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Friday, August 29, 2008

Economic Growth in Chile

By Claus Vistesen: Copenhagen

There are many perspectives through which to look at economic development and growth. Geography, institutions or perhaps just plain good old physical capital accumulation are all important parameters. This small piece suggests a further metric and attempts to frame the argument with Chile as a case study.

Specfifically, this note explains the process known as the demographic dividend and conceptualizes it in a Chilean context. The analysis shows how Chile during the last two decades has benefited from the dividend proxied by the increasingly favorable trend in overall age structure of the society. By some measures Chile’s demographic dividend is thus ending during these very years. Yet, by adapting a slightly broader definition of the optimal working age and subsequent productivity profile, it appears that Chile still finds itself in the proverbial sweet spot and will continue to do so for the next decade. Coupled with the favorable windfall from copper exports and the subsequent transformation of this into an unprecedented net wealth position of Chile’s public accounts, the economy looks on a very solid footing to face whatever travails that might come next.

A Good Run

As can be observed below, Chile did indeed lose a substantial amount of output surrounding the Latin American debt crisis in the 1980s as well as the Asian currency crisis in 1997. Yet, and although Chile’s economy did not emerge unscathed from the past three decades of emerging market crises, the economy still managed to recover in terms of output. [1]

Chile's growth performance depicted by the chart is interesting in so far as it shows us the period that some scholars have dubbed Chile's Golden Age (Gallego and Loayza, 2002) due to the extended period of high growth rates. Between 1984 and 1998 Chile's growth rate in output per capita averaged 5.15% a year with a volatility of 2.64% p.a. This compares with an average growth rate in output per capita between 1998 and 2008(f) of 2.61% and a subsequent volatility of 1.73%. The 1985-1998 figures are remarkable and thus deserve some explanation.

According to Gallego and Loayza (2002) Chile's impressive growth performance primarily comes down to improvements in total factor productivity induced by increased investment in human capital and the development of a sound and coherent institutional setup. As such, and not unlike other growth accounting exercises the authors initially find that TFP accounts for the biggest share of output growth alongside the usual suspects of capital accumulation and growth in the labour force, the latter which is (in)famously coined as synonomous with population growth in the neo-classical growth model

The empirical approach is rather straight forward in terms of methodology, and is closely related to the tenets of endogenous growth theory as well as of course Mankiw, Romer and Weil's (1992) seminal findings that investment in human capital be considered an important part of capital accumulation. Formally, the authors first estimate a cross-section regression framework (GMM) based on a, more or less, standard neo-classical growth model augmented with human capital (schooling rates and life expectancy). The authors also include; government consumption to GDP, financial market development, terms of trade shocks, trade openess, and a black market premium. They find that this model account for 43% of the growth observed in Chile.

Unsatisfied with this result, the authors imbue the model with a number of variables whose origin in the growth theory framework are inspired by the tenets of endogenous growth theory. These variables include proxies for the political system, governance, public services and infrastructure, and with these, the new model moves reaches a coefficient of determination of 73%.

In line with endogenous growth theory the authors consequently find that this initial "residual" best be explained by improvements in the institutional edifice of Chile's economy. As a result and although the notorious convergence effect will tend to lead to lower overall growth rates in period t0 than in period t-1, the authors suggest that Chile focus further on institutional improvements to foster growth in the future.

Far be it from me to take issue with these results. However, in the following I propose another way to look at the past and future growth performance of Chile. It is important to understand that the two approaches are not mutually exclusive but ultimately directs the attention to a different set of governing mechanisms when it comes to economic growth.

A Demographic Dividend?

In one of their many papers on the subject David E. Bloom and David Canning (see Demographic Challenges, Fiscal Sustainability and Economic Growth, PGDA Working Paper no. 8) provide a useful historical sweep of the different approaches to demographic changes and their significance on the economic edifice. From the Malthusian epoch to a more optimist view on the benefits of vibrant population dynamics (see e.g. Simon Kuznets, Julian Simon, and Ester Boserup) and on to what Bloom and Canning coin as the “neutralists” [3] , the perspective on the importance of demographics has certainly changed a lot.

One crucial lesson to draw from the historical prism of demographic discourses is that the demographic transition is a far more complicated process than a mere transition in population growth rates as well as one of sectoral shifts in the economy. Lee (2003) consequently shows how the demographic transition also fundamentally changes the age structure of society whereas others such as Malmberg and Sommerstad (2000) and Hugh (2006) have suggested that the demographic transition be re-thought all together. Common for these contributions is the shifts in age structure, the complex mechanisms which govern these changes, and their subsequent effect and operationalization on the macroeconomic edifice.

Bloom, Canning and their fellow scholars on the PGDA at Harvard, [4] have furthermore showed how age structure makes a much more solid demographic yard stick, for gauging economic trends, than merely looking at population growth and absolute size of the population. This, I think, is the ultimate lesson to derive from decades worth of thinking on demographic processes. I would essentially divide the lesson into two irrefutable points. One is that age structure matters much more than population growth and that a simple metric such as median age can give us a tremendous amount of information on an economy's given and future growth path. The second points is simply that the demographic transition is not, by a long shot, over. In fact, nobody knows when it will end.

It is within this framework that the process known as the demographic dividend enters, and not surprisingly, it is all about age structure and how economies who go through the demographic transition at some point will find themselves with above average conditions for growth as the working age as well as productive share of the population is maximized. In terms of median age and as a crude benchmark, we can say that those economies with median ages between 25-35 are situated in or close to the optimal age structure for economic growth. Nothing comes for free however, and it is crucial to point out that the demographic dividend provides an opportunity rather than a sure benefit. For example, it seems that Eastern Europe and Russia, by and large, have gone through their demographic dividends without experiencing the corresponding win-win situation in which favorable growth conditions coincides with advances in terms of institutional quality and political stability.

The demographic dividend operates through two interconnected mechanisms in the form of falling fertility and declining infant mortality. In most countries, falling mortality as the economy moves through the demographic transition has been accompanied, with a lag, by falling fertility Bloom and Canning (2006). If we add a steady increase in life expectancy to proxy the general improvement in the health of the population these interconnected processes endow an economy with a period of, let us say, 15-20 years in which the young and working cohorts of the society are relatively big compared to the dependent cohorts. The former are often defined as the cohorts aged <20-25 [5] years and for the latter's part >65. As for quantitative importance, Bloom and Canning (2004) have shown this to have a positive effect on per capita output as well as they have famously shown how one third of the East Asian Tiger economies’ impressive growth spurt in the latter part of the 20th century can be explained by the demographic dividend.

More generally Bloom & Canning et al. (2007) have also demonstrated, through cross sectional regression data, how age structure can significantly improve the forecast of economies' growth rate relative to world GDP.

Chile’s Demographic Dividend

If large parts of East Asia have already had their demographic dividend what about Chile then. Is Chile about to receive, or more aptly; is she in the middle of her demographic dividend?

As can readily be seen, Chile almost displays a textbook case of economic development. In this way, infant mortality has fallen back sharply since the middle of the 1970s as well as life expectancy has increased. Outside the immediate realms of economics, biologists and health economists speak of the process known as the epidemiological transition to explain the progression of the change in (and drivers of) variables such as mortality, life expectancy, and other public health metrics.

The reduction of, and subsequently the current level of, infant mortality in Chile rivals that of many developed economies. According to Albala and Vio (1995) Chile managed to reduce infant mortality by 82% between 1970 and 1992 and Jimenez and Romero (2007) further shows how provisions of services to counter perinatal risks and acute respirator distress have helped Chile to reach an impressive infant mortality rate of 8.9 infants per 1000 thousands in 2000.

