Thursday, February 26, 2009

Italian Business Confidence and Retail Sales Fall As Bond Spreads Rise

Italian business confidence fell to a record low in February as concern that the fourth recession in seven years will damp orders more than offset lower oil prices and borrowing costs. The Isae Institute’s business confidence index dropped to 63.2, the lowest since the index was created in 1986, from a revised 65.4 in January.

Italian executives also reported having more problems getting credit in February. The report showed that 40.2 percent of those surveyed said the credit situation worsened, up from 33.5 percent in January. The new orders sub component also fell, to minus 65 from minus 58 in January, the lowest since 1991. And manufacturers’ expectations for production over the next three months fell to minus 24 from minus 20.

Retail Sales Fall

Italian retail sales contracted for the 24th consecutive month in February as the credit crunch tightened its grip on spending, and consumers put off purchases of cars and home appliances.

Italy's entered its fourth recession in seven years in the third quarter of 2008. The Italian government now forecasts the economy will contract 2 percent this year, the second consecutive year of contraction, and even this seems optimistic at this point. The government has announced an 80 billion-euro stimulus plan and 2 billion euros in incentives for the purchase of cars and home appliances., but in general the country is too indebted to be able to do anything very ambitious.

So Italy waits, in the hope that help may come from Brussels, where the 27 members of the EU will meet on Sunday - lead it seems by Angela Merkel - to decide what to do next.

And I hope you are "readying up" that rescue plan Angela, since the difference between German and Italian benchmark bond yields widened to the most in nearly 12 years today as Italy sold 10 billion euros ($12.8 billion) of government securities.

The spread between the 10-year note yields increased as much as four basis points to 161 basis points today, the widest since May 1997, based on generic Bloomberg prices. It was at 155 basis points as of 12:05 p.m. in London. The average in the past 10 years is 31 basis points.

Germany or the International Monetary Fund may be forced to rescue members of the euro bloc that struggle to refinance debt, former Bundesbank President Karl Otto Poehl said today.

“The first will certainly be a small country, so that can be managed by the bigger countries or the IMF,” he said in an interview with Sky News. “There are countries in Europe which are considering the possibility to leave the eurozone. But this is practically not possible. It would be very expensive.”

US Fiscal Deficit Projected At 12.3% of GDP In 2009

According to the 2009 budget Barack Obama is sending to congress today, the United States will have a $1.75 trillion deficit this year. The figure represents 12.3 percent of estimated gross domestic product, double the previous post-war record of 6 percent in 1983, and the highest level since the deficit totaled 21.5 percent of GDP in 1945, at the end of World War II. It seems the numbers are about to start getting let out of the bag, and it will be interesting to see how the markets react. You can find many more details here.

Now if you look at the chart below (prepared by Lazard for a presentation on consumer deleveraging) you will see that this is not the first time something like this has happened. The earlier peak in US indeptedness occured (of course) between 1930 and 1933, when total debt peaked at 299% of GDP. In fact total debt expanded quite rapidly between 1930 (211% GDP) and 1933, largely as a result of GDP contraction and price deflation (which is why it would be preferable not to see extensive price deflation this time round). As a result, while private sector debt contracted between 1930 and 1933, public sector debt held steady, and rose from 34% of GDP to 72% of GDP (for better viewing click on image, and try zooming in a bit. Sorry, that's the best I can do/suggest).

This is the phenomenon we are seeing now. If the stimulus programme is successful then we might see US debt to GDP stabilising around 2013, since the deficit is expected to remain around $1 trillion for the next two years before starting to decline to $533 billion in 2013, according to budget projections.

So what is likely to happen to prices? Well, if we look at the chart below, we can see that US consumer price inflation was pretty lacklustre right the way through from 1920 to 1940 (that's why I would call the whole interwar epoch a deflationary one), so I guess, if we're lucky, we might get to see some serious inflation around 2020. If history is any guide that is, which ain't necessarily the case, but still.

Friday, February 20, 2009

Europe's Economic Contraction Intensifies In February

Hopes that Europe's battered economies might be about to turn themselves around took another sharp knock today (Friday), as the preliminary flash reading on the purchasing manager survey signaled that activity in both the manufacturing and the services sectors are contracting at a new record pace in February.

The preliminary Markit euro-zone manufacturing purchasing managers index, or PMI, fell to a record low of 33.6 in February from 34.4 in January, while the services PMI also fell to a record low, dropping to 38.9 from 42.2 in January. As a consequence the euro-zone composite PMI reading dropped to its own record low of 36.2 from 38.3 in January. Any reading below 50 on these indexes indicates month on month contraction.

Barring some spectacular (and entirely improbable) turnaround in March it now seems likely that the Q1 GDP contraction will be worse than the Q4 2008 one. If we consider that the eurozone contracted by 0.2% in Q3 2008, and by 1.5% in Q4, then, in my humble opinion, the data we are seeing for this quarter are entirely consistent with a 2% quarterly contraction (or an annualised 8% rate of contraction). Not quite Japan territory yet, but not far behind. And for those who simply don't believe the PMIs can tell you so much, here is Markit's own chart, showing the strong underlying relationship between movements in GDP and the *flash* composite PMI. Pretty impressive I would say.

Germany's Contraction Intensifies

The German service PMI came in at at 41.6, showing the fifth consecutive month of contraction. This was a sharp drop from last months 45.2 reading, and means that the recession is now feeding through from manufacturing to services. The difficult conditions have lead service business owners to hold to the grimmest outlook in the last decade, that is since the index was started. More ominously, the recent data points to a strong reduction in the employment level.

On the other hand February saw the tiniest of upticks in the manufacturing sector, since the PMI came in at 32.2, from January's 32 , the best that can be said here is that the rate of contraction may have stabilised.

France Holds Up Slightly Better Than Most

In France, the manufacturing sector (see chart below) gave up on most of January's rebound, and the PMI fell to 35.4 from 37.9 in January, while services (see chart above) slipped to a record low of 40.1 from 42.6 in January. Nonetheless France is visibly performing rather better than Germany, and when all this is over we will have plenty of time to hold the debate as to why that has been.

Wednesday, February 18, 2009

The EU Bonds Story Rumbles On

Wolfgan Munchau was complaining only last weekend about the extraordinary narrow-mindedness of Europe's economic and political leadership in the face of the current financial and economic crisis, from Ireland in the West to Hungary in the East, and from Greece in the South to Sweden in the North. But more than narrow mindedness what we are faced with is innocence and inability to react, and frankly I am not sure which is worst. I say "innocence" because it is by now abundantly clear that they simply haven't yet grasped the severity of the problems we face (in countries like Spain, or even Germany itself, let alone in the East), and I say inability to react, since they are always and forever moving too little and too late. The initial response to the banking crisis last October was one example (where we saw a landshift-style volte face in the space of only one week) and the way we are now confronting the need to live up to the promises then made about guaranteeing the banking sector, and in particular the "systemic" banks, would be another.

The complete confusion which seems to reign over at the ECB about whether or not the Eurozone can operate some sort of US/Japanese style quantitative easing would be a third.

Only today we are faced with yet another example of how our leaders are meticulously dangling their toes in the icy water where a more seasoned mariner would simply see the need to dive straight in and rescue the drowning man.

It is reported this morning that Germany and France are now contemplating the possibility of bailing-out entire nations, rather than simply individual banks, as European government budget commitments steadily mount-up while their sovereign debt ratings start to buckle under the weight of a growing and deepening European recession.

As reported in my post yesterday (here) German Finance Minister Peer Steinbrueck became the first senior European politician to broach the topic earlier this week, when he stated that some of the 16 euro area nations are now “getting into difficulties” and may need help, citing Ireland as an example. French officials are also reportedly concerned about how the current "stand alone" sovereign debt situation is leading to widening spreads on Austrian, Irish, Greek and Spanish debt as the cost of insuring against default rises to records. What we have before us is not simply a case of seeing "fiscal irresponsibility" punished, it is a mechanism whereby the eurozone can be peeled apart, and where those states who enter a negative economic growth-bank bailout-fiscal deficit dynamic which means the cost of financing their debt (and thus their bank bailouts) rises so prohibitively that it virtually excludes the possibility of giving further fiscal stimulus to their sinking economies, and does so in such a way that a self reinforcing (and self fulfilling) process may be produced, a process which only leads in one direction and to one conclusion: that of sovereign default.

The problem is that it is not just one or two quarters of negative growth we are talking about here, we are talking of deep depressions, and ones during which deep structural damage can be inflicted on the economies of those states who are hardest hit.

