Friday, February 29, 2008

German Retail Sales January and PMI February

Some slight easing in the downward process is Germany is now taking place, the recent data are too consistent to ignore on this front. The IFO reading was not as weak as might have been expected, the GFK consumer confidence reading remained stationary, unemployment continued to fall on a seasonally adjusted basis,and the January retail sales data and February PMI reading indicate an expansion in German retail sales for the first time in several months. Of course how long this will last, and how important the phenomenon will prove to be, is very hard to say at this point. Looking at the general economic environment I wouldn't be betting on any kind of very strong upswing, but the numbers are interesting, and I wouldn't be surprised at all to see some slight recovery in the export situation in January when we get the data. An Eastern Europe effect perhaps? Certainly several economies are still accelerating there, almost to overheating.

Now for the retail sales data.

According to provisional results released by the Federal Statistical Office turnover in the German retail trade was up by 2.7% in nominal terms and 0.6% in real terms in January 2008 over January 2007. When adjusted for calendar and seasonal variations the January turnover was in 1.9% higher in nominal terms and 1.6% in real terms over December.

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

As I say at the start of this post, it is very hard to decide how to read all of this, but I imagine things will become clearer as the days pass. The retail PMI report also recorded an increases in France to 58.8 in February, up from January’s 56.2 while retail sales in Italy where slighly better in February at 43.8 from the 43.0 level recorded in January, but still contracting, since any reading below 50 indicates contraction.

Italy Retail Sales PMI February 2008

Italian retail sales fell for a 12th consecutive month in February as economic growth slows and inflation rises according to the Bloomberg purchasing managers index. The seasonally adjusted index of retail sales rose to 43.8 from 43 in January, and the reading has stayed below 50, the level that signals a contraction in sales, since February 2007.

Wednesday, February 27, 2008

German Unemployment February 2008

Germany's seasonally adjusted unemployment rate declined again in February (although the non seasonally number of actual unemployed rose slightly for the second month as is normal at this time of year) and reached the lowest level in more than 15 years as mild weather and global demand for machinery and cars led companies to increase their workforce. The actual number of unemployed was 3.61 million, while the seasonally adjusted number of people without work fell by 75,000 to 3.34 million. This brings the number of jobs created in the past 12 months to more than 500,000.

The jobless rate, adjusted for seasonal swings, (and as calculated using the German methodology) dropped to 8 percent from 8.1 percent in January, the Federal Labor Agency in Nuremberg said today. That's the lowest level registered since November 1992. Using the ILO compatible data - published two months behind the national data (see comparative chart below) - Germany had 3.52m jobseekers in December, and an unemployment rate of 8.2 per cent.

Employment is being supported to some extent by a mild winter that helps construction companies retain workers. At 3.6 degrees Celsius the average temperature in February was 3.3 degrees higher than the long-term average, said Andreas Friedrich, meteorologist at the Offenbach-based weather service DWD.

However despite the drop in umeployment domestic consumption has been falling:

For a detailed explanation of why this improvement in employment may not be passing through to an improvement in consumption see this post here. The Financial Times point out in this article that employment growth seems to be conyinuing apace in small to middle size companies, but there is some concern that larger firms may be shedding labour. The engineering group Siemens and tyremaker Continental have both recently announced staffing reductions and BMW and consumer products group Henkel added themselves to the list this week announcing that 8,100 and 3,000 jobs were to go respectively.
In the past, such large cuts have mainly affected workers outside Germany owing to the legal difficulties and high costs associated with implementing redundancy plans at home. However, since a package of reforms introduced in 2004 increased the flexibility of Germany’s labour market, economists say such big cuts could now have a swifter impact on the labour statistics.

Some evidence to support this view can be found in the fact that the number of workers in jobs liable to social security contributions dropped back again in November and December (the last months for which we have data at this point), although if we look at the chart we can see that some of this may well be seasonal, since a similar tendency can be seen last winter.

However, the federal labour agency stressd that both the mild weather this winter and the changes in the laws governing seasonal unemployment, which mainly affected construction workers, might be influencing the figures, since these factors will not yet been adequately incorporated in the seasonal correction formula. So we need to wait a couple more months yet awhile before we can really see what is happening here. Interestingly enough Frank-Jürgen Weise, head of the labour agency, pointed to three factors as possibly influencing the data at this point: strong economic growth, the impact of past labour market reforms, and a shrinking active population as the German workforce ages. This last component in particular is far too often neglected by employment commentators. Again we are still at an early stage in this process, but some indication of recent movements can be gained from the chart below.

German GFK Consumer Confidence, The Euro and the Future of Eurozone Growth

German market research group GfK's forward-looking consumer climate index was unchanged at 4.5 points in March 2008 from February. Since the forward index is unchanged at a rather low level this is not especially positive news.

And since the constant reading is the by-product of a number of significant shifts in the sub-components, it is perhaps worth looking at these in detail. Firstly economic expectations:

The slight improvement in economic expectations apparent in January has not been sustained for long. After rising by a good 5 points at the start of the year, the indicator dropped considerably in February and fell 14.1 points to stand at 14.6. A decline of this order of magnitude has not been since the end of 2006.

The evolution in this index does not look at all positive, to say the least. Then we have the propensity to buy.

After two consecutive rises in a row, consumer propensity to buy in Germany dropped back significantly in February and the indicator fell from minus 8.8 points in January to minus 15 points.

This index is now well bogged down in negative territory, which is entirely consistent with the contraction in domestic consumption seen in Q4 2007. Finally income expectations.

After a slight dip in January, income expectations rose again this month, with the indicator climbing 4.2 points to its current level of minus 0.5 points. After two slight falls in a row, consumers’ expectations regarding their own financial situation are therefore once again at the level recorded in November 2007.

As we can see, this has stabilised and even improved very slightly in the last couple of months. Unfortunately, this is likely to be the most carefully watched indicator over at the ECB, and this sudden revival in income expectations is just what they don't want to see. Basically the distribution of the sub components would seem to be the worst of all combinations from the point of view of macro economic policy making, although not - it is worth noting - from the perspective of euro/dollar market participants, and it is not surprising that the combination of yesterday's news about the IFO reading and this GFK one has finally sent the euro through the 1:50 barrier.

The Munich-based Ifo institute said yesterday that its business climate index, based on a survey of 7,000 executives, increased to 104.1 from 103.4 in January. But as we can see in the chart below this rise was only a very moderate improvement, and the change was largely in the current conditions component, without much significant change in the longer term outlook.

The dollar in fact went up as far as $1.5047 per euro, the lowest since the European single currency was introduced in 1999, before trading at $1.5017 as of 6:47 a.m. in London from $1.4974 in late New York yesterday. The euro reached a six-week high against the yen as traders continued to bet the ECB will keep its 4 percent rate unchanged in coming months, with euro falling back to 160.56 yen after reaching 161.39.

Obviously what now gets to happen next would seem to be anyone's guess, since we are well past the point were previous experience could be considered a sure guide. Clearly one possibility is that this euro "rally" will rune out of steam (but would we be right at this point in treating this simply as a rally, may it not be more a structural by-product of something or other, see below). For one thing, for the euro to receive a substantial downward correction one has to assume that the US treasury would simply sit back and let it happen. But the US is itself in the midst of its own hard fought "dollar correction" which is seen as being essential to correct the current account imbalance, so at the present point the US Treasury are far from being unhappy with the current state of Euro-USD, and they could resist anything which smelt of a sharp upward correction in the dollar, maybe even by selling dollars.

I am sure they would accept a moderate downward adjustment, say - guessing for illustration purposes - to 1.40. But I am not sure they are ready willing and able for a major upward hike in the dollar. Nor are very many people in the financial markets anticipating this outcome, even though the macro economic data we are seeing would be much more in harmony with such a view.

Again, neither the Japanese and nor the Chinese would be especially happy about the advent of a "cheaper euro" since they have been tending to regard the European markets as a convenient fall-back position in the face of a weakened export market in the United States (and it might be interesting for someone or other to explore what the Russians and the Gulf-peggars would be looking for at this stage). Basically there are some pretty hefty players at the central bank level out there pushing their own interests, and many of these will not coincide with the forward looking macro concerns at the ECB, so we need to try think about and monitor how they respond at each given stage.

Basically, as I have been arguing, there are two opposite tendencies at work here. A short term one for the dollar to fall vis a vis the euro, and a longer run one whereby both of them have fall against an as yet unspecified basket of currencies. The basket may be unspecified, but my guess is that the rupee and the real will be in it. Possibly the Turkish lira. In fact how all this might pan out is that those who are left in the basket of emerging market currencies tracked by Bloomberg after the coming correction is over (ie, for example, after Eastern Europe has been forcefully stripped out) might well go to form the emerging nucleus here. So market realities rather than G7 policy may well be the final determinant here, which I suppose, given the zeitgeist of the times, would only be appropriate.