With respect to life expectancy Albala and Vio (1995) describe how the mortality rate of people aged 65 and more decreased 73% between 1970 and 1992 . Especially, a reduction in the mortality from cardiovascular causes is highlighted. In a more recent paper Albala, Vio et al. (2002) also latch on to increasing risk posed by a transition from a prevalence of infectious diseases to on in which chronic diseases ascend in importance. The usual suspects here would be an increase in obesity as a result of malnutrition through the consumption of high-fat/high-carbohydrate energy-dense foods and a decrease in physical activity. Chronic diseases which spring from such developments would then be e.g. type 2 diabetes and cardiovascular diseases. Evidence of this development appears in the context of school children; from 1987 to 2000 the prevalance of obesity among first grade school children rose more than 100% for both boys and girls.

Much debate has and will be devoted to the extent that such adverse developments from economic development could, at some point, break the curve in terms of life expectancy. At this point however, it seems as if advances in healt care services and the subsequent improvements in old age life expectancy are enough to keep the curve ticking upwars.

Returning to the question of demographic dividend in Chile, the trend of the decline in infant mortality exhibits the expected negative concave relationship as per function of the fact that the value cannot fall below 0. In order to build a simple model framework and by applying the logic expressed through theory above, we can construct a rudimentary econometric model to formalize the argumet.

Consequently, we let the lagged change (one year) [6] in the infant mortality rate predict the change, in year 0, of the fertility rate. Given the properties of the time series in question, and the theoretical framework above we would expect a positive but also a concave relationship since both variables are bound by the fact that they cannot fall below 0. In general terms, this model clearly assumes that the process of decline in fertility throughout the demographic transition is infinitely simpler than it really is. The crucial point here is that while the decline in infant mortality may be able to explain the decline in fertility on a certain part of the curve it cannot, and may in fact see its sign reverse, as we move further towards replacement level fertility and beyond. One could even with reasonable claim ask whether in fact the decline in fertility towards replacement levels is driven by infant mortality reductions alone. Nevertheless, the model estimated looks as follows where both variables are in changes.

Which leads to the following estimation:

The visual inspection of the model can furthermore be derived from the graph below.

In general, the model is far from solid but it manages to get the message across in the sense that it links the decline in fertility to the lagged decline in infant mortality [7] . The key thing to remember is the implicit and theoretical concave relationship cited above; a relationship also confirmed by the scatter plot.

The interesting thing about Chile here is that, according to standard demographic theory, the demographic transition should, by and large, end now as fertility trends towards replacement level. Not a lot of serious scholars would believe that however and we can thus expect fertility to decline below replacement level (see e.g. Wolfgang Lutz here). The extent to which it does not, Chile would clearly constitute something of a remarkable case. This is also why policy makers would be wise to consider implementing steps to avoid fertility dropping into lowest-low territory [8] , since what we know with almost certainty is that the demographic transition does not stop once infant mortality hits near rock bottom.

This point also highlights the idea that while the demographic dividend presents a window of opportunity so does the backdrop represent a penalty. This point is crucially related to the fact that only very few economies (e.g. the US and perhaps also France) have been able to stay at, or return to, replacement levels of fertility. In most other cases, fertility seems set bound to fall further and the only real metric to gauge is the speed by which this occurs. In an emerging market context the evidence is worrying to the extent that many economies have seen their fertility rates crash completely over the course of less than a decade. The next 5-10 years in Chilean, and indeed Latin American context, will be extremely interesting to watch in this regard.

Given the fact that Chile's fertility level is already approaching replacement level, the model cited above has, in all likelihood, run its course. What will likely cause Chile's fertility rate to fall below replacement level requires an entirely different set of explanatory variables and also theoretical edifice. Key trends would for example include an elaboration of the quantum and tempo effect of fertility in a context of rapid economic development and changing social norms.

To summarize the argument in a Chilean context, the ultimate data series to gauge, in the context of the demographic dividend would be age structure and the effect from the processes described above.

As per usual, beauty is in the eye of the beholder since depending on which definition you ascribe to the optimal age structure, Chile could be said to be in and out of the demographic dividend. The truth probably is that Chile is in the twilight hours of its demographics dividend. However, with a median age of about 30 years Chile still enjoys, and will continue to do so in the immediate future, the benefits of an age structure conductive to balanced economic growth.

One important point to note here is that the 25-44 bracket peaked sometime in the middle of the 1990s. Much evidence suggests though that it is a bit untimely to make the cut at the 44 year old age group, since many people are perhaps not far from their productive peak between 44 and 64. On the other, the peak of the 25-44 age bracket may still constitute an upper level of economic capacity if viewed as the ability and propensity to sustain housing booms, large negative external balances etc.


Chile still has ,and will continue to enjoy for the immediate future ,a favorable age structure for harboring economic growth and dynamism. Favorable is in this context defined through the spectrum of the demographic dividend and the subsequent increase in, and high proportion of, working age people to total population. Depending on fall in fertility, the demographic dividend is definitely tapering off at this point. If experience from East Asia is anything to go by Chile as well as its Latin American peers are now set to enter a new phase of the the demographic transition in which fertility steadily moves below and beyond replacement levels. The speed here is crucial. If it happens slowly, Chile can expect to posses a relatively balanced age structure in the decades to come but if the decline is swift and lingering the effect could be otherwise.

This small piece has also touched upon the way we conceptualize economic growth and development. I would not want to discount methods such as the one deployed in Gallego and Loayza (2002). However, I have suggested that a different perspective is a also considered. I would, in particular, emphasise this in the context of the future drivers of economic growth. Nobody can disagree with the impetus to move forward on strong institutional settings. Yet, economic development is not only accompanied by a demographic dividend but also, arguably, a demographic penalty which occurs as the effect of the dividend recedes and the decline in fertility continues. This would be where concepts such as the quantum and tempo effect of fertility comes in. it is also where policy makers would be wise to consider that a relentless strive to reach the apex of the value chain will also bring with it a deficit in terms of the proper quantity/quality mix of human capital.

List of References

Albala, Cecilia; Vio, Fernando; Kain, Juliana and Uauy, Ricardo (2002) - Nutrition transition in Chile: determinants and consequences, Institute of Nutrition and Food Technology (INTA), University of Chile

Albala, Cecilia and Vio, Fernando (1995) - Epidemiological transition in Latin America: The case of Chile, Institute of Nutrition and Food Technology (INTA), University of Chile

Bloom, D and Williamson, J (1998) Demographic transitions and economic miracles in emerging Asia. World Bank Economic Review. 12(3) 419-456.

Bloom DE et al. (2007) - Does Age Structure Forecast Economic Growth? PGDA Working Paper no. 20.

Bloom, DE & David Canning (2006) – Demographic Challenges, Fiscal Sustainability and Economic Growth, PGDA Working Paper no. 8.

Bloom, DE and Canning, D (2004) - Global demographic change: dimensions and economic significance, In Global demographic change: economic impacts and policy challenges (proceedings of a symposium, sponsored by the Federal Reserve Bank of Kansas City Jackson Hole)

Gallego, Francisco & Loayza, Norman (2002) - The Golden Period for Growth in Chile: Explanations and Forecasts, Working Paper, Central Bank of Chile no. 146

Hugh, Edward (2006) - Rethinking the Demographic Transition (can be downloaded by request)

Jiménez, Jorge and Inés Roméro, Maria (2007) - Reducing Infant Mortality In Chile: Success In Two Phases, Health Affairs, 26, no. 2 (2007): 458-465

Lee, Ronald (2003) - The demographic Transition: Three Centuries of Fundamental Change, Journal of Economic Perspectives, 17 (fall 2003), pp. 167-190

Malmberg, Bo & Lena Sommestad (2000) - Four Phases of the Demographic Transition, Implications for Economic and Social Development in Sweden, Working Paper 2000:6, Institutet for Framtidstudier

N. Gregory, Mankiw; Romer, David, and David N., Weil (1992) - A Contribution to the Empirics of Economic Growth, Quarterly Journal of Economics, vol. 107.

Kuznets, S (1967) Population and economic growth, in Proceedings of the American Philosophical Society, III (3).

Simon, J (1981) the ultimate resource. New Jersey: Princeton University Press.

[1] Although Chile did not recover from the Asian currency crisis to pre 1997 levels.

