Thursday, February 18, 2010

Drawing the Right Lessons from an Obscure tale of Obsure Interest rate Swaps

By Claus Vistesen: Copenhagen

The Eurozone's current problems are not mainly a result a of prolifigate and reckless spending of government resources in the Eurozone periphery [1]. Even nobel laureate Paul Krugman has begun to forcefully push this argument arguing that the real source of the malaise is the steady build up internal Eurozone imbalances. I only conditionally agree. As I have argued on several occasions, the key to understand the current situation in the Eurozone is to see the connection between the obvious inflection point reached in the context of the public debt/deficit and the need to correct through an internal devaluation (relative price deflation). The main point is then to recognize that the while the former is definitely a prerequisite for the latter, the process itself (deflation) will only serve to intensify the short term and long term pressure on public finances.

Moreover, the recent flurry in the context of interest rate swaps used by the Eurozone (and other) governments to generate current assets for future liabilites in an effort to massage public deficits only serves to add a further layer of confusion and uncertainty to the fiscal aspect of the situation. More generally, and ever since the inception of EMU the growth and stability pact (SGP) has been critisized for being an ineffective tool to police the need for fiscal soundness in the Eurozone member countries. The re-emerging discussion on on the use of interest rates swaps and other financial instruments by Eurozone member countries only further serves to emphasize this critique. Interestingly and despite the rather massive coverage, many financial market pundits have emphasized this as a non-event because the use of such techniques are not new [2]. I respectfully disagree that this is the main point here even if I agree that the there is no reason, in particular, to point the guns at Goldman Sachs [3] either.

In this way, I think this is in fact quite significant, and I am a bit surprised to see that no-one (bar my regular complice) seems to be getting the main drift here. This is consequently not a question of creative accounting by part of Eurozone debt management offices, but simply a question of drastically poor balance sheet management. Thus, one wonders where we would have been today if these people had actually studied the nature of assets and liabilities of the institutions (i.e. (macro)economies) they were employed to safeguard and how it is affected by things such as a population ageing and the demographic transition rather than studying more or less exotic financial instruments (click on picture for better viewing).

Oh well and before I turn completely Neanderthal on you I am obviously being unfair here. There is nothing wrong with an interest rate swap itself and anyone with even a basic economic intuition can see the clever and sound proposition offered by an interest rate swap in the context of debt issued in foreign currency while your liabilities, obviously, remain in domestic denomination. This would be good balance sheet management then.

What transforms it into poor debt management and essentially poor governance is when those same currency swaps are entered at an exchange rate which is unfavorable to the private market counterparty. The immediate effect is to create a lump sum transfer of funds to the issuer of the underlying debt (e.g. Greece). This is then used to bring down the running deficit or the public debt for the purpose of reducing interest rates. However, it also creates a future liability not recorded in the balance sheet. Felix Salmon provides the best no-nonsense explanation I have seen so far;

How might a deal like this work? Let’s say that Greece issues a bond for $10 billion, which it would then normally swap into euros at the prevailing interest rate, getting $10 billion worth of euros up front. In this case, it seems, the swap was tweaked so that Greece got $11 billion worth of euros up front — and, of course, has to pay just as many euros back when the bond matures. Essentially, it has borrowed $11 billion rather than $10 billion. But for the purposes of Greece’s official debt statistics, it has borrowed only $10 billion: the extra $1 billion is hidden in the swap.

So, why might this be a problem then? Well for a whole host of reasons, but I can think of one in particular.

Essentially, the future liabilities (and assets) of the state finances of Greece, Italy and all other sovereign states ultimately hinges on the demographic transition. At least, this is the case in developed economies where societal structure is largely built upon intergenerational contracts and various forms of pay-go pension and health systems. In this way, trading liabilities into the future for a short term cash flow concretely helps to undermine already eroded public finances. But it gets worse. It creates a mismatch on the balance sheet of the government which is effectively hidden from the market and other stakeholders. More worryingly is then the fact that while these swaps imply long term lump sum liabilities such liabilities can easily be discounted to the present and in the current context with bond vigilanted at large fixing their gaze on the Eurozone sovereigns, long term liabilites may soon turn into current ones if push comes to shove (i.e. this is then what the Titlos affair is all about). This naturally directly undermines whatever credibility the SGP had left, but it also effectively adds uncertainty to a situation which is already beyond difficult for the EU and the Eurozone to handle.

Now, at this point all this is obviously water under the bridge and what is really left now is to slowly but surely try to figure out the extent of the liabilities Eurozone governments have swept under the carpet. As noted, the maturity structure on such instruments mean that while they are not set to payment in the immediate future the implied future liability and its effect on the current stalwart attempts to breathe life back into these economies is likely to make all those neat recovery plans drafted so far worth next to nothing. I would hold this to be particularly true in light of the obvious fact that this is not only something done on the sovereign level, but also on lower levels of governance. It will be interesting indeed to see whether the bond vigilantes will draw the final gasp on this one.

The Right Lesson

At the end of the day the issue of interest rate swaps and other derivatives used by public entities to hide and mask debt is likely going to pass over quickly exactly because it is, as the current choir sings, not news. I understand this dynamic of the market discourse. However, this should not deter a simple macroeconomist from drawing out a longer line of thought.

In this way, I believe that if the Eurozone is going to have a credible future on the back of this mess, it must be equipped with institutions that adamantly establishes a much tighter fiscal coordination mechanism among its member economies. The flurry described above only serves to accentuate this furhter. The SGP should thus be relegated to the eternal dust bin of poor institutional setup where it deserves to be

The idea of a common monetary union was always flawed in a number of ways, but there is also a way forward. Yet, it requires I believe a much more transparent fiscal supranational body to complement the single monetary policy wielded in Frankfurt. Naturally, this will not solve any of the looming problems in the context of how to get and sustain growth faced with a demographic transition locked in towards very rapid ageing. However, it may provide a sound institutional setup on which to start building a future more solid economic edifice.

Many will recoil in horror from this blatant political and Eurofederalist argument. Let them recoil I say, but as an economist I see no other alternative. And that, contrary to blaming Goldman Sachs or emphasizing the fact that it is not news, is exactly the right lesson to draw from an obscure tale of obscure interest rate swaps.


[1] - Someone please look at the future liabilities of Germany!

[2] - See an original source here, this from FT Alphaville, as well as this which is the original academic piece detailing the issue in an Italian context.

[3] - Who has been under much scrutiny by part of the Eurozone finance ministers in the context of a particular swap arranged with Greece back in February 2009 under the notional name of Titlos PLC (all this is very wonkish!)

Sunday, February 14, 2010

Just What Is The Real Level Of Government Debt In Europe?

“If you don’t fully understand an instrument, don’t buy it.”

To the above advice from Emilio Botín, Executive Chairman of Spain’s Grupo Santander, I would simply add one small rider: Don’t sell it either, especially if you are a national government trying to structure your country’s debt.

In a fascinating article in today's New York Times, journalists Louise Story, Landon Thomas and Nelson Schwartz begin to recount the mirky story of just how the major US investment banks have been able to earn considerable sums of money effectively helping European governments to disguise their growing mountain of public debt.
Wall Street tactics akin to the ones that fostered subprime mortgages in America have worsened the financial crisis shaking Greece and undermining the euro by enabling European governments to hide their mounting debts.