What I am trying to work out as all this moves forward is what weighting (in that mental topological map we all carry round in our heads I mean) to give to each of the processes - the short one and the long term on I mean. Up to the end of last year I was always expecting a euro crash against the dollar (since the underlying longer term macro seemed to suggest this), but then so many things have happened that neither I nor anyone else was expecting (I WASN'T expecting so many immigrants to arrive in Spain over the last 5 years, for example, and I wasn't expecting the Japanese housewives loss of home bias, nor the way in which local central banks could lose control of monetary policy etc etc) that I think the only thing to beware of at the moment are the "we've seen all this before" type of arguments".

So now I am not so sure at all what gets to happen next, and I am would be simply arguing for keeping a semi-open mind, and following closely what actually happens as it happens. This is also the case since there is no easy and obvious solution that suits everyone here, and that is always a problematic factor.

Meanwhile, the German economy is visibly slowing. The detailed GDP data were out earlier in the week, and quarter on quarter growth is slowing steadily and inexorably.

The rate of increase in monthly exports is also falling raidly (to zero in December)

while houshold consumption has suffered a complete slump since the heady days of the pre VAT hike in Q4 2006.

And it is not simply the German economy that is slowing, none of the "big four" could be argued to be in perfect shape. Italy may already be in recession. ISTAT haven't even had the stomach to release the Q4 2007 numbers yet, although everyone who will have seen the provisional version of them has been busily revising down the 2008 outlook considerably.

Almost all the macro data we have seen coming out of Spain over the last three months (retail sales, industrial output, services activity, consumer confidence) has been unequivocally bad. Strangely the only vaguely positive reading was Q4 2007 preliminary GDP data, and we are still waiting for details to try and understand why this should be the case. Spain seems to have had a bank loan sudden dead stop in December, and according to the latest Eurostat release construction activity is now falling heavily (down 9.5% year on year in December). So we now seem to face the very preoccupying possibility of a credit crunch and systemic banking crisis feeding into a naturally slowing real economy.

The only vaguely positive outlook among the big four would seem to be in France, where performance is holding up rather better than the rest, but how long this will prove to be sustainable if the rest continue to head south is a very moot point indeed.

Germany continues to constitute the major puzzle for many observers. Job growth continues, but at the same time consumption slides. Evidently with so many older workers being sucked into employment the bang per buck in jobs for consumption terms seems low, and many of the jobs being created may have a very low real economic content. On the other hand, despite some slowdown of late Germany is apparently exporting and investing like hell, but what the question we need to ask ourselves is just how vulnerable that may be to any problems which boil over in Eastern Europe.

Basically German export growth is highly interlocked with growth in the EU10, and to a lesser degree Russia, Ukraine, Serbia, Croatia etc. Some of these economies are still accelerating very rapidly - Poland, Slovakia, the Czech Republic, Romania Ukraine, Russia etc - and obviously Germany is getting a lot of very positive spin off from this. But much of this frenetic growth this isn't going to last very long. The strong uptick in inflation across the whole region suggests that one economy after another is now overheating, and some who have already blown out after the over-heat are now steadily "cooling" - Latvia, Lithuania, Estonia, Hungary, possibly Bulgaria. So how far are we away from all this overheating producing a sudden bout of "cooling" in a wider group of East European economies. Months at the most I would say. And if this view is right, and Germany can no longer continue to boost sales in Eastern Europe to get growth, what does that tell us about the ability of its export dependent economy to stand the pressure of a very high euro-dollar as we move forward? This I think is the key question we should all be asking ourselves at this point.

Tuesday, February 26, 2008

Italy Business Confidence February 2008

Italian business confidence declined to its lowest level in more than two years in February as slowing Italian and global economic growth damped orders and political uncertainty sapped optimism. The Isae Institute's business confidence index fell to 89.8, the lowest since October 2005, from 91.3 in January, the Rome-based research center said today.

A sub-index measuring Italian manufacturers' foreign orders fell to minus 17 from minus 11, and an index measuring domestic orders declined to minus 15 from minus 12, according to today's report. Manufacturers grew more pessimistic about Italy's economy in the coming months, according to a sub-index that fell to minus 34 from minus 25 in January.

Sunday, February 24, 2008

Spain's Balance of Payments, Bank Funding and Covered Bonds

This post constitutes a first attempt at making an assessment of the extent of the damage which has been sustained by the Spanish economy as a result of the global credit crunch.

The first thing to get clear (and very clear) in our heads at the present moment is that the economic correction which is currently taking place in Spain is very unusual one in terms of what we have become accustomed to in developed economies in modern times, since the transmission mechanism for Spain's problems does not run from a problem arising in the real economy (a correction in house prices for example), nor does it run from an attempt by a central bank to "burst" some sort of perceived asset bubble or other (Trichet and the ECB's tightening of interest rates), but rather the mechanism operates via a direct blow-out in the cylinder head gasket of the global financial system, a blow out which has produced an immediate and direct change in global credit and lending conditions, and in the level of risk appetite which prevails in the securitised morgatges/covered bonds sector of the wholesale money markets, and it is this change which is now making its impact felt on the real economy in Spain, with the actual and present danger that these negative consequences for the real economy may then be fed back into the financial sector, in the process creating some kind of ongoing lose-lose dynamic.

As I say, such a phenomenon is certainly unusual in a modern European context, although some may wish to point to parallels with what happened in Japan in the early 1990s, and the subsequent "lost decade". I wouldn't go so far at this point as to suggest that Spain is facing a lost decade, although the situation is very very serious (as I hope to show in the charts that follow), and at the very least Spain now faces several "lost years" and a massive macroeconomic structural adjustment.

Now a quick browse through the back posts on this blog should give any interested reader a reasonable resume of the current state of Spain's key macro economic indicators, and so I am not going to dwell on this part here. There are approximately 500,000 unsold homes standing on someones books in Spain, and the Spanish banks now attend the weekly liquidity auctions at the ECB to raise some 48 billion euros of funding (a figure which is double the 24 billion euro number they needed before the summer).

However, as Jean Cluade Trichet points out, "there is no question that the Spanish - or any other - banks are being bailed out" at this point. This, like so many of Trichet's statements is entirely true. But it is not the whole truth. That is, there is a bigger picture. And herein lies the problem.

It is, for example, also true that the ECB has not changed its rules to accept mortgage backed securities (like the US Fed had to under pressure last August), but this apparent constancy in rules also stands alongside the fact that a banking system which didn't need much recourse to the facility in question has now doubled its use of it, and in a very short space of time.

It is also true that Spanish banks were not allowed by the Bank of Spain to set up special purpose vehicles to finance their lending, but again, they set up the cedulas hipotecarias to find another way to do something which, at the end of the day, is not that disimmilar. The argument against SIVs is that off balance sheet lending is likely to be more risky, but in a certain sense (and as I try to argue and explain in my post here on the cedulas system) the cajas regionales have played the role of off balance sheet entities for the principal banks, and since we still don't know how far down the value of the entire Spanish mortgage pool is going to fall, we have no way at this point of making a valid assessment of the level of risk that has been actually taken on board.

It is also the case that the level of mortgage defaults in Spain is at this point comparatively small, but then again the whole process is only just starting, so it is far to early to say at this point whether or not cover will prove adequate in the longer term, but then again, the problem for the Spanish banking system may not originate in defaults in the first place, but rather from a perceived rise in their risk level if the value of the entire pool of mortgages on their books declines significantly.

Spain's External Balances

My main point of focus here is going to be on Spain's external imbalances. Essentially Spain has been living on a large external trade deficit in recent years. This deficit has produced a continuing deficit in the current account, and this deficit has effectively been balanced by attracting the funds from outside Spain to finance mortgage lending in the recent Spanish construction boom. It is this nexus of relations that I think it is necessary to have clear, otherwise the greater part of what now happens next will catch you completely unawares.

Now as I keep pointing out, another of the very specific characteristics of the way in which the property boom was financed here was the ability of the Spanish banking system to provide very low interest (variable) rate mortgages. Curiously, many commentators imagined that this (variable) component was the greatest rsik element in Spain. That is, they imagined that it was Spain's mortgage borrowers who were assuming the greatest part of the risk here. They were wrong. The risk at present has almost all been inadvertently assumed by Spain's banking system, and this decidedly odd situation has arisen (I'm sure this was never the intention) due to the recourse of Spain's banks to the widespreased use of securitised (or covered) bonds - the so called cedulas - and the provision of variable mortgages at very narrow margins (lets say around 0.75% or 1% over 1 year euribor). Now the banking system considered they were onto a sound bet here, since they in there turn could borrow (thanks to the investment AAA grade assigned to these bonds, making them virtually equivalent to government paper)at very fourable rates themselves (normally three month euribor), so they thought they were on a very safe bet. Again they were wrong, since it is just this very global repricing of risk appetite I mentioned earlier, and the reassessment of the AAA rating which was assigned to their mortgage bonds which goes with it, which has produced the problem.