[2] Bloom & Canning (2006) – Demographic Challenges, Fiscal Sustainability and Economic Growth, PGDA Working Paper no. 8.

[3] Basically, this would be the modern institutional paradigm that has emerged within the economic growth/development discourse (see e.g. Daron Acemoglu, Dani Rodrik and Amartya Sen).

[4] See numerous contributions here: http://www.hsph.harvard.edu/pgda/working.htm

[5] I would argue that this is the right threshold (unlike the <15>

[6] The time series are in changes to correct for non- stationarity. As for the lag, the optimal number of lags could be more rigorously verified on the basis of theory and the statistical properties of the time series in question (VAR)

[7] Although, as can also be observed in the graphs, it cannot predict sudden reversals in fertility trends; i.e. these would essentially be treated as exogenous shocks to this model.

[8] A TFR of <1.5

Wednesday, August 27, 2008

German Recession Danger Rises As Consumer and Investor Confidence Falls

by Edward Hugh: Palamos (Costa Brava)

Well, I'm supposed to be on holiday at the moment, but since economic events simply refuse to stand still (not even for me, and especially not in Russia), what else can I do. I'm supposed to be resting quietly in that nice building you can see behind the lighthouse (in the photo above), but since German business sentiment and consumer confidence fell more than we might have anticipated in August - thus raising the likelihood that Europe's largest economy may now be steadily slipping into a recession, dragging in the process aggregate Eurozone GDP data along behind it - then here I am sitting sweating it out in a cyber cafe.

Business Climate Worsens In August

The Munich-based Ifo institute's business climate index, based on a survey of 7,000 executives, dropped to a three-year low of 94.8 from 97.5 in July. Ifo's gauge of business expectations dropped to 87, the lowest since February 1993, when Germany was experiencing the worst recession of the past two decades. A measure of current conditions eased to 103.2 from 105.7.

"The German economy is encountering an increasingly more difficult situation,"
Ifo President Hans-Werner Sinn

Consumer Confidence Down Again

At the same time GfK AG's consumer sentiment reading slumped to its lowest level in five years. GfK AG's index for September, based on a survey of about 2,000 people, fell to 1.5, the lowest since June 2003, from a revised 1.9 in August, the Nuremberg-based market-research company said in a statement today.

GfK's sub-index measuring economic expectations plunged to minus 21.8 from minus 8. A measure of consumers' propensity to spend fell to minus 27.9 from minus 26.2 while a gauge of income expectations improved to minus 16.8 from minus 20.

Subdued economic prospects and the expectation of additional price hikes continued to depress consumer sentiment in August. While income expectations recovered slightly from the marked downturn in the prior month, economic expectations were dampened further. The propensity to buy, which in a long-term comparison has been far below average for many months, recorded a further slight reduction.
GFK Press Release

Second Quarter GDP Contraction Confirmed

Further detailed data released today by the Federal Statistics Office confirmed that the German economy contracted in the second quarter, while most of the short term indicators we are now receiving seem to suggest that it may fail to grow in the third quarter as well. While oil prices have receded from a record $147.27 a barrel, they're still up 60 percent over the past year, putting pressure on consumer spending power and just as the slowdown in Southern European economies like Spain and Italy start to weigh heavily on German exports.

The economy contracted 0.5 percent in the three months through June as construction dropped back sharply and companies and households reduced spending, according to the detailed data from the Federal Statistics Office.

Building investment was down 3.5 percent in Q2 from the previous quarter, investment in plant and machinery fell 0.5 percent and consumer spending decreased 0.7 percent. Gross domestic product fell a seasonally adjusted 0.5 percent from the first quarter, when it rose a revised 1.3 percent. The Q2 contraction is the biggest drop since the second quarter of 1998.

Ironically, the headline GDP number was helped by a sharp drop in imports. This drop in imports was the direct result of a weakening in domestic demand (down 0.3% on the quarter), and thus GDP growth was improved by people actually getting worse off.

German exports fell 0.2 percent in the second quarter from the previous three months, when they rose 2.1 percent, today's report showed. However imports dropped even further (due to the weak domestic consumer demand) - by 1.3 percent from the first quarter (when they increased by 3.2 percent). So, despite the deterioration in the export situation, the net impact of trade on GDP was positive (0.4 percentage points were added to growth by this effect, or, if you like, without it the contraction would have been around 0.9%) due to the sharp drop`in imports. This result is even stranger than it seems at first sight, since the strong imports in the first quarter meant that trade in Q1 was in fact a negative for GDP (minus 0.3 percentage points) despite the relatively stronger earlier export performance. As the German Federal Statitistics Office Put It:

"However, growth was supported by foreign trade. Compared with the first quarter of 2008, downward trends were recorded for both exports and imports. As, however, imports decreased much more strongly (–1.3%) than exports (–0.2%), the resulting export surplus (net exports) contributed 0.4 percentage points to economic growth."
Weak Performance Looking Forward

According to the most recent PMIs for Germany, performance in the manufacturing sector continues to deteriorate, and manufacturing barely expanded in August:

while services fared a little better, coming in at 53.1, which was slightly up from July's 52.1.

All in all the outlook which seem to hinge on what happens to German imports and exports in August and September. Looking at what just happened in Georgia, and given the dependence of Germany on exports to Russia and the CEE, it is hard to be optimistic at this point about German export growth.

Thursday, August 21, 2008

Eurozone Recession On the Horizon?

by Edward Hugh: Barcelona

Is the first zone wide recession in the short history of the eurozone about to be registered? Certainly the flash PMI estimates for August give the impression that it might. The Royal Bank of Scotland Group Plc's composite index came in at 48 after 47.8 reading in July. Any result under 50 indicates contraction. Unfortunately we only get flash estimate breakdowns for France and Germany, but it isn't that difficult to deduce from the composite number that Spain and Italy continue to contract - although given that the composite rebounded slightly, while both services and manufacturing slowed in Germany, and in France manufacturing contracted more sharply in July while the contraction eased a bit in services, then it may be that Spain and Italy weren't contracting quite so strongly in August as they were in July.


The German manufacturing index fell to 49.9 in August, its lowest level in three years, after slipping back index to 50.9 in July.

Helping to push down the manufacturing indicator was the export component, which fell to its lowest level since June 2003, according to the report from Markit Economics.

The services PMI reading was not much better, falling to 50.6 in August from 52.1 in June. As things stand German services are riding just shy of contraction if the flash reading is borne out in the final result.

In its report, Markit Economics noted that the business expectations sub-index for Germany had slipped to the lowest level since November 2002.


Activity in France's manufacturing sector contracted at the sharpest rate in over six years in August, with a contraction of 45.1 being registered, down on July's 47.1 and the lowest level since December 2001.

The service index came in at 48.5, above July's 47.5 but still only its second time in negative territory since mid-2003. New business logged by service firms shrank at its fastest pace since the data was first collected in May 1998.

"If you extrapolate these figures through to the third quarter you're probably looking at stagnation of GDP (gross domestic product)... This is not a harbinger of imminent upturn," said Chris Williamson at data compiler Markit Economics. "Nothing points to a fundamental turnaround... I think there's been a spillover effect from Italy, Spain and now Germany, and France has followed suit."
So Is It Recession, and Will We See Rate Cuts From the ECB?

Gross domestic product fell 0.2 percent in the second quarter from the first, when it grew 0.7 percent, according to the data released ny Eurostat (the European Union's statistics offic) last week, and it now seems clear that this contraction may well pass over into the third quarter. In fact Germany's Economy Ministry said only yesterday that the economic outlook in Germany has worsened even beyond the second quarter, when gross domestic product shrank for the first time in four years.

European consumers are not getting much relief from falling oil prices either, since while oil prices have fallen 20 percent from a record $147.27 a barrel on July 11 the euro has dropped 7 percent ($1.4780 today) from its peak of $1.6038 hit on July 15, taking a lot of the edge off the drop. The fall in the euro will however make exporting outside the zone easier, the difficulty is that the demand for exports is slowing generally as the global economy slows.

