The German Economy Is Essentially "Intact"

by Edward Hugh: Barcelona

According to Bundesbank President Axel Weber, Germany’s economic recovery is “essentially intact”, and is now set to benefit from stronger demand in countries outside the euro region.

“I firmly believe that the recovery process that began in summer 2009 is essentially intact, and that it will continue despite the slower growth dynamic in the winter semester. An additional factor in this context is that the German labor market continues to be in extremely robust shape.”

What exactly it means to say that an economy is intact we will explore below, but it is clear that some confirmation for the view that the German economy is benefiting from increased demand originating outside the Eurozone can be found in the latest press release on manufacturing industry turnover from the Federal Statistics Office, where they note that while January's manufacturing sector turnover surpassed that of January 2009 – by a working day adjusted 2.6% - domestic sales actually fell (by 1.1%), and export turnover rose by 7.3%. Most interestingly, as between destinations, sales to euro area countries only increased by 2.4%, while those to other foreign countries were up 12.0%. This illustrates two points: that the German economy is now more dependent than ever on exports, and that sales to emerging markets are what is really driving export growth at this point. This latter development is hardly surprising given the strong fiscal corrections being applied in many of Germany's former customer countries.

In fact, while German industry is surely now in "recovery mode", the process is something of a stop-start one (see chart below), since even though according to the latest data from the technology ministry output was up by an estimated 0.6% in January over December (and even up by 2.2% over the very low level hit in January last year) it is still down by 18.5% over the March 2008 peak.

More Export Dependent Than Ever


Still the story of the German economy remains very much one of a tale of two components, with net trade offering some relief to pretty negative domestic demand data. According to the Federal Statistical Office, German gross domestic product stagnated in the fourth quarter of 2009, remaining unchanged from the level of the previous quarter level(0.0% change). Thus the slight upward trend noted during the second (+0.4%) and third quarters of 2009 (+0.7%) did not continue.



GDP from October to December was down by 1.7% on a year earlier. The decrease, which was smaller than in the previous quarters of 2009 still meant that German GDP fell by 5% in 2009 as a whole when compared with 2008.



Economic growth in the fourth quarter of 2009 was, in fact, only really supported by foreign trade: exports rose 3.0% on the previous quarter, while imports decreased 1.8%.



The resulting balance of exports and imports contributed 2.0 percentage points to GDP growth. That positive contribution was, however, entirely offset by a fall of 2 percentage points in total domestic demand (including inventory movements). Both household consumption expenditure and gross fixed capital formation exerted a negative impact on growth.

Final private consumption expenditure fell by 1.0% shaving 0.6 percentage points from headline GDP growth.

Interestingly German wage rates rose (see chart below) in the second half of 2009 (although due to significant quantities of short time working, gross wages were more or less stationary), but even this seems surge to have had little in the way of positive impact on consumption.



Gross fixed capital formation fell back, and was down by 0.5% (spending on machinery and equipment fell by 1.5%).



In addition the German government started to rein in spending (after many quarters of significant support) following the election, and government final consumption expenditure fell by 0.6%.



So We Are Back To Inventories

In fact however, the biggest drop in domestic demand did not come from household spending, or from fixed capital investment, or from government consumption: it came from movement in inventories. Inventories were cut back sharply again during the quarter, and made a negative contribution to growth of 1.2 percentage points (out of the 2 percentage point negative contribution from domestic demand as a whole). This drop followed a considerable increase in inventories in the third quarter, wherby they contributed 1.5 percentage to growth.

Now, I think I am begining to discern a pattern in these large swings in trade and inventories which characterise German GDP movements. Basically, it is important to keep in mind the East European component in German manufacturing (Hans Werner Sinn's Bazaar - not bizarre - economy idea). Basically a significant part of German exports are assembled products put together from materials manufactured in the East (a process which Delia Marin suggestively calls Maquilladores in reverse), and thus there may well be a correlation between high imports in one quarter (based on anticipated demand) and rising inventories (and falling imports) in the subsequent one as demand expectations systematically fail to be achieved (the excessive business expectations factor). Let's see.

