelandic expansion. In this way, Iceland's three largest banks (Kaupting, Glitnir, and Landsbanki) have all seen their credit rating being scythed by the rating agencies recently. In one of their recent much appreciated daily digests Eurointelligence reports how credit default swaps have risen to alarming levels even if we should note that the three big Icelandic banks have branches in mainland Europe allowing them to potentially knock down the ECB's door for liquidity.

(...) the FT reports that credit default swaps for Icelandic banks have risen to extreme levels, for example to 912bps for Kaupthing. The article also makes the piont that Iceland’s three top banks, Kaupthing, Landsbanki and Glitnir, have branches in mainland Europe, which means they can tap the ECB for funding.

The rather precarious situation of the Icelandic economy recently prompted the central bank into pulling a reverse Bernanke as it was decided at an emergency meeting to raise the main refi rate by a healthy 1.25% bringing it to 15% in total. The immediate impetus for the move were indeed the global financial turmoil and by derivative the fact that the Icelandic krone had, in the past weeks, taken a flogging which would make the buck look like Cassius Clay in his prime. The chart below provides a sniff of the situation at hand as it shows the nominal exchange rate of the EUR/ISK as an index with 2.1.2006=100. As can be seen the recent weeks' turmoil have more than halved the nominal value of Iceland's currency vs the Euro (click on picture for better viewing).

Yesterday the FT furthermore reported how the central bank and the government would move in tandem to shore up short term market liquidity, in part, by issuing €80m worth of short-term bonds. Whether this will work as a remedy to hold off the immediate crisis is basically impossible to tell. At the moment the only thing we can really do is to sit back and look where it will pop first. In the short term Iceland, with its floating currency, obviously seems more inclined to go to the pillory than many Eastern European countries who have pegged their currency to the Euro. We should however, in this context, never let our glance stray away from Hungary who recently was 'forced' to lift its trading band on the Forint. Over at the Hungary Economy Watch Edward and me are following the situation closely. We could also, I think, ask with some validity whether it is really such an advantage for many of the Eastern European countries to have married themselves with the Euro in the sense that this was done in first place on the expectation of future membership of the EMU. At this point this consequently seems all but a fool's hope for most of the countries in question I would argue.

I don't think it would be timely at this point to downplay the potential fallout facing Iceland and as Macro Man aptly noted a while back; you cannot spell risk without 'ISK.' As always in these kind of situation the main risk is that markets call the authorities to the poker table in which case the central bank's reserves are certain to be drained faster than many investment banks' balance sheets are currently being re-furnished. Given the size of the Icelandic economy such a move would likely be nasty, brutish and short. I don't know whether all those loans in Iceland are denominated in Euros which would clearly represent a substantial degree of translation risk but even without this issue the situation is still getting increasingly more precarious. Obviously, not all view it this way and we would be well advised to pay attention to the following as quoted from the FT ...

Richard Portes, president of the Centre for Economic Policy Research, and the author of a respected report on Iceland’s economy last year, has urged investors to pay more attention to the data. He points out overheating is being tackled, with economic growth slowing, hitting 2.9 per cent in 2007 and zero this year. He adds that Iceland’s current account deficit – the source of many of the concerns about the economy – has narrowed from 26 per cent of GDP in 2006 to 16 per cent in 2007. He has also made clear that Iceland’s banks are sound by international standards, with deposit ratios in line with international norms, high capital adequacy ratios by European standards and credible funding profiles. Finnur Oddsson, managing director of the Icelandic Chamber of Commerce, said: “The global turmoil is certainly hurting the financial sector, but the danger of things toppling over here is greatly exaggerated.”

What we have here is analogous to the debate we are having in the context of Eastern Europe and whether the landing will be hard or soft? Definitions as always are important here but it is obvious for anyone with a basic understanding of macroeconomics that having a floating currency also yields to potential of actually correcting the external balance without resorting to deflation something which the Baltics et al. may soon realize. Obviously, the flipside as should be clear from the oveview presented above is that the correction is too swift thus bending the stick so far that it ultimately break. Moreover, and as we are seeing in Hungary the traditional correction by which an undervalued currency boosts exports is not likely to cut it if inflation stays high (i.e. eroding the competitiveness) and the income flows on the current account pulls the balance further down as a result of an overweight of foreign owned domestic assets relative to domestic investors' foreign assets. Whether this applies to Iceland is dubious. More than anecdotal evidence suggests that Icelandic investors and money men have been active in particularly Scandinavian asset markets. Moreover, and if you accept the fact that Hungary's and indeed the whole Eastern European situation has something to do with the fact that these countries have moved(still moving actually) through the demographic transition far quicker than the traditional economic development process has been able to keep up I think we have a good basis for analysis. This thus leads me to the point I should perhaps have started with, namely a long term and structural assessment of the Icelandic economy. You should not worry though as I have all my bases covered. It would thus serve us well to go back to May 2007 and have a look at my colleague Edward Hugh's piece on Iceland posted at Global Economy Matters. In this note, Edward indicates why any worry about Iceland in the long term and from a structural point of view seems to be largely unfounded even if of course the imbalances themselves run the risk of causing an abrupt crisis. In fact, Edward lifts a quote from the Economist Intelligence Unit where the specific risk from financial markets and potential spillover effects into the currency with a subsequent wage-inflation spiral to follow are mentioned. This would then be where we are situated now but allow me still to quote Edward in his final remarks ...

So is this really so bad as it seems? Well let's revisit an argument Claus advances in his recent French post, which is that if some countries with high median ages are now structurally tied to dependence of exports for growth (and sustainability in their public finance), then logically other countries (with somewhat lower median ages) are going to need to run ongoing trade deficits. Claus was referring to France in its ongoing relationship with Germany, but the argument could easily be extended to Iceland and points further afield. Iceland still has a median age of around 34 years, which makes it a very young country in developed economy terms. So if we can apply Modigliani's Life Cycle Hypothesis to populations in the case of the elderly economies (Japan, Germany, Italy, Finland etc), why shouldn't we apply the same notion to the relatively more juvenile economies, who can with some greater realism accumulate liabilities now which can be paid off later, as the population ages and domestic saving increases? I know this as all somewhat politically incorrect, but I do worry just exactly what would be the impact on overall economic welfare of all the younger median age societies bringing their economies into trade balance, since the level of ongoing global growth would obviously be lower, and I am not really convinced that this would be especially desireable as an end result.

I certainly have no idea whether Iceland is about to go but given the recent events investors would be wise to keep an eye out. Moreover, any longterm structural bullishness on Iceland clearly need to take the proverbial part as wing man in what is about to unfold since at the moment it is all about animal spirits as Keynes famoulsy articulated it. To end, after all, on an analytical note I would argue that the underlying external position of Iceland seems to be in a better shape than the ones we are seeing in Eastern Europe but that does not mean that any rapid adjustment won't be tough since the size of Iceland's economy virtually gurantees that it would be a swift kill for risk averse international investors and punters alike.

Wednesday, March 26, 2008

Ms Watanabe Not Easily Deterred

by Claus Vistesen: Copenhagen

As Bloomberg puts it on their news site sometimes markets roar and sometimes they whisper. In the last couple of weeks they have certainly roared as the crisis in financial markets have haunted the steps of Wall Street bankers and the Fed. At this point in time we are wearily waiting in Europe to see whether (or more precisely when and where) the fangs of the credit crunch will take hold. In the context of whispering markets we got a small but rather significant snippet from Bloomberg last week when we learned that the accumulated value of Japanese household assets fell for the first time since 2002. As an exception I am quoting the entire piece below.