As worries over Greece rattle world markets, records and interviews show that with Wall Street’s help, the nation engaged in a decade-long effort to skirt European debt limits. One deal created by Goldman Sachs helped obscure billions in debt from the budget overseers in Brussels.

Even as the crisis was nearing the flashpoint, banks were searching for ways to help Greece forestall the day of reckoning. In early November — three months before Athens became the epicenter of global financial anxiety — a team from Goldman Sachs arrived in the ancient city with a very modern proposition for a government struggling to pay its bills, according to two people who were briefed on the meeting. The bankers, led by Goldman’s president, Gary D. Cohn, held out a financing instrument that would have pushed debt from Greece’s health care system far into the future, much as when strapped homeowners take out second mortgages to pay off their credit cards.

In fact, concerns about what it is exactly Goldman Sachs have been up to in Greece are not new, and the Financial Times have been pusuing this story for some time, in particular in connection with the investment bank's ill fated attempt to persuade the Chinese to buy Greek government debt (and here, and here). Nor is the fact that the Greek government resorted to sophistocated financial instruments to cover its tracks exactly breaking news, since I (among others) have been writing about this topic since the middle of January - Does Anyone Really Know The Size Of The Greek 2009 Deficit? - following the arrival in my inbox of a leaked copy of the report the Greek Finance Minister sent to the EU Commission detailing the issues.

What is new in today's report from the NYT team is the extent to which they identify the problem as a much more general one, involving more banks and more countries, since "Instruments developed by Goldman Sachs, JPMorgan Chase and a wide range of other banks enabled politicians to mask additional borrowing in Greece, Italy and possibly elsewhere". I very strongly suggest that our NYT stalwarts take a long hard look at what has been going on in Spain, and especially at the Autonomous Community level.

So the question naturally arises, just how much in debt are our governments, really? As the NYT team point out, Eurostat has long been grappling with this matter, and as far back as 2002 they found themselves forced to change their accounting rules, in order to try to enforce the disclosure of many off-balance sheet entities that had previously escaped detection by the EU, since up to that point the transactions involved had been classified as asset "sales", often of public buildings and the like. Following advice paid for from the best of investment banks many European governments simply responded to the rule change by reformulating their suspect deals as loans rather than outright sales. As we say in Spain "hecha la ley, hecha la trampa" (or in English, when you close one loophole you open another). According to the NYT authors:

"As recently as 2008, Eurostat.... reported that “in a number of instances, the observed securitization operations seem to have been purportedly designed to achieve a given accounting result, irrespective of the economic merit of the operation.”"

So just what is all the fuss about. Well, in plain and simple terms it is about an accounting item known as "receivables". Now, according to the Wikipedia entry:

"Accounts receivable (A/R) is one of a series of accounting transactions dealing with the billing of a customers for goods and services received by the customers. In most business entities this is typically done by generating an invoice and mailing or electronically delivering it to the customer, who in turn must pay it within an established timeframe called credit or payment terms."

However, as we can learn from another Wikpedia entry, often the use of "accounts receivable" constitutes a form of factoring, and this is where the problems Eurostat are concerned about actually start:

Factoring is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount in exchange for immediate money with which to finance continued business. Factoring differs from a bank loan in three main ways. First, the emphasis is on the value of the receivables (essentially a financial asset), not the firm’s credit worthiness. Secondly, factoring is not a loan – it is the purchase of a financial asset (the receivable). Finally, a bank loan involves two parties whereas factoring involves three.

But how does all this work in practice? Well, the World Wide Web is a wonderful thing, since you have so much information near to hand, at just the twitch of a fingertip. Here is a useful description of what are known as PPI/PFI schemes, from UK building contractor John Laing:
A Public Private Partnership (PPP) is an umbrella term for Government schemes involving the private business sector in public sector projects.

The Private Finance Initiative (PFI) is a form of PPP developed by the Government in which the public and private sectors join to design, build or refurbish, finance and operate (DBFO) new or improved facilities and services to the general public. Under the most common form of PFI, a private sector provider like John Laing will, through a Special Purpose Company (SPC), hold a DBFO contract for facilities such as hospitals, schools, and roads according to specifications provided by public sector departments. Over a typical period of 25-30 years, the private sector provider is paid an agreed monthly (or unitary) fee by the relevant public body (such as a Local Council or a Health Trust) for the use of the asset(s), which at that time is owned by the PFI provider. This and other income enables the repayment of the senior debt over the concession length. (Senior debt is the major source of funding, typically 90% of the required capital, provided by banks or bond finance). Asset ownership usually returns to the public body at the end of the concession. In this manner, improvements to public services can be made without upfront public sector funds; and while under contract, the risks associated with such huge capital commitments are shared between parties, allocated appropriately to those best able to manage each one.

And for those still in the dark, Wikipedia just one more time comes to the rescue:

The private finance initiative (PFI) is a method to provide financial support for "public-private partnerships" (PPPs) between the public and private sectors. Developed initially by the Australian and United Kingdom governments, PFI has now also been adopted (under various guises) in Canada, the Czech Republic, Finland, France, India, Ireland, Israel, Japan, Malaysia, the Netherlands, Norway, Portugal, Singapore, and the United States (amongst others) as part of a wider program for privatization and deregulation driven by corporations, national governments, and international bodies such as the World Trade Organization, International Monetary Fund, and World Bank.

PFI contracts are currently off-balance-sheet, meaning that they do not show up as part of the national debt as measured by government statistics such as the Public Sector Borrowing Requirement (PSBR). The technical reason for this is that the government authority taking out the PFI contract pays a single charge (the 'Unitary Charge') for both the initial capital spend and the on-going maintenance and operation costs. This means that the entire contract is classed as revenue spending rather than capital spending. As a result neither the capital spend nor the long-term revenue obligation appears on the government's balance sheet. Were the total PFI liability to be shown on the UK balance sheet it would greatly increase the UK national debt.

And here are two more examples of what is involved which were brought to light by a quick Google. First of all, the case of Italian health payments. Now according to analysts Patrizio Messina and Alessia Denaro, in this report I found online from Financial Consultants Orrick:

In the last years many structured finance transactions (either securitisation transactions or asset finance transactions) have been structured in relation to the so called healthcare receivables.The reasons are several. On one side, the providers of healthcare goods and services usually are not paid in time by the relevant healthcare authorities and therefore, in order to gain liquidity, usually assign their receivables toward the healthcare authorities. On the other side, due to the recent legislation that provides for very high interest rates on late payments, the debtors as well as banks and other investors have had the same and opposite interest on carrying out different kind of transactions. In this brief article we will analyse, after a quick description of the Italian healthcare system, some of the different structures that have been used in relation to transactions concerning healthcare receivables and, in particular, we will focus on transactions concerning the so called “raw receivables”, which are lately increasing in the Italian market practice, by analysing the legal means through which it is possible to ascertain/recover such receivables.

This system thus has two advantages (apart from the fact that it effectively hides debt). In the first place the healthcare providers gain liquidity in order to continue to run hospitals, pay doctors, etc, while those who effectively intermediate the transaction earn very high interest rates for their efforts, interest payments which have to be deducted from next years health care provision, and so on.