Below you will find three charts summarising movements in the key components of German GDP during the last three quarters of 2009. In Q2, as you will see, trade is up (as exports rise much faster than imports), while inventories are down, as accumulated stocks are exported.

The in Q3 we see the opposite phenomenon, as inventories pile up, as imports surge without the expected growth in exports.

Then finally we have Q4, and the opposite happens again, imports fall, exports rise, net trade is a growth positive, and inventories are cut back. In each case the other components of growth are rather insignificant, and have in fact weakened as the recession has progressed - I hope this is not what Axel Weber means by saying that the German economy has survived the recession "intact" (namely that it is as export dependent now as ever it was).

Well, this is only a hypothesis. But if the hypothesis has any validity we should be able to make some predictions on the basis of it. I would make two.

Firstly, since East Europe's economies are often dependent for their growth on exports to the West, and in particular to Germany, then we should be able to see some "shadow" of this German process cast out into the East.

In the second place, we should see the process continue to some extent in Q1 2010. That is, based on what we have seen so far, in Q1 imports should rise, as industrial output in the early parts of the supply chain surges, and net trade should as a consequence be less positive than in Q4 2009. On the other hand, all the imported components awaiting processing should make inventories rise. So that's a prediction. Now we need to wait and see how good it is.

But on the upstream componenents, maybe we can learn something from the East. Let's start with Hungary, which has Germany as its largest single customer, and the manufacturing Purchasing Manager's Index (PMI).


Well, basically if we think about the fact that German inventories were run down in Q4 last year, and imports slumped, then it is interesting to note that Hungarian manufacturing, after improving steadily during the earlier part of the year (barring August), slumped back again in the three months from October to December.

If we also look at Czech industry, a similar sort of picture emerges - stagnation in Q4 2009, and a surge in activity in this quarter.

When we come to Poland things are rather different, since the Polish economy have vibrant autonomous demand, so the Polish industrial sector has local market growth to give some impetus, but things did taper off a bit in Q4, and they have now rebounded.

So What Does "Intact" Really Mean In The German Case?

So, to come back to Axel Weber's point, I fear intact does mean "business as usual".

Certainly, if we look at the most recent manufacturing PMI, the pace of expansion has improved slightly over the previous quarter, which may mean that those good old inventories are simply piling up again.




While the services element has, if anything, lost momentum over Q4.



Bad weather seems to have sent construction falling off a cliff - falling an estimated 14.3% in January:



And the February construction PMI looks even worse, with the indicator showing the worst decline in activity since the survey was introduced in September 1999.

Poor weather conditions continued to have a negative impact upon the construction sector in February. Anecdotal evidence pointed to widespread weather disruptions, alongside relatively weak underlying demand. As a result, the headline seasonally adjusted Construction Purchasing Managers’ Index – a single-figure snapshot of overall activity in the construction economy – fell sharply from 40.2 in January to 28.9 in February. This was the lowest reading in the survey’s ten-and-a-half year history.

Consumer and business confidence readings are faltering:





Retail sales have been in serial decline since the VAT increase in January 2007.



And the February retail PMI showed another sharp contraction, although again, weather conditions do seem to have played a part.

Retail sales in Germany declined sharply on a month-on-month basis in February. At 42.1, down from 42.7 in January, the seasonally adjusted Retail PMI was below the 50.0 no-change threshold, continuing the trend observed since June 2008.The latest reading pointed to the sharpest rate of contraction since January 2009, which survey respondents linked to a combination of bad weather and unfavourable economic conditions. A post-scrappage scheme downturn in demand for new cars was also cited by those in the automobiles sector.