“When push comes to shove Germany, France, the larger players will bail out those smaller peripheral players,” said Alex Allen, chief investment officer of Eddington Capital Management. “You can’t let one part of the system fail because it leads to failure of the whole system.”

European deficits have evidently surged enormously this year as governments are faced with the need to provide funding for the heavily strained banking system and provide some kind of stimulus to their rapidly contracting economies. EU member states have already committed more than 1.2 trillion euros in an attempt to save the banking systems from collapse, and it is evident that a second and possibly larger wave of bailouts may now be imminent.

In particular many of us our now concerned that the eurozone bond market could potentially face a crisis similar to that unleashed by the collapse of Lehman Brothers in September 2008. As ECB board member Lorenzo Bini Smaghi put it earlier this month there’s a “risk that the mistrust that there is today in financial markets” is “transformed into mistrust in states.”

“I would be very reluctant to say: ‘O.K., let Ireland or Greece default, the market will sort it out, punish them for their irresponsibility of the past,’” said Thomas Mayer, co-head of global economics at Deutsche Bank AG in London. “They tried it with Lehman and realized that was not a good idea.”

The Spreads Widen

The gap between the interest rates Greece, Austria and Spain must pay investors to borrow for 10 years and the rate charged Germany yesterday rose to the widest since before they adopted the euro. Credit-default swaps on Ireland rose to a record on Feb. 16, climbing to 378.4 points. Greek credit-default swaps, 270 points on Feb. 16, show a 4.5 percent chance that the country will default in the next 12 months, according to ING Bank NV.

Are Bailout's Possible Under Maastricht?

The simple answer to the above question is most emphatically yes, under article 119 of the Treaty. As follows:

Where a Member State is in difficulties or is seriously threatened with difficulties as regards its balance of payments either as a result of an overall disequilibrium in its balance of payments, or as a result of the type of currency at its disposal, and where such difficulties are liable in particular to jeopardise the functioning of the common market or the progressive implementation of the common commercial policy, the Commission shall immediately investigate the position of the State in question and the action which, making use of all the means at its disposal, that State has taken or may take in accordance with the provisions of this Treaty.

Which in plain English basically means, through you go with your proverbial coach and horses. Indeed they may well have already been driven through, last November, in the case of Hungary.

“The European Commission stands ready to provide a loan of €6.5 billion to Hungary,” the EU executive said in a statement on Wednesday (29 October), adding that “the concrete modalities will shortly be finalised in cooperation with the Hungarian authorities”. Under the plans, the Commission will borrow money from the markets using EU-denominated bonds and then lend it to Hungary, without drawing from the EU budget. The facility is established under Article 119 of the Treaty.It is the first time that Brussels has used the instrument to help an EU country (see background). The facility foresees an overall ceiling of €12 billion of outstanding loans. This funding is limited to EU countries which are not part of the euro zone.

The €12 billion ceiling currently provisioned for in the bond facility has not so far been reached, but it has long been evident that other Eastern EU countries would need to draw from the facility for financial help. Thus it is hardly surprising to learn that French President Nicolas Sarkozy had already proposed raising the ceiling to €20 billion at an EU summit on 7 November.

"I will propose on 7 November that the European Union itself, which has 12 billion available to support a certain number of liquidities and to support a certain number of states, should go up to at least 20 billion (euros) to increase our capacity to respond to the crisis," Sarkozy said, according to Reuters.

As one EU official told journalists at the time "the Commission could also change the regulation and lift the ceiling". Or, in other words, when needs must, it will.

A Little History

The principle of borrowing money from financial markets on behalf of the European Community has previously been applied to grant aid to extra-EU countries, in particular before the 2004 enlargement. Kosovo, Moldova and Georgia are all currently receiving financial help through EU loans raised on the market. In January 1993, Italy, a member of the European Community (the EU's forerunner), was granted an eight billion ECU loan to support its strained balance of payments. Since then, no member state has received financial help through this instrument.

The idea of borrowing money via the issue of EU bonds was first launched by former Commission President Jacques Delors via his 1993 plan for growth, competitiveness and employment. Delors initially wanted EU bonds to fund the European budget. But the majority of member states opposed the idea, fearing it would ultimately increase their expenditure on the Community budget.

Borrowed money has been used by the EU to fund projects in several cases, although the amounts involved have been small. For instance, a 'New Community Instrumentexternal ' was used in the late 70s and early 80s to help regions affected by earthquakes in Italy and Greece. Italy has recently proposed using European bonds to fund key EU projects, but the idea garnered little support

The gateway for the coach and horses is also being prepared on another front, as the Financial Times reports this morning. In this case we are talking about the European Investment Bank, which, according to the FT, is set to lend the European car industry 7 billion euros in the first half 2009 to support the manufacturing of environmentally clean vehicles. This is already a substantial increase on the approximately 2 billion euros a year the bank extended to the industry before the crisis, and there may be more, much more, to come. Pathways are being prepared, even as the wheels on the coach are oiled and the horses' mains groomed.
Philippe Maystadt, the bank’s president for the past decade, revealed the €7bn figure to the Financial Times, as he explained the EIB’s plans to shoulder a bigger financing burden in crisis-hit Europe. Member states have already asked the EIB to increase its annual lending programme by €15bn ($19.2bn, £13.3bn) to €63bn for this year and next in an effort to revive the economy.

So Why The Criticism?

So why, if there behind the scenes so many preparations are now being made did I start this post by saying that more than narrow mindedness, what I felt we were faced with is innocence and an inability to react? Well basically, because I think that Europe's leaders are still in general denial on the scope of this problem. We are not talking simply of little cases, like Greece and Ireland, we are talking about potentially much harder chestnuts to crack, like Spain, and Italy, the UK, and even Germany itself. Remember Germany's economic is now contracting at an almost astonishing pace, and German bonds are getting harder to sell all the time.

The full extent of the problems in the German banking system, as defaults mount in Spain and Eastern Europe, is yet to be measured. Only today German Chancellor Angela Merkel’s Cabinet approved a draft bill allowing the state to seize control of property lender Hypo Real Estate Holding AG, paving the way for the first German bank nationalization since the 1930s. And the volume of assets thought to be likely to need to be bought by any bad bank (or banks) created is very large. Hypo's loans alone are thought to total almost 260 billion euros, and numbers in the 400 to 600 billion euro range are being mentioned. So the fear here is not that a German sovereign default is looming, but that German debt may no longer maintain "benchmark" status, and thus the rate of interest the German government may have to pay to maintain its debt may rise, again impeding efforts to help maintain the economy afloat, and almost inevitably biting into the country's already strained health and pension systems.

Finance Minister Peer Steinbrueck was quoted by the Frankfurt Allgemeine Sonntagszeitung weekly newspaper as saying he could "not imagine (the establishment of a "bad bank") economically or above all politically". A bad bank would need to be financed with 150 billion to 200 billion euros of taxpayer funds, he said. "How am I supposed to present that to parliament? People would say we are crazy." Steinbrueck said no one could predict whether the rescue fund would need to be expanded given mounting losses at banks, but noted it still had room to distribute more money.

And one last example for today, of how the one half (the Commission) doesn't know what the other half (the Nation State leaders) is up to. Joaquin Almunia (who is so often "really out to lunch" on economic issues, he is, as they say "challenged" by the complexity of macro economics, see for example this post here) has warned that Brussels could take action soon against EU member states which let their budget deficits rise above the 3% threshold (see P O'Neill post here).

The EU's executive arm plans Wednesday to examine the budgetary circumstances of several countries, including France, Germany, Greece, Ireland, Malta, the Netherlands and Spain, to see whether action is needed. Most of them, notably France, Greece and Spain, have already forecast that their deficits will blow out beyond three percent of gross domestic product (GDP) -- the limit set out in the EU's Stability and Growth Pact.

France, which has called for the EU limit to be eased as governments grapple with the worst economic downturn in decades, has said it expects its deficit to be 3.2 percent GDP in 2008 and 4.4 percent in 2009. Ireland's deficit is expected to blow out to 5.5 percent in 2008, and then 6.5 percent in 2009, with Dublin hoping to bring things back into line in 2011. Spanish authorities expect a deficit of 5.8 percent this year. Germany, Europe's biggest economy, has forecast three percent this year but believes the figure could grow to more than four percent in 2010. Greece, for its part, foresees a deficit of 3.7 percent in 2009. The Netherlands is due to publish its latest figures Tuesday and might just scrape through.

Given the difficult, and unforseen, pressure we are all up against, this is, quite frankly ridiculous. Not that rising fiscal deficits, and rising debt to GDP ratios, are something we should be casual about, but I think what we need is a certain loosening of the rules in the short term, to be followed by a much stricter tightening as we move forward. And do you know the mechanism I would use to discipline the reluctant states when it comes to paying off the accounts run up during the emergency? Why yes, you've got it, the availability of those much-easier-to-finance EU backed bonds.