As the Orrick report points out, Italy’s national healthcare service (servizio sanitarionazionale, “nhs”) is regulated by the legislative decree of December 30, 1992, no. 502 (“decree 502/92”).The reform introduced by decree 502/92, as amended from time to time, provides for a three-tier system for the healthcare service, as outlined below: State level The central government provides a national legislation limited to very general features of the NHS and decides the funds to be allocated to the single regions according to specific criteria (density of population, etc.) for the NHS.

As the Orrick analysts note: "the Healthcare Authorities usually pay the relevant Providers with a certain delay".
Usually, when healthcare funds are allocated, in the national provisional budget, the central government underestimates the amount of healthcare expenditure. Since the central government does not provide regions with enough funds, regions are not able to provide enough funds to Healthcare Authorities, and payments to the Providers are delayed. Since the Providers need liquidity, they usually assign their receivables toward the Healthcare Authorities. To deal with all the above issues, Italian market practice has been developing an alternative system of financing through securitisation and asset finance transactions of Healthcare Receivables.

As the analysts finally conclude:

Despite of the risks concerning the judicial proceedings, Italian market players are still very interested on carrying on securitisation transaction on this kind of asset, principally because Legislative Decree no. 231/02 provides for very high interest rates on late payments (equal to the interest rate applied by ECB plus 7%) - my emphasis

Another technique Eurostat have identified as a means of concealing debt relates to the recording of military equipment expenditure, as described in this report I found dating from 2006. At the time Eurostat were worried about the growing provision of military equipment under leasing agreements. Basically they decided that such provision was debt accumulable.
Eurostat has decided that leases of military equipment organised by the private sector should be considered as financial leases, and not as operating leases. This supposes recording an acquisition of equipment by the government and the incurrence of a government liability to the lessor. Thus there is an impact on government deficit and debt at the time that the equipment is put at the disposal of the military authorities, and not at the time of payments on the lease. Those payments are then assimilated as debt servicing, with a part recorded as interest and the remainder as a financial transaction.

However, a loophole was found in the case of long term equipment purchases:

Military equipment contracts often involve the gradual delivery over many years of a number of the same or similar pieces of equipment, such as aircraft or armoured vehicles, or including significant service components, such as training. Moreover, in the case of complex systems, it is frequently the case that some completion tasks need to be performed for the equipment to be operational at full potential capacity. Some military programmes are based on the combination of several kinds of equipment that may be completed in different periods, so that the expenditure may be spread over several fiscal years before the system, globally considered, becomes fully operational.

In cases of long-term contracts where deliveries of identical items are staged over a long period of time, or where payments cover the provision of both goods and services, government expenditure should be recorded at the time of the actual delivery of each independent part of the equipment, or of the provision of service.

Payment for such items are only to be classifed as debt at the time of registering the actual delivery, which may explain why, if my information is correct, the Greek military as of last December were still officially "testing" two submarines which had been provided by German contractors, since final delivery had still to be formally registered, and the debt accounted.

A lot of information about the kind of things which were going on before the 2006 rule change can be found in this online presentation from Europlace Financial Forum. Here are some examples of private/public sector cooperation in Italy.

And here's a chart showing a list of advantages and possible applications:

Now, at the end of the day, you may ask "what is wrong with all of this"? Well quite simply, like Residential Mortgage Backed Securities these are instruments that work while they work, and cause a lot of additional headaches when they don't. I can think of three reasons why debt aquired in this way in the past may now be problematic.

a) they assume a certain level of headline GDP growth to furnish revenue growth to the public agencies committed to making the payments. Following the crisis these previous levels of assumed growth are now unlikely to be realised.
b) they assume growing workforces and working age populations, but both these, as we know, are now likely to start declining in many European countries.
c) they assume unchanging dependency ratios between active and dependent populations, but these assumptions, as we also already know, are no longer valid, as our population pyramids steadily invert.

Given all this, a very real danger exists that what were previously considered as obscure securitisation instruments, so obscure that few politicians really understood their implications, and few citizens actually knew of their existence, can suddenly find themselves converted into little better than a glorified Ponzi scheme.

And if you want one very concrete example of how unsustainable debt accumulation can lead to problems, you could try reading this report in the Spanish newspaper La Verdad (Spanish, but Google translate if you are interested), where they recount the problems being faced by many Spanish local authorities who are now running out of money, in this case it the village of San Javier they have until the 24 February to pay a debt of 350,000 euros, or the electricity will simply be cut off! The article also details how many other municipalities are having increasing difficulty in paying their employees. And this is just in one region (Murcia), but the problem is much more general, as Spain's heavily overindebted local authorities and autonomous communities steadily grind to a halt.

Friday, February 12, 2010

Poor Eurozone GDP Figures for Q4-2009

By Claus Vistesen: Copenhagen

GDP releases are, by their very nature, lagging indicators and thus do not tell us a whole lot about the current momentum in an economy. Moreover, the immediate focus of attention in the Eurozone remains, and rightly so, the situation in Greece (and Spain), and what precise plans are likely to emerge from the busy schedule meetings which is taking place between Eurogroup and EU finance ministers and heads of states. Yet, despite all the known shortcomings, GDP data remains our basic source of information about the health and progress of our economies, and with the Q4 data out today and the 2009 GDP summary we are able to arrive at some sort of interim conclusion [1] on what was obvioiusly an absolutely abysmal 2009. More importantly we are also able to take stock of a recovery which permanently promises to arrive, but never actually seems to do so, much to the chagrin, I am sure, of the various Eurozone policy makers (click for better viewing)

Call me smug if you will, but I for one am not surprised to see that France is all over this reading and basically it is thanks to France that the Eurozone is seeing growth at all. I would venture the claim that this is the beginning of a trend. In terms of the figures, the Eurozone (EU16) grew 0.1% from Q3 when the economy pulled out of recession by growing 0.4% qoq. The figure was primarily held down by continuing contractions in Greece and Spain (-0.8% and -0.1% respectively) as well as of course the stagnation in Germany where the growth rate was flat at 0% qoq after a strong showing in Q3. In Italy, the strong rebound in Q3 GDP at 0.6% qoq was somewhat given back in the form of a -0.2 contraction in Q4.

Year on year, Eurozone output fell by 2.1% with Germany, Greece, France, Spain, and Italy contracting 2.4%, 2.6%, 0.3%, 3.1 and 2.8% respectively.

The biggest losers with respect to national output remain Spain and Greece. Yet, the rest, save France, do not seem to be able to take up the slack for the these two hitherto dynamic sources of demand. The Economist pinpoints the order du jour quite adequately;

The main problem is a familiar one: consumers within the euro zone are not spending enough and the strong currency is making it hard to tap demand in the rest of the world. The best hope for a home-grown stimulus is Germany, where firms and consumers had practised thrift when the rest of the world indulged in a spending boom. Sadly Germany still relies too heavily on exports. Consumer spending and investment both fell in the fourth quarter and were it not for a boost from foreign trade, the German economy would have shrunk. This week Axel Weber, the head of Germany’s central bank, gave warning that cold weather could mean that GDP falls in the current quarter.

Other countries are tapped out. Spain was once a rich source of internal euro-area demand but its consumers are now weighed down by debts accumulated during a long housing boom. The unemployment rate is perilously close to 20% and its rigid jobs markets mean it is unlikely to come down soon. Bond-market pressures mean Spain's government is having to withdraw some of its support to the economy sooner than it would like. The wonder is that Spain is not in a deeper funk. GDP fell by 3.1% in the year to the fourth quarter, not much worse than in Germany.