Japanese households' assets fell for the first time in five years as the nation's benchmark stock index fell, eroding consumer wealth and reducing the prospects for their spending to support economic growth. The value of assets held by households as of Dec. 31 slid 0.6 percent from a year earlier to 1,545 trillion yen ($15.5 trillion), the Bank of Japan said today in its quarterly flow of funds report in Tokyo. Japan's Topix index has lost almost a fifth of its value this year, crimping household assets already depleted by higher prices and falling wages. Consumer confidence is at a five-year low, making it unlikely that their spending will support the world's second-largest economy as overseas growth slows. ``The drop in household assets is another reason why consumers don't want to increase spending,'' said Takeshi Minami, chief economist at Norinchukin Research Institute in Tokyo. ``Japan's economy will remain fragile as stocks continue to decline and downside risks from the U.S. economy increase.''

The Topix lost 12 percent of its value last year and has shaved another 18 percent since January. The Nikkei 225 Stock Average has fallen 19 percent this year.

Holdings in shares dropped 16.8 percent in 2007 from a year earlier, according to Masanobu Ishii, director of financial and economic statistics at the Bank of Japan. The value of holdings in government bonds, insurance and pension funds rose to a record, which confirms a trend that households are seeking higher returns than those available from cash deposits, Ishii said. At 0.5 percent, Japan has the lowest benchmark interest rate in the industrialized world.

The point conveyed by this small Bloomberg piece is not at all insignificant even if it is still too early to derive a general trend. We consequently need to think about what potentially drives the dynamics of Japanese savings and subsequent attempt to make all those pennys work to earn yield. As such and keeping the point above in mind the reason why Japanese savers are now sitting on a dwindling asset base is of course partly to be found in the context of Japanese asset markets themselves. With an interest rate of 0.5% and a main stock index stubbornly bend hell on declining Japan does not exactly spell an attractive investment opportunity even if we are still talking about the world's second biggest economy with a corresponding stock market capitalisation to boot. Foreign investors seem to be voting with their feet even if of course the unwinding of carry trade means that the Yen, much to the chagrin of Japanese companies and policy makers, is rising.

Foreign investors last week sold the most Japanese shares since the Black Monday market crash in October 1987 after the yen rose to a 12-year high, clouding the profit outlook for exporters. Outflows from Japanese stocks by foreign investors were 922.7 billion yen ($9.26 billion) on a net basis in the week ended March 14, according to figures released today by the Tokyo Stock Exchange. That was the most since the period ended on Oct. 23, 1987. Japanese stocks have attracted net buying on a weekly basis by overseas investors once this year.

One week does not of course make a trend but if we step up in the helicopter and look at the big picture I do think that the main tendency supports what was rather dramatically demonstrated last week. As Morgan Stanley's main man on Japan Robert Alan Feldman put it a couple of months back; 'investors just don't find Japan that exciting anymore!' So, what am I really getting at here? Well, in what follows I try to sketch a rudimentary framework for my argument as well as I provide some further recent evidence. Basically (and this is only on the consumer side), we are moving into life cycle theory and how it connects with the well known inclination for investors to invest dis-proportionally (from an optimization point of view) in their home country assets (i.e. the home bias). In terms of life cycle theory I would argue that we are stuck in that damn 'we don't know' situation since we cannot look into the future and currently, with Japan, we are standing on the edge of the demographic frontier in an ageing context. In short, it is very difficult to gauge the future saving and consumption pattern in Japan since, and this is of course merely my personal guess, the life cycle is endogenous to the demographic transition at the same time as institutional and cultura factors exert influence. What we do know however with a reasonable degree of certainty is that as the ratio of retired to working people increase and as (presumably) the labour market shifts onto lower value added work for the ageing cohorts (i.e. all those part time jobs we are seeing coming online in Japan) we can expect an overall process of dissaving on the aggregate scale. But (and this is a big but), the traditional way to narrate this process is not very satisfactory in the sense that it tends to take place in 2050 or something and the prediction of a great asset price meltdown. Me and my colleagues have always found this venue of debate rather tedious since who the hell knows what happens in 2050 and in any case it is what happens in the meantime which will make all the difference. In this way, I feel that a couple of the traditional dissaving assumptions need to be considerably loosened.

  • People do not dissave to 0 since by very nature of the human life cycle they don't know when they pass away. Add to this that there might be some altruism and bequest involved. Also, remember that people in the dissaving part of their life cycle do not take on debt which is a very important point to take aboard when we talk about a country's 'capacity' to 'sustain' a housing boom etc. Obviously, this does not negate the dissaving hypothesis but it does tend to differentiate it not least because evidence suggests that people do not dissave with pace that theory predicts
  • Rising life expectancy across the board will induce people to save longer and/or dissave more slowly as well as we can perhaps expect people to try to live off of their assets (i.e. dividend income, interest etc) in stead of spending them.
  • Forced savings(?) Perhaps this is where people tend to get lost since if you don't think about the inter generational and thus 'sustainability' perspective from society's point of view you don't get it. As such, we need to think about the fact that ageing costs and if you are a young worker coming out of a Japanese university you will, quite literally, need to start saving from day one. I mean, the public pay-as-you system simply won't be able to cover it and to the extent that policy makers try to keep it alive they will levy taxes on the population in order to pay for it. This would be the 'forced' savings part. In short; the working cohorts are fewer in number, face a less dynamic economy, and need to support an ever growing burden. This means quite naturally that they will have less money over their life cycle to pump up consumption than if the population pyramid had been more stable. This hypothesis would one of the main arguments for why ageing economies will tend to exhibit congenially weak domestic demand.

Now, I don't know whether this is an adequate explanation of the process. Empirical testing and a sound strategy of scientific falsification will see us through this one. But when I look at the evidence I feel somewhat vindicated. One key part of the picture here is consequently the decline in home bias amongst Japanese investors which cuts a straight line from those savvy carry trading housewives to buyers of Samurai bonds both on which I have reported several times. Recently, we got further indication that this is a process set to linger.

Japanese retail investors are still showing an appetite for overseas assets despite the dollar's tumble to near 13-year lows -- more weary of low returns at home than frightened of foreign exchange risk. Driven away by razor-thin yields on domestic bank deposits, Japanese retail money has piled into overseas investment in recent years, such as foreign bonds, mutual funds that invest abroad and leveraged currency trading. Japanese brokerages said that while there had been some withdrawals in investment trusts targeting Japanese equities, overseas securities, especially non-U.S. dollar securities, were faring well. "Japanese retail investors are keen on investment trusts targeting foreign bonds as they believe that the dollar is near a bottom against the yen," said Koichi Kitamura, general manager of Daiwa Securities' investment trust department. "Although they are somewhat reluctant to spend now, we expect to see an increased inflow of retail money to investment funds focusing on high-yielding foreign bonds," he added.

"There has been no panic. Investors are still calmly allocating toward foreign bond funds and newly issued foreign bonds," said a spokesman for Nomura Securities, who declined to be identified. Earlier this month, Nomura Securities sold A$590 million in Australian dollar-denominated "uridashi" bonds issued by Toyota Motor Credit Corp, a unit of Japan's Toyota Motor Corp. The two-year bonds came with a coupon rate of 6.82 percent. Nomura also sold A$650 million in two-year Australian dollar-denominated uridashis issued by International Finance Corp [IFC.UL], the private-sector lending arm of the World Bank, with a coupon rate of 6.71 percent.

The general point about how Japanese retail investors living in a low yield environment will attempt to ship their money abroad in order to earn income is important to take aboard. In this context it is crucial that we are able to distinguish between the microeconomic and macroeconomic perspective. We consequently need to think about the fact that while saving in a microeconomic sense is governed by the strict rules of life cycle theory it is completely different on a macroeconomic scale. A society cannot dissave or at least it will fight long and hard to avoid this since this would ultimately erode its level of existence. This could be why ageing economies will try to live off of their exports of goods and capital in order to survive; remember that an external surplus is a proxy for savings and in this present context not only the trade balance but also the income balance is worth watching. Of course, dissaving will happen but paradoxically and even if household saving rates will be declining we could see a process by which the capital surplus is kept high. As an important aside here note the concept I often refer to as 'capacity.' Basically, I start out differently than most growth theorists by noting that the ultimate measure of capacity is 'human capital' both qualitatively (i.e. education, productivity etc) and quantitatively (ratio of old people to young (working) people). The amount of physcial capital you can absorb (i.e. growth) depends on your human capital and if there is a mismatch we run into trouble. Currently I would say that this is materialising itself on two fronts.