You see while the first argument in favour of EU bonds may be an entirely pragmatic one, namely that it doesn't make sense for subsidiary components of EU Inc. to be paying more to borrow their money when the credit guarantee of the parent entity can get it for them far cheaper, the longer term argument in favour is that it may well enable the EU Commission to become something it has long dreamed of becoming - an internal credit rating agency for EU national debt. Basically in the mid term the EU bonds system can only work if it is backed by a very strong Lisbon type reform pact for those countries who apply to make use of the facility. This is what now needs to be worked on. And how do we know that that there won't be yet another round of backsliding on all this? Well we don't, this is the risk we just have to take, but sometimes you do need to simply cross your fingers and jump, since the burning building behind you looks none to attractive either, but what we do know is that since there will now be a mechanism whereby the bad behaviour of the few really can penalise the many financially, then there really will be some meaningful incentive to generate a pact, this time, that really has teeth to stop that penalisation taking place.

Tuesday, February 17, 2009

Santander's Banif Fund Suspends Payments

"I would now expect several eurozone countries with weak banking sectors to get into serious difficulties as the crisis continues. There is a risk of cascading sovereign defaults. If this was limited to countries of the size of Ireland or Greece, one could solve this problem through a bail-out. But solvency risk is not a problem confined to small countries. The banking sectors in Italy, Spain and Germany are increasingly vulnerable."
Wolfgang Munchau, Financial Times, 15 February 2009.
German Finance Minister Peer Steinbrueck said on Monday euro zone countries would have to pull together if one of them faced a "serious situation," adding that Ireland was in a "difficult situation."
Investors are increasingly concerned that Ireland may default on its national debt as the government pledges more money to help troubled banks, the Sunday Times said. Credit-default swaps on Ireland’s government bonds reached record levels last week as debt investors rate the nation as Europe’s most-troubled economy, the paper said. Ireland has pledged financial help for lenders that would be more than double its annual economic output and the loans held by its banks are more than 11 times the size of its economy, the report said. Credit-default swaps on the five-year sovereign debt of Ireland, which is rated AAA by Fitch Ratings, jumped 49 basis points on Feb. 13 to a record 377, according to CMA Datavision prices. That’s 18 basis points more than the cost to protect the debt of Costa Rica, which Fitch rates BB, or 11 grades lower than AAA, from default.
Bloomberg, 16 February 2009

Well push is, I think, now getting much much nearer to shove time, and we now wait restlessly to know what EU leaders are going to offer in the way of a second round of bank bailouts at the end of this month. As I argue in this post, and as Munchau also suggests, more than sweet words will be needed to honour the commitment made on October 12 2008 in Paris that no "systemic" EU bank would be allowed to fail, as a minimum we need a comprehensive mechanism financed by the issuing of EU bonds.

The most recent and most obvious example of the push coming to shove situation is the announcement by Spain's Banco Santander, yesterday (Monday), that its Banif property fund, the largest of its type in Spain, could not meet the avalanche of redemption requests it had been receiving, and consequently had asked the stock market regulator for permission to suspend payments for up to 2 years.

According to the bank's own statement clients (of whom there are a total of around 50,000) holding 80 percent of the investments, or 2.62 billion euros, had asked to redeem their holdings while what is the eurzone's biggest bank had had to admit that the Banif Inmobiliario Fund FII lacked the cash to facilitate this, and that they, Banco Santander were not going to inject the liquidity necessary to enable the fund so to do.

This decision stands in sharp contrast with the earlier action of Spain's second-biggest bank BBVA who, when faced with a similarly massive demand from clients to redeem their investments at the end of last year, opted to buy 95.6 percent of their 1.57 billion euro fund, which is the second biggest in the Spanish market.

Banif has 67 percent of its assets invested in housing, 18 percent in offices, and 14 percent in commercial property, according to the fund's fourth quarter report. These properties are distribuited around Spain, with heavy concentrations in Madrid, the Balearic Islands and the north-west. Offices and commercial premises are mainly centred in Madrid and Barcelona. The fund's assets lost around 15 per cent of their value between the third and fourth quarters as values were adjusted to reflect price declines. Property sales are in constant decline in Spain - according to figures released yesterday, total sales December home sales were 26 per cent down over December 2007. House prices in Spain fell January on January by around 10% and may fall by a further 20 percent this year according to a report last week fromTasaciones Inmobiliarias SA (TINSA), the country’s biggest property valuer.

Banif, which is described in its prospectus as “low risk,” produced a yield of 1.37 percent last year, down from 5.87 percent in 2007, according to the fourth-quarter report, while assets under management fell 4.2 percent in January, according to data published by Inverco, the Spanish asset management association.

Analysts are evidently alarmed by this development and are warning of the immediate danger that this news could spark a a massive demand for redemption from investors in other Spanish real estate funds. There are currently nine such funds in Spain, with assets totalling around 7.25 billion euros under their management.

"I've never seen a case like it," said one fund manager at Madrid brokerage Renta 4, who asked not to be named. "It could trigger a snow ball effect; that's one of the consequences when you start to hear that the biggest (fund) is doing badly".

Santander's property division propose to use 10 percent of the fund's assets - valued at 3.41 billion euros at end-December - to pay investors partial redemptions, saying that if the necessary capital could not be raised through asset sales, it would inject cash itself. The statement also said that should the fund not be in a position to fulfil repayment requests within two years it would wind itself up. Clearly this news was not exactly enthusiastically greeted by the Spanish Bolsa, and Santander stock closed 4 percent lower at 5.49 euros after a sharper sell off in the last 30 minutes of trade. This compares with a 3 percent fall in the DJ European banking index.

“What’s happened is another symptom of deep structural problems facing the Spanish real estate industry, which will take years to resolve,” said Juan Jose Figares, chief analyst at Link Securities in Madrid.

Bad Debts Rising At Santander

Spanish banks, including savings banks and co-operatives, saw bad loans rise by 5.2 percent in December to 59.16 billion euros ($75.49 billion) from 56.12 billion euros in November, Bank of Spain data showed yesterday. The non-performing loans (NPL) ratio for all institutions was 3.3 percent at end-December, compared with 3.13 percent in November, with rates among savings banks the highest, at 3.79 percent, up from 3.63 percent the previous month. The bad debt ratio for commercial banks rose to 2.81 percent from 2.61 percent.

In the case of Santander such loans more than doubled to 14.2 billion euros in 2008 as a recessions in Spain and in the U.K. lead to rising defaults by borrowers. Loan arrears as a percentage of total lending totaled 2.04 percent at the end of December, up from 0.95 percent a year earlier and 1.63 percent in September. The bank added 3.6 billion euros in bad loans in the fourth quarter. The bank stated during the presentation of its full year results that NPLs in the Spanish banking system could rise up to 8 percent in 2009 as the country heads in to its worst recession in 50 years.

Full-year profit fell 2 percent to 8.88 billion euros as the bank booked 350 million euros in costs tied to compensating customers hit by the alleged Madoff fraud.

“The U.K. is a terrible place for a bank to be and Spain is also looking more and more dreadful,” said Lecubarri, who manages about $250 million, in a telephone interview ahead of results. “What’s key for investors is judging how this will keep affecting asset quality.”

Santander has said it will pay 1.38 billion euros to clients hit by losses from investments with Madoff, making it the first bank to offer a settlement in the affair. The bank’s Optimal Investment Services hedge fund unit, based in Geneva, had 2.3 billion euros with Madoff.

Metrovacesa To Be Handed Over To Creditors

Metrovacesa, which is Spain's biggest property firm, will be handed over to its creditors on February 20, slightly later than its main shareholder originally planned, in return for the banks cancelling debt. The Sanahuja family, which has an 81 percent stake in Metrovacesa, have said in a stock market announcement said it will hand over 54.75 percent of the office, mall and housing developer to six creditor banks next Tuesday.

"The arrival of some documentation has been delayed and the entry of the banks is delayed until next Tuesday. The company will also publish (full year) results) on Tuesday," a spokesman for the family said.

The Sanahuja family accumulated between 4 and 5 billion euros in debt through their acquisitions, but got into difficulties when the market turned and banks restricted further lending. As a result of the "handover" BBVA, Santander, Sabadell, Banco Popular, Banesto and Caja Madrid will each take 9 percent of the company. The Spanish banks are thus constantly expanding their property portfolio as the non performing loans pile up.