Basically, this is like a relay race where the change of baton has gone horribly wrong. Consequently, we were supposed to see a rebalancing of intra-Eurozone growth whereby the consumers of Spain, Greece etc were given a much needed break with those of particularly Germany taking over. This has not materialised and while France is still standing strong it is hardly enough to propel the entire Eurozone economy let alone its export dependent economies growing rapidly in number. I have argued several times that this exactly is now set to be an enduring feature of the Eurozone as an economic entity which of course makes it even harder for those intra-Eurozone imbalances to be resolved in an orderly manner.

Additionally, Eurozone growth or the lack of an even more catastrophic contraction in some member countries is still driven by large fiscal deficits. In this way, it does not take much economic intuition to see that if 2010 is set to be the year of the big fiscal scare (in a global context) the natural and inevitable retrenchment of fiscal deficit spending is going to reveal, in all certainty, just what the underlying growth momentum is. Personally, this is where I think the biggest negative surprise will come in terms of overall activity measured by national output.

More generally something, naturally, has to give here and according to the FT's Martin Wolf, Germany needs to return the favor as he puts it, or more specifically; the Eurozone needs German consumers.

(...) Germany was able to offset extreme domestic demand weakness with robust external demand, from both inside and outside the eurozone. Indeed, as much as 70 per cent of the increase in Germany’s GDP between 1999 and 2007 was accounted for by the increase in its net exports.

Germany needs to return the favour. More precisely, the only way for eurozone countries to slash huge fiscal deficits, without their economies collapsing, is to engineer another private-sector credit bubble or a huge expansion in net exports. The former is undesirable. The latter requires improved competitiveness and buoyant external demand. At present, none of this is available. It is difficult to regain competitiveness when the euro is strong, partly because Germany is so competitive, and eurozone inflation also so low.

This argument is similar to one Mr. Wolf made recently on Japan and in the context of which he and I had a tête-à-tête on just what the possibilities are for Japan's economy and its consumers to stage a recovery driven by domestic demand. My argument and beef with Mr Wolf is the same here. Thus, it is not because I think that Wolf is wrong and certainly not because I cannot see the fundamental need for Germany to attempt a rebalancing of its economy. However, the key question here is not what Germany needs to do, but whether it is feasible to expect Germany to pull forward the Eurozone through growth in domestic demand? I think it is not and I think you need to take a long hard look at the increasingly ageing German population and how this feeds into the ability of the economy to generate growth based on domestic demand.

Yet, as Martin Wolf adequately pointed out to me during our bataille on Japan that argument hardly brings anything to the table in terms of solution. I concur that it does not in the state that I present here. Yet, the consequence of the argument (and thus in some sense the solution) is very clear I think. If the Eurozone before the financial crisis had economies that were able, or who were allowed/pushed onto an unsustainable growth path where domestic demand/credit flourished it does not have these economies anymore (save perhaps France). It follows logically from this that while Germany (and Italy) was the main export dependent economy in the Eurozone before the financial crisis, the whole Eurozone is now effectively dependent on exports to grow. Notwithstanding the Economist's point that this means the recent weakening of the Euro is actually a blessing, it also provides a very important perspective to the discourse on the global imbalances and how to unwind them.

Post script:

It is all about the Eurozone at the moment of course and not so much about the Q4 reading but more fundamentally about the Eurozone/EU itself in the wake of the growing economic crisis in Spain and most notably Greece. My good friend Edward Hugh is pretty much pushing forward the discourse at this point (on Spain and in general) especially with his new blog for the newspaper Expansion (in Spanish!, but see also this) as well as his amusing yet important post on Chart Wars featuring as prominent a cast as the recent economics nobel laureate Paul Krugman and the Kingdom of Spain itself. Meanwhile, in a different media another good acquaintance of mine, Jonathan Tepper from Variant Perception, has an interview on the economic situation in Spain which is also much worth a look. Finally, I had a piece this week on the Guardian's Comment is Free edifice which got a host of interesting comments.

So, enjoy reading!


[1] - We don't have a detailed break-down yet on the country and Eurozone-wide level.

The Italian Economy Contracts Again in Q4 2009

Well, it isn't only my German economy Q4 call, or my Japanese economy one which look OK right now, this Italian one also now seems very much to the point.

In fact, as I suspected it might, the Italian economy went back into contraction mode in the last three months of 2009.

Italy's economy shrank by 0.2 percent in the fourth quarter of 2009, inverting the growth it had experienced in the third quarter, according to national statistics agency Istat in a preliminary forecast. Italian gross domestic product (GDP) shrank by 0.2 percent compared to the third quarter when adjusted for seasonal variations.

Italy's GDP shrank by 4.9 percent in the 2009, a result which was slightly worse than than the 4.8 percent contraction the Italian government had predicted. The fourth quarter figure was worse than had been expected by economists who had forecast a 0.1 percent growth, according to a consensus polled by Dow Jones Newswires. Istat blamed the decrease on a fall in the value added by Italian industry. In January, the Italian government revised its economic growth forecast for 2010 upward - from 0.7 percent to 1.1 percent.

Perhaps the best way of putting the seriousness of Italy's situation in some kind of perspective is to say that GDP levels are still below those of early 2003. My opinion is that even in the best of cases Italian trend GDP growth is now below 0.5% per annum, and indeed it may well be approaching zero.

Chart Wars

A new kind of battle is going on out there at the moment. In what must surely be a new twist to the old dialectic of blow against blow argument, a combination of the internet age and sophistocated data management software is adding an additional and striking dimension to the current crisis debate, let's call it the birth of the "charts war". I think you could safely say Paul Krugman kicked off the latest round off, with this simple blog image post.

The Kindom of Spain was not amused, and struck back in their London roadshow (courtesy of Elena Salgado and Manuel Campa) with their own version of the same issue.

Spain, we are informed is not so badly off, since Italy's position is much worse. Even more to the point, adding 3 million or so unskilled workers to the dole queues, and closing down a large chunk of Spain's core construction industry (driving the unemployment rate up to 19.5% in the process) has been extremely beneficial, since cleaning out all those low productivity, unskilled workers has meant that the productive power of the rest looks a lot better (since average productivity of those in work has risen). But isn't this just where the fiscal deficit issue comes in? These workers are still being supported by the rest via the Spanish system of employment benefits, so the productivity improvement (as far as Spain as a whole is concerned) is simply an optical illusion.

This is a point that Krugman could have picked up on but didn't, although he did follow through with a further post full of very revealing charts. The core issue here is that the problem Spain faces, as Paul stresses, is not essentially a fiscal one, a point which may be clearly seen in the following comparison of German and Spanish fiscal deficits over the last decade.