Oh, yes, and there's a third little detail which makes all of this just that little bit worse. The different term structures of the lending and the borrowing. Basically the Spanish banks, and especially here the regional cajas who undoubtedly have the lions share of the problem, borrowed short and lent long. The majority of the mortgages issued between 2000 and 2007 were for between 20 and 30 years. Indeed during the last two years of the boom it even became fashionable to offer mortgages over 50 years, so sure did the banks feel of themselves.

But they borrowed short. Not the very short liquidity type borrowing we are increasingly seeing Spanish banks resorting to at the ECBs weekly money auctions, but rather the lions share of the borrowing, which was done using cedulas, and normally over a ten year term. That is to say, that while the vast majority of the mortgages issued will still be outsanding come 2025, almost all of the bonds which go with them will need to be refinanced, between 2012 and 2017. And here is where we hit the snag, since the money markets which the Spanish banks need to do the refinancing are currently closed to them. These money markets can of course be reopened, but at a price (ie the price of a risk premium), and that is really the bigger half of the snag, since the debtors are on "variable" mortgages which are effectively fixed (at 1 year euribor plus something, euribor can of course go up, but it can also go down, as I think we are about to see in the next moves at the ECB), so the borrowers, it turns out, really do have a yardstick that lets them know what they are into. This is not the case with the lenders though, since while we do not know what eventual risk premium will be built in to fund Spanish banks (this in part depends on how far and how fast property prices fall, and how much difficulty they have maintaining their mortgage pools), we do know that the euribor 3 month days are over, and we could even contemplate the possibility that if bad goes to worse, and even worse, and then worse again, then they could be asked to pay even more than they are recieving from their mortgage paying clients!

And the amounts of money are not small. One good recent estimate put the total quantity the banks will need to "roll over" in the space of about 5 years at some 300thousand million euros.

OK. Now lets look at some charts. First off we could take a look at the level of incoming bond purchasing funds into Spain over the last several years (thanks to the monthly balance of payments data made available by the Bank of Spain).

Now as we can see on a rough and ready basis the bonds boom really took off sometime in 2002, and it came to a sharp and rather unfortunate end in the middle of 2007 (I would say on or around the 9 August). In any event the height of the boom was in 2005, 2006 and the first half of 2007. Now before going any further with my line of argument, lets just look at one more piece of rather important evidence, the refi interest rate set by the ECB (and which of course regulated 1 year euribor) and the rate of inflation in Spain.

And as we can see here, the take of date for the bonds boom is hardly coincidental, since it more or less coincides with the arrival over a sustained period of time of negative interest rates in Spain, a fact which to a large extent explains the intensity of the housing boom, since under these conditions borrowing money does not seem especially onerous, and indeed it might even be considered illogical not to do so. Certainly Spain's very low level of personal savings in recent years can only be properly understood in these terms.

Now if we return to the task in hand, lets take a close-up look at the most recent years for those bond inflows.

As we can see, the last few months is not the first time that these flows have "wobbled", but this time the wobble is much more sustained and, since the wholesale money markets are at this point effectively closed to the Spanish banks to raise money in this way, there are good reasons for imagining that this time the change will be a more permanent one.

Now, why, apart from the implications for the banking system, is all this so important for Spain? Well lets now take a look at another chart, the one for the current account deficit. And as we can see, the growing consumer boom associated with the construction one had a long term and pretty disastrous impact on Spain's trade balance (and in particular its energy component, all those extra houses use energy remember). And this deterioration in the external trade position has remained, and arguably even gotten slightly worse, even as the economy has started to slow down.

Now normally this deficit has been offset by the sum total balance of funds coming in as part of the financial account, but as we can see in the chart below this has also dropped off somewhat since August last year.

The consequence of this is that Spain's banks are increasingly having to find the money via the eurosystem to make the books balance, and this is basically the significance of that increase in borrowing that the Spanish banks have had to undertake at the weekly ECB auctions (referred to in this post - also please note that I have changed this post at this point thanks to some clarification from a knowledgeable commenter, see comments). If we look at the chart below, which shows the net asset and liability position of the Spanish banks vis-a-vis the eurosystem, those months when the bars are above the zero line indicate there has been an increase in the amount of money borrowed by the Spanish banks from the eurosystem (presumeably largely or exclusively at the ECB weekly auctions), and this money is essentially needed to settle the monthly deficit in the balance of payments account. As we can see, prior to August 2007 these quantities showed no particular trend, but since August, and for every month for which we have data, the Spanish banks have needed to raise additional money at the ECB. This is really a direct result of the fact that the banks have been unable to sell their cedulas for cash in the global markets. What the Spanish banking system lacks right now is a way to generate cash on a stable basis to meet the needs of the current account deficit.

And cash may well not be that easy to find since, while money may be attracted by offering higher interest rates, it is not clear what the funds would be needed or used for (rolling over existing liabilities should be more or less neautral here) and the rate of increase in bank lending has been slowing steadily all through 2007.

A country with a large and sustained current account deficit - as we can see in the case of the United States - can do one of two things. It can tighten money and credit conditions in order to try and use an indirect method to slow internal demand, or it can allow the value of the currency to slide (as we have seen with the dollar) in an attempt to reduce the deficit. Well Spain has no autoctonous currency to let slide, so the only real alternative is to squeeze internal lending to try and reduce the deficit, and in the meantime lean on the ECB for money. The contraction in lending needed to reduce a deficit of this magnitude might be very large indeed, and the consequences for the real economy would be substantial, so it is to be anticipated that in the short term some other alternatives will be sought. However it is interesting to note that in December 2007 the month on month increase in lending came to almost a dead stop. At this point it is too early to know exactly what significance to attach to this. But clearly the position does need watching carefully.

Basically this kind of sudden stop in lending, coupled with a growing sense of systemic crisis in the banks would be the worst of all worlds. To be monitored.

Friday, February 22, 2008

February EU Commission Interim Forecast

The European Commission released a new interim forecast for the EU economies yesterday. Of particular note was the fact that the forecast significantly reduces the growth forecasts at the same time as sharply raising its inflation estimate The Commission said it was concerned that expectations of steadily rising prices were becoming entrenched in the 15-nation area.

My own opinion is that the current forecasts are far more realistic than than those issued in last November's autumn review. The outlook for growth in the eurozone as a whole for 2008 has been cut to 1.8 per cent from an earlier 2.2 per cent, but of more significance perhaps are the individual country estimates. Italy, which has been the eurozone’s slowest growing economy for the past 15 years, once again comes in at the bottom of the pile, with the Commission halving its growth forecast for this year to a mere 0.7 per cent. This follows a downward revision of the Italy growth forecast by the Bank of Italy (in the middle of January) to 1%, and a revision (earlier this month) by Confindustria, Italy's largest employers' lobby, who slashed their forecast also to 0.7%. Back at the start of January I said this on my Italy blog:

I personally will be very surprised if we still see calendar year 2008 anything like as high as 1.8%, but more to the point even 1.3% may be rather on the high side if we get a significant deterioration in the external environment, especially in Eastern Europe on which Italy is fairly dependent, and where the Italian banking sector has significant exposure. So that puts me much nearer to Pillona's "basement bargain" number of 0.5% than to any of the others. One of the reasons for my pessimism relates to my assessment of Italy's current trend growth rate, and to the level of fiscal and monetary tightening which may be operating on the economy even as it slows. During 2007 the Italian govenment has been running a fiscal deficit of comfortably below the 3% of GDP required by the EU commission. But since this fortunate situation was in part acheieved by the use of one off measures, and in part by the strong tax inflow from the above trend growth, the government will need to maintain a comparatively tight fiscal stance to keep things on course, and any attempt to further loosen may run into real problems with the EU commission and the credit rating agencies. And as I keep arguing, it is very hard to see an accomodative monetary posture from the ECB in the near future. The IMF in their October World Economic Outlook came in with a similar figure of 1.3% for 2008, the Economist Intelligence Unit is forecasting 1.7% in 2007 and 1.4 in 2008, and the latter 2008 figure was also endorsed by the EU commission in its November forecast.

As I indicate, my own view is well to the downside of all this. The only apparent bright spot on the horizon is employment, but I am dubious that in the context of Italy's ageing workforce this will work through as some are hoping, as I expain at some considerable length in this post here. My opinion is that Italy will enter recession at some point during 2008, and that we may well have 2 consecutive quarters of negative growth. The continuing high euro will maintain pressure on Italian exports, and high oil and food prices will maintain pressure on the inflation front, at least in the firts half of 2008. At the same time, and despite rumours that Romano Prodi's government is compemplating a large tax cutting package, I anticipate that the fiscal environment will remain tight. Italy's large (106% GDP) accumulated debt, and the vigilance from the gentlmen at Standard and Poor's and the other credit rating agencies more or less guarantee that.