1) The old and ageing industrialised economies of which many are now steadily becoming dependent on exports in order maintain a respectable and much needed growth rate if they are to pay for their welfare systems. They simply have too much capital (physical and non-physical) for their domestic economies to absorb.

2) Emerging economies who have moved through the demographic transition way too fast relative to the growth expectations levied upon them. Eastern Europe/Russia and perhaps now China would be examples here.

On both 1 and 2 the global economy is faced with notable challenges. In terms of number 1) we need to remember that Japan and Germany won't be the only ageing economies to come on stream. In fact, if Edward and I are right the whole global economic system is in for a significant stress test since the principles on which the current system works cannot be sustained in the long run. This would then be where number 2 comes in. We need those importers but we also want to make sure that we don't burn them off like fire crackers over the course of a decade as well as we could say that we need to avoid those US style bubble bursting recessions even if this has nothing to do with demographics it a direct sense. Especially, China has now become a pressing issue at this point.

And why all this fuss then? Well, I think that we have mounting evidence for the 'demography matters' thesis yet no one in the high circles has come close to addressing it yet. Quite simply, the demographic transition is not this automated process with a fixed beginning and an end and it is not one which exhibits the same features across countries. I mean, this is where it all shores up. How can we e.g. expect China to simply become the new 'US' given the underlying toll of the one-child policy? Ironically (or tragically?) the turning point by which China is forced into this new role may come now at the precise point in time where the effects of its demographic profile are materialising.

Wednesday, March 19, 2008

India's Inflation, Capital Inflows, The Rupee and Macro Management Problems

by Edward Hugh: Barcelona

India's inflation unexpectedly accelerated again in the first week of this month, in the process taking the level to a nine-month high , and making it more difficult for the central bank to reduce interest rates in as a response to the now evident slowdown in economic growth. Indian wholesale prices rose by 5.11 percent year on year in the week ended March 1, up from the previous week's 5.02 percent, according to data released by the Ministry of Commerce and Industry in New Delhi last Friday.

What is obvious from the above chart is that the steady uptick inflation since last autumn. Rising energy and food costs are likely to continue, and These will only add to the problems facing the administration. Crude oil jumped to an all-time high of $111 last week, putting pressure on India's government to continue increasing prices following February's initial increase in the cost of retail gasoline and diesel. Central bank Governor Yaga Venugopal Reddy last week said rising food and energy prices pose "acute policy dilemmas". Reddy also indicated that India's benchmark interest rates, currently at a six-year high, won’t be coming down in a hurry, due to the current inflation and the difficulties arising from uncertainty in the global financial markets.

Reddy recently stressed that tackling inflation was a higher priority for the RBI than boosting economic growth, which, as we can see in the chart below has been slowing - although not dramatically so - and growing at the slowest pace since 2005 during the last quarter of 2007 as tighter central bank credit reduced the rate of consumption expansion and a higher rupee slowed export growth. The economy expanded by 8.4 percent in the three months ended Dec. 31 over a year earlier, after rising by 8.9 percent in the previous quarter.

"The large segments of the poor tend to reap the benefits of high growth with a time lag while the rise in prices affects them instantly.....Considerable weight is currently accorded by the Reserve Bank of India to price and financial stability while recognizing its twin objectives of growth and stability."

Speaking following the latest inflation announcement Reddy did hint, however, that the Reserve bank of India (RBI) might offer some relief to banks by widening the liquidity adjustment facility (LAF) corridor. He stressed that this action would be taken as a response to the difficulties being presented by the current global uncertainty. The LAF corridor is the difference between the repo (rate at which the RBI lends overnight money to banks) and reverse repo (rate at which banks park their surplus cash with the RBI). Reddy said that the current 175 basis point difference between the RBI’s repo and reverse repo rates was a direct reflection of the level of uncertainty in financial markets. The repo rate is at 7.75%, while the reverse repo rate is 6.0%. The margin can be widened by either raising the repo rate or cutting the reverse repo rate.

Reddy has also indicated that the current wide gap between the two policy rates is the result of monetary operations and not the consequence of a specific predetermined policy decision.

One of the key questions lying in the background here is the functioning of the market stabilisation scheme (MSS). The MSS is essentially a liquidity absorption mechanism which has been adopted by the RBI and involves the issuance of treasury bills and bonds to suck out excess liquidity as foreign capital inflows continue. The need to service the coupons on these bills has increased the government’s fiscal burden and as a result affected the fiscal deficit target mandated by the Fiscal Responsibility and Budget Management (FRBM) Act.

The scheme has become an embarrassment for policy makers as the MSS target of Rs 250,000 crore exceeded government borrowings of around Rs 111,196 crore. As a result the government’s liquidity management function has gone well beyond mere borrowing to meeting current expenditure needs. The government is absorbing funds to manage liquidity and compensating by making coupon payments on treasury bills and bonds issued under MSS rather than borrowing for planned expenditure. The result is that in order to address the twin requirements of meeting the FRBM target of reducing the fiscal deficit to 3 per cent of GDP by the end of the next financial year and of maintaining inflation within the RBI target range, the government may have to sacrifice public welfare expenditure if inflows continue at the current rates.

Bank Lending and Financial Inflows

Meanwhile bank lending continues to rise, and was up 21.88% year-on-year in the two weeks to February 29, 2008, as compared with the 21.84% growth rate logged in the fortnight ended February 15, according to Reserve Bank of India data released last Friday. Outstanding loans rose by Rs 41,481 crore to Rs 22.51 lakh crore in the two weeks to February 29. Non-food credit rose by Rs 39,988 crore to Rs 22.07 lakh crore over the two weeks, while food credit rose by Rs 1,493 crore to Rs 44,311 crore in the same period. Deposits were up 23.7% in the two weeks to February 29 from a year earlier. Banks' deposits rose by Rs 43,539 lakh crore to Rs 30.81 lakh crore.

At the same time the country's foreign-exchange reserves continued their upward march and increased by $2.2 billion in the week ended March 7 to $303.5 billion, according to the RBI.

The Weakening Rupee

One of the greatest incognitas on the India macro economic horizon at the present time is the future path of the rupee. The rupee has been weakening steadily over the last couple of months, and has fallen more than two per cent against the dollar so far this year (at the same time, it will be remembered that the dollar is also falling quite substantially). Conventional explanations of this movement are the pressure produced on the currency by equity outflows and a temporary but severe shortage of spot dollars in the market. India Sensex, which has been Asia's worst-performing major benchmark index so far this year, fell 1.4 percent again last week, declining for a second week in a row after industrial production growth slowed in January, a reflection the higher interest rates are having on demand for consumer durables. Rising credit defaults in global stock markets have also had an impact on Indian stocks.

Curbs on foreign borrowing imposed by the Indian government last year and the general global credit woes caused by the US subprime crisis have also reduced the appetite for Indian equities in recent weeks. However, despite the decline in demand for equities - and as noted above - the capital inflows continue.

As a rsult, and after gaining more than 12 per cent in 2007, the rupee has fallen steadily in 2008, and is now around 40.5 per dollar, its weakest level since mid-September and well off the near 10-year high of 39.16 reached in November.

The rupee really started to drop significantly in February following the withdrawal by the Indian unit of Emaar Properties of its $1.8 billion initial public offer (IPO) due to the volatile situation in the Indian stock market. Foreign investment in IPOs had constituted a major support for the rupee in January, ever since Reliance Power raised $3 billion within a minute of opening for sale. India's trade deficit, which has suffered on the back of the rise in the rupee - and which swelled to $9.4 billion in January, more than three times larger than in the same month a year earlier - clearly hasn't help underpin expectations that the Indian monetary authorities will feel comfortable accepting the continuing rise in the currency. In February, US investment bank JP Morgan - feflecting widespread sentiment in the banking and investment sectors - lowered its forecast for the rupee to 40 by March 31 from its earlier projection of 38.5.