As he shows, Spain had no fiscal problem till the housing boom went bust. No of course, the need to prop up the economy, and support all the "unproductive" labour which doesn't show up in the unit labour costs chart is producing a massive fiscal deficit. Thus the fiscal issue in Spain is a symptom, not a cause. The root of the problem lies in the structural distortions produced by the massive overheating of the economy during the boom years, an overheating which lead to excessive inflation, large-scale dependence on imports, and a complete loss of competitiveness in the non-tradeable sector - a loss of competitiveness which even the Kingdom of Spain accept.The problem with the Spanish argument is that it seems to neglect the rather inconvenient fact that those workers who are deployed in the tradeable sector also eat bread and go to hairdressers and ride in taxis and buy or rent homes just like everyone else. So they themselves need to pay prices set in the non-tradeable sector, and their salaries have to reflect this. Hence a problem in non-tradeables becomes a much more general one. And it shows up, naturally enough, in the current account balance.

Of course, just as there is more than one way to peel an onion, there are a variety of different ways to measure competitiveness (GDP deflator, unit labour costs, etc). My own favourite back-of-the-envelope measure is what is known as the Real Effective Exchange Rate (REER, which shows at roughly what sort of virtual rate the Peseta would trading with the Deutsche-mark (were the two still to exist, of course).

Smokin' Gun

Indeed, analysts at PNB Paribas recently took the REER argument one step further, and showed how, far from addressing the competitiveness issues in Greece and Spain the recent bout of fiscal spending was in fact making the situation worse.

This is a point I have been trying to make in a number of recent posts by using two simple charts. The ECB eased liquidity in the Spanish banking system last June with a massive injection of one year funding.

This money went, via bank purchases of Spanish Treasury Bonds, to fund the government deficit, leading to a large injection of demand into the real economy. But what happened to that demand? Just look at the chart below. The trade deficit started to widen again, as Spaniards availed themselves of their additional spending power to buy yet more foreign products.

So essentially the issues is this one. Spain's economy will not recover, and return to growth till Spanish products become more attractive in price terms, and this only means one thing: some sort of internal devaluation is inevitable, and all the talk about an exclusively fiscal correction is simply an attempt to get rid of the smoke without going to the trouble of extinguishing the fire which is producing it.

Saturday, February 06, 2010

Greece Gets The Green Light, But Will It All Work?

Well, as reported over the weekend on this blog, the EU Commission did in fact demand "more sacrifices" from the Greek people, and in the end Prime Minister Papandreou had to make a last minute TV appearance to explain to his incredulous listeners that the time had come "to take brave decisions here in Greece just as other countries in Europe have also taken....We all have a debt and duty towards our homeland to work together at this difficult time to protect our economy." I thought that that time had come last November, but evidently I was precipitate in my judgement, but now it has finally arrived, although I ould note that hope does spring eternal, and that even now not everyone is 100% convinced.

When Adreas Papandreou said Greece needed the same brave decisions others have taken I presume he was in fact referring to Latvia, Hungary and Romania.

More than the measures themselves, what is interesting about the Brussels acceptance speech were the series of measures put in place to monitor and control Greek economic policy. As the Financial Times put it, the EU puts Athens under close scrutiny.

"The European Commission, the guardian of Europe’s fiscal rules, struck out into uncharted territory by placing Greece’s economic and budgetary policies under closer surveillance than has yet been applied to a eurozone country."

In fact the European Commission has put Athens on an unprecedentedly short leash, since there is to be a mid-March interim progress report, a further one in mid-May, and quarterly updates thereafter. In addition, an infringement procedure was also launched against Athens for "failing in its duty to report reliable budgetary statistics".

The Commission recommendations will now be forwarded to EU finance ministers for possible approval on 15-16 February. If endorsed, it will be the first time that a eurozone member country will be put under such strict surveillance.

And the agreed measures are obviously far from being the end of the road, since the EU executive only conditionally approved Greece's three-year fiscal plan and warned further cuts in public sector wages would be required (that dreaded internal devaluation) if, as many economists believe, the measures so far announced prove to be insufficient to generate the economic growth which will be needed to meet the steep deficit-reduction targets. Thus the die is cast, and Greece will not, as I recommended, be going to the IMF. Such a move is now seen as superflous, since the EU Commission is steadily transforming itself into a local "mini-version" of the Fund in order to try to handle the cases of those countries who show continuing reluctance in implementing those much needed deep structural reforms. I only hope the Commission have the will to follow this through with all the determination that is needed, since if Greece do now finally go to the IMF for help it will surely now be as an ex-member of the Eurogroup.

Not that this weeks session was entirely accident free. Retiring Economy Commissioner Joaquin Almunia gave yet another example of how clumsy he can at times be, by declaring that "En esos países (Greece, Portugal and Spain), observamos una pérdida constante de competitividad desde que son miembros de la zona euro" (a "continuous" loss of competitiveness), which appeared in the English language press as: "Almunia Says South Europe Has ‘Permanent’ Competitiveness Loss". It isn't clear to me from this distance whether he was speaking in English and his core message got "lost in translation", or whether he thought the speech out in Spanish, and the faux pas is down to his advisers. Either way the damage was done, causing even more problems than needed - according to data from CMA datavision, Credit Default Swaps were up on Spanish Sovereign Debt to 151 bps, or up 18.24 on the day. Portugal CDS also rose sharply on the day - 28.47 bps to 195.80.

As Deutsche Bank's Jim Reid said after the announcement:

Clearly aggressive fiscal tightening can look plausible on paper but the reality is that the path will be full of potential roadblocks. Future strike action will be sign of how prepared the general population is to take the hard medicine. The jury must still be out on this and the market will look to exploit any set backs. However in the short-term the market does seem to have lined up an alternative target.
So the jury still is very much out on just how viable the GDP targets being offered by the Greek government really are. George Papaconstantinou, Greece’s finance minister, may have told the Financial Times that he expected a return to economic growth from the middle of this year - boosted, he said, by strength in the shipping and tourism industries and the “hidden power of consumers” in the shadow economy. But saying this is one thing, and achieving it is another. Growth across Europe will at best be modest this year - let's say between 0.5% to 1% of GDP at the most optimistic - with labour markets week everywhere, so I think it is rather unrealistic to expect a tourist boom going much beyond the one we saw (or didn't see) last year, and the same goes for shipping, which is a sector where surplus capacity still abounds. As for those affluent Greek consumers he is talking about, we have to hope they all dig deep into their wallets, and that each and every one of them now insists on a VAT valid invoice!

But so far there is not much sign of this, and retail sales are actually falling steadily (see chart below). In fact I seriously doubt we are going to see much support from internal consumption at this point. Greece is all about exports now, but where are they going to come from? And how is the country going to get a trade surplus big enough to achieve the sort of economic growth they are talking about without a much stronger internal devaluation?

Industrial output has been falling for some time.

And the latest January PMI only served to underline how Greece was becoming detached from the recovery elsewhere.

Commenting on the Greece Manufacturing PMI survey data, Gemma Wallace, economist at Markit said:

“The onset of the new year brought little hope of a near-term recovery in Greek manufacturing. Accelerating contractions in new orders, output and employment caused the headline PMI to sink to an eight-month low. Meanwhile, firms were struggling to cover rising costs, as strong competition and unfavourable demand conditions rendered them unable to raise charges.

Eurozone unemployment hit 10% for the first time in December, underlining the extent to which the timid economic recovery has yet to translate into job creation. Spain's jobless rate rose to nearly 20%, and Ireland, which like Spain has also been hard hit by a housing downturn, saw its jobless rate climb to 13.3% from 13%. As is normal Eurostat didn't have data on the jobless rate in Greece, where, as Market Watch point out, statistics are notoriously hard to come by. The lastest - EU comparable - number we have is for October, but at this point such a data point is the next best thing to useless. A similar situation exists in the construction sector, we have no clear idea of what is happening since the Greek statistics office simply to not supply comparable data to Eurostat.