I wouldn't say it exactly makes me happy to be being proved right here, but we do need some more realistic perspective on Italy's current growth potential from those responsible for forecasts and policy, and some more realistic appraisal (ie of population ageing) to try and understand why things are this way, rather than assuming it is all to do with some sort of congenital weakness on the part of the Italians.

The Commission lowered its country forecasts for Germany (to 1.6 per cent, from 2.1 per cent), and France (to 1.7 per cent, from 2.0 per cent), for the UK (to 1.7 per cent, from 2.2 per cent), and for Spain (to 2.7 per cent, from 3.0 per cent). Of these the French one looks to be the most realistic. The German forecast obviously contains strong downside risk, while the Spanish one seems to be talking about "another country" from the one I live in, when we come to look at the rate of the slowdown in the real economy (retail sales, industrial output, services etc), and add to this the growing tensions in the banking and financial sectors. I would stick my neck out and go for sub 1% growth in Spain this year, and feel reasonably comfortable with this.

Economy and Finance Commissioner Joaquim Almunia stressed the Commission’s view, which has been expressed many times since the financial market turbulence began last August, that the European economy would weather the storm because of its "sound fundamentals" – stable public finances, no huge current account deficits, relatively low unemployment and stronger international competitiveness. The strange thing is that he actually comes from Spain, a country which, it is true, has sound public finances at this point, but does have a huge (or whopping) current account deficit, which since last autumn it is having trouble financing since the monthly inflow of funds has dropped by around half, high (and growing) unemployment (around 10%) and poor producyivity growth (one of the worst in the EU) and hence comparatively weak international competitiveness. For these and many other reasons I suggest the 2.7% number is absolutely "pie in the sky", and may have a lot more to do with the fact that Spain is going to have elections in the middle of next month, with Mr Almunia's own party (PSOE) attempting to secure re-election.

On the inflation side the Commission raised its estimate for 2008 for the 27-nation EU to 2.9 per cent from the earlier 2.4 per cent, a revision which won't make the task of the ECB any easier when it comes to trying to use monetary policy to address the growth slowdown issues.

Thursday, February 21, 2008

France Inflation January 2008

French inflation accelerated in January to the fastest pace in at least 12 years, led by higher food and energy costs.

Consumer prices climbed by an annual 3.2 percent, up from 2.8 percent in December, based on European Union-harmonized methods, Insee, the national statistics bureau, said today in Paris. That's the fastest since 1996, when Insee began reporting the data. Prices were unchanged from November.

In France, energy costs climbed 12.3 percent in January on the year, while fresh food costs jumped 3.3 percent and overall food costs added 4.4 percent. Tobacco prices rose 6.3 percent.

Inflation in the euro region quickened to 3.2 percent in January, the fastest in 14 years. The International Monetary Fund yesterday forecast consumer prices would increase an average 2.3 percent in France this year compared with 1.6 percent last year.

Italy Consumer Confidence February 2008

Italian consumer confidence remained near its lowest level over two years in February as rising energy prices, accelerating inflation and a certain degree of political uncertainty weighed on consumer optimism.

The Rome-based Isae Institute's consumer confidence index, based on a survey of 2,000 families, rose ever so slightly to 103 from 102.2 last month. If we exclude last months even lower reading this is still the lowest since August 2005.

A measure of optimism about the general economic situation rose to 82.6 from 80.9, though pessimism about personal finances worsened to minus 5 from minus 2, and concern about rising prices was at a four-year high, the report said. Isae said.

Italian consumer prices rose an annual 3.1 percent in January, the highest in at least 11 years and industrial production declined for a fourth month in December. Italian retail sales dropped last month at the steepest pace in four years.

Italy's economy, the fourth biggest in Europe, may grow as little as 1 percent this year, the Bank of Italy predicted Jan. 15. That compares with a July forecast of 1.7 percent. The government's next official predictions will come out in March.

One other factor in the confidence situation is evidently the election campaign which is now underway, following the collapse of Prime Minister Romano Prodi's government on Jan. 24 after 20 months in power. Both leading candidates, two-time premier Silvio Berlusconi and former Rome Mayor Walter Veltroni, are promising tax cuts as their "remedy" to revive growth. This position is barely credible, since given the economic slowdown and the likely increase in Italy's already massive public debt that this will lead to, it is difficult to see where - if anywhere - there is room at the moment for tax cuts, unless, of course, you countrebalance this with a major cut in health or pensions expenditure, but then, perhaps this is the part you shoul really be explaining to the voters first.

Wednesday, February 20, 2008

German Producer Prices January 2008

German producer prices rose at the fastest annual pace in 13 months in January, underlining European Central Bank concern that inflation is accelerating. Prices for goods from newsprint to plastics jumped 3.3 percent from the same month a year earlier, compared with 2.5 percent in December, the Federal Statistics Office in Wiesbaden said today. The month on month increase in January was 0.8%.

Evidence that companies are passing on higher costs has raised concern among ECB policy makers of an inflation spiral, such as demands for higher pay to compensate for rising prices. ``The pricing power of firms, notably in market segments with low competition, could be stronger than expected,'' ECB President Jean-Claude Trichet said Feb. 7.

So basically the most important impact of this rise in producer prices is likely to be on the policy making process at the ECB.

The price of oil has surged 71 percent in the last 12 months, reaching a record $100.10 a barrel yesterday in trading on the New York Mercantile Exchange and pushing German inflation to 3 percent last month.

Oil products gained 18.7 percent from a year earlier, the cost of gasoline was up 11.8 percent, today's report showed, heavy heating oil surged 47 percent. Producer prices excluding energy rose 2.5 percent in January 2008 from January 2007.

German consumer confidence held near a two-year low in February as inflation reduced households' spending power.

Monday, February 18, 2008

The Spanish Banks' War Chest

Leslie Crawford had another very useful article in the Financial Times last week (a handy addition to this earlier one).

According to Crawford the Spanish banks are accumulating a “war chest” of assets to be used later as collateral to access European Central Bank credit in the event their liquidity needs rise while wholesale money markets in asset backed paper continue to remain closed to them.

It is important to remember here that the huge expansion in mortgage credit in the country in recent years has been largely fed by the banking sector’s widespread use of mortgage-backed bonds to fund lending growth (the so called Cedulas Hipotecarias, see my post on this here), and that the Spanish banks have been second only to the UK in Europe in this respect.

In recent months, and with the Cedula market effectively shut, Spanish banks have been steadily increasing their use of funding from weekly liquidity auctions conducted by the ECB, which has long accepted mortgage-backed bonds as collateral.

The banks have done this by securitising pools of mortgage debt, which they keep on their balance sheets rather selling, and these are pledged to the ECB in exchange for funding. Now I am macro economist, rather than a banking specialist, and it is not immediately clear to me what the banks who are doing this hope to achieve in this way, since if they are themselves effectively having to buy their own bonds using cash, and cash is at the end of the day even more liquid than bonds, where is the benefit? One answer could be that they are issuing new mortgages backed by these bonds, and then using the bonds as collateral for the ECB loans, in which case they are effectively swopping cash - which earns of course no yield - in their reserves for securities which do pay yield, since indirectly this yield is paid by those who pay the mortagages which are being used as backing (and are of course themselves "illiquid"). The recent widely publicised offer by Banco Santander to take-over mortgages (and customers) from other banks, always providing that these mortgages originated prior to 2002, could be an indication that this is in fact the objective. But again all of this only makes sense if the banks in question are increasing their reserves as a "war chest" against anticipated future losses on the mortgage side of their business, and what we need to think about from a macro economic point of view are the implications of this increase in the cash reserve ratio (ignoring for the moment the fact that they may be doing this via the "eating their own" bonds technique, which may reduce the damege to bank profitability, but does little to offset the money supply contraction implied as far as I can see). Certainly this would seem to imply yet another channel of indirect credit tightening.

And of course none of this tells us very much about two crucial questions: what the rate of new mortgage issue is going to be moving forward (since the banks are offering a maximum loan to value ratio of 80% in an environment where few people have savings), and what the position of the smaller - regional cajas - banks is here, since they are evidently the most exposed to the whole problem. The cedula-backed bonds have been largely issued on a 10 year renewable basis, and start coming-up for rollover in substantial quantities after 2010. Basically some 300 billion euros need to be "rolled over" during 7 years, and since the existing holders are likely to cash in, it isn't at all clear where the regional cajas are going to find the resources needed to do this. So could the Spanish government be faced with an inevitable "Northern Rock" type solution here? This is doubly the case, since noone at this point has any realistic idea of the actual forward path of Spanish property values over the 2010 to 2017 horizon, and this is basically the reason why the asset back securities market is closed to Spanish products - and unlikely to open any time soon - and basically why the cedulas are so different from the German Pfandebriefe (with which they are so often compared) since the latter where sold on the market AFTER the correction in property prices following the end of the 1995 boom, and were thus pretty resistant to further downward movement, and in any event in the German case the bonds were ultimately backed by government guarantees to the deposit holders in issuing banks, and so in this sense the investment grade rating had a certain logic to it.