Foreign funds have pulled more than $3 billion out of Indian shares so far this year, and the outlook remains full of uncertainty. Slowing economic growth, the government's reluctance to push ahead with reforms in the run up to national elections and the benchmark Sensex share index's 25 per cent tumble from its high in January have all served to spook investors. External purchasers seem to have moved large quantities of cash into Indian shares to take advantage of arbitrage opportunities between the cash and futures markets, rather than as the result of any strong convictions about underlying fundamentals.

Not everyone, however, is convinced by the standard explanations, and some analysts are arguing that the weakening in the rupee has been engineered by the Reserve Bank of India, which was busy dollars heavily all through 2007 in an attempt to slow the currency's appreciation as it began to squeeze the margins of export-focused companies in sectors like software and textiles.

Ila Patnaik, a senior fellow at the National Institute of Public Finance and Policy, has pointed out the apparent inconsistency in the fact that the rupee's decline in February came even as India's foreign exchange reserves jumped by $11.7 billion on the month to reach a record of $301.2 billion.

"This suggests that the depreciation of the rupee was engineered," she wrote in The Indian Express last Wednesday, arguing the rise in the dollar value of reserves could not have come from the simple revaluation of other currencies (or gold) in the reserves against the dollar.

Patnaik suggested that the recent hefty US interest rate cuts were drawing cash into higher-yielding Indian assets. India's benchmark lending rate at 7.75 per cent against the Federal Reserve's three per cent offered a 4.75 percentage arbitrage opportunity for foreign investors.

"Interest rates in India are higher and if the rupee was also going to get stronger, dollar returns would be even higher," Patnaik wrote. "In this situation, the RBI may have tried to break the one-way bet by pushing the rupee to depreciate."

So, will the rupee's decline be an enduring phenomenon, or will the market turn? Perhaps in the short term the rupee may well not strengthen significantly, but the long-term outlook for the rupee has to be bullish simply because India's $1 trillion economy, which is Asia's third-largest after Japan and China's, is set maintain robust growth of eight per cent plus in 2008, and in all probability this pace will accelerate further over the next couple of years, as India's growth once more resumes its long upward haul.

Tuesday, March 18, 2008

What Happens Next?

By Claus Vistesen Copenhagen

[Update Added Below: Did Bernanke dissappoint markets? 'Only' 75 basis points.]

As the ever succinct Macro Man pointed out yesterday the current situation is not one in which the Devil goes to Georgia to play the fiddle over Johnny's soul but more like Lucifer and his kin scouring the big Street in NYC to claim their due in the form of over leveraged traders' and institutions' souls. Obviously, the Street has called in their favorite exorcist in the form of Ben Bernanke but it appears, at this point in time, that the legions from below might just be on the winning side on this one. Markets in general are in complete "shock and awe" mode at the moment on the back of the demise of Bear Stearns and the subsequent buy-out by JPMorgan.

Equities are taking a beating if there ever was one and in FX markets the caning of the USD continues even if there do seem to be slight signs of the Dollar Smile as the buck has reasserted itself against both the CAD and AUD (among others) lately. It is all very difficult to call at the moment and in the meantime the war drums are thundering about more skeletons rattling out of the closet as more financial institutions move nearer to the point where they are either bought up (bailed out) or find themselves having to close up shop. As an opaque veil over this whole situation the credibility of and faith in the Fed are being stretched to new lengths as the play-book increasingly falls short in terms of delivering a workable solution to the debacle. Moreover, the Fed is being criticised from many angles for what is perceived as "fiddling too much" with what was an inevitable rout in the first place and thus risking an exacerbation in the backdrop as an overly lax monetary stance fuels inflation. Note in passing that I am not being normative here. I think there is plenty of time for that later. However, whatever you think about the merits of the Fed's actions I am sure we can agree on one thing; if markets get to the conclusion that the Fed is out of control the mother of all self-fulfilling prophecies will ensue.

So, what happens next?

If only I knew. The first thing we need to dispense with is today's Fed meeting where traders and observers are now pencilling in a 100 basis point cut which would take the federal funds rate down to 2%. This would be a very aggressive move and as the Fed's armory gets steadily depleted one of the main yard sticks with which to assess such a measure would be the extent to which it restored some kind of calm to markets. I don't believe the Fed can (and should) hope to prevent financial institutions from faltering at this point and it seems pretty clear that a recession cannot be avoided either. In light of the uncertainty surrounding the effects of today's Fed decision I am however looking at a couple of themes that I believe will emerge in the weeks to come.

One thing which we have been discussing on and off here is the probability for a coordinated intervention to halt the buck's slide. Particular focus has been directed towards the BOJ as it had been presumed that once the USD/JPY moved below 100 the risk of the BOJ/MOF dipping their toes in the water would increase. As the JPY has appreciated to about 97-98 to the Dollar it has not so far prompted comments or action from Japanese authorities. Of course, we are only now going to discover what the new governor and leadership at the BOJ is made of, or are we? One thing is for sure, the charade which I (and others such as Takehiro Sato and Ken Worsley) predicted surrounding the BOJ nomination has now materialised. Muto, who was the original nominee from the leading LDP party was predictably given the proverbial thumbs down by the DPJ who control the upper house. The current governor's mandate expires in two days time and given the current market situation the last thing we need at the BOJ at the moment is a vacuum. Today, we seem to be moving into round two as the Prime Minister Fukuda presents a new nomination in the form of former Finance Ministry official Koji Tanami. The initial signs of relief do not look promising and in fact the DPJ seems quite keen on picking a fight on this one ... (quotes, IHT and Bloomberg)

``If the DPJ approves this nomination, they would let themselves fall into a political trap because they have argued monetary policy and fiscal policy must be separated,'' said Tomoko Fujii, head of Japan economics and strategy at Bank of America in Tokyo. ``An approval would make the DPJ look like they don't seriously care about the principal issue.''


A senior lawmaker in Japan's main opposition Democratic Party, Kenji Yamaoka, said there was almost no chance the party would accept Tanami as Bank of Japan governor. "Personally, I think it is almost impossible," Yamaoka said.


Japan's main opposition party said it will reject Prime Minister Yasuo Fukuda's second candidate to lead the central bank, assuring a vacancy before the current governor's term expires tomorrow.

What the situation at the BOJ will do to the potential for intervention is difficult to see. However, if the stalemate continues and a vacuum becomes a reality I think that intervention may well be the knee jerk reaction as well as of course a new general election seems immediately to be in the cards. More generally on the point of intervention we learned recently that both Goldman Sachs and Morgan Stanley are now officially in intervention watch mode and in this light Stephen Jen from Morgan Stanley moves in with some worthwhile observations. In his view the ground is not yet ripe as he puts it...

Our recommended tactical posture is to remain short the dollar for the time being, despite it being grossly undervalued against the majors. The preconditions for coordinated interventions are not yet met. However, given that a weakening dollar is fueling dangerous vicious circles through commodity prices and eroding confidence, it is prudent to remain on an intervention watch, monitoring closely whether the preconditions for interventions are met.

It is difficult to disagree with much in Jen's argument but I do think that there is a risk that events in Japan may unfold so as to make intervention come sooner rather than later. In Frankfurt of course the ECB is sticking to its one-page play-book on the back of the last meeting's turn in the discourse towards price stability as the main objective. Obviously the noose is tightening at the ECB. Despite some pockets of resistance from recent German data releases the European economic edifice is now visibly slowing and as an ever ominous shadow we have the situation in Eastern Europe where especially Hungary, the Baltics, and Romania are now set to grind to a halt. In this immediate light we could ask what in fact a 100 basis point slash by the Fed could do to the ECB's play-book? Or put differently, when will the ECB blink if at all? I still maintain my view that the course of events will force, or steer if you will, the ECB to cut rates in the first half of 2008 but I also concur that such a move won't be easily wringed and thus that the ECB is likely to postpone it as long as possible given the underlying inflation pressures.