Meanwhile the drama in the bond markets looks set to trundle on:

Greece's acute problem is the need to raise financing to allow it to roll over maturing debt in April and May, while preserving sufficient cash to fund current expenditure. We estimate an additional funding need of at least €30bn by May. The concentration of maturing debt is unusual, but even if this immediate source of stress can be overcome, the funding profile for coming years remains demanding. The next three months will have a heavy bearing on the profile that is followed, but whatever happens, Greece and other peripheral euro area countries will still suffer from a chronic need to improve productivity, raise national savings and cut government borrowing.
Christel Aranda-Hassel, Director, European Economics, Credit Suisse.

An all the doubt continue as to whether, with the fiscal retrenchment process and the competitiveness correct Greece can manage to achieve the debt to GDP reductions promised in their Stability Programme. As Credit Suisse's Giovanni Zanni puts it, previously

Nominal GDP growth was systematically higher than the average rate of interest paid on the government’s debt. The implication was that the government could run significant fiscal deficits and still reduce the debt-to- GDP ratio. It did not exploit that advantage significantly, however, and the Greek government’s debt ratio fell only slightly over the period. Things have changed drastically since last year. Nominal growth fell to 0% in 2009. Although it should recover from 2009 lows, we think it will remain subdued relative to the recent past. Even if Greek sovereign credit spreads versus Germany fall back somewhat from the peaks reached last week, it seems extremely unlikely that the favourable dynamics of the past will reappear anytime soon. As such, there are few options open to the government other than to move the primary balance into surplus – a surplus that is sufficient to first stabilise the debt-to-GDP ratio and then push it downwards.

This primary surplus seems a very, very long way off at this point. And Greek bonds fell again yesterday, pushing the premium investors demand to hold 10-year securities instead of German bunds up by 12 basis points to its highest level in a week. The move followed news that Greece’s biggest union had approved a mass strike while tax collectors began a 48-hour walkout. The Greek 10-year yield jumped 8 basis points to 6.76 percent as of 11:45 a.m. in London. The difference in yield, or spread, with benchmark German bunds was at 365 basis points. It widened to 396 basis points on Jan. 28, the most since before the euro’s debut in 1999.

And Citicorp warns that investors may well continue to cut their holdings of Greek bonds amid skepticism the government can overcome public hostility to budget cuts.

“Although Greece has secured the expected backing from the EU for its latest austerity program, we expect markets to remain very fearful of the potential for the fiscal consolidation process to slide or to be derailed by public dissent,” according to Steve Mansell, director of interest-rate strategy at Citigroup in London. Investors, he said, may be “more prone to lighten exposure on any significant spread tightening moves”.

And it isn't only the bank analysts who are not convinced. According to this article in Le Monde IMF head Dominique Strauss Kahn and his close associate Jean Pisani-Ferry, director of the Brussles based think tank Bruegel also have their doubts:

Celui-ci estime que l'UE n'a ni la vocation, ni les équipes, ni les techniques pour analyser les carences d'un pays et préconiser des remèdes. L'Union n'a pas l'habitude d'affronter l'impopularité des thérapies de choc et pourrait céder aux manifestations de rue. Le FMI peut jouer de sa réputation de dureté pour aider le gouvernement grec à imposer les sacrifices inévitables.

Which in plain English says that they thing the EU Commission has neither the vocation, nor the teams, nor the technical experience to take on a job of this size, and while it is vital that the necessary structures and policy tools are developed, in the meantime the clock is ticking away, and the infection is spreading to the Sovereign Debt of other countries - even as far away as Japan. Basically M. Strauss Kahn seems to feel that the EU Commission is assuming an unnecessarily high risk, and that the Greek dossier should really have been sent to the IMF as a matter of some urgency. I cannot but agree.

Wednesday, February 03, 2010

Spain's Incredible Consumer Confidence Index

According to Spain's Instituto de Crédito Oficial (ICO) the ICC-ICO (consumer confidence index) went up in January by 6.1 points from its December value and is now at its highest level since August 2009. This confidence improvement is largely due to a significant rise in the Expectations Indicator (+5.7 points) and to a smaller one in the Current Economic Conditions one (+2.3 points).

As can be seen from the chart below, confidence while up, is not exceptional by historic standards, which is hardly surprising given the deep recession which Spain is in.

What is really striking - nay astonishing - is that when you come to look at the breakdown of the index into its components (see chart below) you find that the bulk of the work is being done by the expectations indicator, which at 108.5 is now showing its second highest reading ever, and only just below the all time series high of 109.7 which was hit back in the heady days of January 2005! (The indicator series only goes back to September 2004).

This is not only incredible, it is extraordinarily hard to understand. Even those who doubt that the situation is quite as bleak as people like me argue it is must surely admit that Spain now faces a difficult and testing time. My contention is not that there is anything wrong with this finding, but rather that this is how Spanish people actually think at the present time. They have no idea of the actual economic reality, or of what the future has in store for them. They are virtually being kept in the dark. This is the worrying part, and I fear that all this may well now end badly, very very badly.

Global Manufacturing Continued Its Expansion In January

The global manufacturing expansion continued to gather momentum in January. Coming in at 56.1, up from 54.6 in December, the JPMorgan Global Manufacturing Purchasing Managers’ Index registered its highest reading for five and a half years. The latest improvement in overall operating performance reflected accelerated growth of production and new orders, while there was a slight gain in staffing levels for the first time since March 2008.

Production increased for the eighth successive month in January, with the rate of expansion hitting a 69-month high. The improvement in the performance of the United States manufacturing sector was most noticeable. The Institute for Supply Management output index rose by 6.5 points since December to reach its highest level since April 2004.

Elsewhere the position was much more uneven, with West European and Japanese manufacturing having a much more qualified start to 2010, with rates of expansion growth well below the global average, - and in the case of some countries well below. Meanwhile emerging economies like Brazil,India and Turkey continued to show a strong performance.

Asia and Emerging Markets

In Japan activity slowed, although at 52.5, the seasonally adjusted Nomura/JMMA Purchasing Managers’ Index pointed to a moderate improvement in operating conditions in the Japanese manufacturing sector at the start of 2010.

Commenting on the Nomura/JMMA Japan Manufacturing PMI data, Minoru Nogimori, Economist of Financial & Economic Research Centre at Nomura, said:

“The Japan Manufacturing PMI fell 1.3 points to 52.5 in January. It remains above the key dividing line of 50.0, but has continued to fluctuate in recent months. Although the PMI has been holding firm, the sharp rebound phase from February through to August in 2009 has lost steam. Furthermore, the New Export Orders Index fell rapidly, by 3.2 points to 51.5, signaling that the yen’s appreciation has depressed exports which are the main factor behind the current recovery in the Japanese economy. Exports are an important factor of the future of the Where an expansion of production was signalled, panellists generally attributed growth to higher intakes of new orders, which increased for the seventh month running in January. However, the latest improvement in firms’ order books was the slowest in that sequence amid concerns over the sustainability of economic growth. Export sales placed at manufacturers rose again in January, extending the current period of expansion to eight months. Nonetheless, the pace of expansion was the slowest since last June. Anecdotal evidence suggested that increased new business from China and other Asian countries continued to support export growth.