The European Central Bank, which raised its benchmark rate by a quarter point to 4.25 percent in July, currently predicts growth will slow to about 1.8 percent this year from 2.7 percent in 2007, but today's PMI data would seem to confirm that the ECB's growth projections are no longer realistic and that the time to move over into rate cuts mode is fast approaching.

Wednesday, August 20, 2008

Testing Paulson's Resolve?

By Claus Vistesen Copenhagen

It never rains, but it pours; so goes an old adage and while the US authorities are still scrambling to figure out just what to do in the context of the erstwhile jewels, but now broken, mortgage giants Fannie and Freddie Mae foreign investors are beginning to vote, as it were, with their feet. As such, the big news so far this week must certainly be the extent to which portfolio managers at foreign central banks held suspiciously back in their hunger for Freddie Mac's three year note auction. Reuters and the IHT provide the details.
On Tuesday, Freddie Mac had to pay a steep premium on a $3 billion issuance of five-year debt. The company will pay an interest rate of 1.13 percentage points higher than the rate the U.S. government pays for comparable borrowing. Earlier this year, the premium was as low as 0.6 points, according to Bloomberg.

Even with Freddie Mac's debt promising investors a rich return, overseas demand for the issuance was weaker than in the past. Asian investors bought about 30 percent of the debt, while Europeans took 10 percent, according to a person familiar with the offering. By comparison, for the 12 months leading up to July, Asian investors accounted for 36 percent of the company's debt and Europeans held 15 percent, according to data released by Freddie Mac.

Apparently, the notion of a risk free rate and by derivative security is a rather fickle concept not least in this context where hitherto government grade paper now has to pay a premium 30 bp above the one levied just a few months ago. As always however, there is a silver lining. In this case, it would go something along the lines of how especially foreign institutional investors are cashing in on the call option which was explicitly handed to them as congress approved secretary Paulson to do "whatever it takes" to ensure that the agencies did not run into a default. Moreover, the script for this play was typed already in the immediate aftermath of the Fannie/Freddie bust, as institutional portfolio managers from Asia in particular were quick to denounce the increased risk on their holdings. The main emphasis was consequently that our good foreign fund managers were not holding equity from Fannie and Freddie Mae (which was visibly getting flogged), but rather their debt; and that, naturally, was all but secured by the government.

As such, and perhaps as a sign of good faith Freddie Mac's offering on the 18th of July was munched with great appetite as 61% of the auction was taken by foreign investors (of which 34% going to Asia); a number which was actually up from the previous 55% at the May meeting. Good sentiment abound treasurer at Freddie Mac
Timothy Bitsberger simply noted;

While some investors may have lost confidence in the companies, all I know is that we've been able to sell paper this week.

Well, that was then and this is now and in light of this week's meager demand, and subsequent increase in yield, Paulson is getting closer to the point where he has to pay for the option issued to the holders of agency debt. Brad Setser who also devotes a piece [1] to this topic seems to be getting to the center of things when he says:

(...) it certainly seems like the GSE’s creditors aren’t in the mood to extend credit just on the expectation that the GSE’s will be backed by the government if there is a need. The world’s central banks want to the Treasury to show them some money. That means changing the GSE’s current structure.

That sounds about right to me and yesterday's price action tells us as much. Brad also makes the succinct point that whatever yield the GSEs (government sponsored entities) would be able to pay above the benchmark treasury, it would certainly not be enough to compensate reserve managers from a potential default. This is to say that as long as the debt remained in some kind of quasi government backed limbo, the potential yield offered over treasuries would not suffice [2]. Of course, this is almost an argument non-sequitur because there is also a simple limit to the premium Fannie and Freddie could afford to pay on the outstanding debt without having to tap federal resources on the back of the interest expenses alone. I mean, either you mark to market, junk bond style, or you tie up the government guarantee in a formal arrangement. Remember too that the more Fannie and Freddie have to pay to finance their going concerns, the more expensive it becomes for holders of mortgages to finance and re-finance.

Add to this the small detail of the incoming debt roll-over just shy of a quarter of a trillion and I think the future of the GSEs is pretty much bent in neon. Paulson et al. will have to knit together a working solution which involves federal funds. It aint going to be pretty and the rascal in me (and others) would have no trouble seeing foreign reserve managers suffering from the party hangover they themselves contributed to. But at this point it seems, there really does not seem to be any alternative.

Cat and Mouse, but who is who?

In a more general light this is obviously a cat and mouse game, and one particular game where the roles are not ex ante assigned. In this way, one could ask with reasonable legitimacy whether in fact the small but significant demonstration this week constitutes a credible threat?

At a first glance it sure does look like the Petroexporters, Asia et al. are holding all the aces. The US does not only need to do something about the GSEs in order to shore up what must clearly be coined a dubious arrangement; there is also the small detail of the external deficit and what would happen if foreign investors decided to shun agencies. Obviously, if they decided to park their funds in treasuries in stead it would actually help the US economy as it would make it de-facto cheaper to finance the inflows needed to cover the external balance. Paulson is not likely to be that lucky however which suggets, more than anything, that some variant of a bail out is coming. Otherwise, the ensuing panic would be immense.

However, there is a different way to interpret this tune. As such and while the US definitely needs to make domestic debt attractive to foreign investors in order to attract inflows [3] so do foreign holders of agency debt need to protect their investments and USD denominated assets. This goes back to my argument of a potential point of no-return that basically suggests how major foreign agency holders, at this point in time, cannot afford a default or crash anymore than the US economy can. In a wider context it also cuts laterally through the discussion on global imbalances and where funds should flow. Sure, the USD and its associated debt looks rather rubbish at the moment but if you are unwilling, or more importantly unable, to muster the subsequent boomerang effect from a tanking USD then it suddenly becomes a little bit more complicated. Add to this that a candidate towards which the SWFs, reserve managers and other savers of the world could plausibly put their money does not seem to be on the table at the present time. At least, there is no single candidate which incidentally also makes a new variant of a Plaza agreement rather difficult to knit together. This would then exemplify the global game of old maid in which everybody can the see the impetus for the US economy and her currency to correct, but also where the process is gridlocked by the fact that the role of global capacity absorber/consumer of last resort remains equivalent to holding the old maid.

[1] Not only Brad Setser massages this topic. I would highlight Yves Smith and her commentary section in particular; Setser's comments section is good too by the way.
[2] Or this, as it were, is how I understand it.
[3] On a longer term, portfolio inflows pertaining to equity are sure to favor the US too.

Where Now for Brazil?

By Claus Vistesen Copenhagen

In case you did not notice, the Eurozone recently slipped into a near recession and so did Japan. Together with an already limping and essentially recessionary US economy this has prompted some analysts to ponder the probability of a global recession or more aptly; a significant and serious widespread global slowdown. Nouriel Roubini, who recently got some fine words in the NYT by Stephen Mihm (hat tip: Stefan Karlsson), massages the probability of a global recession in a recent piece. This is a topic also taken up, in a US context, by Joachim Fels in his recent installment over at Morgan Stanley's Global Economic Forum.

Now, as Roubini points out, the global economy would "officially" be in a recession, according to the IMF, if global GDP were to decline to below 2.5% y-o-y. In general, one certainly has to agree with the main thrust of Roubini's argument in the sense that it is becoming increasingly difficult to spot the upside in what is increasingly becoming an all out hard landing across the board. In the context of this argument, I would add my own point which emphasises the extent to which the slowdown initially set in across countries with external deficits. It should be quite clear that surplus nations will suffer accordingly too. As such, the global economy is experiencing a widespread decline in the willingness and ability to absorb investment and credit (this really is the ultimate game of old maid) which in turn is naturally hurting both excess capacity and liquidity providers.

However, there are of course economies out there who may be able to weather the storm better than most in terms of the ability to maintain headline growth. This is to say then that there are some economies who, regardless of global credit and liquidity conditions, will have sufficient internal momentum to stay at reasonable growth rates. This, at least, is my hypothesis. I would highlight three economies (Turkey, India, and Brazil) here in particular, all of them singled out due to their relative clout in the global economy and the fact that they are, in these very years, experiencing their demographic dividend. In this small piece, we shall be looking at Brazil.