And The Credit Crunch Continues

German Chancellor Angela Merkel and French President Nicolas Sarkozy called on European Union states on Monday to focus efforts on ensuring credit lines were restored to the battered European economy. "The restoration of the supply of credit must be our top priority," they wrote in a letter to the Czech EU Presidency, a copy of which was obtained by Reuters. "We must renew our commitment to a return to sustainable public finances," they added in the letter, which also called for a special summit on the economic crisis later in February.

According to the latest report from Markit economics Spanish manufacturers are being hit the hardest by credit squeeze as the financial crisis deepens and factories swoon into closure. Markit found that more than one in five manufacturing companies in Spain feel the deterioration in credit conditions is hurting their business, while 46 percent reported that credit availability had worsened from three months earlier.

In an attempt to address the problem and provide credit direct to the customer, the Spanish government have now approved a 4.17 billion-euro plan to aid the car industry. The plan involves an injection of 800 million euros this year to improve productivity and 1.2 billion euros which will be made available for consumers to finance new-car purchases. The plan also includes loans for companies and permits manufacturers to delay paying social security taxes. The At the start of the recession the Spanish car industry represented around 6 percent of Spain’s economy and employed more than 350,000 people. Spanish January car sales were down 42 percent from a year earlier, according to the trade group ANFAC.

Action At The EU Level Urgently Needed

I will close this post as I opened it, with a quote from Wolfgang Munchau. Wolfgang suggests that the action which is needed is not going to happen. It could well be he is right, although I personally at this point have not abandoned all hope. But we should be in no doubt, the price of inaction at this point will be high, as high as that which Wolfgang suggests. The EU banking system is in danger, and it is danger not just in Southern European "PIG-like" economies. It is in danger in Germany, it is in danger in the UK. We need a collective response, and we need it now!

The right course would be to solve the underlying problem – to shift at least some of the stimulus spending to EU or eurozone level and, ideally, drop those toxic national schemes altogether and to adopt a joint strategy for the financial sector, at least for the 45 cross-border European banks. But this is not going to happen. It did not happen in October, and it is not going to happen now. As a result of the extraordinary narrow-mindedness of Europe’s political leadership, expect serious damage to the single market in general and the single market for financial services in particular. As for the eurozone, I always argued in the past that a break-up is in effect impossible. I am no longer so sure.


Reuters have a very useful piece of background which gives us a bit of insight into current thinking. Comparisons are being made with what happened after Spain's last recesssion, since banks bougtht up large chunks of the of the property industry during the 1993-95 recession before making up to seven times their original investment by selling them on in the 1997-2007 property bubble. However there are serious question marks over whether a model like this will work this time round, since property prices may simply take a substantial fall, and then prices may well stay low, as happened in Japan after 1992. Certainly current conditions look nothing like Spain in 1994, and the banks' current haste to buy property, rather than allow failing businesses to go bust, is artificially lowering NPL rates now, only to delay future loan losses, losses that will hit sooner or later (my guess is 2011) as it finally sinks in that this is not a normal recession and that there will not be a normal recovery. Santander, for example, bought 2.6 billion euros of property last year at 10 percent under the (official) market rate. The bank argues that had it not swapped that debt for property, loans on 13 percent of those assets would have defaulted.

Spanish banks are returning to property ownership to avoid loading more bad loans on to their balance sheets but the strategy is risky and unlikely to be as profitable as their real estate buying spree 15 years ago. Spain's eight biggest banks last year formed or resurrected property wings that have bought up 7.8 billion euros ($9.9 billion) worth of property from struggling home-owners and developers.

The main threat to Spanish banks has come not from the toxic U.S. mortgage debt that has poisoned U.S. and British institutions, but a rapidly deepening recession propelling their bad loan rate to an expected 7 percent this year and 9 percent in 2010 from 2.8 percent last October, according to the Bank of Spain. Mindful of the need to keep bad loans to a minimum, bankers are doing everything to stop another major developer filing for administration as Spain's biggest house builder Martinsa Fadesa

Not only will creditors likely take years to recover debts from Martinsa but the default also ramped up non-performing loan (NPL) rates as they provisioned 25 percent of the loan, or 250 million euros in the case of No.2 savings bank Caja Madrid. "By buying real estate assets the banks stop loans becoming bad loans. In so doing, the client's debt with the bank is canceled and they avoid not only increasing bad loans, but they also avoid having to make more provisions," said Nuria Alvarez, an analyst at Madrid brokerage Renta 4.

Monday, February 16, 2009

Staring into the Abyss

By Claus Vistesen: Copenhagen

“If you gaze long into an abyss, the abyss will gaze back into you.” - Frederic Nietzsche

When you get that close to the abyss, you can always jump tomorrow.- Unknown

This beautiful Saturday morning in Copenhagen, I am reading the latest edition of the Economist and there are a couple of interesting bits and pieces I want to start with. First of all, the Economist runs a long piece on Irving Fischer and his debt-deflation theory. Since I am digging hard in the annals of economic history at the moment I find it a good read. Personally I am actually studying Fischer at the moment, not because of his debt-deflation theory, but because of his seminal work on the theory of the interest and how fundamental his work is in the context of economic modelling as they teach us on grad school.

Moving into the present, the Economist are none to happy about the Obama plan and bailout and call it too timid as well as a watsted opportunity. They are not the only ones who are drawing this conclusion. The Capital Spectator calls it big, bold, but vague, the FT's Martin Wolf also seems sceptical particularly with respect to the measures to shore up the financial sector, James Hamilton also seems most timid in his praise, whereas Paul Krugman pure and simple calls it the failure to rise (hat tip; Mark Thoma).

Perhaps those astute commentators above are jumping the gun a bit although I would have to say that I have not studied the plan in great detail. However, I agree on the banking side since what we need now is probably widespread nationalisation. Every bit of my liberal fiber is trembling by saying this, but the semi private market solution through re-capitalisation, with government funds à la Sweded, seems even more unlikely to work I think. Quite simply, it strikes me that the latter may be much more complicated than the former in terms of speed and thus, in the present context, efficiency.

With respect to the overall plan I latch on to Krugman's (and others') point that in the end it all turned into bipartisanship which is a pity. For example, I am certain that all those money spent on tax cuts are useless in so far as goes to remedy the immediate slump in demand. By all means, let us keep ideology out of this, but I think simple economic logic tells us that Ricardian Equivalence and the propensity to save (precautionarily as we call it in economics) are very high in this environment especially with unemployment rising by the week. And with respect to the coming steps of this crisis unemployment will rise much faster across the board than people expect. An anecdotal story from my home country shows this. My sister here works for a municipal unemployment service where she negotiates with businesses on behalf of "disabled" citizens who can only do part time work or certain kinds of non-physical work. Clearly, these people are getting laid off by the buckets at the moment which is making their life difficult. However, she is also reporting that each week her and her coworkers can actually SEE the lines grow at the more regular unemployment offices. Each Monday the line is just a little bit longer. This is almost 1930s soup kitchen style.

Finally, the Economist runs a long piece on Irving Fischer and his debt-deflation theory. Since I am digging hard in the annals of economic history at the moment I found it a good read. For my own part I am actually studying Fischer at the moment and especially his seminal work on the theory of the interest and how fundamental his work is in the context of economic modelling as they teach us on grad school. It is always funny to understand why it actually is we are being taught the way are, because I can tell you this is one thing which is painfully absent in modern teaching.

Mickey Mouse Numbers in Japan and Eastern Europe

With respect to the data, I am not sure whether to laugh or cry (although I am pretty sure it is the latter at the IMF and in Latvia). Actually, my first reaction when I saw two research snippets, sent around by some friends, on Latvia was to laugh. This is Mickey Mouse numbers folks! An expected 20% contraction here and 10% there. The actual numbers confirm this. Q4 GDP fell a healthy 10.5% in Latvia and 9.4% (yoy) in Estonia. This means that 2008 saw a contraction, in Latvia, of 3.6% which follows a 6.3% expansion in 2007. Now, how long was it that we had the discussion about a soft v hard landing in the Baltics? Ah well, I will refrain from commenting.

Further afield, the traditional survvey conducted by Bloomberg suggests that Japan may have contracted a full 11.7% (annualised) in q4 which, of course, is quite disturbing. Clearly Q4 was always going to be a shocker, but this is quite disturbing. As I noted in my last large review on the Japanese economy all gauges were pointing firmly down and it these numbers indicate that this is most definitely the case. Expectations have it that Japan may have contracted a full 3.1% qoq in Q4 which is just massive and really raises all kinds of questions.