January data signalled that backlogs were depleted at the fastest rate since last June, largely as a result of slower new business growth and a robust rise in output.

Elswhere in Asia, both China and India showed strong expansions. At 57.4, up from 56.1 in the previous month, the headline HSBC China Manufacturing PMI rose to a record high at the start of 2010, signalling a continuing improvement in operating conditions in the Chinese manufacturing sector. The index has now risen more than sixteen points since posting a record low in November 2008. Export sales also rose in January, increasing at a near-record rate. This was in sharp contrast to the severe reductions seen at the beginning of 2009.

Commenting on the China Manufacturing PMI survey, Hongbin Qu, Chief Economist for China at HSBC said:

“Industrial activity continues to accelerate, implying stronger GDP growth in 1Q. But rising input and output prices also point to greater inflationary pressure, which will likely prompt more tightening measures in the coming months.”

The Indian manufacturing sector expanded at fastest pace for nearly one-and-a-half years in January. Climbing to 57.6 in January, its highest level for seventeen months, the seasonally adjusted HSBC Markit Purchasing Managers’ Index signalled a considerable improvement in operating conditions faced by Indian manufacturers. The headline index has now signalled expansion of the sector since April 2009, and at increasing rates for the past two survey periods.

Commenting on the India Manufacturing PMI survey, Robert Prior-Wandesforde, Senior Asian Economist at HSBC said:

“Any lingering concern that India's manufacturing recovery was tailing off should be well and truly put to rest by this strong release. A second consecutive rise in the PMI has taken the series to a new cycle high, consistent with on-going double digit rises in industrial production. The most impressive part of the release was the more than 5 point jump in the new export orders index, which took it to its highest level since October 2007 and indicated that the recovery is by no means dependent on domestic demand alone.

“At the same time, however, price pressures are clearly intensifying. The rate of increase in input prices was the largest since the PMI began nearly 5 years ago, while the survey suggests that companies are more willing to pass on these rises in the form of higher output prices - something which the RBI is unlikely to take too kindly to. Admittedly, the employment index only inched above 50 but it can't be long before job hiring picks up more aggressively.”

Elsewhere among emerging economies, the Brazil performance stood out, with the sector expanding at a considerable pace as shown by the fact the headline seasonally adjusted Brazil Manufacturing PMI climbed to 57.8 in January, its highest level since data were first available in February 2006.

Commenting on the Brazil Manufacturing PMI survey, Andre Loes, Chief Economist, Brazil at HSBC said:

“The Brazilian manufacturing industry expanded at a survey record pace in January. The Manufacturing PMI reached 57.8, up from December’s 55.8, with all five of its components supporting the strong performance of the composite indicator.

“In our view, the particularly strong growth of output, new orders and input stocks – all of them reached series record peaks – indicate further vigorous expansions in manufacturing going forward. Employment also grew faster, but as a variable that normally lags production, its expansion fell short of the three components mentioned above. Last but not least, charges rose, albeit modestly, for the fourth month in a row.

“All in, January’s Brazil Manufacturing PMI confirms the very favorable dynamics of manufacturing activity. This highlights the concern recently expressed by the BCB, that the quick reduction of idle capacity could result in increased inflation pressures.”

While the South African PMI continued to show an increase in activity. The index surged to its highest level in 21 months in January, indicating that a recovery in manufacturing is gathering pace as consumer spending picks up, according to Kagiso Securities who prepared the report. The seasonally adjusted index increased to 53.6 from 52.5 in December. The PMI has now been above 50, which indicates an expansion in factory production, for three consecutive months.

Western Europe

In Europe, solid expansions in output were recorded in Sweden, France, Germany, the Netherlands and Austria, but these were in marked contrast to the deeper recessions in Spain, Ireland and Greece.

The Eurozone PMI hit a two-year high, with France and Germany leading the recovery, while Spain and Greece fell further behind. The headline final Eurozone Manufacturing PMI – a composite index based on measures of production, orders, employment, inventories and supplier performance – posted 52.4 in January, its highest reading for two years. The index value was above both its earlier flash estimate of 52.0 and the final reading of 51.6 posted in December. The level of the PMI has risen in each month since hitting a record low last February and has now remained above the neutral 50.0 mark for four consecutive months.

Commenting on the PMI data, Markit Senior Economist, Rob Dobson said:

“The January final PMI readings confirm that the Eurozone manufacturing sector has built on its positive end to last year, with growth of output and new orders the fastest since mid-2007 and above the earlier flash estimates. However, the recovery is becoming two-track, with Spain and Greece in particular falling further into recession when growth in most of the other nations, led by France and Germany, is accelerating. Manufacturers are also continuing to focus on reducing headcounts and lowering stocks despite gains in output. This suggests that they retain a cautious outlook, especially while sales are still being supported by price discounting.”

But the West European picture was characterised by two extremes. On the one hand we have France and Sweden, were economic activity is rebounding strongly, and on the other there is Spain and Greece, where the contraction continues, and the outlook seems bleak.

Business conditions in the French manufacturing sector improved for a sixth consecutive month in January. The headline Purchasing Managers’ Index posted 55.4, up from 54.7 in December. The rise in the PMI reflected faster expansions of both output and new orders during the latest survey period, while supplier delivery times lengthened at a sharper rate. Manufacturing production increased for the seventh month running in January. Furthermore, the rate of growth accelerated to the strongest for almost nine-and-a-half years, with over one-third of panellists reporting a rise.

Commenting on the Markit/CDAF France Manufacturing PMI final data, Jack Kennedy, economist at Markit, said:

“The recovery in the French manufacturing sector remained intact at the start of 2010. Output rose at the strongest rate for almost nine-and-a-half years in January, as the rebound from the record contraction seen in early 2009 continued. While domestic demand remained the primary driver of growth, there was also evidence of strengthening export sales, indicating a broad-based expansion. However, staffing levels continued to be cut as manufacturers targeted cost savings and productivity gains at a time when input price inflation reached a sixteen-month high.”

In Sweden, activity simpled roared ahead, and the Silf / Swedbank Sweden Manufacturing Purchasing Managers' Index stood at a seasonally adjusted 61.7 in January, well above December's 58.2. The production sub-index surged to 70.2 in January from 59.7 in the previous month. The new orders sub-index climbed to 66.8 from 63.7, with the new export orders sub-index gaining 4.2 points to 62.3. Despite the improvement in new orders and production, employment levels were slashed again. The employment sub-index stood at 49.6, up slightly from 49.5.

In Spain January data pointed to a further deterioration of operating conditions at Spanish manufacturing firms. Both output and new orders fell at faster rates than in the previous month, while employment continued to decrease sharply. Companies offered discounts to clients in an attempt to boost sales, despite input costs rising again during the month.

The seasonally adjusted Markit Purchasing Managers’ Index remained well below the 50.0 no change mark, edging up slightly to 45.3 in January, from 45.2 in December, indicating that business conditions deteriorated for the twenty-sixth successive month. Production contracted for the sixth month running in January, and at a steeper rate than was registered in the previous month. The latest decline reflected a further reduction in new business.