Recently, in an economic outlook on Brazil I emphasised how Brazil naturally was going to slow down due to the global correction, but also how I was more sanguine than many analysts with respect to Brazil's ability to avoid a sharp and volatile correction. Moreover, I have also detailed in a more general context how I really did not feel that Brazil could be branded as an "emerging" economy any more.

But is all that optimism really warranted?

In an analysis from Morgan Stanley, Marcelo Carvalho is not very optimistic when it comes to the immediate outlook for Brazil. The key component in Carvalho's analysis is the link between Brazil's growth performance and her export prices. More specifically the argument lays out how weakening commodity prices would strongly feed into export prices and subsequently rob Brazil of an important income effect. Moreover, it could also tip over the external balance into negative as the hitherto positive goods balance almost certainly would swing into negative. Of course, there is no such thing as unambiguouty in economics and in this way, weakening commodity prices would most likely ease the pressure on the Real's appreciation as the central bank would be able to leave its hawkish stance. This means that Brazil would be set to gain some lost competitivness against a rising USD.

Yet, retorts Carvalho. This is really a question of choosing your poison, since in the event of a resurgence in commodity prices the central bank would be forced into tightening even more to reign in runaway prices. This certainly seems to be true. At the last meeting, central bank governor Mereilles, along side his council, consequently opted to hike interest rates 75 basis points to bring the nominal rate to 13%. Furthermore, and even though headline inflation has shown signs of abation lately, it is widely held that Meirelles' gaze is firmly set for a target at around 15% to halt a core inflation rate running close to the threshold upper limit of the 4.5% target.

This specific set of fundamentals has obviously mad Brazil a virtual magnet for international funds and with a booming stock market [1] and a real rate on government bonds at around 7%, it is not difficult to see why one would want to park a bit of money in Brazil at the moment. A continuation of the central bank's hawkish position is likely to keep the fire going under the Real for a while although it does seem to be running a bit out of steam as commodity prices have fallen steadily. However and even though the Real looks set to lose some of its strenght, its recent impressive run is indicative, I think, of the role Brazil, whether it likes it or not, seems to be playing in the global economy.

In a more general perspetive, I find it difficult to disagree with Carvalho's main conclusion in the sense that Brazil looks set to slow down. However, I don't think that this point is particularly interesting in itself. More interesting is the point that while global economic conditions since 2003 have been very accomodative for Brazil, they are now set to become less so. I completely agree in the sense that Brazil, like everybody, else has been riding the recent expansion and perhaps benefitted more than most. The key question that remains though, is the extent to which Brazil has internal momentum to keep on going on its own. In this way, Brazil does not seem able to escape the fact that as long as the central bank stays in a hawkish mode, the currency will be supported and so, by derivative, will the consumers' purchasing power. Coupled with a potential drop in the windfall from oil in the form of a demand and valuation (income) effect it would tip over the external balance.

But would this be so bad or more aptly; should we expect it to be any other way? One interesting way to illustrate this would be to scrutinize the underlying argument for the central bank's hawkishness. A while back, economist Antonio Carlos Lemgruber consequently critisized the central bank's policy because he thinks it is based on a potential growth rate which is too low. According to Lemgruber the central bank is operating with 3-4% as the potential growth rate while he himself believes it to be closer to 7%. Accordingly, the central bank is keeping nominal interest rates high to reflect the perceived existence of a positive output gap. However, is this really the appropriate way to interpret the signal emmitted from Brazil? Not all think so. In a recent analysis Pablo Bréard from Scotiabank suggests that the high nominal rate maintained by the central bank, in part, is a hedge of future risk aversion and subsequent retrenchment of capital flows from emerging markets. I don't agree.

Personally, I would turn the conventional arguments around and claim that a high interest rate, in the context of Brazil, is a de-facto sign of the economy's high potential growth rate or at least this is the way capital flows react in the current global economic edifice. We could then consider a high nominal interest rate as a sign of capacity to grow and ultimately capacity to offer whatever yield the given nominal rate prescribes. Or put differently; if you offer high interest rates, you better be sure that you are able to suck up the ensuing inflows. Otherwise, the whole edifice may end up catching fire. I would peer wearily across Eastern Europe for confirmation on this.

This means that the effects from a high interest rate and subsequent strong currency is ambiguous when it comes to inflation. It is true that it makes imported goods cheaper, but it does not necessarily halt capial formation or build up of credit since these two components may well be supplied from external sources regardless of domestic capacity to muster the inflows.

Of course, some countries such as e.g. Iceland have recently (and will need to in the future) upped interest rates in a classic attempt to defend the domestic currency and the financing of the external deficit. We would thus always need to consider the risk of any given amount of yield. In this context, many have cautioned the recent upgrade of Brazil's local currency debt to invesment grade. It comes at a bad time they argue as Brazil may, at precisely this point in time, be on the verge of transisting towards a less favorable set of fundamentals than the ones which prompted the upgrade in the first place. This may be true or, at least, it does not seem to be completely wrong. Yet, I also have to say that the whole international global rating edifice is beginning to smack a bit of insignificance, in the sense that if India can receive a downgrade at the same time as Italy's and Japan's ratings are maintained, I really would like to know where capital is supposed to flow in order to reach its most efficient destination.

What all this means for Brazil in the coming slowdown is too early to say at this point. My guess is that the central bank, absent any major global deflationary rout, will maintain its hawkish position. In July, inflation rose another notch to 6.4% which is close to the upper range of the central bank's formal 4.5% target. Both JPmorgan and BNP Paribas expect the SELIC rate to move as far up as 15% (which is my formal target) due to recent data from Q2 pointing towards a continuation of inflationary pressures.

Generally, most of the sell side research I have been looking at suggests that Brazil probably peaked in H01 2008 with respect to headline GDP growth. Most analysts also concur that a likely halt in the appreciation of Real coupled with a slowdown in commodities will make for is likely to put a downward pressure on Brazilian growth. The argument here would be that a depreciation currency would stoke inflationary pressures even as commodities slowed which in turn would make the values of Brazil's exports lower. In this context, the worst scenario for Brazil would be a case where a slowdown coincided with a sharp retrenchment of capital to support the negative external balance (note that the while the goods balance is in surplus the current account is in the red mainly due to the income balance). This could force the central bank to keep rates higher than domestic inflationary pressures would otherwise merit.

In conclusion, there can be little doubt that Brazil, as with the rest of world, is heading for more lacklustre times with respect to economic growth. I am not sure however that Brazil may be in for such a tough time as many predicts. I would especially emphasise Brazil's ability to maintain growth on its own regardless of external factors. I consequently think that there are two crucial points to consider as we move forward.

  • One would be the meaning and interpretation of the central bank's high interest rate and indeed a high interest rate in general. In this way, we could also see Brazil's yield advantage over many of its peers as a simple reflection of the economy's capacity to grow. At least, I think this is an important perspective held together with the more traditional, and indeed valid interpretation that the central bank is trying to keep inflation in check. I would consequently argue that if you accept the tenets of my analysis (to some degree or the other), Brazil would be one of those global economies to which capital would simply have to flow. In fact, and this is ultimately what Lemgruber is talking about. I think that he (and others) worry that a high interest rate in the current global environment could lead to too much inflow of funds and thus a serious overshoot of the domestic currency. The risk is certainly there that Brazil may be taking on too much weight within the whole global imbalances structure, but my argument would simply be this is structurally buil into Brazil's growth path. Ironically of course, this general point means that a low potential growth rate would call for a lower nominal interest rate, but since this is currently unfeasible due to the global surge in headline inflation many central banks are finding themselves between a rock and a hard place.
  • The second point would be a simple test in the good spirit of falsification. My question would then simply be the extent to which we will see risk aversion shoot up to such a degree that an economy such as Brazil would find it difficult to finance a negative external balance. How much would those dreaded credit default swaps really rise and would it make sense at all to imagine that Brazil had to raise rates, 1980s style, to avoid a capital flight. Clearly, if we assume that Eastern Europe, Iceland, etc are already dead and gone at this hypothetical point, even a retrenchment of funds from the likes of India, Brazil, and Turkey would mean a rather violent surge in traditional safe havens in the form of the US, Japan, the Eurozone. I guess, what I am really asking is whether Brazil could be seen as a safe haven in what comes next or more precisely how will Brazil's relative standing in the global economy look during and after what is clearly a quite severe global slowdown?
I clearly have my bias and some have theirs; now let us wait and see what happens. It will be an important test for many hypotheses and views.