Japan’s economy probably shrank 3.1 percent from the third quarter in the first set of GDP data made available for the period following the collapse of Lehman Brothers Holdings Inc., economists said. That would be almost triple the pace of contractions in other major economies -- the U.S. shrank 1 percent quarter-on-quarter and a report out this week is expected to show the Euro-zone GDP fell 1.3 percent.

As could have been expected and despite the BOJ's valiant attempts and determination to keep the corporate debt sector afloat the massive decline in economic activities is transmitting itself quite dramatically into corporate debt markets. The cost of protecting Japanese corporate bonds from default rose to a record as the world’s second-largest economy battles a worsening recession.

The Markit iTraxx Japan index of credit-default swaps on the debt of 50 investment-grade borrowers rose 25 basis points from Feb. 10 to 455 at 12:55 p.m. in Tokyo, BNP Paribas SA prices show.

“The credit profile of the Japanese corporate sector has deteriorated quite substantially in the past couple of months, and the situation could get worse even though companies are trying to cut costs,” said Yasunobu Katsuki, chief credit strategist for Japan at Mizuho Securities Co. in Tokyo.

So, what is going on here? Well, I will tell you what is going on. Without the benefit of growth in foreign markets Japanese companies simply have no future revenues to sell and thus no collateral against which to sell debt. And why is this you might ask; well because, absent a solid growth in exports, Japanese companies have to rely on the domestic market for growth (at least to some extent) and this is quite literally impossible with Japan's demographic profile.

In the Eurozone, the Noose Tightens

Turning to my home turf in the form of Europe Eurostat published the the initial estimates for Q4 GDP and boy does it look ugly. Edward dishes up all the important arguments and data points; on Italy, Spain and Germany. Needless to say that the aggregate picture is reflective of this as GDP in the Eurozone contracted 1.5% over the third quarter and as a result analysts and commentators are pulling out big doom and gloom brush on this one.

Kenneth Wattret who is a senior economist at BNP Paribas simply noted that the news was dire and dished up the thump of a forecast that we are going to see three consecutive quarters of contraction as well as a huge rise in unemployment. Over at Illuminati, Jim O'Neill noted rather smugly that the downturn is worse in Europe than in the US which, given the fact that the whole thing started in the US, is quite an achievement as he puts it. In terms of economic dynamics the Eurozone is being hit by a severe slump in domestic demand as well as a sharp decline in global and intra EU27 trade volume (yes, my dear reader, the East-European connection is important). Add to this that governments in the Eurozone are pretty much out of bullets at this point as well as the fact that the ECB refuses to fire offs its, albeit timid, remaining slugs and the outlook is grim and nothing but grim.

How to Deal With That Abyss then?

I could go on and on dishing up one scary market report after the other (believe you me, I could!). However, it will suffice I think with a reference to Brad Setser's recent installment in which he simply notes how how this is now a truly global slump. As I have argued endlessly and as I try to sketch out in the context of global imbalances here and, more wonkishly, in the context of protectionism here we need to look at the export dependent economies why they have this characteristic and what it means. Brad Setser thus gets to the heart of the matter when he says;

It consequently is striking to me that the countries with the steepest falls in output in q4 have been the countries that are known for relying heavily on exports for growth –

They in effect are suffering from a sudden stop in global demand, which has given rise to a sudden stop in trade flows. Or perhaps a sudden stop in finance led to a sudden stop in demand, a sudden stop in trade and sharp falls in output.

For me it is not so striking, but then again I suspect it is not for Brad either because he, for one, has been breathing down Asia's neck with respect to the region's growth path. On this background, it is naturally presicient to ask what the hell to do? It has been clear for a while that Q4 data both corporate and macroeconomic would point to a severe slump and whether you are surprised or not is really not relevant at this point.

Going back to my initial remarks I will consequently end this on a reflective note.

It is true that in every recession the old adage "there is nothing to fear but fear itself" has some meaning. Psychology and (rational?) expectations are a wonderfully complex set of mechanisms really in relation to economics and it is obvious how, in the current environment, people can easily get very afraid of their own shadow. Better not to look in that abyss then it seems, and try to look elsewhere, perhaps outwards across the horizon towards better times. I would certainly hold that this is fundamentally a sound way to live your life and look at the existence of us all as we engage in those famous economic transactions (without going into a discussion of what FN really meant by this).

However, sometimes you also need to engage the demons which are looking back or more specifically; sometimes it is dangerously complacent to assume that one will actually have the opportunity to jump tomorrow. Tomorrow the chasm might have widened and you find yourself tumbling down towards the bottom. I remain fundamentally certain that we will jump as a global economy, but I sure hope that we won't loose too many to the abyss in the progress.

Friday, February 13, 2009

Germany's Incredible Shrinking Economy

The FT says this is worse than feared, and I say it is just what I was expecting (see here, I do hope that doesn't make me one of those "visionaries" you are all so busy talking about).

Germany’s economic slump in the final quarter of 2008 proved worse than feared, official figures showed on Friday, with the country posting the sharpest fall in gross domestic product since the country was reunified in 1990.The larger-than-expected 2.1 per cent plunge in GDP in the final three months of the year showed Europe’s largest economy contracting at a faster pace than the UK in the same period and threatening to drag down the performance of the 16-country eurozone.

A 2.1% quarterly contraction, for those who are confused by the way we economists do things is equivalent to an 8.4% annualised rate of contraction, which is quite something (although in fairness some of this comes from Q3 when there was a big build up in inventories, which has now unwound). But the real question, when all the dust settles, is going to be why it is that economies like those in Germany and Japan are so incredibly export dependent (remember, all those "decoupling" arguments which were so in fashion not so long ago). My view is "its the demography silly", but then we can't go back 30 years and change all that with the wave of a wand, so we really don need some out of the box thinking on the global imbalances soon (see Claus's arguments in his last post).

Meantime the EU are working furiously away on the next "top secret" European bank bailout proposal (does this have anything to do with the unexpected rapid departure of Michael Glos last weekend? - all of this was most strange, see here). Details are sof the coming bank bailout proposals are still scarce at this point, but the excitable Telegraph do come up with a very hair-raising number (16.3 trillion pounds, see here). As I have been arguing, far from Germany subsidising the rest of the EU, Germany may well be at the heart of the bailout, needing support from the rest of us, which is why we need EU bonds, and we need them now. United we stand, divided we go down the plughole!

And if you have any doubt about the export connection, just look at the chart below, not an exact fit, but an obvious close correlation. Germany needs a demographic fix, simply going for longer shopping hours (and the like) won't work in a case like this.

And as for labour market reforms, just look how many jobs Germany created this time round.

A case for (short term) Protectionism?

by Claus Vistesen: Copenhagen

It is not only economic data and the punditry and commentary following this which is all at rage at the moment, so is a growing mixture of more or less interesting debates amongst (academic) economists about public spending v. tax cuts, bloodletting v. actually doing something and, as it were, the odd case for or against protectionism. Add to this the growing array of voices attacking the inner workings of the economics profession and it seems that all the pieces are there to make it a nice rejuvenating time for economics as a social science. I still have my sincere hopes that this is true, but I am not sure that significant steps have been taken at this juncture.

Thus, and as much as I would like to have a go myself at the various themes and agendas flying around I have opted to stay a bit clear; or so I thought. As it turns out and with my most recent post I have inadvertently hauled myself into the eye of the storm in connection to the potential next major arena in the context of the discussion on protectionism, whether there is an extraordinary case to be made for it in the short run, and how the economics debate is still tainted by old ideologist knee jerk reactions (of which I may myself have fallen victim).
Yet before I get ahead of myself, let us return briefly to the initial writ which set my commenters and thus myself in motion.

My immediate impetus for writing the post was a leader in the Economist strongly opposing the provisions included in the recent fiscal stimulus passed before congress about buying American. I strongly latched on to the Economist's critique if anything then for my need to express the opinion that I wholeheartedly agree with those who are worried about the emergence of protectionist and nationalist voices from all over the globe as the going is set to get decidedly tough in 2009. Especially, I agree with the point that protectionist and economic nationalism are not likely to be merely short term even if good intentions are abound in the initial stages.