So we only have questions here as we move forward.

Nonetheless recent Spanish banking data does make interesting reading. According to data released by Spain's central bank, Spanish banks doubled their share of the ECB’s weekly funding auctions in the final quarter of last year, taking their borrowing up to €44bn in December from a running average of about €20bn over the previous 15 months. This extra lending from the ECB of almost €24bn outstrips the quarterly amounts raised previously by Spanish banks from securitisation markets, which is an important comparison because the banks have increasingly used mainly mortgage-backed securities as collateral with the ECB. This jump has increased its share of Europe-wide borrowing from 5 per cent of the ECB’s total to 10 per cent, a number which more or less proportional to the weight of Spain in the eurozone economy, but what is so striking is the rapid rate of expansion. Before this money wasn't needed, and now it is.

Jean-Claude Trichet, the ECB president, who in fact came on a vistit to Spain only last week, went out of his way to stress that in no way was the Spanish or any other eurozone banking system being bailed out. “We have not changed our rules [in order to accept mortgage backed bonds],” he is quoted as saying.

Another noteworthy detail about this sudden "eat your own bonds" expansion, is that larger amounts of securitised bonds are being created appears to be being used. Santander, Spain’s largest bank, said it has €30bn in loan-backed securities on its books that it could use as collateral, while BBVA, Spain’s second- biggest lender, has €60bn in such bonds available.

Popular, a mid-sized bank that relied on wholesale markets for 42 per cent of its funding before the credit crisis, says it has €11.4bn in bonds that could be used in ECB auctions, but says it has to date not resorted to raising funds via the ECB.

So the bottom line here is that the European Central Bank has effectively been indirectly responsible for funding new lending in Spain in recent months, replacing banks’ traditional use of wholesale capital markets, since these have been effectively strangled by the global credit crunch. And so there is one last point to think about. Spain has been running a substantial external deficit, one which it needs a constant inward flow of funds to underpin.

During the last seven years, external funding into the cedulas (which ammounted to some 60% of the total) essentially offset the deficit. But now these flows have stopped, so how is Spain going to finance its deficit? Another way of thinking about this would be to say that private borrowers were effectively attracting the funds into spain which then paid the current account deficit. Or if you prefer, (on a sort of back of the envelope basis) not a single barrel of oil consumed in Spain since 2000 has to date been paid for. It has all been supplied on tick. So the problem now is that not only does Spain actually have to start paying for its oil, it also has to pay back all the oil which was consumed between 2000 and 2007 (as it will discover when "rollover time" on the cedulas arrives). Or is the ECB also going to reinvent itself here, becoming payer of the last resort on the individual national external deficits?


Commenter Geert sent me a question which possibly reflects some of the difficulties people may be having with this post.

"I must confess that I don't really fully understand this post."

Since I have tried to answer him at length, I though it might be useful if I reproduced my explanation above the fold.

Well first off, and as I mention in the post, I am not an expert on any of this, since my area is macro economics, not banking and finance, and I am just scratching my head, and trying to work things out.

I do think, though, that to get the background here you need to go through the posts on the whole blog, and especially the one on cedulas hipotecarias, where I have a little diagram which shows how all of this has been working over the last six or seven years in Spain, driven of course by negative interest rates made possible by the eurosystem. When a country has negative interest rates for an extended period of time (assuming it wasn't in a deep depression) it isn't surprising if large "buuble like" imbalances accumulate which will then correct, under the right circumstances. The changed attitude to credit - and in particular the 80% loan to value ceiling (previously it was 100% or above and cases of 110% and even 120% were not unknown) - is this circumstance. And far from being in deep recession between 2000 and 2007, Spain was constantly up against capacity limits which is why a large chunk of the capital (via things like the cedulas) and the labour (via 5 million or so new immigrants) which was put to work had to be imported.

And this dependence on external funding rather than home grown deposits is the main reason why what is happening in Spain is more a result of the US initiated "financial turmoil" than it is of ECB interest rate policy.

What I am trying to say is that the Spanish housing boom was not financed via bank deposits - since there were very weak, but via the creation of the cedula bonds - 300 billion euros worth of them - which were sold to the tune of about 60% to non Spanish investors. Basically the vast majority of these investors would now like to offload these bonds, since everyone knows that this particular "play" is over, and that Spanish property prices are set to decline considerably, either rapidly (the hard landing scenario) or slowly (the soft landing one). In any event the value of the underlying asset backing the bonds is going to move south, and so the value of the bonds themselves is likely to deteriorate.

All this is complicated by the rules under which this type of covered bond is set up, which are quite strict. Basically, if the value of the properties in the pool deteriorates, then they have to "top up" the pool by adding more properties, but given that the vast majority of mortgages since 2000 (which is the majority of mortgages by value, since obviously there was a hell of a lot of refi going on) it is not clear where these properties will come from.

Certainly it will be hard to do anything from new mortgage business, since in the first place there are few of these (since young people don't have the savings to meet the 20% downpayment now being asked), and secondly since these mortgages are financed by issuing yet more bonds (or trying to do so).

I mean, all I am saying at this point is.

1) There is a substantial underlying marcro economic crisis arriving in Spain. The duration and depth of this is currently unknown. The situation needs careful monitoring. One consequence of this real economy problem will be a substantial correction in house prices (either sudden or protracted).

2) The macro crisis has been provoked by a financial crisis. The root of the problem is that Spain was a low net household saving society, so the expansion could not be fuelled by bank deposits, but had to be financed in another way, a way which has now become very problematic.

3) The big players in the banking market - Santander, BBBV, La Caixa - all realised that this mortgage busines was extremely risky, and especially given the low margins they were working with, so they effectively stayed on the sidelines, leaving the "dirty work" to the regional cajas, who have a very small deposit base, and huge outsanding liabilities via the cedulas. If the value of the whole Spanish property pool drops (or should I say when here) then these entities will rapidly become insolvent (think Northern Rock very very bigtime).

So people like Santander are simply being prudent, I guess, and getting ready to protect themselves from "contagion" when the problem does break out, by increasing their reserves to offset against inevitable losses in the housing business in the least expensive way possible (ie with bonds). I think it is important here not to confuse Santander as a global entity, with its operations in Spain. What we are looking at here is Spain only balance sheet protection. Also remember that serious defaults haven't really started to hit the banks here yet, since the price still hasn't really fallen in any serious way (all of this is still to come) and the majority of people who are having problems are still under 6 months behind in their payments. My feeling is that this situation begins to accelerate as the numbers with over 6 months arears startes to mount, and the banks have to start to decide what to do about this.

Another flashpoint will come with the periodic inspections of the quality of the assetts in the mortgage pool which backs the cedulas issued by the regional cajas.

Sorry if all this is a bit technical, but at this point it is like that. There is virtually no transparency here, so we are all left guessing. All we do know for sure is that Spanish banks have suddenly come to depend much more on the ECB for short term funding. But this is only short term, and my guess is that Trichet was here last week to listen to what plans the Spanish banks have for addressing the problem in the longer term. As I say, I don't see that the ECB can keep accepting and accumulating at par cedulas which are dropping in value for ever, or the ECB at some stage will start having capital loses on a par with the Bank of China, and I think I am right in saying that the statutes of the ECB do not permit them to do this. Basically it is important to understand that accepting this paper in this way, the ECB is temporarily subsidising the Spanish banks.

And also, if this came to a push comes to shove situation where the ECB had a some point to tell the Spanish banks (ever so politely) to get lost, then this would have much bigger implications, IMHO, since people imagine that the ECB is the ultimate "bail out" point for all the problems of the eurosystem, and things are a long way from being like that, and the Spanish banking crisis (if and when it comes) could be the event which shows that the emperor doesn't have as many clothes as everyone imagines he does.

Friday, February 15, 2008

France GDP Q4 2007

The economic expansion in the euro area's two largest economies cooled in the fourth quarter, marking the start of a slowdown that may deepen in 2008. Gross domestic product in Germany, Europe's biggest economy, rose 0.3 percent from the third quarter, when it increased 0.7 percent, the Federal Statistics Office in Wiesbaden said today. Expansion in France also eased to 0.3 percent, from an 0.8 percent rate in the second quarter according to INSEE.

In France, consumer-spending growth eased to 0.4 percent in the fourth quarter from the 0.8 percent in the third. Corporate investment rose 1 percent, after 1.1 percent in the third. Exports fell 0.6 percent after having risen 1.3 percent in the third quarter. So the trade deficit is definitely acting as a drag on growth.