[1] - Although not so booming as of late.

Tuesday, August 12, 2008

Is the Buck Back?

By Claus Vistesen Copenhagen

CAN you feel it? That cold empty void that should have been Macro Man's dissection of last week's flight of the buck. Of course, this only goes to show that our good MM's initial hunch was right in the sense that when he sets off on holiday fireworks spark from the sky in market land. Last week consequently marked the biggest USD rally (against the Euro) since the conception of the single currency. Actually, last week had the buck written all over it as Uncle Sam's currency rose against almost anything that moved to erase everything but a small part of the loss it had sustained so far in H01 2008. It seems that the exercise of leafing through those Benjamin Franklins is not as pityful an endeavor as it used to be, only a few months ago.

Of course, the past week's performance of the USD is of such a magnitude that many FX punters and analysts are expressing caution as to how much further traders can expect it to go on.

Bloomberg consequently serves up a nice batch of conflicting analyses from the currency desks of the world's investment banks and other money movers. A lot of interesting points can be derived from the piece, but the main message for now seems to be that if you did not manage to catch a ticket to the ride last week, the current level does not seem to offer more juice.

Stefan Karlsson suggests that the past week's move is nothing but a sucker rally which I am sure that anyone having the forsight or luck to buy some USD - leverage style - last monday would happily accept as they buy back their positions today. More specifically he also suggests that now would be a good time to shed any remaining dollar denominated assets due to the obvious relative valuation advantage. Clearly, the thrust of the rally cannot be expected to endure but I feel confident that the relative weakness of other regions and economies could mean that the USD will a find a new higher level. This would apply, in particular, against the Euro, the Kiwi, the Aussie, and the JPY. In this light, I am latching on to Stephen Jen's and Luca Bindelli's general point as expressed here that the rest of the world is finally re-coupling to the US slowdown. It is important here to understand the nature of re-coupling and de-coupling. The main point here would be that the economies of the world who are dependent on exports and foreing income to grow cannot, on the basis of simple logic, decouple from a slowdown which cuts laterally through the economies of the world with substantial external deficits. In this spectrum, the US has already taken its share of the beating and now fellow deficit nations will need to make a similar choice. If interest rates are kept high there is plenty of excess savings to go around which in turn will make sure that the purchasing power of the currency stays high. But it is wise to follow the Fed's lead down?

In this context, I think that the following point made by Morgan Stanley's Sophia Drossos (quoted by Bloomberg) represents a good example of the issue at hand.

That means investors will continue to suffer inflation-adjusted returns that are negative based on the current annual consumer price index of 5 percent and Treasury securities yielding between 1.695 percent for three-month bills and 4.53 percent for 30-year bonds.

This has to be one of the most significant deterrents in the context of buying USD denominated assets. However, it also suggests that those who are more than willing to finance the external US deficit with a nominal yield below inflation, are not buying those bonds because of the current return (segmentation theory anyone?). Actually, one could argue that the US, by submitting its creditors to this treatment, is trying to release itself from the yoke of global consumer of last resort. For a time it seemed as if the Euro could take up the baton but this was obviously always going to be a tosh. The Eurozone is likely to have entered a recession in Q2 and going into Q3, but the simple point is that the Eurozone is extremely fragile. At this point the ECB's hawkish tone on inflation carries a distinctly hollow tune with Spain and Italy in the ropes and an export dependent Germany whose main customers in the form of its fellow Eurozone bretheren, and the CEE economies, are heading for serious corrections.

Another mitigating effect on the USD would be the recent drop in Oil prices which, coupled with a stronger USD, seem certain to improve the overall trade balance. Furthermore, if the oil related deficit is set to fall it will also lay bare the improvements made in the context of the non-oil deficit since 2006. Before you get your hopes up though, I would reiterate Felix Salmon in pointing out how FT's Krishna Guha is a must read this week. Especially the following point also highlighted by Felix;

At today's prices the value of oil in the ground exceeds the combined value of all the world's equity and debt markets. Oil-importing nations are paying oil-exporting nations roughly $1,500bn per annum for oil - about 2.5 per cent of global gross domestic product - by some measures the biggest income transfer in history.

And then Felix' reasoning on the basis of Guha's argument;

Yes, the savings rates of oil exporters might start falling as their capacity for domestic investment rises. But there's no doubt that their savings in absolute terms will rise impressively for the foreseeable future. If you think the SWFs are big now, just wait another decade: they'll have major geopolitical importance then.
The last two waves of petrodollar investment both turned very sour in the end, and I can't say that the medium-term outlook is any better. The magic of capital markets is that they're meant to somehow take capital from investors and funnel it to where it can be put to best use in the real world. But with banks deleveraging and investors staying risk averse, it's not easy to see that happening with any elegance in the future.

This is an extraordinarily important point in my opinion, since what Felix essentially latches on to is the fact that excess liquidity is a structural global phenomenon, not necessarily because of evil doings by Greenspan and Bernanke, but because of too much capital chasing too little yield. Ok, I might be putting Felix' good name on to more than he would like, but it is important to understand these dynamics. The current crisis will only serve to exacerbate the structural trend of more money chasing yield, since the main fault line of the crisis cuts across economies who are net absorbers of global capacity (i.e. the external deficit nations!)

I agree in this regard that lowering interest rates to serve up negative real interest rates for one's creditors is a dangerous strategy indeed; especially with the funding need the US has. However, it is also, I think, a deliberate attempt to free the US economy from the role as global consumer of last resort.

But what does all this have to do with USD then?

Well, there are two important points here.

1. I think that there is good reason to expect the USD to move for a higher level against a number of key currencies. I would note the Kiwi and the Aussie in particular here as the two most recent external deficit nations who have succumbed to a slowdown. By consequence, the respective central banks are now beginning to prepare markets for potential rate cuts (the RBNZ has already moved in to trim rates). I would also mention the Euro here since the violent movement of the EUR/USD in the past year has been pinned on a hope and belief that the Euro would somehow take over the USD's role and obligations in the global economy. This is obviously not going to be case and as such, I believe it to be quite in line with fundamentals that the EUR/USD is drifiting lower. However, there is also a floor for the USD's potential descend here since the interest rate differential is likely to stay in favor of the Euro for the forseeable future. Whether the Euro will stay strong, in historical terms, against the USD will also depend on the nature of the incoming slowdown. I see considerable downside with respect to the events unfolding in the Eurozone, which also ultimately translates into further downside for the Euro. An important point to watch in this regard will be the extent to which the Euro manages to claw back the past weeks' sharp drop. In short; are we seeing the EUR/USD establish a new level here or will it scoot back to its hitherto maintained 1.54-1.56 band?