Now, the world is never black and white and most certainly not as black and white as the old and essentially arcane models of Ricardo's comparative advantage and Hecksher-Ohlin's three factor model would have us think (although the latter actually can predict why some factors (e.g. labour) loose out when engaging in free trade). In this way, I realize that just as I have been, on a personal level, much annoyed by the amount of knee-jerk ideologism and freshwater v. saltwater bla. bla. in the current debate, I realize that I may, inadvertently, have added myself to the roster of knee-jerk ideologists with my post on the Economist's leader. At least, I feel that I was rightfully taken somewhat to task by one very smart frequent commenter, Geert, who pointed me towards the danger of falling into the trap that Einstein so eloquently warned us against about making things simpler than the complexity of the situation demands (or so I understand his points). His full comment reads;[1]

Nationalism and protectionism should not be confused. The link made between them serves the purpose of mutening the debate on protectionism. What should be done is investigate whether the benefits of international comparitive advantages through specialization really exist and consequently why in some cases protectionism led to an ugly outcome.History shows that mutual advantages through specialisation do not really exist at least not in the long term and not in an objective sense, and that supposed free trade creates imbalances that are themselves the root of the ugly outcome that is contributed to protectionism. Most confuse symptoms and causes.The core issue is that in an ideal world where every country plays the game of free trade by the rules, it works, but that world never existed and will never exist. And it's easy to recognize the cheaters and benefitors of the game for they shout the loudest to keep "free" trade in this non-utopian world.

I find much sense in these points and especially so in the context of how comparative advantage does not constitute an objective truth even if it does seem so when you derive the increase in welfare after that horizontal tariff line has been removed in the SS/DD diagram. In this sense naturally, I stand on fairly wobbly ground with my initial stab at the protectionism discourse where I forcefully oppose the idea. I thus contend that even the most seemingly solid convention should not be believed nor asserted in too uncritical a manner.

So much for the mea culpa then, because it does not end here, far from it.

Consequently, my good friend Veronica also moved in with a comment and more concretely with a link to a post by Paul Krugman in which he makes the claim that perhaps, just perhaps, short term protectionism is warranted in the current situation. This naturally thickens the plot quite extensively and although I sort of squirmed out above, of my position taken initially, let me now reaffirm it by ever so humbly attempting to take the recent nobel laureate to task on this.

First of all and as could have been expected Krugman has taken a lot of flack for his hmm, let us call it musings on protectionism and for example in response to FT correspondent Clive Crook's comment on his suggestion Mr. Krugman labels the article as hysterical. Now, in all fairness, Crook's article is behind the firewall for me so I shall neatly stear clear of comment on that specific piece but Henry over at the Crooked Timber engages in an eloquent summary and discussion of the current combat between economic pundits, bloggers and journalists. As for Krugman, he makes the following point that I would like to emphasise;

Speaking of which, Clive and others have, in my view, a fundamentally flawed view of how to defend free trade. They believe that you should scream “Heresy! Sacrilege!” at anyone who even suggests that the world is more complicated than the simple Ricardian model of comparative advantage.

From the above it should be immediately be clear that I agree especially with the spirit of the argument and what is more, no sane economist would seriously believe that Krugman is advocating to slam on the tariff barriers and see the US return to some version of the old king of the hill doctrine (in an economic sense). Now the reason I reiterate this is that while I don't agree with Krugman here, I do think that it is worthwhile to see what in fact it is he argues since it does raise some very important points. More importantly, I tend to see Mr. Krugman in quite a high regard since I consider him one of the few economists in the know (Bernanke would be another, but that is for another day I think). On that note, let me begin my explaining what I actually think Mr. Krugman means since, and to be fair, he does not really articulate his view very well or does not want to spend time articulating what, perhaps, is ultimately a hypothetical point. For me the key quote is this ...

Let’s be clear: this isn’t an argument for beggaring thy neighbor, it’s an argument that protectionism can make the world as a whole better off. It’s a second-best argument — coordinated policy is the first-best answer. But it needs to be taken seriously.

The right argument, I think, is in terms of political economy. Everything I’ve just said applies only when the world is stuck in a liquidity trap; that’s where we are now, but it won’t be the normal situation. And if we go all protectionist, that will shatter the hard-won achievements of 70 years of trade negotiations — and it might take decades to put Humpty-Dumpty back together again.

But there is a short-run case for protectionism — and that case will increase in force if we don’t have an effective economic recovery program.

Now, in my post which set this off I said the following;

(...) arguments in favor of protectionism to ward of recessions are still build on nonsensical arguments; this recession is global and thus we must act globally to counteract it. More specifically, the free flow of goods, services, and capital is chief in whatever recovery we want to engineer.

With respect to Krugman's points there is an interesting link here. I argue a global way out, but to Krugman the idea of acting globally clearly seems an ideal but is, in the current environment, not possible and thus each economy should be able to ward for themselves. Of course, I have not fleshed out what I mean by "acting globally" and I shall not belabor it here since it is besides the immediate point I think [2].

Now turning to the economics of Krugman's argument and thus to more safe grounds for yours truly I see the argument as a sort "bang for the buck" argument. The US is spending a lot of money on this fiscal stimulus and in stead of using all the greenback propping up the US deficit and by consequence the US' creditors one should make sure that the money spent is actually to the benefit of the US economy. In essence, it seems as if Krugman believes that absent some targeted buy American strategy the fiscal stimulus would be somehow diluted. Now, whether this constitutes an argument about a closed economy relative to an open economy multiplier I shall not say, and before the ideological tomahawks come flying through the room I will not make inferences on this. In this immediate context, the argument may this sound a bit weird, but in fact it is not.

Consequently, I think that since one of the main economic features of the global economy is the nature of global imbalances by which the US is a provider of a huge amount of global capacity through the accumulation of more investment than is matched by domestic consumption, then one of the main routes we do not want to take is to take steps to solidify this trend. In this way, I concur that a world where the emerging world devalues at the same time as the OECD issues a truckload of IOUs to finance the cleanup is not necessarily the way ago. On the other hand, Italy is currently dependent on Libya to keep one of its biggest bank afloat and the US itself is also in a position where it needs to offload investment opportunities to foreign investors. So, it is not clear who would be helping who here.

Perhaps this is also here that I diverge from Mr. Krugman.

My own, albeit still most timid, research has lead me to the idea that the ability of economies to intertemporally substitute consumption for saving is not only central to understand the nature of the global economy, it is also at one and the same time the root as as the solution to our current plight. Let me explain further.

As a foundation, the idea of intertemporal substitution and consumption smoothing on the aggregate level is not new. In fact, it is almost as old as it gets. Originating from Irvin Fischer's seminal Theory of Interest published in 1930 the idea of intertemporal preferences and substition governed by a market and a subjective discount rate form one of the backbones of neo-classical economic modelling [3]. In this sense I propose no novelty but rather what I am arguing is that in a time of great demographic shifts of the magnitude we are seeing the idea of macroeconomic intertemporal substitution (and incidentally a thorough understanding of time horizons) becomes a crucial vehicle through which to understand the global economy as demographic changes are transmitted to the economy through the life cycle and life course. Specifically, we need to ask who is in fact going to do the importing in the future to sustain the growing emergence of some economies' intertemporal preference for excess domestic saving over investment and which economies should (can) we in, this context, rely upon to stand tall and perhaps even, oh dear oh dear, increase their debt towards its trading partners.

Krugman however starts elsewhere. For him, the reasoning seems to be that since we are in a global liquidity trap an uncoordinated global attempt to fight the fire would be less effective and that this is the reason why there might be a case for short term protectionism. This point is not without merit in terms of economic intuition. Since the different countries' and regions' response to this crisis by definition (almost) would be uncoordinated both in timing and measure, it might be better for each economy to allow for a home grown solution which are not diluted by carry traders and piggy backing by other economies reluctance to do something (and devalue instead) as its peers boost their economies fiscally. This, in my opinion, is what leads Krugman to argue that short run protectionism may in fact the world as a whole better off. Or perhaps if you would allow me to be polemical, it would make the US better off since what strikes me is that this argument is very well suited for the US situation since there is simply no way that the US can take up where it left before the abyss was opened by the subprime crisis.

It is thus on the global merits of short term protectionism that I disagree.

For me, the openness of the global economy and the recognition of why some economies have to export their way out of this mess is chief. As Krugman was adamant in pointing out on his behalf in the context of beggar thy neighbour policies, this is not an argument for a wave of competitive devaluations. However, I am quite confident in my claim that what we need is an asymmetry of responses whereby some economies should be allowed to devalue (export) their way out of trouble. If this turns protectionist in the form of some kind of "every man for himself" mantle, some economies will fall apart and their demise would have severe consequences for global financial and economic stability. However, I also recognize, for reasons stated above, that the US represents a somewhat special case in the sense that while I am fundamentally positive on the future of the US economy it is also now put in such a situation where desperate measures are needed. Yet, ultimately I don't think that short term protectionism should constitute one of these measures and conclusively I would pin my argument on two points.

First of all, I think that the Economist's intuition is fundamentally right; the probability that short term protectionism would be anything but this is very large. I am not necessarily referring to the historical example with Reed Smoot and Willis Hawley, but rather to the point that since this crisis is going to be long lived the risk of using protectionism in what ever explicit form is too large.