So, to conclude where we started, we can well agree with Axel Weber that the German economy is indeed intact - intact and near stationary. If we look at the composite PMI below (which is the nearest thing we have to a GDP indicator), it does show slight improvement over Q4 2009, but only a very slight one. Given everything I have said above about swings in imports and inventories, I would say German GDP will be very near to stationary again this quarter, with a possible slight upside depending on the inventory swing, but whatever upside we do see will more than likely disappear as quickly as it came when we get to the Q2 2010 data.

Hanging In The Balance Over At The ECB

by Edward Hugh: Barcelona

In the time of my confession, in the hour of my deepest need
When the pool of tears beneath my feet flood every newborn seed
There's a dyin' voice within me reaching out somewhere,
.............

It's not often that I await the ECB after-meeting press conference statements of Jean Claude Trichet with such an intense feeling of anxiety and bated breath. But this time, as the song goes, it will be different. This time there are plenty of reasons to think that, having been the first off the mark in looking for the exit, Europe's monetary leaders may sound a note of caution at tomorrow's meeting, and indeed indicate there may well be solid grounds for at least taking a time out, if not engaging in a longer process of pausing for extended thought. My advice: if you don't actually have any pressing need to hit the eject button, then don't do it.

In the first place we have the latest batch of Eurozone PMI data, which suggest that the process of economic recovery is going to be neither so rapid, nor so straight forward, as was initially thought. And even more to the point, exit from the recession is being more characterised for its unevenness than it is for its uniformity. Growth in February was heavily weighted to the manufacturing rather than the services sector, and in manufacturing there was more dynamic in demand from the ex-Eurozone export area, than from internal orders, suggesting that the 6% drop in the Euro is having a positive impact on external competitiveness, while domestic demand remains weak and lacklustre.



In the second place, in addition to the generally weaker condition of the services sector, there are pronounced general weaknesses in some countries: Spain, Greece and Ireland are obvious cases (and Greek manufacturing even managed to lose ground in export markets in February), but output and activity in Portugal and Italy also look quite fragile at this point.



In Italy the phasing out of the car scrappage scheme had a strongly negative impact on February sales in the Italian retail sector, with the PMI dropping sharply from 54.4 in January to 44.5, and after three succesive months of increase sales now seem to be solidly back in contraction mode. Even more worryingly, firms operating outside of the autos sector also noted in their responses to the survey that weak consumer sentiment had been a key theme in February.



As Markit Chief Economist, Chris Williamson puts it:

“The PMI has portrayed a steadier recovery of the Eurozone economy over the past year than the more volatile official GDP data, and suggests that upward momentum has been sustained so far in the first quarter of 2010. The data are consistent with GDP rising by around 0.4% in Q1. However, not only has the divergence widened between the surging manufacturing and struggling service sectors, but national trends continue to worry. Robust growth in France and Germany contrasts with a deepening downturn in Spain. These divergences raise concerns about the sustainability of the recovery, as well as posing difficult questions for policy-makers.”

Slow but solid as the growth in the EuroArea has been, the performance has hardly been spectacular, and we are a long, long way from a "V" shaped rebound. In addition, outside of France there has been little evidence of any sort of solid, home-grown, domestic consumption growth, and the general picture is one of overall fragility, with the continuing danger of relapse back into quarterly contraction.

Headaches For ECB Policymakers

All of which offers us the background for a fairly extended series of headaches for policymakers over at the ECB. Indeed members of the Governing Council may well be having a hard time of it deciding what their next move should be. Having moved policy steadily up to the door marked "crisis exit this way", they may well be having second thoughts about whether this is exactly the right time to cross the threshold. Indeed as Ralph Atkins noted on the FT Money Supply blog, the European Central Bank has gone strangely quiet.

Since the beginning of December ECB board members have collectively made fewer speeches than in any three month period since the global financial crisis erupted in mid-2007. According to the ECB website list, since the start of the year Jean Claude Trichet has made only one full-scale address - in Sydney earlier this month - and even then his remarks were overshadowed by his decision to return early to join eurozone leaders in talks on the Greek crisis. In the first two months of last year, Mr Trichet gave at least nine speeches.