2. Then there is the much wider question of global imbalances and what role the US economy should (and indeed is willing to) assume in the global economy. Hardly anyone with but a faint whiff of economic wit would disagree in the fundamental impetus for the USD to fall. Whopping twin deficits, a sharp drop in nominal yield advantage, and a incoming recession are all factors to suggest that the USD should be in for a beating (and beaten it most certainly has). Yet, the US deficit cannot suddenly dissapear without a subsequent reduction in its creditors' surplus or an increase in other nations' deficit. I do think that most will agree here. And this is where the mechanics of the global economy, and I have to say some analysts reasoning, begin to falter. Because, who will be willing and indeed capable to suck up the excess global liquidity? Sure, India, Turkey, Brazil et al will do their part but it is not going to be enough, that is for sure. Meanwhile, and as I have pointed out before, not only mercantilist emerging markets are to blame here. So is the great demographic transition which is sweeping our planet at this very point in time, and on whose end point we can only guess

In a US context, the policy choice is furthermore complicated by the large composition of oil in the external deficit. The point here would be that a strenghtening of the USD would actually reduce the oil deficit in the sense that it makes commodity imports (denomimated in USD) cheaper [1]. This of course, would bring another part of the equation into the spotlight in the sense of the ties to China and her ever growing exports. In a more general light, one could also easily argue that the last thing the US needs at the present time, is for an increase in purchasing power to potentially prolong a show featuring a consumption binge, which has been on the showcase for way too long.

Thus, it seems as if re-balancing is slowly moving forward as per reference to today's news that the US trade deficit improved in june as exports rose 4.1% [2]. Clearly, the recent week's theatricals in the FX markets have little to do with this and even if the USD finds a new level e.g. against at the Euro at around 1.40 it would still be weak in historical terms. This also applies for the current levels of the AUD and NZD as well as to JPY where we would need to see 120-130 before reaching pre-credit turmoil levels.

Ultimately though, long term fundamentals in the global economy are much more than standard textbook theories of inflation and external balance driven currencies. It is also about demographics, a subsequent hunt for yield and investment capacity as well as a mixture of floating and fixed exchange rate regimes. In this context, the USD still needs to weaken (or stay weak), but the relative level and duration of this weakness may not be as unambiguous as many would have you believe.


[1] Although of course, it is never as simple as it looks. See Econbrowser for good discussion on this and the relationship between the USD and oil.

[2] Of course, there is a negative demand effect here to as the US consumer is simply not spending as vigorously anymore

Monday, August 11, 2008

Japan - Gearing Down for a Recession

[Update: Japan contracts 2.4% in Q2,]

By Claus Vistesen Copenhagen

In my last note on Japan asked how much longer Japan could continue to fight off the incoming recession faced with a continuing shaky outlook on exports as well as a domestic economy steadily slowing down. Well, it seems as if the answer to this question can now be provided. With the recent news that industrial production continues its slowdown as well as the news that exports actually fell in June I am thus confident to stick with my call that Japan will enter a recession at some point in 2008-09. The exact timing will be suggested below.

In fact, a recession seems to be almost a foregone conclusion at this point since if we look at the recent messages emanating from official Japanese authorities, they are indeed bracing themselves for something ugly. Perhaps someone from the statistics department sent a primer of the Q2 GDP figures (due 13.08.2008) to parliament? I sure don't know, but the cabinet office recently released a statement in which the slump in industrial production and exports were used as impetus to argue that the cycle has now definitely turned. The secretary general of the ruling LDP party also chimed in as he notes how especially the economic situation en dehors de Tokyo increasingly resembles a recession. Shigeru Sugihara head of the Cabinet Office's statistics department also noted recently how the economy is very likely to have entered a recession. Finally Bloomberg connects the threads by suggesting that the Japanese economy may have shrunk -0.6% in Q2 after an impressive 1% showing in Q1. These numbers are built on the illusive median forecasts at this point but are indicative of what to expect.

As per usual, this note will feature a look at developments in prices, domestic demand, industrial production (and exports) as well as the JPY. Obviously, the main thrust will be what exactly to expect in terms of the downturn; how serious it will be and how the BOJ and MOF will act.

Cost-Push Thrust Continues - To the Consumers' Lament

Adding to the pressure on Japanese consumers, prices rose at its highest pace in June as the main inflation index clocked in at an all time high of 2.0%. Moreover, the US style core price index also managed to eek out a slight increase at 0.1%. This is the second time this year that the core of core index is in the positive but on an aggregate basis Japan remains in deflation.

As ever, the point to take away is how headline inflation from cost-push pressures not necessarily will lead to an underlying effect on core-of-core prices. This is to say that it is difficult for companies to push forward cost-push inflation through the value chain in a situation where real wages are falling and where domestic demand, in general, is structurally weak. This broken link between headline inflation and core inflation and the congeniantly weak demand can be connected to the demographic profile of Japan. Quite simply, Japan does not posses the domestic demand to generate demand-pull inflation to any significant degree and this is reflected in the core-of-core index. Moreover, this is also why those much discerned second round effects are not very likely to materialise in Japan's context domestic demand dynamics do no support this as external demand slows.

Finally, this also underpins the lack of activity in corporate capex to spill-over into the domestic economy as so many pundits have been expecting during the recovery. It is important to understand the dynamics in this regard. As such, macroeconomics 1-0-1 tell us how to treat excess domestic investments over savings as a leakage which leads to an external surplus (otherwise S=I, and capacity for investments would be a lot smalle than is currently is the case). This rather mechanic perspective is important in so far as it shows us how activity in the corporate sector may be responding to external demand rather than domestic demand. And thus, we have the ensuing disconnect between industrial activity and domestic demand.

In light of the fact that oil seems to have peaked, for now at least, it appears that Japanese consumers not to mention companies may have experienced the worst of things. However, Morgan Stanley's Takehiro Sato seems to be less sanguine than official estimates from Japanese authorities. Alongside colleague Takeshi Yamaguchi he estimates that it will take in the region of 6-12 months for the current back drop in energy and food prices to have a material effect. This suggests that the cost-push thrust is set to linger throughout 2008 and perhaps some time into 2009.

Shifting gears over to consumption the Japanese consumer thus seems to have firmly caved in. With wages now falling, in nominal terms too, it does not take much of an economic literate to see that Japanese consumers are getting sandwiched at the moment. Wages in Japan fell back 2.9% (in real terms) in June and this marks a third consecutive drop this year. The meager evolution in wages has been a consistent feature of the Japanese economy throughout this so-called recovery. Yet, now that cost-push inflation is being added to the equation it is predictably feeding strongly into domest consumption expenditures, which still constitute the largest, if shrinking, share of Japan's GDP (55%).

It is now quite clear that domestic consumption in Japan is contracting and even though expenditures in June contracted less than in previous months the overall trend is one of a slump. Given the trajectory of real wages and inflation this is not particularly surprising but does mean that with external demand now also faltering, Japan is left without any kind of real growth engine.

As per ususal Ken Worsley provides the details of the monthly consumption report through which we learn how especially spending in durables and semi-durables contributed to the decline. If SY is right with respect to the lag in which falling energy prices feed through to the price indices it is difficult to expect a rebound in H02 2008.

Corporate Capex and Exports - The Final Dam Breaks

Perhaps the most significant snippet coming in off the wire since we last convened to look at Japan was the news that Japanese exports actually shrank in June on a y-o-y basis. Coupled with a rising import bill as a result of surging headline inflation, it means that the monthly trade surplus decreased a whopping 89% on a y-o-y basis [3].

If the level of Japanese exports is heading inexorably down, the trend in foreign demand composition is also interesting to consider. It shows that while a savvy Japanese export industry indeed did manage to decouple from the US or more aptly recouple to the big emerging markets, it cannot de-couple from the world. This is the nature of being dependent on exports and foreign asset income to grow. In this light, both exports to the US and Europe dropped at a hefty pace in June, the former being the 10th straight decline and the latter seing a second consecutive drop. Exports to emerging markets and not least China expanded, but at a much slower pace suggesting that the current account margin is narrowing.

Yet, Japan's external is not only about exports.

In fact, the recent years' increase in Japan's positive external position owes more to the accumulation of foreign assets than to exports per se. This is also I point I latch on in my note on how Japanese savings, as a function of its demographic profile, will tend to go for yield.

In 2007, the net foreign asset position of Japanese savers (i.e. both companies and households) stood at around 250 billion Yen of which around 75-80% was made up of debt instruments. This makes up a nice cushion off of which to pull income. Add to this the currency gain as the continuation of outflows, due to the low interest rate environment, will tend to keep value of the Yen down (more about that below). I think it is important for investors to lock on to this trend as it tells a lot about global capital flows.