Secondly, I think that global current imbalances are important to take into account here and if we want to allow economies to enjoy the ability to substitute consumption for saving (and vice versa) over time one fundamental pre-requisite is a commitment to openness. This does not mean that this will be the solution in and of itself. As I also pointed out above, this openess and the factors which may be deliberate in a political sense (e.g. pegging to the USD forming BW II) or more structural (demographic) are also one of the roots to why we are here. Yet, I think that we are still better off not considering protectionism for the simple reason that I believe whole economies (and not just small ones) would be devastated as a result.

[1] - He elaborates his points in a new comment, and it is well worth a look.
[2] - Although I would strongly argue that organs such as the IMF, World Bank, etc be heavily engaged in the global hot spots and especially emerging markets.
[3] - And before I am hauled into court for actually uttering the words neo-classical economic modelling let me say that I am not a fundamentalist as to how this idea should be modelled or articulated. It is however a historic fact that one of the main sources of knowledge on how economic agents "smooth" consumption through time comes from economists such as Fisher, Harrod, Modigliani and Friedman. I am sorry, but that is the way it is; whether you like lagrange multipliers, calculus and equilibrium analysis or not.

Tuesday, February 10, 2009

Russian Debt And The Euro

Keynes’s genius – a very English one – was to insist we should approach an economic system not as a morality play but as a technical challenge.
Martin Wolf, Financial Times

The euro fell again yesterday, by 1.1 percent against the dollar (to $1.2860) and by 1.2 percent against the yen (to 117.52 yen). The change, even if quite large in a short space of time, is hardly dramatic, but what is of more interest is the why. Russian companies announced yesterday that they were thinking of opening negotiations to "restructure" their debt. Bloomberg:

The euro fell after a Russian bank official said the nation’s lenders asked the government to help moderate talks with foreign lenders on $400 billion of loans, adding to speculation financial turmoil in Europe is worsening.

The euro fell versus 13 of the 16 most-active currencies after Anatoly Aksakov, president of the Russian Association of Regional Banks, said in an interview with Bloomberg News that the group has written to the government after talking with foreign banks. He said $135 billion of the loans are due this year and the remainder of the $400 billion within four years.

The “report of rescheduling debt is driving the euro lower because European financial institutions have a bigger exposure to Russia than their counterparts in other countries,” said Takashi Kudo, Tokyo-based director of foreign-exchange sales at NTT SmartTrade Inc., a unit of Nippon Telegraph & Telephone Corp., Japan’s largest fixed-line phone company.

And then there is Kazakhstan to think about:

Kazakhstan’s banks may have their ratings cut as the devaluation of the nation’s currency makes it harder for them to repay foreign debt and “substantially increases” credit risk, Moody’s Investors Service said yesterday.

And Mr Euro, like me, is getting worried:

The widening spreads between the interest rates that different euro-area nations must pay bond investors are “worrying developments,” according to a “speaking note” prepared for Luxembourg Finance Minister Jean-Claude Juncker and obtained by Bloomberg News.

In fact, while there is a growing feeling that the worst phase of the financial-system meltdown may be over in the U.S, unease is mounting that here in Europe the worst may be yet to come. The reason? Europe's commercial banks have more exposure to distressed emerging markets than their U.S. counterparts. By one estimate, European banks provided three-quarters of the $4.7 trillion in cross-border loans to the Baltic countries, Eastern Europe, Latin America and emerging Asia. Thus it is quite likely that the emerging-markets exposure of European banks exceeds even that of U.S. lenders to Alt-A and subprime loans.

“People expect that part of these debts were from the European banking system,” said Sebastien Barbe, a strategist at Calyon in Hong Kong, the investment banking unit of France’s Credit Agricole SA. “You already have a very weak banking system in Europe. If you have these Russian issues, the next step would be questions about whether similar problems will come out of other Eastern European countries.”

Dory Wiley, president of Commerce Street Capital, a money-management firm that invests in banking stocks argues that "most of the big banks in Europe are insolvent........That is what made them great - but unpredictable - shorts. They represent major components in those country funds everyone buys." The big danger now is that European governments, since they are the prime backstops for their commercial banks, will see their debt liabilities balloon and steadily be forced, in a domino like contagion process onto the slippery path towards downgrade, rising yield spreads and default.

Unicredit Saved Again By Libya

I think it should now go without saying that Unicredit is deeply involved in many of the most problematic countries from this point of view - Russia, Ukraine and Kazakhstan to name but three. So while, as reported here yesterday, the Italian bank seems to have scraped its way over the latest hurdle thanks largely to the timely intervention of the Libyan central bank, this hardly seems to be a stable situation (links to the posts which give some background on all of this can be found here).

Libya's central bank will fill half of a 500 million euro ($645.5 million) gap in bank UniCredit SpA's 3 billion euro capital raising measures, newspapers reported on Monday. Shareholders Fondazione Cassa di Risparmio di Torino (CRT) and Carimonte Holding will also take up about 230 million euros of the shortfall, Il Messaggero newspaper said...........La Stampa said Libya's central bank would hold about 7 percent in UniCredit after the capital increase and become the biggest single shareholder.

Making The Punishment Fit The Crime, Or the Crime Fit The Punishment?

Many readers are, unsurprisingly, outraged by the idea that the EU should create bonds to help a distressed Italian (or Austrian, or Irish) banking sector. Typical of many responses is this from an Italian:

I'd favour a liberal approach, but it's only my humble opinion, anyway I think bad banks should have to pay for bad policies, households should have to pay for their reckless borrowing, governments should have to pay for communicating the sunstainability of currency pegs and expantion policies. I'd like to see these kind of attitude, negotiating a volunteer currency convesion and a longer repayment time for forex loans, sharing the losses and extra costs among banks borrowers and government. otherwise the ones who acted properly will not see any advantage in acting the right way.

I think this view is being advanced in a very well meaning way, in the sense that the person voicing it simply wants to see some sort of justice, some sort of sense of responsibility. But as I pointed out in my reply to him, the issues here are systemic ones, and the majority of Germany's citizens are hardly responsible for the bad decisions made by representatives of the Russian subsidiaries of their banks. What I am trying to say is there is no effective mechanism as far as I can see whereby those who took the decisions (many of whom are already bankrupt, and others soon to become so) can be made to pay up and put things right. Meantime innocent parties get trampled on. Being intentionally emotive for a second, think about the one million people who lost their jobs in India in December, and all those millions of other people in poor countries across the globe, what responsibility did they have for the irresponsible lending practices of a limited group of Unicredit managers and employees who caused the financial shock waves they are now receiving?

Take the Latvian case. Looking through the IMF standby loan document, I was amazed to find that as a result of this bailout national debt to GDP will rise from 8% in 2008 to 50% in 2010. The thing is the only "crime" of those Latvian citizens caught up in the Parex problem were those who happened to have their money on deposit there. Now such were the covenants on the syndicated loans contracted by the banks that those who provided them (they certainly knew what they were doing) seem to have first call on any funds the government puts into the bank over and above the needs of the hard pressed depositors. Given the rapid population ageing Latvia now has coming and the serious economic growth problem they face as a result of the boom bust my feeling is that they will be unable to fully recover from the blow and will more than likely have to do some sort of sovereign default at some stage - unless, of course, they are admitted to the eurozone, the debt is "restructured" and some kind of EU institutional support offered. I personally consider the current "sit back and watch" approach to be grossly unfair, especially given that the root of their problem really lies in making it a condition of their EU membership that they join the eurozone, and then withdrawing the possibility when the financial destabilising effects of the original condition send their economy sprialing out of control.

Bad decisions were certainly taken by Latvian politicians, but I have no doubt that the fundamental structural cause of their current problems was the one I have just mentioned. So sending a whole country into bankruptcy because of the decisions and speculation of a few people in a bad bank does not seem to be like using our emotional intelligence, and this is why I think the EU have to help them. We simply cannot continue to perpetuate this kind of injustice in our midst.

I can't help feeling that inflicting significant economic pain on large numbers of innocent people is not a fitting process of retribution. It is more akin to the unfortunate campaign of intensive bombing carried out by the Allied Powers against Dresden, simply to make the German people "pay" for the crimes of Adolf Hitler. It is amazing to me that we are still having the same kinds of argument 60 odd years later.