Another theme I am watching is at what point the rest of the world will re-couple to events in the US. Intervention in the currency markets and/or cut in the interest rates by either Japan or Germany would obviously represent such re-coupling. However, the front line of all this is more likely to be one or more of the small emerging economies where recent excessive capital inflows, rampant inflation and now recessionary growth outlooks threaten to bring down the deck of cards. As my readers know I have been peering towards Eastern Europe for an example of this where Hungary in particular seem to be positioned as the main candidate not least on the back of the scrapping of the Forint's trading band. However, and by all means, Iceland is perhaps an even more apt candidate?

The Icelandic krona slumped against all 178 currencies monitored by Bloomberg today as the risk of its government and banks defaulting on debt soared to a record. The krona dropped to an all-time low against the euro and had the biggest one-day decline against the dollar in 15 years on signs credit-market losses are widening after JPMorgan Chase & Co. agreed yesterday to buy Bear Stearns Cos. Iceland's banks are ranked among the least safe in the world by traders of credit- default swaps, and the chance of Iceland defaulting on its sovereign debt climbed.

And don't for a minute believe that Iceland is a 'piqsqueak' by any means. You see, Icelandic investors have been very busy in recent years investing heavily in Scandianvian capital markets and financial institutions. There is thus, unlike the well known tectonic fault line cutting across Iceland in a vertical sense, a potential financial fault line which runs from Iceland to Scandinavia and on to Scandinavian banks' operations in Eastern Europe in terms of market correlation. This, at least, is a connection worth pondering I believe. More generally on the theme of de-coupling and re-coupling Stephen Jen also finds the time come up with some worthwhile observations ...

However, the macroeconomic data for much of the rest of the world (RoW) continue to surprise on the upside. In this note, we argue that, if the US does indeed fall into a recession, there will be repercussions for the RoW and their currencies. But this domino effect could follow four – not mutually exclusive – fall-lines. First, in times of broad risk aversion, we could see the currencies of current account (C/A) deficit countries weaken. Second, as the ‘Anglo cycle’ of debt and housing falters, the economies with financial systems and debt cycles similar to those of the US may suffer in turn. Third, if indeed the global economy is infected by the weakening US, commodity prices may put in a top, and commodity currencies may suffer. Fourth, perhaps the most obvious fall-line is how a slowing US economy could affect the RoW through trade.

I kind of like these four points since they allow us to make some subtle yet crucial distinctions between the linkages with which the US situation will spread. The most important thing to note here is that the current financial crisis in the US is not uniquely a US debacle. Note in particular in this context that what we are now seeing is how those countries with significant external deficits are the ones steadily moving into the front line of the incoming slowdown. This is an important point as it indicates the intimately coupled nature of the global economy. For each deficit there is a surplus and if we look at the surplus nations we see that domestic demand in these countries (e.g. Japan, Germany, China etc) is not at this point strong enough to maintain growth rates at the current level. This also highlights my main gripe with the whole de-coupling discussion in the sense that it should never have been a discussion of whether the USD should fall or not but against who it was going to fall! The current shift of liquidity in favor of the Euro, Yen and if you will the Swissie is not sustainable in this light. Rather we should be looking towards India, Brazil, Turkey, Thailand and of course China even if she does represent some sort of special case. Interestingly, this tendency is not hidden in the data. It is just that people do not seem to be paying much attention. Allow me then the luxury of quoting the final note from Morgan Stanley's GEF 17th March edition in which Marcelo Carvalho reports how Brazil is trying to pull a 'Thailand' as the authorities attempt the stop the inflows from coming in too quickly ...

The Brazilian authorities have this week announced measures to contain BRL appreciation. While such measures seek to temper near-term pressures for further BRL strengthening, we suspect that they will ultimately prove counterproductive, as fundamentals should prevail over time. The context. The local press has reported that the recent measures are aimed at containing BRL appreciation, supporting exporters and slowing the rapid deterioration in Brazil’s external accounts, as imports are currently growing much faster than exports. According to the reports, advisors to the president have warned him that the presidential elections in 2010 could take place amid a widening current account deficit, potentially reintroducing concerns about external vulnerabilities.

This my dear reader is the real process of de-coupling and unlike the one we are currently witnessing with the Euro and the JPY it will take time not least because the US economy itself need to finds its place in a new global economic edifice. As I noted in a recent piece on China what the world really needs is a slew of economies who are able to run a respectable deficit without running into excessive overheating like we have seen in Eastern Europe. I still believe the US economy is such an economy but it is not alone.

Ok, time to hold for now I think.

Markets are still in a rout as we move closer to today's Fed's interest rate decision and there are certainly an ample amount of potential risks to choose from out there. Some attention obviously needs to be directed towards the US and the Fed's desperate attempt to calm markets. I am already hearing rumours that Lehman Brothers may be the next to join the pillory. Meanwhile, I have also tried to look beyond the US where I noted how political conditions in the BOJ in Japan are deteriorating to such an extent that a risk is now emerging of unexpected actions and measures. What we need to realize is that the DPJ has now effectively chosen to pick a fight perhaps in an attempt to force a general election to flush out the highly unpopular Fukuda.

Another scenario which is popping up at the moment is for the LDP themselves to oust Fukuda but that would hardly solve much unless they were able to find a 're-uniting' figure, something I find rather doubtful. I also looked at the potential for coordinated intervention by the G7 in order to stem the tide on the USD. I agree with Jen that now is not yet the time but I also stress that Japan may be the source of some unexpected action.

One such action could be the lowering of Japanese interest rates to 0.25% or perhaps even the re-instatment of ZIRP. This would be tantamount to a process of re-coupling where the BOJ and ECB moved in to follow the Fed down. So far, this does not seem to be on the cards. As have been stressed endlessly here at GEM there is a short term and a long term trend here. On the former front I am expecting some kind of re-recoupling as the I simply don't see how the Euro and Yen can continue to appreciate against the USD to the extent that we are witnessing; the same goes for the Swissie here although, and in the same vein as with the Yen, carry trade unwinding seems to be the main driver here. On the latter account and thus in terms of the more structural nature of re-coupling I think that the world already has decoupled from the US. However, this will not be a process without hiccups. As I show with Brazil above and as we have seen with Thailand it won't be easy but we better start on it now since the current shift liquidity movements in favor the Eurozone and Japan cannot persist.


Was this the first time that the Fed did not give the market exactly what it wanted? It could appear so. Of course, few would be able to argue that this was not an aggressive move if there ever was one. Not only, did the Fed lower its main funds rate by 75 basis point to 2.25% it also lowered the discount rate, the cost of direct loans from the central bank, to 2.5 percent. Yet, markets were expecting 100 basis points and to my knowledge this is first time during these tumultous times that the Fed did not respond in kind to such expectations. Both Bloomberg and Reuters (as well as everybody else) have the story. Note in particular the slight bias towards acknowledging inflation. Could this be the last cut From Bernanke and co?

The Federal Reserve cut its main lending rate by three quarters of a percentage point to 2.25 percent as officials try to prop up the faltering economy and restore faith in the U.S. financial system. ``Today's policy action, combined with those taken earlier, including measures to foster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity,'' the Federal Open Market Committee said in a statement after meeting today in Washington.

Dallas Fed President Richard Fisher and Philadelphia Fed President Charles Plosser voted against today's decision. Stocks pared gains after the decision, while Treasury notes remained lower. The dollar recouped part of its loss against the euro. ``Relative to where inflation is running is where you begin to get the real tension between addressing the liquidity problems in the banks and the capital markets, and trying to encourage inflation to be under control for the long run,'' former Fed governor Susan Bies said in an interview with Bloomberg Television. `They are running very close, in this very high inflation environment, to how much they can deal with.''