An additional point here would be that since the majority of Japan's foreign asset is in debt, the income flows will be less affected, from the credit crunch, than if it has been tilted towards equity (although one has to assume that asset income will go down with global growth). Obviously and depending on the kind of debt you own, defaults and yield obtained from securities you own and those you buy will depend greatly on where, and in what, you choose to invest.

Ultimately however, the point remains that as Japan external balance is now contracting, in relative terms, it will have a substantial impact on aggregate economic performance.

With exports faltering it should not come as a surprise that industrial output and capex are also slowly but surely trending downwards. On a m-o-m basis production dropped 2.8% and on a seasonally adjusted index (see this graph) it appears that the high levels of the latter part of 2007 are now replaced by one of those famous lower plateaus. In a quarterly perspective, it can also be seen below how the cycle now seems to have turned.

Judged by forward looking indicators and production assements, it appears that the first two quarters of 2008 may well have seen a q-o-q contraction of industrial output. However, it also seems clear that industrial activity may have a long way to fall as it enters the current correction with a lag. Especially the likely reluctance of external demand to reach hitherto heights will make it difficult for Japanese firms to build up production. It would subsequently mean that production plans will need to be further downscaled.

Sato and Yamaguchi (SY) field some pretty grim numbers for the potential course of industrial activity and manufacturing. They consequently forecast, based on information from previous recessions, that total output may have to come down as much as 6%. SY also indicate that the recent Tankan survey may have been too optimistic in its top line outlook. Should this turn out true, production assessments will have to be further cut.

There is still however some disagreement on the actual outlook here. Bloomberg consequently features a more sanguine analysis in a recent article. The point would then be that forward looking indicators in the form of equipment and machinery orders declined less than forecast. This might be true in so far as goes Bloomberg's own meadian forecast but I think it is quite difficult to see anything remotely positive in the incoming figures. Whether the incoming slowdown will resemble the 2001 recession is another question of course, but at this point I think that it is also an irrelevant one.

The JPY - Macrofundamentals to Take Over?

With the recent turmoil surrounding the near bust of Fannie and Freddie Mae many FX punters would perhaps expect it to be a sure bet to buy some Yen crosses. Consequently, more than notional evidence has suggested how traditional carry trade crosses (CHF and JPY) have been negatively correlated with risky assets. In times of market turmoil and volatility, the only thing a savvy currency trader thus need to do is to pile up on JPY and CHF longs as she was betting on the unwinding of short term highly leveraged carry trade positions. If it was ever so easy.

I am unsure as to whether the correlation is broken entirely, but it is quite obvious that is has weakened significantly in the past two months. As such and while I would still expect the JPY to react on extreme risk aversion two other factors are at work. The first, I think, is related to the recent drop in headline inflation from oil in particular. Not only has this boosted the USD across the board and by derivative the USD/JPY, it has also provided a cushion for stocks and other risky assets. This story has been roaming financial market punditry for the better part of the last month, and suggests the importance investors ascribe to the adverse effects of inflation.

The other factor is more structural in nature and relates to the points made above on Japan's positive income balance and net investment position. In this way, Japan quite literally needs to ship its capital and goods abroad in order to grow. This is a simple reflection of the country's demographic structure and subsequent low domestic interest rate environment. This decline in home bias can thus be considered a lingering structural trend, as it effectively links up with Japan's demographic profile[2]. The conclusion is consequently that the JPY is set to stay weak and steadily weaken against its trade partners. This would apply for the level of the JPY in particular.

If we add the fact that exports of goods and services are now actually falling and the terms of trade shock from a high oil price, the immediate outlook is for further JPY weakness.

Obviously, I still owe somewhat of an explanation since when does one effect take over from the other?

My immediate response to this question would be that an increased decline in home bias, low domestic interest rates, and the subsequent steady outflow of funds (and goods and services) will dominate and keep the JPY down. In this way, I do not deviate much from Stephen Jen with respect to fundamentals. Yet, this is also a discussion about the nature of capital flows. In this way, the fundamentalist view would hold that the JPY is being held down by plain and simply unlevered outflows or more aptly; diversification out of Japanese risky assets with respect to the market portfolio.

However, there is another perspetive too. If the low JPY is primarily driven by carry trade positions and levered bets against the uncovered interest rate parity it would make sense for the JPY to be sensitive to reversals in the market. This indeed has been the focus of many articles and op-eds over the course of credit turmoil and beyond. For example, we learned recently that the number of margin trading accounts in Japan has now exceeded 1 million and that the funds attacted to these accounts rose 13.5% y-o-y totalling 6.3 billion USD. In this context, the actions of Ms. Watanabe and other savvy Japanese housewives represent an important case in point. Of course, with the recent change of tact in the Aussie and the Kiwi (at least against the USD) one has to wonder whether in fact the fundamentals of the trade is changing, if only for a while.

I will forgive my readers if the conclusion may be a tad bit difficult to discern on this topic. As stated, I hold the view that outflows (levered and non-levered) will continue to keep a lid on the JPY's appreciation. However, the extent to which the JPY will react on sudden spurts of volatility is still something to be aware of, and is likely to depend on the level of levered carry trade positions.

A Recession it is Then - So, What About Policy Response?

I think that SY manage to pin point the situation quite neatly when they note how Japan lost two engines in Q2 2008; personal consumption and exports. Of these two, the latter will by far have the biggest impact since in the case of the former, it never really got past first gear during the present and so-called recovery.

SY roll out the big forecasting kit in their attempt to give an impression of when Japan's economy may hit the trough; with the assumption being that it peaked in Q4 2007. The conclusion is that Japan is set to hit bottom in Q1 2009 after which it will steadily pick-up. There can be no doubt that this argument is solidly built upon historical performance measures. However, I don't think that the recession as such is the major news point here, in the sense that such things come and go. The key for me is the regularity by which recessions have hit Japan since 2000 and the subsequent nature of the "recoveries". In this way, I am not expecting a recovercy as such, in the sense that unless exports find a new decisive foothold towards external demand, Japan is likely to limping ahead very close to a zero growth rate.

This brings us neatly over to the policy reactions from all this.

Obviously, with growth now slowing the quants in the treasury are being forced into revising their revenue models. Specifically, the objective to balance the budget by 2011 may now be nothing but a good faith declaration on paper with no real bearing towards reality. One immediate consequence here is obviously that issuing more sovereigns to finance government spending is out. In fact, with a public debt/GDP ratio close to 170%, any faint muttering as such would be sure to prompt the rating agencies into attack mode.

Moreover and as per usual, the prospect of increasing the incoming consumption tax is rearing its head. In May, Economics and Fiscal minister Yosano, from the LDP, consequently suggested that Japan double a planned 5% consumption tax by 2015. No one can deny that the government's top line needs additional input, but it is also important to understand that levying tax on consumers will only further solidfy Japan's growth path whereby domestic demand stays weak and the economy relies on exports to grow. There is nothing wrong with that per se. The problem however is that export dependency will become a structural tendency for many economies during the next decade so Japan will finds its growth strategy more crowded as we move forward. [4]

Regarding monetary policy, the BOJ held rates steady during their last convention and is widely expected to maintain this stance for the forseeable future. SY are fiddling with the BOJ moving in with a 25 basis point cut in Q2 2009. I am not willing to look that far ahead. Given the already low level of interest rates anything short of a sharp backdrop into deflation or a very severe slowdown would not justify, I think, a move back towards ZIRP. This may happen and the data should be watched closely in this regard. For now however, I am sticking to my guns that the BOJ is likely to stay on hold.


[1] See the following notes in particular; Japan - Still Fighting off the Recession; When Will the Strength Ebb Out? and Inflation Returns to Japan - Tightroping Between a Slowdown and Recession

[2] See this note and also Morgan Stanley's Stephen Jen (here and here)

[3] See this chart

[4] See further points on export dependency here