We live in an imperfect world and the reality principle suggests we accept it as such. When you get hit by a tragedy in your life the best advice, I think, is that you do a bit of psychological counselling, put the issue behind you, and get on with your life. Don't go off on a "fatal attraction" kind of obsessive vendetta to try to make the guilty parties pay. Just do what has to be done, stop Europe's financial system melting down, change the regulations for the future, and let's all go to work and get on with things. A first step in this direction would be - as I argued on Sunday - for the EU Commission to negotiate a substantial EU Bonds issue with the Swedish, Italian and Austrian governments, and stopping the rot on this whole problem before things get further out of hand.

Saturday, February 07, 2009

Italy Needs EU Bonds And It Needs Them Now!

You see, this isn’t a brainstorming session — it’s a collision of fundamentally incompatible world views.
Paul Krugman

As a wise man recently said, failure to act effectively risks turning this slump into a catastrophe. Yet there’s a sense, watching the process so far, of low energy. What’s going on?
Paul Krugman
First, focus all attention on reversing the collapse in demand now, rather than on the global architecture. Second, employ overwhelming force. The time for “shock and awe” in economic policymaking is now.
Martin Wolf

OK, I think no regular reader of this blog could seriously suggest I have much sympathy for the sort of views you normally find being propagated by Italy's Finance Minister Guilio Tremonti, but when he starts to send out the kind of red warning light danger signals that he has been doing over recent days, then I think we should all be taking note, and when the republic is in danger, then its all hands to the pumps, regardless of who is sounding the alert. This is not a brainstorming session, it is a real flesh and blood crisis.

Perhaps few of you will have noticed it, but our erstwhile logician has been getting extremely nervous in recent days, and most notably chose his visit to Davos to indicate that he personally would look extraordinarily favourably on any move to inititiate the creation of EU bonds (for a brief explanation of why these are important, see Wolfgang Munchau's argument in favour of such bonds here. (Or the longer version here)

Italy's Finance Minister Giulio Tremonti has said he favoured the issuance of government debt by the European Union. "Now my feeling -- I am speaking of a political issue not an economic issue -- is ... now we need a union bond," Tremonti said at the World Economic Forum in Davos. Countries in the euro zone currently issue sovereign debt in their own name, rather than regionally. Bond traders concerned about the mounting public debt of Italy, Greece and Ireland have pushed down the value of their government bonds, sparking speculation they might be driven out of the euro zone.

Now why would he be arguing this? Well the state of Italy's own banking sector would be one part of the explanation, and the fact that the Italian government is in no position to mount a rescue operation on its own given the size of its existing debt to GDP commitment, would be another. In particular, and as I have been arguing, Unicredit - and its Eastern Europe exposure - is a huge worry.

Indeed the situation is now so delicate, that according to this Reuters report last week, Unicredit really doesn't know which government to turn to. The Italian one perhaps, or the Polish one, or "it could consider doing it in Austria".

Italian bank UniCredit is considering requesting state support in Italy and Poland, a source close to the bank told Reuters on Thursday. "The bank does not exclude possible state support in Italy and Poland," the source said on condition of anonymity. In an extract of an interview to be published in Germany's Handelsblatt newspaper on Friday, UniCredit Chief Executive Alessandro Profumo said the bank could consider "state support as insurance against unpredictable events." If the bank does seek state aid, it could consider doing it in Austria, for example, he added.

UniCredit SpA is considering asking for government capital amid the credit crunch, Chief Executive Officer Alessandro Profumo said. “State support as insurance for unforeseeable events” is conceivable, Profumo told Handelsblatt newspaper in an interview at the World Economic Forum in Davos, Switzerland. A UniCredit official confirmed the comments to Bloomberg. Italy’s top bankers met with central bank Governor Mario Draghi last week to discuss the financial crisis, which has caused bankruptcies and government bailouts across the world, while stocks have plunged and credit markets have seized up. UniCredit and some of its rivals have tumbled in Milan since the start of 2008 amid concern about the strength of their finances.
Bloomberg 29 January 2009

The announcement that Unicredit was seeking state aid came on the same day that the bank admitted that investors had placed orders for only 0.5 percent of the shares they were offering in a rights issue. The bank received orders for a mere 14.3 million euros of stock out of a total of 3 billion euros, and the plan was to sell leftover stock in the form of convertible bonds, but even this hit a snag, as

The shares were offered at 3.083 euros apiece, or over twice what they were trading for in Milan at the time (around 1.408 euros). Shareholders, including Allianz SE and the Central Bank of Libya, are among those who agreed to buy the convertible bonds, according to the bank offer document. Shares of UniCredit have dropped 54 percent since October, when the rights offering was announced, amid concern the capital raising won’t be sufficient. But even the bonds issue is running into trouble, since Il Sole 24 Ore reported that Unicredit may raise only 2.5 billion euros rather than the full 3 billion euros because because investor Fondazione CariVerona, which holds a 5 percent stake in the bank, reportedly hasn’t received approval from the government to buy the securities, however, the reason they have not received approval may well be that they have not yet applied since the Italian Treasury, in what is a rather unusual step, said on Thursday announced that they had yet to receive a request from CariVerona to sign up for the bond issue. All this suggests, of course, that Tremonti's warning about an imminent bailout could be a piece of brinksmanship, designed to presssure CariVerona to stop playing "positioning" games and come up with the money, but irrespective of whether or not this is the case, some sort of rescue operation for Unicredit surely cannot be far away at this point.

And the fact that Bulgaria's Finance Minister Plamen Oresharski was running around last week assuring everyone that Bulgaria's banks have not asked for state rescue aid so far, and that the government is not worried about the banking system's health for now, is hardly helping to calm already troubled nerves. About 80 percent of the 29 commercial banks operating in Bulgaria are foreign-owned, with the biggest lenders being run by Italy's UniCredit, Hungary's OTP Bank, Greece's National Bank of Greece and Austria's Raiffeisen.

And only today Tremonti has warned that the announcement of more EU bank bailouts is imminent, and maybe as early as this weekend.

European governments may have to bail out more banks as soon as “this weekend,” Italian Finance Minister Giulio Tremonti said today. “So far in Europe there have been more than 30 bank bailouts and I can’t rule out that there will be more this week- end,” Tremonti said, speaking at a press conference after today’s Cabinet meeting in Rome.

So how should we address this danger, imminent or otherwise? At this point in time I have four proposals:

a) The creation of EU bonds
b) The introduction of quantitative easing by the ECB (quantitative easing is the monetary policy which is currently being applied in both the US and Japan, and probably soon in the UK too).
c) Letting those members of the East who want to join the eurozone immediately do so.
d) A new "pact" - one which would be much, much stronger than the old Stability and Growth Pact - to be signed by all countries who enter the EU bond system, a pact which gives direct fiscal remedies to Brussels in the event of non-compliance together with a substantial dose of effective control over the economies of individual countries - since nothing, Mr Sr. Tremonti, ever comes completely for free.

Obviously all of this is quite radical, and indeed fraught with danger, but these are hardly normal times. In all of this (d) is obviously the most important part, as any protection given to EU member economies by the Union must be credible and serious. So no country could or should be forced in, but it should also be pointed out to those who chose sovereignty and remaining on the fringes to participation that they would run an enormous risk. Since almost all EU economies seem vulnerable at this point, anyone staying outside could rapidly see themselves exposed to the risk of forced default, since lack of protection is simply an invitation to attack. Letting ourselves get picked off one by one is not an appetising prospect (Latvia, Hungary, Greece, Austria, Italy, Spain, Ireland, the UK, Romania, Bulgaria.........).

Clearly those who wish to remain "dissenters" should have the liberty to do so, but they should bear well in mind that should they do so they could very easily end up in a group - possibly lead by Diego Armando Maradona - together with Yulia Timoshenko (Ukraine), Cristina Fernadez (Argentina), Rafael Correa (Ecuador) and (possibly) whoever is the new prime minister in Iceland, bankrupt, and without the aid of international financial support to help deal with their mess.

Perhaps readers may think I am being rather shrill here, and perhaps at this point Tremonti (for whom I have no afinity, elective or otherwise, see linked post above) is only playing brinksmanship, but if he isn't, and Unicredit is about to need bailing out, then push does quickly come to shove, since the EU leaders agreed on October 12 in Paris to bail out systemic banks, and Unicredit is a systemic bank. So will will need to know how they plan to stand by their commitment, and if they don't, well then everyone of us stands exposed, since credibility rapidly falls towards zero.

Maybe this is a false alarm situation, and Unicredit will not need bailing out this weekend, or the next one, but one day it will, and one day Spain's huge non performing loan and household debt default problem is going to need sorting out. So I think this is a line in the sand situation, and we are much nearer to having to make up our minds which side of the line we are on than many seem think.

To paraphrase Paul Krugman again, in flirting with the idea of whether the first to default should be Greece, or Hungary, we truly are flirting with disaster.