So the expansion in the eurzone economies is losing momentum as a surge in the euro against the dollar makes exports less competitive abroad just as the U.S. economy hovers near a recession and households grapple with faster inflation. The question is, since the French economy never went up as far as the German one during the recent upswing, may we expect it to resist falling so far down during the downswing? This is my impression, but, of course, we are all about to see. Certainly with a relatively younger population than Germany, France may have more leeway on the fiscal front to adopt counter-cyclical policies, much as this may be frowned on from Brussels and Frankfurt. Clearly there is considerable volatility in the quarter on quarter data, but over the longer haul may Frech GDP prove to be the more solid and stable of the pair?

Thursday, February 14, 2008

Spain Preliminary GDP Q4 2007

Well, blow me down! Spanish GDP growth apparently accelerated in the last quarter of last year, with the quarter on quarter rate increasing very slightly from 0.8% in Q3 (over Q2) to 0.9% in Q4 over Q3 according to data released by the Instituto Nacional de Estadistica earlier today. The year on year growth rate was still 3.5%. This means something somewhere is resisting the slowdown. Since most of the indicators have been pointing to red during the quarter, and since we have elections coming in March one good guess is an increase in public spending (and I'm not suggesting there is anything improper in that, since this is how fiscal policy should be used, countercyclically). Another possibility, since Spain runs a systematic trade deficit, is that imports slowed on the back of slowing domestic demand, and in this way the trade deficit reduced somewhat, thus constituting less of a drag on GDP. Also construction is still working reasonably steadily at this point - which is why all those unsold houses are accumulating - since builders are still completing houses which were contracted before the August credit crunch, and it is important to notice that Spain is working to some extent back-to-front with the US promlem, since the difficulties really appeared in the financial sector first, and they are only now spreading to the real economy, starting with construction. But all of this at this stage is simply idle guessing, and we won't really know anything for sure till we get the detailed data from the INE on 20th February.

According to the quarterly GDP advance estimate, during the fourth quarter of 2007, the Gross Domestic Product (GDP) generated by the Spanish economy registered a real growth rate of 3.5%, as compared to the same period of the previous year. In this way, the Spanish economy slowed its rate of progress by three points, as a result of a slow-down in national demand, which was partially compensated by the less negative contribution of the foreign sector. Moreover, the quarter-on-quarter GDP growth rate stood at 0.8%, one tenth more than in the previous quarter. By temporary aggregation of the four quarters, real growth of GDP for the entirç year 2007 was estimated at 3.8%, one tenth less than in 2006.

But as I say, all the dials ARE steadily moving over to red in Spain now, and as if to make the point Eurostat yesterday published the December industrial output figures, which show that there is now a significant and steady slowdown taking place.

And indeed, on a month on month basis we had contraction in industrial output in both November and December. Add to this the fact that retail sales also contracted in both the same months and it isn't hard to see that there isn't a exactly a lot of life in the Spanish economy at this point, despite the apparent "acceleration".

Tuesday, February 12, 2008

ZEW Economic Sentiment Index February 2008

Investor confidence in Germany rebounded slightly in February, perhaps because expectations on tax rebates and the impact of recent interest-rate cuts in the U.S. suggest that demand for German exports may withstand the downturn. The ZEW Center for European Economic Research said its index of investor and analyst expectations for the next six months rose to minus 39.5 from the 15-year low of minus 41.6 last month.

This being said, the rebound was only very slight, and since the situation in Germany is far from disastrous at the present time, it is hard to see why analysts expected the reading to continue going down when it was already at a 15 year low.

Again, whether or not exports will hold up in the coming months is still a very much open question, since year on year rates of increase have been - as reported in this post - almost in "freefall" recently, and once annual increases in exports fall to zero then its normally recession time in Germany's export dependent economy.

German GDP Q4 2007

According to data released by the Federal Statistics Office today the German economy continued to expand in the fourth quarter of 2007. The rate of economic growth, however, was down on the previous quarter. Gross domestic product rose by 0.3% in the fourth quarter of 2007 when compared with the third quarter (on a working day and seasonally adjusted basis). In the third quarter of 2007 the GDP grew by 0.7%. Looking at the data on retails sales, exports and industrial output we have been seeing of late this result is hardly a surprise.

GDP was up 1.6% in the fourth quarter of 2007 when compared with the same quarter a year earlier. On a calendar-adjusted basis, the growth rate was 1.8%, since in the fourth quarter of 2007 there was one working day less than a year earlier.

The previously released provisional growth rate of 2.5% (calendar adjusted +2.6%) for German GDP in whole year 2007 remains unchanged.

Economic growth in the fourth quarter was driven by capital investment in machinery and equipment, and on net exports (ie the trade balance), which were partly sustained by the slowdown in imports. A negative contribution was made by domestic consumption, which was characterised by decreasing household final consumption expenditure.

Employment growth remained strong in the fourth quarter, with 40.3 million persons in employment, an increase of 617,000 persons or 1.6% on Q4 2006.

What is evident from all of this is that Germany's expansion is losing momentum as a surge in the euro against the dollar makes exports less competitive abroad just as the U.S. economy hovers near recession and households grapple with faster inflation. The government last month cut its 2008 growth forecast, citing the euro and oil costs., and it now expects the economy to expand 1.7 percent this year, following the 2.5 percent achieved in 2007.

Confindustria Reduce Italy Growth Forecast For 2008

Confindustria, Italy's largest employers' lobby, cut its forecast for Italy's 2008economic growth to 0.7 percent today. This is less than half the 1.8 percent rate of expansion predicted for 2007. Confindustria had been forecasting that Italy's economy, Europe's fourth biggest, would grow by 0.9 percent, and this had been a strong markdown from earlier higher estimates. The Rome-based employers' group updated its forecast after the national statistics office yesterday said December industrial production unexpectedly declined for a fourth month (see this post yesterday).

Also they seem to agree with me that Italy may well already be in recession, and say that the Italian economy probably contracted 0.1 percent in the fourth quarter of 2007 when compared with the previous quarter, according to a statement released yesterday by their research department. Technically a recession is two quarters of back to back negative growth. So we may have just had the first one, and now we need to see in more detail what happens in Q1 2008. Confindustria are, however, rather more optimistic than I am on this front, since they forecast that industrial production will "bounce back" in January, rising 2 percent from December. We will see. Clearly, after so many months of decline, some sort of recovery is to be expected, but conditions are hardly favourable at this point.

Really I would simply like to reiterate what I said at the start of January:

I personally will be very surprised if we still see calendar year 2008 anything like as high as 1.8%, but more to the point even 1.3% may be rather on the high side if we get a significant deterioration in the external environment, especially in Eastern Europe on which Italy is fairly dependent, and where the Italian banking sector has significant exposure. So that puts me much nearer to Pillona's "basement bargain" number of 0.5% than to any of the others. One of the reasons for my pessimism relates to my assessment of Italy's current trend growth rate, and to the level of fiscal and monetary tightening which may be operating on the economy even as it slows. During 2007 the Italian govenment has been running a fiscal deficit of comfortably below the 3% of GDP required by the EU commission. But since this fortunate situation was in part acheieved by the use of one off measures, and in part by the strong tax inflow from the above trend growth, the government will need to maintain a comparatively tight fiscal stance to keep things on course, and any attempt to further loosen may run into real problems with the EU commission and the credit rating agencies. And as I keep arguing, it is very hard to see an accomodative monetary posture from the ECB in the near future. The IMF in their October World Economic Outlook came in with a similar figure of 1.3% for 2008, the Economist Intelligence Unit is forecasting 1.7% in 2007 and 1.4 in 2008, and the latter 2008 figure was also endorsed by the EU commission in its November forecast.

As I indicate, my own view is well to the downside of all this. The only apparent bright spot on the horizon is employment, but I am dubious that in the context of Italy's ageing workforce this will work through as some are hoping, as I expain at some considerable length in this post here. My opinion is that Italy will enter recession at some point during 2008, and that we may well have 2 consecutive quarters of negative growth. The continuing high euro will maintain pressure on Italian exports, and high oil and food prices will maintain pressure on the inflation front, at least in the firts half of 2008. At the same time, and despite rumours that Romano Prodi's government is compemplating a large tax cutting package, I anticipate that the fiscal environment will remain tight. Italy's large (106% GDP) accumulated debt, and the vigilance from the gentlmen at Standard and Poor's and the other credit rating agencies more or less guarantee that.

As most of the forecasts suggest, we have been seeing growth which is somewhat above trend during the upswing in the last couple of years, so it would not be surprising if we now saw some below trend growth. Trend growth (over a 5 year average) in Italy may even have fallen into the 0.5 to 1% range, so if I have to put a number I would say 0.7% with a definite "downside risk" tag attached. The nearest forecast to this that I have seen is the 1% one from the Morgan Stanley GEF team. The implications of such sustained low growth are, I think, important, since if Italy cannot find the way to raise trend growth up towards the 2% mark there is simply no way the government debt can be stabilised and sustained. And with each passing year we have one year less to crunch time.