So why the comparative silence? The ECB is not normally reticent in coming forward to guide market expectations. Could the communication pause reflect growing uncertainty among board members about what to do next?

With Greece and other countries in Southern Europe having so many problems returning to growth no one is very clear anymore what the ECB exit strategy is actually going to be. And obviously, if you aren't clear about something then maybe it is better not to talk about it.

And the ever vigilant markets are noticing the change in stance.

Previously, the European Central Bank was seen as delaying an increase in interest rates out of concern for some of Europe's weaker economies. But with the German economy now in a stall, and Italy's possibly back in recession, expectations for ECB rate increases have been driven further and further back, and financial markets are not now expecting the first increase in the ECB’s main policy rate until September next year. The recent announcement that Eurozone annual inflation slipped from 1 per cent in January to just 0.9 per cent in February - undershooting to an even greater extent the ECB’s goal of a rate “below but close” to 2 per cent - have only reinforced their view. If there is little inflation danger, and the recovery is week, then what is the point in raising rates?

In addition, the prospect of sizeable fiscal tightening in many EMU countries will also act as a disinflationary force in these countries in coming months, pressuring the euro downwards and keeping up the pressure on the ECB to stay on hold until at least next year. Aggressive fiscal tightening by Greece, Spain and Portugal looks likely to plunge all these economies back into even deeper recessions. All else being equal, this calls for a looser monetary policy, as does the need to at least keep the euro where it is, and stimulate export activity to destinations outside the monetary union.

Beyond the interest rate issue, Jean-Claude Trichet is also scheduled to announce further steps to gradually return liquidity provision to pre-crisis levels for eurozone banks. “Timely” action, the ECB argues, is justified as financial markets normalise and the risk grows of distorting investor behaviour.

The ECB stopped providing 12-month liquidity in December, and Thursday’s governing council meeting is in theory going to consider toughening the terms of what is planned to be a final six-month liquidity offer, as well as scaling-back the three-month and one-month liquidity offers. The bank will also have to give serious consideration to how to cope with the expiry on July 1 of its first 12- month liquidity offer, which saw €442bn pumped into the system a year earlier – the largest amount ever in a single ECB operation.

And Spain's banks don't stop drinking at the fountain. According to the latest data from the bank of Spain, the dependence of Spanish banks on ECB finance hit a new high in January - following the "last" one year offer in December - with €88.6 billion outstanding in longer term financing operations. To date they have only made use of some €77.3 billion of this (see chart below), but they have a further €10.5 billion parked on deposit at the ECB, ready to use as needed.



Despite the apparent success of the recent EU delegation to Athens in achieving further cuts from the Greek administration, doubts remain about how 6 minus 2 can sum down to five, or, if you will, how growth and fiscal austerity can come together. And in particular how Greek (or Spanish, or Irish) banks, who in theory will no longer have access to the extensive liquidity provision whose benefits they have been so enjoying of late, will be able to cope. Between public and private sector financing needs, Spain will have to fund borrowing (including rollovers) to the tune of something like 50% of GDP this year.

So, as Ralph Atkins puts it, despite the apparent success of the EU Commission in obtaining agreement on a further €4.8 billion package of austerity measures Greece is still far from receiving the all-clear. Ironically, market concerns will in all probability now shift to worries that Athens has gone too far in slashing budgets and raising taxes, and that the fiscal measures announced will simply act as a massive brake on economic activity. The risk is that Greece is now in a vicious circle in which fiscal austerity sends the country ever deeper into recession - and Athens has to react even more aggressively to bring down the public sector deficit as a share of GDP.

There will be no easy-to-find Aristotelean mean here I'm afraid. So how will they play it? As I say, at 2:30 tomorrow afternoon I will be all ears, with my eyes totally glued to that ECB webcast.