Sunday, March 16, 2008

German Exports and Growth Resilience: January-February 2008

by Edward Hugh: Barcelona

Evidence is now mounting that the German economy has managed to find some sort of second wind, and at this point in time continues to endure the global downturn rather better than might have initially been expected. Perhaps the first clear indication that the downward progress of the German economy had been arrested and that the economy had to some extent stabilised came with the February reading on the EU Business Sentiment Index, which although remaining at rather lower levels than those registered during most of 2006 and 2007 was - at 103.7 - nonetheless up slightly on the January reading of 103.1. That is to say there was some evidence that the rot had been stopped, at least for the time being.

This confidence reading has been followed by at worst a flattening out and at best a slight uptick in a whole slew of German indicators like the IFO and Zew indexes, the GFK consumer confidence index, the February manufacturing and services purchasing managers indexes, and the performance in retail sales. All these point more or less in the same direction. So what is causing this rather unexpected resurgence in life?

Exports Lead the Way

Well since the German economy is basically export and not domestic-consumption lead, perhaps our instincts should tell us that export performance would be the best place to look to try and get a handle on what has been happening, and it seems that if we follow our instincts and do just this, then we will find that at least on this occassion our intuitions have not failed us, since according to the lates provisional data from the Federal Statistical Office, a decisive improvement can be noted in January's export performance over the December 2007 one, and indeed January marks the first month of improvement after several months of weakening on the export front.

In fact in January 2008 Germany exported goods to the value of EUR 84.4 billion while imported goods to a value of EUR 67.3 billion (thus having a trade surplus of EUR 17.1 billion). What this means is that German exports were up 9% year on year (and imports up 10.2%) when compared with January 2007. When allowing for calendar and seasonal factors, German exports increased by 3.8% and imports by 4.2% over December 2007.

As we can see fromn the above chart, German exports staged a definite recovery in January, and this recovery is thoroughly consistent with data readings we have been getting on other (previously mentioned) fronts, like the IFO and ZEW indexes, and the manufacturing and services PMIs. Curiously this situation is also consistent with results we have been seeing for exports in Japan (and for more comparisons between what is happening in Germany and what is happening in Japan see my Q4 2007 GDP revisions post, and Claus Vistesen's Is Japan Resisting one).

It is important to stress that this development does not by any means constitute a 100% U turn for the German economy, but it does mean that a pretty effective short term brake has been applied to the downward movement in economic activity, and it now remains to be seen how this deceleration/acceleration struggle pans out over the next two to three months. The broad brushstroke conclusion we might draw is that this rebound is unlikely to be a permanent one, but for the time being it is cushioning the German economy to some considerable extent.

A large share of German growth is driven by exports, and in particular by the foreign trade balance which showed a surplus of EUR 17.1 billion in January 2008 up from the EUR 16.4 billion achieved in January 2007.

It is also important to be aware that to get GDP growth Germany needs not only to maintain the balance, but increase it and to keep increasing it, since the correlate between GDP growth and export growth is a pretty strong one. But it is just in Germany (and Japan's) anility to keep increasing the size of the surplus as we move forward that their whole growth dynamic may falter.

In January 2008 Germany exported EUR 54.3 billion of goods to EU Member States, while it received EUR 43.1 billion worth of imports from EU countries. Compared with January 2007, dispatches to and arrivals from the EU countries increased by 7.7% and 11.2%, respectively. Goods to the value of EUR 36.2 billion (+6.3%) went to euro area countries in January 2008, while imports from those countries were EUR 29.9 billion (+10.0%).

Goods to the value of EUR 18.1 billion (+10.5%) went to EU countries not belonging to the euro area in January 2008, while goods arriving from those countries had a value of EUR 13.2 billion (+13.9%).

Germany exported goods to the value of EUR 30.0 billion to and imported goods to the value of EUR 24.2 billion from countries outside the European Union (third countries) in January 2008. Compared with January 2007, exports to third countries were up by 11.5% and imports from those countries by 8.5%.

Exports 2007

In 2007 Germany imported goods to a value of 772,511 million euros as compared with 733,994 million euros in 2006, an increase of 5.2%. In 2007 Germany exported goods to a value of 969,049 million euros as compared with 893,042 million euros in 2006, an increase of 8.5%. In 2007 the goods trade surplus was 196,538 million euros as compared with 159,048 million euros in 2006. This means there was an increase of 23.6% in the trade surplus between 2006 and 2007, and it is the trade surplus that to a large extent drives German GDP growth.

It's Where The Exports Are Going That Matters, Silly!

In 2007 about three quarters of German exports went to European countries, and 65% wentto the member states of the European Union. The second sales market after Europe was Asia with a share of about 11%, followed closely followed by America, with a share of approximately 10%. So Europe is the key to German growth, this is both evident and a very clear indication of why German exports have been so resilient to the rising value of the euro. To put things in perspective in 2007, and despite all the talk about the "China factor" Germany in fact exported effectively the same quantity of products to the Czech Republic ( 26,026.6 million euro) - population circa 10 million, as it did to China (29,922.7) - population circa 1.3 billion. meantime the quantity of products exported to the United States actually fell between 2006 and 2007.

Below you will find lists of German exports by countries for 2006 and 2007 for the leading destinations. A quick look through the two lists is revealing. Of particular interest are, for example, the fact that the numbers for China only increased by 8.7% on the year (up from 27,520.6 million euro in 2006 to 29,922.7 million euro in 2007, a difference of 2,402.1million euro) while exports to the Czech Republic (up from 22,255.3 million euro in 2006 to 26,026.6 million euro in 2007 or an incease of 3,771.3 million Euro) were rising at almost double the Chinese rate (up by 16.9%). The importance of United States as an export destination, on the other hand, declined, since exports there were down from 78,011.4 million euro in 2006 to 73,356.0 million euro in 2007, a decrease of 4,655.4 million Euro or 6%. Poland, which is another important destination for German exports was up from 28,820,4 million euro in 2006 to 36,083.2 million euro in 2007. An increase of 7,262.8 million Euro or 25.2%. Spain was also up considerably (as was Italy), rising from 42,159.2 million euro in 2006 to 48,157.7 million euro in 2007, that is an increase of 5,998.5 million Euro or 14.2%. The Russian Fderation is up from 23,371.8 million euro in 2006 to 28,185.2 million euro in 2007, that is an increase of 4,813.4 million Euro or 20.6%.

Now the list I have just gone through is scarecly a randomly chosen one. The decline in importance of the United States as an export destination for both Germany and Japan - which are the world'd No 3 and No2 economies respectively, and are both export driven - surely has some implications for the whole decoupling-recoupling debate. Also, the dependence of the German economy for exports growth on Poland, Czech Republic, Russia, Italy and Spain - all of which may have economic issues in 2008 of greater or lesser importance - is surely more than a minor detail, and the evolution of the east european and latin economies needs to be closely monitored for what they can tell us about the future path of the German one.

Whole Year 2007 German Exports by Country in Million Euro

France 93,860.6
United States 73,356.0
United Kingdom 70,998.8
Italy 65,148.0
Netherlands 62,373.5
Austria 52,762.5
Belgium 51,407.0
Spain 48,157.7
Switzerland 36,355.3
Poland 36,083.2
China, People's Republic of 29,922.7
Russian Federation 28,185.2
Czech Republik 26,026.6
Sweden 21,677.6
Hungary 17,304.9
Denmark 15,358.2
Turkey 15,082.7
Japan 13,075.2
Finland 10,291.4
Korea, Republic of 8,733.0
Slovakia 8,550.3

Whole Year 2006 German Exports by Country in Million Euro

France 86,093.0
United States 78,011.4
United Kingdom 65,340.5
Italy 59,971.4
Netherlands 55,876.5
Belgium 49,249.2
Austria 48,921.1
Spain 42,159.2
Switzerland 34,725.7
Poland 28,820.4
China, People's Republic of 27,520.6
Russian Federation 23,371.8
Czech Republik 22,255.3
Sweden 18,881.2
Hungary 15,870.8
Turkey 14,389.9
Denmark 14,020.4
Japan 13,860.9
Finland 9,299.6
Korea, Republic of 8,476.2
Slovakia 7,621.3
Portugal 7,460.5

In Conclusion

So what I want to say in this post is that it is now quite evident that some slight easing in the downward path of the German growth process is now taking place, the recent data are simply too consistent on this front to be ignored. As I mentioned at the start, the IFO reading was not as weak as might have been expected, the GFK consumer confidence reading remained stationary, unemployment continued to fall on a seasonally adjusted basis, while the January retail sales data and February retail PMI readings indicate an underlying expansion in German retail sales for the first time in several months.