Monday, February 11, 2008

An Interesting Week Ahead

By Claus Vistesen

Cross-posted from Alpha Sources

I am staying a bit in Eurozone Watch mode this Monday morning as I look forward to the coming week. In this way and on the back of my most recent analysis on last Thurday's ECB meeting I am coming in with a small preview of a rather important data point this week. Regarding the ECB, the big 'news' was that Trichet changed the tone ever so slightly towards a more balanced approach between growth and inflation in favor of the former. Not everybody is convinced that the ECB will lower rates as soon as the next session (March) which I have had the audacity to suggest recently. Macro Man for once does not seem to be too convinced ...

Frankly, reading through the comments, Macro Man really can't see what is so uber-dovish in Trichet's remarks.


Perhaps next month's staff forecast revisions will give the ECB an opportunity to exchange their hawks' talons for the gentle cooing of doves. But from the sound of it, M. Trichet still sounds several months away from beginning to seriously contemplate trimming rates. Unsurprisingly, that's pretty much what's embedded in cash markets at the moment. Three month Euribor fixed at 4.35% today, which is much lower than December's panic highs but still represents an unusually large basis for a central bank firmly on hold.

I would be a fool not to take MM's views into account since he is normally very much on the mark but I still have a feeling that he might be too careful on this one. As for the future rate implied by the Euribor I second the main point made my MM but also emphasise that this gauge can come down quite fast once the potential news solidy towards a cut. In terms of news I have said before that Q4 GDP figures will be an important indicator as these will point towards the speed with which the slowdown is coming in. And wouldn't you know it; this week will see the release of the provisional estimates for the Eurozone as well as German GDP figures on Thursday the 14th of February. Whatever the result it is almost certainly going to dissapoint on the downside not least because of the upward revision of the Q3 figures which suggests a rather sharp backdrop in Q4. In case you don't remember the Q3 figures I reproduce here the graphs from my notes on the release ... (note that the charts show the figures before they were revised upwards and thus the main Eurozone aggregate as well as the German figure should be nudged upwards 0.1%)

As always, I want to emphasise the caveats of looking at the Eurozone as one single economy and in this light I will be looking forward with some weariness to the provisional estimate for Italian GDP. Also the slowdown in Spain and more specifically its pace will be important for forecasting purposes I think. As for the Q4 figures' bearing on the ECB and the Euro I am not sure what to expect. Trichet already somewhat punctured the Euro with his slight change in discourse last week and as such markets may not be moved as much as could have been expected. I think that the ECB, some way or the other, chose to shift its stance just a bit in anticipation of a pretty dim reading and thus in order to be at the forefront of events. In any case, be sure to keep your eyes open come Thursday. More generally, GDP figures are of course only good as far as goes a very crude picture but this nonetheless what we have to play with.

French Industrial Output December 2007

Well, industrial output in France, while struggling, does continue to some extent to resist the downward trend. Industrial production in France rose in December, helped by gains in auto manufacturing and energy, helping avoid a decline in the quarter.

Production at factories, utilities and mines, which account for 15 percent of the economy, added 0.7 percent to output from November, when it dropped strongly, by a revised 1.7 percent, according to the national statistics bureau, Insee, earlier today. Obviously after Novembers sharp fall, some revound was only to be expected.

Industrial output in what is the eurozone's second-largest economy has fallen in six of the last 12 months, highlighting the way companies' are struggling to maintain competitiveness in the face of the high euro. Evidence for import substitution is everywhere, and the trade deficit widened to a record in December. Year on year total industrial output - including energy - rose 2.4 percent.

The auto-production increase followed a surge in car sales. December car and light-truck sales jumped 17 percent to 220,094. Car production added 3.5 percent in December. Production of consumer goods, though, slumped for a second month, declining by 0.4 percent in December following a 1.9 percent plunge in November.

Italian Industrial Output Q 4 2007

Well the storm cluds certainly continue to gather over the Italian economy. We learn today that Italian industrial production fell for a fourth month in December as slowing economic growth cut demand for manufactured products.

Production declined 0.5 percent from the previous month, the Rome-based national statistics office ISTAT said today. Production dropped a workday-adjusted 6.5 percent from December 2006, the biggest year on year decline since December 2001.

The line from August you can see in the chart above seems very clear. And if we put the data on industrial output together with that for retail sales and the evolution in the trade deficit, then the possibility certainly exists that Italy fell into recession in Q4 2007. Anyway we shall all soon know, as ISTAT will be releasing provisional data before the end of the month.

The drop in Italian production in December contrasted with the situation in France, where a gain output expanded, according to the French Statistics Office INSEE, and French industrial production rose a month on month 0.7 percent.

Production of consumer goods declined 1.4 percent from November as the output of durable goods like refrigerators fell 1.3 percent. The output of non-durable goods declined 1.5 percent. Investment goods production fell 2.3 percent in the month and intermediate goods dropped 0.3 percent.

The decline in output in December contributed to a 3.4 percent drop in Italian production in the fourth quarter on a workday-adjusted basis. Production fell 0.2 percent in 2007 on an adjusted basis from the previous year. Unadjusted output gained 0.4 percent in 2007.

The decline in production may well be continuing into 2008, since Italian business confidence declined to a two-year low in January as a bleaker economic outlook hurt consumer demand for manufactured products.

Confindustria, Italy's largest employers' lobby, cut its 2008 growth forecastin December to 1 percent, about half the estimated pace for 2008. The Organization for Economic Cooperation and Development also cut its forecast for 2008 Italian growth on December 6th to 1.3 percent, from the 1.7 percent predicted in May. All these numbers may well now be subject to considerable downside risk.

Friday, February 08, 2008

German Exports December 2007

German exports fell for the second month in succession in December, offering us a clear sign that growth in Europe's largest economy is about to slow significantly.

Sales abroad, adjusted for working days and seasonal changes, fell 1.2 percent from November, when they declined 0.5 percent, the Federal Statistics Office in Wiesbaden said today. Equally importantly, the year on year growth in exports fell to zero in December (when compared with December 2006). Today's report suggests that the surge in the euro, which makes exports less competitive abroad, is hitting manufacturers in Germany just as the U.S. economy hovers on the point of recesession.

In the year, exports were unchanged and imports rose 0.1 percent, today's report showed. Imports rose 5.3 percent from November. The trade surplus narrowed to 10.8 billion euros ($15.6 billion) from 19.5 billion euros. In 2007, the surplus was 198.8billion euros, up from 159 billion euros in the previous year.

A number of indicators on the export front are giving a clear warning of the problem which is arriving. The first of these would be the year on year chart for the rate of export growth. How anyone can look at the slope of this line and say that recent events in Europe and globally have had no effect on the German economy I simply don't know.

Now it is important at this point to get hold of the idea that Germany is a high median population age society, and cannot fall back on domestic demand in times of trouble, since this is now as congenitally weak as I am congenitally hard of hearing.

Basically German GDP growth no tracks exports growth - or perhaps better put - export surplus growth, as the above chart indicates. If we look what happened to GDP growth after export growth collapsed in 2000, we can perhaps get the best idea of what is about to happen next in Germany. I think the part of the picture many people simply aren't getting at present is the implication of being export dependent.

Thursday, February 07, 2008

Spain's Election Hubris

Leslie Crawford has a reasonably balanced contribution to an opinion editorial in the Financial Times today, where he raises the issue of the excessive optimism of the Spanish government in the face of the growing crisis here. As he notes ...."Only the government predicts Spain will grow by as much as 3.1 per cent in 2008." This view is evidently ridiculous, as far as I can see from the current data Spain may well have entered recession (being defined in this case as having the first of two consecutive quarters of negative economic growth) in Q1 2008. And even allowing for some sort of rebound later in the year annual GDP growth in 2008 is hardly going to be above the 0.5% - 1% range, and may well be lower. What is so striking about Spain at the present moment is the speed with which it is slowing, like an airplane that is losing velocity fast, as if someone punctured an air cushion.

Another interesting point contained in his piece is the estimate from the IPE business school that by March there may be 500,000 unsold homes in Spain - more or less one year's residential construction output at the old pace. This is going to need a long time to correct and work out of the system. Of course, Zapatero is right when he mentions that Spain is running a 2% of GDP fiscal surplus, and so fiscal policy is available to correct the problem to some extent. But as we have learnt in the previous case of Japan - which went into a major economic crisis in 1992 following a significant housing bust - this strategy can only be a short term holding operation, the Spanish economy needs to "reinvent itself" and quickly.

(of course, the other lesson we were supposed to have learned from the Japanese experience is that to prevent a country in this situation - where they may be a major and severe correction in housing prices, and a "wealth effect" motivated deflation in demand, is that a rapid and decisive loosening of monetary policy is called for to ward off the risk of price deflation - constinuing strong price inflation in Spain is very unlikely if we look at what is happening to domestic demand - but the ECB seems to be light years away from waking up to this danger at the present time. Of course, since what we have is inpart a credit crunch, even traditional monetary policy measures like lowering short term interest rates may have little effect, but that is no excuse for not doing so).