Of course how long this process will last, and how important the turnround will prove to be, is very hard to say at this point. Looking at the general economic environment I wouldn't be betting on any kind of very strong upswing, but the numbers are interesting, and I wouldn't be surprised at all to see the recovery in the January export situation being carried over into February. An Eastern Europe effect perhaps? Certainly several economies are still accelerating there, almost to overheating, and the strong growth rates in German exports to Poland, the Czech Republic and Russia are unmistakable signs of something.

It is also significant that we can see some slight consumption effect in provisional results released by the Federal Statistical Office for turnover in the German retail trade in January, with sales up by 2.7% in nominal terms and 0.6% in real terms over January 2007. When adjusted for calendar and seasonal variations the January turnover was in 1.9% higher in nominal terms and 1.6% in real terms over December.

Now this is not an earth-shattering change, but it is significant. If we add to these results the latest reading on the Bloomberg retail sales purchasing managers index, which rose to 52.1 in Feb from 44.2 in Jan (according to data released yesterday by NTC economics), then obviously we be reasonably confident that the sales climate has improved somewhat. In fact February was the first month in almost a year when German retailers anticipated that their future sales performance would exceed their initial plans. The last time the retail PMI registered a monthly sales expansion was back in September 2007.

As I say at the start of this post, it is very hard to decide how to read all of this, but I imagine everything will become clearer as the days pass. One thing we should not be expecting though is any large and significant expansion in private domestic consumption to prop the economy up when exports do finally falter. Overall final domestic consumption expenditure now constitutes an almost permanent impediment to German economic growth. In particular we might note how final consumption expenditure by private households fell markedly (–0.8%) in Q4 2007 and to this weak private consumption was added a reduction in government final consumption expenditure, which had been increasing slightly during the first three quarters, but which also was down 0.5% in the fourth quarter when compared with the third.

As can be seen in the chart above, German private consumption has not proved able at this point to recover from the pre VAT increase surge in Q4 2006. Will the decison to raise taxes to try to "painlessly" address ageing population related fiscal problems finally turn out to have been one of the worst errors of economic judgement in recent European policy making? It certainly look this way, but at the end of the day only time will tell.

Friday, March 14, 2008

China's Inflation and Labour Shortage Problem, It's The Fertility Stupid!

by Edward Hugh: Barcelona

China's inflation accelerated to its fastest pace in 11 years in February as the worst snowstorms in half a century disrupted food supplies, adding to pressure on the government to step up administrative measures to try and slow the economy and on the central bank to raise interest rates. Consumer prices climbed 8.7 percent in February from February 2007 following a gain of 7.1 percent in January, according to the statistics bureau in Beijing earlier today.

This is obviously very bad news indeed, and makes the Chinese problem look ominously like the ones we have been seeing in some East European economies and Russia. Obviously rising living standards which produce pressure on restricted global food prices don't help, nor does the strong flow of speculative funds entering China in the expectation of yuan revaluation. But to the discerning eye there is obviously a much more profound process at work here. The problem seems to be that China - despite its enormous size - is chewing up its labour reserves faster than new labour market entrants are arriving, and this is happening in large part due to the structural population break which has been produced by several decades of one child per family policy.

The issue is simply that China cannot continue to grow at anything like the double digit rate it has become accustomed to in recent years, in particular due to the growing constraints on labour supply. It should be remembered here that China has so far been focusing on low value work which is hugely labour intensive.

If you want some idea of what this means in practice, just look at this opening sequence from Jennifer Baichwal’s documentary "Manufactured Landscapes". And notice, apart from the scale of the enterprise, and the types of activity engaged in, the comparatively young age of most of the workers.

The New York Times's Keith Bradsher was in China last summer, and he pointed out that while there are no really reliable figures for average wages in China there is widespread evidence that factory owners and experts who monitor the labor market are noting how that businesses are having a hard time finding able-bodied workers and are having to pay the workers they can find ever more money.

For decades most labor economists saying that China’s vast population would supply a nearly bottomless pool of workers. So many people would be seeking jobs at any given time, this reasoning went, that wages would be stuck just above subsistence levels, probably for decades. As recently as four years ago, some experts estimated that most of the perhaps 150 million underemployed workers in the countryside would be heading to cities. The reality however has been quite different. Instead, from 2003 onwards sporadic labor shortages started to appear with growing intensity at factories in the Pearl River delta of southeastern China. Now those shortages seem to have spread to factories up and down the Chinese coast.

Only this week the Economist reports - in an article entitled Where is Everybody - that the vast annual migration of around 20m people that has been fuelling the manufacturing boom in southern China over the past two decades is rapidly diminishing.

The Guangdong Labour Ministry is reporting that 11% of the workers did not return after the January holiday period, and independent estimates put the number as high as 30%. Whatever the exact details, many factories are reeling. Wages were already rising (according to government figures by around 20% y-o-y) now they will surely go up further. Meanwhile, revenues are falling due to slowing demand from America and a reduction, following pressure from other countries, in China's complex system of export subsidies.

The Federation of Hong Kong Industries have also produced some gloomy looking figures. Members estimated 10-20% of the 70,000 factories in Guangdong province had closed in the past year, and they expected a similar number to close within the next two years. Two-thirds of those polled said they were unsure whether to invest more in the region; one-third planned to cut investment. Only one respondent was optimistic. As the Economist notes, not all of this is bad news by any means since to some extent the closures are the objective behin a recent government plan to force dirty, low-paying industries out of business or into poorer interior regions that have so far missed out on the country's growing industrial wealth. But then we have the inflation data, and we can see that there is more at work than a simple "facelift" operation.

When pressed Chinese officials are quick to say that there is no overall shortage of labor — rather, there is a shortage of young workers willing to accept the low wages that prevailed in the 1990s (see again the video clip above). Factories in cities like Guangzhou advertise heavily for young workers, even while employment offices consider it a success if someone over 40 can find any job in less than a year.

Keith Bradsher quotes Jonathan Unger, director of the Contemporary China Center at Australian National University in Canberra, to the effect that “Now they’re taking workers into their early 30s, but anything older than that and they think they can’t take the conditions, the 11-hour days.... as well as work on weekends, and a tedious life in factory-owned dormitories". and as Brasher says "Plant owners’ refusal to hire blue-collar workers over 35 or 40 is colliding with the demographic reality of China’s one-child policy". And on his vists to villages from tropical Gaoyao in the southeastern corner of the country to dusty Houxinqiu in the northeast, what he found most striking was how few young adults remained after so many had left for the cities. He cited a recent government survey of 2,749 villages in 17 provinces and autonomous regionswhich found that in 74 percent of villages, there were no workers fit to travel to distant cities. Of course this is what they are now noting in Guandong.

The Real Issue is Inflation and Rapid Growth

The big unknown in 2008 in China is what is going to happen happen to inflation. Most analysts are assuming that the application of a traditional set of policy measures - letting the yuan rise, raising interest rates at the central bank - will produce a very gradual slowdown in China. Having seen what I have seen in Eastern Europe, and looking at what is now happening in Russia, I have my doubts abou this.

The inflation problem they have is a very real one - as we are now seeing month after month -and at this point in time it is hard to see how they can adequately address it. Certainly unchaining the yuan could just as easily lead to an acceleration of inflows and an increase in the overheating problem as to any more benign outcome, and I would treat New Zealand (and India for that matter) as the "Canary in the Coalmine" (or if you prefer "smoking gun") here. So I would just like to put up a question mark on this count, and I would do this especially in the context of the underlying and strong structural break in the Chinese population pyramid which has been produced by many years of the one child per family policy. Looking at those other canaries - Latvia and Estonia (and then Russia) push-comes-to-shove time does seem to arrive a lot earlier than we had all been anticipating. As I say, 2008 could well be the year that inflation gets a hold on China. In which case the whole thing could simply continue overheating till it simply cannot anymore, and then we could see a quite severe slowdown, a slowdown which given China's size and growing economic importance could have an impact across the entire global economy.

The danger is that a feedback mechanism is created whereby rising wages (according to data from the statistics office Chinese wages are now rising at something like 20% year on year) feed into producer prices, which then feed into consumer price inflation, and so we go on. Certainly this weeks producer prices data was hardly reassuring, since producer prices climbed 6.6 percent in February, the fastest pace in more than three years, giving us yet one more indication that the "cheap Chinese labour" global disinflation process most likely has now come to an end.

What we really need to be noting here is the fact that China's demographic trajectory is virtually unique, especially in terms of economic growth and China's demographic transition, since it is surely the case that China was getting some sort of demographic dividend or other (in terms of having an increasing proportion of the population in the workforce) well before the recent growth wave really took off in the late 1990s.

What we do know is that from the late 1990s onwards China systematically introduced a very extensive labour and financial market reform process, and this certainly has served to unlease a huge amount of pent-up potential both interms of labour supply and sectoral shifts in economic activity, and it is this which has given us the sustained growth since the turn of the century.

What is interesting to note is how the recent uptick in inflation coincides almost exactly with the peaking of the 15 to 19 age group, as you can see in the chart below, and it is important to note that the decline in this age group will now continue as far ahead as the eye can see, and especially over the next several years is really going to be quite dramatic, as you would expect from the drastic one chile per family "torniquet" policy which was applied.

I have selected the 2022 horizon looking forward based on the fact that this is now known data. We can predict with a reasonable degree of accuracy just how many 15 year olds there will be in China in 2022, since they have now already been born. So we have a pretty good idea of China's new labour supply going forward. Obviously China can still get considerable growth by relocating the existing workforce across sectors to more productive ones. But the end of the labour intensive low economic value growth must now surely be in sight, and the big question is can China sustain inflation-free growth of the order of magnitude we have been seeing in recent years, bearing in mind that much of the recent growth in many of the higher growth developed economies - the US, the UK, Ireland, Spain - has been very labour intensive. My feeling is that it can't, this is why all those exhausted canaries swooning in Latvia have been so useful, and that we will see a slowdown in China which will not simply be cyclical, but rather structural. Possibly the moment of inflection (or tipping point) here will come around the time of the Olympic Games.

So, as I say the 15 to 19 age group has now peaked in China, and from here on in it is essentially downhill all the way, as far ahead as anyone can see. The truth is that no-one at this point in time knows what the consequences of this are going to be. But don't worry, since at least one thing is for sure: we are all just about to find out.


Those interested in a more growth-theoretically oriented explanation of the argument in this post may find my "Has China's Economic Growth Passed It's Peak? post well worth reading.

And for a fuller explanation of the inflation dynamics problem in another context see my "Inflation in Russia: Too Much Money Chasing Too Few People?".

Another Bad Friday in Budapest

by Edward Hugh: Barcelona

Oh why is it always Friday, we may ask ourselves, that things get choppy in Budapest! I say this since in each of the three last weeks the greatest pressure seems to come on HUF denominated instruments on a Friday. This morning "efficient cause" was the release by Standard & Poor's Ratings Services of a revision to its Hungary outlook on Hungary to ‘Negative' from ‘Stable' reflecting the “weakening perspective for sustained consolidation of public finances".

“We believe that the increasing political incentives and pressure to dilute the fiscal reforms ahead of upcoming elections, coupled with the increasing cost of external borrowing, will interrupt Hungary's progress in reducing its deficit from 2009 and will keep the debt burden rising," said Standard & Poor's credit analyst Frank Gill.

They argue that political opposition to budgetary reform is increasing and cite - obviously, whoever could have thought otherwise - the results of the 9 March referendum which reflected a weakening in the government's mandate a large majority of Hungarian voters rejected highly sysmbolic aspects of the package.

“The defeat will not meaningfully increase this year's budget deficit but it nevertheless confirms fading appetite among Hungarians to continue with the consolidation process. The recent ill-timed announcement of various tax-cutting proposals for 2009 (ranging from 0.7% to 1.4% of GDP) point in the same direction. Moreover, the possibility of new opposition referenda, which amount to votes of no confidence in Prime Minister Gyurcsány's fiscal reform plan, will further undermine the government's goal of reducing public sector debt dependency"

S&P sees important dangers of slippage in Hungary's public sector deficit reducing programme, with the deficit only coming down to 4.5% of GDP this year (while the government target is 4%) from an estimated 5.7% in 2007 and a massive 9.2% in 2006. More importantly, S&P forecast that budgetary deficits will remain unchanged in 2009 and 2010. The cabinet's agreed aim is to reach a deficit of 3.2% of GDP next year.

Hungary's Finance Minister János Veres dived straight into the fray this morning asserting that Hungary's public sector deficit will drop below 4.0% of GDP this year and that the government has no intention of changing its deficit reduction path set out in 2006.

Personally I think it is very hard to put firm numbers on future budget deficit outcomes before we know the future path of Hungarian GDP growth (and it is noteworthy that Fitch Rating analyst David Heslam has come straight out today and said he thinks this year's deficit target can be met - long live competition between the agencies!). At the present time it is clear that the main risks are all downside, and in this context S&P's general slippage concerns would seem to be entirely justified. What this means is debt to GDP could rise even further, and S&P project a ratio of over 68% of GDP in 2010. In this context the following warning is an important one:

"Lack of a clear perspective for stabilization could eventually lead to a downward revision of the ratings, which would risk undermining investor confidence and could severely hamper Hungary's ability to refinance itself"

This warning should be taken very seriously by all those countries (like Italy) with rapidly ageing populations and important structural problems in achieving fiscal balance.

The Standard & Poor's revision was also commented on in Brussels by Hungarian Prime Minister Ferenc Gyurcsány, who said the change in credit outlook will cost the country billions (of forints). Gyurcsány said the credit rating agency became concerned after the outcome of the 9 March referendum, saying that it considerably diminished chances for Hungary to put in place the necessary structural reforms. This reaction is hardly surprising since Gyurcsany would obviously like to make political capital from it by making the point that it is the initiators of the referendum who are to be blamed for the outlook revision. Political gameplaying it may be, but that doesn't make his point any the less valid, I think.

Industrial Output Blues

To the already existing gloom was added the impact of Hungary's final adjusted output figures which showed that industrial output inched up by 1.0% month on month in January, according to final figures adjusted seasonally and by working days, the Central Statistics Office (KSH). This rate was a downward adjustment from a preliminary 1.3% growth reported earlier. The month on month increase in Dec 2007 was also 1.0% (adjusted upward from 0.9%). So while the short term performance is far from a disaster (although clearly not sufficient to pull forward the now export dependent Hungarain economy) since output volume has risen now for the third consecutive month, today's detailed figures do paint a very gloomy picture on the extent of the likely future deceleration of growth. Total new orders for industrial products were down 2.5% year on yearr in January. New exports orders were up 0.8% year on year, but domestic orders slumped by 11.9%. Total orders dipped by 9.2% year on year. Since Hungary is so highly interlocked with Germany, and further slowdown in the German economy will be sorely felt in Hungary.

The response to all this gloom wasn't long in arriving since the forint was back down in 260 to the euro territory falling 0.6 percent to 259.97 per euro, after trading at a two-week high of 257.07 earlier, up from 258.48 late yesterday. Today's trading follows a very volatile session on Thursday (euro/HUF even reached 262 at one point), and the rapid rise in the yield curve at the long end ( with 10-yr bonds going at auction with an average yield set of 8.62% - up 115 base points on the previous auction of the same instrument) seems to be attracting investors, although evidently yields are now likely to be stuck at these very high levels.