Since in terms of the demographics of the time and the general profile of the problem Japan 1992 and Spain today are so strikingly similar it is hard to resist the comparison (it may be the only relevant one we have to go by) and it is interesting to note that one of the first people to dismiss out of hand Dominique Strauss Kahn's recent proposal to have a concerted G7 fiscal response to the weakening in global demand was Fukushiro Nukaga, Japan's finance minister, who reportedly responded to the proposal by saying: "We have learned what such fiscal spending could mean from our experience after the burst of the bubble," referring to attempts to spend Japan out of recession and deflation in the 1990s. I think Spain's next government really needs to take note of this experience. Short term fiscal stimulus is fine, but you need to get to the root of the problem.

Crawford also points to the growing global presence and importance of Spain's major companies, and this is important, but as Japan has gradually learnt to its cost, in macroeconomic terms it is hard to substitute global corporate prowess for local domestic demand. Spain's economy has been largely driven by domestic consumption and increasing consumer credit in recent years. This is now done. Finished. The situation in this sense - if we look at the comparative demographics - is much more severe than in the United States. Worse, people are going to have to start paying back what they have borrowed, both individually and collectively. The recent boom was not financed by Spanish savings but by a steady and sustained inflow of funds made possible by the eurosystem. Some 60% of the investment which went to finance the Cedulas Hipotecarias came from outside Spain, and these capital flows now have to reverse to some extent. So all of this will be a negative are far as medium term consumption in Spain is concerned. Spain now needs to become an export driven economy, and this is a huge change, and is obviously going to need some years to achieve.

My only real doubts at the present time relate to what is actually going to happen to the immigrants and what will happen to inflation. Maintaining the roughly 5 million recent immigrants who currently live and work in Spain is important to the country's demographic future, given the long term very low fertility that the country has been experiencing. These "replacement migrants" make up for the missing births produced by the birth postponement process (as I explain here). So holding onto these migrants is going to be critical, if hard, since many will be without work in the not too distant future, and with little in the way of formal financial support from the Spanish authorities. Again, this is going to be another of the major items on the "to do" list of the incoming government.

Lastly inflation. Basically the accelerating inflation we are currently seeing is unsustainable in the light of the collapse in internal demand. So the process will reverse, indeed if it doesn't - and the euro stays near current levels - it is hard to see where Spain will get the competitivity from to begin the long march to an export driven nation. The German experience post the collapse of their 1995 construction boom might be instructive: ten years of almost constant wage deflation as relative prices come back into line. This may be hard to contemplate in Spain at this point, but my best guess is that this is where we are headed. Oil prices are unlikely to increase in 2008, and may well drop back if there is a significant decline in global demand - although even this isn't guaranteed, since whatever happens in the US and Europe some countries (like India) will keep growing, and they will be energy guzzlers. Also Spanish property and land prices may start to fall drastically at some point - looking at the one years supply of unsold homes (and remember this is one years supply at the old level, it may well be two years supply at the new one) - so a sharp correction downwards may well take place at some point as bankruptcies start to occur. If this were to happen, then rather than moderate but long term wage deflation, Spain might face outright and straightforwad price deflation, Japanese style. At this point it is too early to say, but this is the other factor to watch for as we move forward.

And now for Leslie Crawford:

Eurostat, the European Union’s data compiler, in December published a dry table that revealed a remarkable fact: Spaniards had become richer per head than Italians, writes Leslie Crawford.

Anyone who knew Spain in the 1970s – when it was a byword for backwardness and governed by an ageing dictator – can only marvel at its political and economic transformation. Along with Ireland, Spain has been one of the unequivocal success stories of the EU, which it joined in 1986. The new member states of central and eastern Europe regard Spain as their role model, for the skill with which it used EU funds to spearhead its development.

But never did Spaniards think they would one day overtake in terms of per capita income one of the founding members of the EU. José Luis Rodríguez Zapatero (pictured), the Spanish prime minister who faces a general election next month, boasts that overtaking France and even Germany by that measure is possible within five years.

Mr Zapatero’s grandstanding, however, has been obscured by doubts. The end of a 10-year housing boom, coupled with financial turmoil abroad, is leading Spaniards to question the foundations of their leap forward. The Spanish sorpasso took place just as the country’s growth was peaking. Might it prove as fleeting as Italy’s famous overtaking of the British economy in the 1980s?

Moreover, its economy is now big enough to affect Europe’s performance as a whole. “If residential construction in Spain contracts in 2008 as sharply as it did in the US in 2007, it could shave 0.2 percentage points off eurozone economic growth,” Holger Schmieding of Bank of America wrote in the Financial Times last month.

During the peak of the construction frenzy two years ago, economists described the Spanish economy as a “monoculture” of bricks and mortar and worried that there was nothing to take its place if the building boom came to an end. Construction employed 13 per cent of the workforce. The banking system channelled 60 per cent of all credit to housing-related activities.

Spain was building more homes than France, Germany and the Benelux countries combined. It was consuming half of all the cement in the Europe and it was borrowing massively abroad. Economists agreed that Spain’s credit-fuelled property boom accounted for most of the country’s growth differential with the EU.

The credit squeeze hit Spain at its most vulnerable point in the economic cycle, with an overpriced and oversupplied housing market and families and companies deep in debt. As a result, the country is on the brink of a property slump that will affect employment, consumer confidence, bank earnings and the economy as a whole, according to a number of recently published reports.

IPE, a business school that specialises in urban planning and property, estimates that there will be 500,000 unsold new homes by the end of March – roughly the number built in an average year. Given government forecasts that 500,000 more were to be built this year, the unsold stock is worrying. About half the country’s estate agents are already out of business, according to their trade association.

One consequence of the building slowdown is that unemployment has shot above the 2m mark. January’s 6 per cent increase in the number of unemployed was the highest monthly rise in 10 years. Immigrants and temporary workers are feeling the brunt of the cuts. The end of the property boom is also worrying for Spanish commercial and savings banks, which have €290bn ($425bn, £217bn) in outstanding loans to property developers and are trying to cut their exposure to the sector.

Not everyone shares the gloom, however. Mr Zapatero is unabashedly confident about his country’s economic prospects, on which his re-election prospects also depend.

“I am an optimist,” he tells business. He expects the economy to grow by “at least” 3 per cent in 2008. Mr Zapatero’s Socialist party is promising to create 2m jobs over the next four years and to raise minimum pensions and wages. If the economy fails to grow at the predicted rate, Mr Zapatero thinks old-fashioned fiscal stimulation should do the trick. The government has a “comfortable” budget surplus of 2 per cent of GDP, he says, to get things moving.

Another reason for optimism is that Spain’s big companies have used the profit windfalls of the past several years to diversify out of Spain. Joaquín Ayuso, chief executive of Ferrovial, the company that in 2006 bought BAA, the British airports operator, says: “Back in 1992, construction – mainly public works – was 90 per cent of our business and it was all in Spain. Then there was a devaluation and a recession.

“We had four horrible years. I was the director for
construction then and I was convinced I would be fired. Those years taught us a lesson: that we couldn’t depend on just one country, one business and one client, the government.”

Today, 90 per cent of Ferrovial’s assets are in the UK, Canada and the US; they include toll roads, airports and baggage handling. Less than 15 per cent of Ferrovial’s income comes from construction.

Santander and BBVA, Spain’s two big banks, have expanded abroad so that a big part of their business is based in Latin America and the UK, where Santander owns Abbey National. Telefónica, the former telecommunications monopoly, has also become world-scale.

Diversification means that even if Spain starts to flag, some companies will be able to cushion the blow with income from other parts of the world. Tighter credit conditions, however, will make it much harder for them to continue an acquisition spree that has included investments of more than €60bn in the UK alone.

In this jittery environment, resilience is a big advantage. What frightens some is the hubris that appears to have taken hold of Mr Zapatero and some of the business establishment. Only the government predicts Spain will grow by as much as 3.1 per cent in 2008. The International Monetary Fund estimate is 2.7 per cent. The Organisation for Economic Co-operation and Development forecasts Spain will grow by 2.5 per cent.

“To draw up economic policy on the basis that we are going to grow by 3 per cent this year is unrealistic, even irresponsible. Not to recognise a problem is the first step to not solving it,” says Lorenzo Bernaldo de Quiróz, of Freemarket, an economic consultancy in Madrid.

Complacency is also frightening because Spain could easily slip into Italy’s “do nothing” malaise. For the moment, Europeans prefer to shop at Zara rather than Benetton. Iberia is a going concern whereas Alitalia is bust. Telefónica is a big shareholder in Telecom Italia rather than the other way around.

“Spain has undergone such a tremendous transformation in the past two decades. Now it has to take the next step,” says Stefan Bergheim, a senior economist at Deutsche Bank. An inflation differential with the EU needs to be tackled. Productivity, which is low, has to be addressed and Spain must move on from bricks and mortar to find a more sustainable route to prosperity.