Commenting on the Spanish Manufacturing PMI survey data, Andrew Harker, economist at Markit, said:

“The Spanish manufacturing sector began the new year with output, new orders and employment all continuing to fall. The steepest decline in input buying for seven months highlights the lack of confidence in the sector, with firms reluctant to invest in new stock until sales have been secured. Manufacturers were again forced to cut prices in January as weak demand made it difficult to pass on higher raw material costs to clients.”

Central and Eastern Europe

Turkish manufacturing sector started 2010 on positive footing as output and new orders rose at robust rates. Increased new orders from overseas continued to provide support to expansion of sector, and the growth in employment was sustained. Higher input cost inflation however droves a further rise in output prices. The headline index posted 53.0 in January, indicating a solid improvement of business conditions in the Turkish manufacturing sector. The rate of expansion accelerated since December, and was the strongest in four months.

Commenting on the Turkey Manufacturing PMI survey, Dr. Murat Ulgen, Chief Economist for Turkey at HSBC said:

“The Turkish manufacturing sector has started 2010 with a solid expansion rate, thanks to robust increases in new orders and output. Overall manufacturing activity has also gained traction, breaking the five-month streak of deceleration in the pace of growth since July. Export order growth was also strong, reflective of an improvement in Turkey’s export markets. Manufacturers continued to slash their finished goods inventories in order to partially fulfil rising orders, while backlogs of work were also reduced for the third month. Employment conditions maintained their favourable trend, improving for the eighth consecutive month. On the other hand, the ominous outlook on cost pressures remained intact in January, as input prices continued to rise much faster than output prices, possibly because of soaring raw material prices. This tells us that inflationary pressures are in the pipeline and businesses may pass on rising costs to their end prices when they feel more comfortable about aggregate demand conditions.”

Business conditions in Russia’s manufacturing sector showed tentative signs of recovery at the start of 2010, according to January survey findings from VTB Capital. Output rose for the sixth straight month, and at a faster rate as new orders increased for the first time since last October. Employment continued to fall, but at a much slower rate than the trend pace recorded over late-2008 and 2009. Inflationary pressures strengthened, but remained relatively weak. The headline seasonally adjusted Russian Manufacturing PMI posted above the no-change mark of 50.0 for only the second time in the past eighteen months in January, indicating an overall improvement in operating conditions in the sector. The latest PMI reading reflected stronger positive contributions from the output, new orders and suppliers’ delivery times indices, and less negative effects from the employment and stocks of purchases components. That said, the latest reading of 50.8 signalled only a marginal overall improvement in conditions, and was below the long-run trend of 52.1.

Commenting on the survey, Dmitri Fedotkin, economist at VTB Capital, reported:

“January’s Manufacturing PMI rose to 50.8, the second reading pointing to an expansion across the sector over the past 18 months. The headline number was supported by new orders crossing the no-change 50 level to reach 53.0, while new export orders also rose (50.8). The output index rose to 52.3, pointing to production rising for six straight months and supporting the recent upturn in official statistics. In addition, at 48.2 the employment index improved for the fourth month running with further stabilization expected on the job market. The input price index rose to 61.4 amid higher commodity prices and freight charges while the output price index rose to 54.0 as companies tried to pass rising costs on to customers.”

Hungary's manufacturing purchasing manager index (PMI) jumped 4.4 percentage points to 53.5 points in January 2010, the Hungarian Association of Logistics, Purchasing and Inventory Management (HALPIM) reported on Monday. This marks a halt in the contraction of the manufacturing industry that had started in September 2008. Hungary's manufacturing PMI stood at 53.5 in Jan 10, up by 4.4 ppts from Dec 09. This is the first time since August 2008 when the index is above 50. (The Dec reading was revised upward to 49.1 from 48.5 originally).

HSBC survey data for the Polish manufacturing sector signalled an overall improvement in business conditions in January, in stark contrast to the marked contraction posted one year earlier. The headline HSBC Poland Manufacturing PMI posted 51.0 in January, having been unchanged at a near two-year high of 52.4 in the previous month. Any figure greater than 50.0 represents an overall improvement in business conditions. The PMI remained above its long-run trend of 49.5 in the latest period.

Commenting on the Poland Manufacturing PMI survey, Kubilay Ozturk, economist at HSBC, said:

“The headline PMI remained above break-even in January, but the momentum that prevailed in the last two months of 2009 appears to have lost some steam, with slower expansions in output and new orders. Domestic and external demand continued to improve over the month, albeit at a slower pace, particularly for the former. A decline in the employment index after a long-awaited rise in December confirms the labour market is not out of the woods yet, while the noticeable drop in output prices indicates a benign inflation environment ahead. Overall, the reading is a reminder that a straight-line recovery may not be that likely, although the Polish economy will continue to outperform its regional peers in 2010.”

Czech manufacturing output grew at fastest rate since March 2008 and the latest PMI data compiled by Markit for HSBC showed an overall improvement in business conditions for the third month running in January. Moreover, the rates of growth for both output and new orders accelerated, and were sharper than the averages over eight-and-a-half years of data collection for the survey. Meanwhile, manufacturers shed jobs at a slower pace and continued to cut charges to support sales drives. Supply delays were again registered as firms raised purchasing volumes. The headline HSBC Czech Republic Manufacturing PMI rose to 53.1, signalling a robust overall improvement in business conditions.

Commenting on the Czech Republic Manufacturing PMI survey, Kubilay Ozturk, economist at HSBC said:

“The headline index improved noticeably in the first month of 2010 on the back of a remarkable increase in output and a solid rise in new orders, underlining the uninterrupted improvement in demand. Both external and domestic markets appear to have been on the mend in January, suggesting a wider economic recovery is under way. The latter was also confirmed by a leap in firms’ purchasing volumes over the month. However, subdued increase in EMU manufacturing PMI in January and the downside surprise in a flash estimate for German 2009 growth suggest the impact of fiscal stimuli and car-scrappage schemes in Western Europe may fade earlier than expected, implying recovery may be gradual and bumpy.”

Tuesday, February 02, 2010

Spain Is A Serious Country

José Luis Rodríguez Zapatero, Spain’s prime minister, said in Davos this week: “We are a serious country and we will fulfil our promises.”

With these words Spain's Prime Minister sought, during his visit to Davos last week to reassure international investors that Spain, despite the severity of the recession it is currently suffering, and the major challenges facing its banking system, is not about to become another Greece.

Just to prove the point he had Labour Minister Celestino Corbacho and Economy Minister Elena Salgado announce in short order that a) Spanish citizens are going to work two more years each in the longer term, and b) face continuing and sweeping cuts in services and increases in taxes in the short term. The trigger for this rather unexpected show of determination seems to have been the growing danger of contagion from debt crisis worries in Greece, as Spanish 10 year bonds spreads nudged briefly through the 100 base point level over the comparable German benckmark. Unfortunately, enthusiasm for the new-found seriousness doesn't seem to have lasted long, since this just morning (and only three days after that strong demonstration of will for change) the Spanish press inform us that Elena Salgado - faced with strike threats from the main trade union organisations - is having second thoughts, and is willing to be "flexible", since the proposal for pension reform, was only that, a proposal which is up for negotiation.

Spain's banks have extensive government bond holdings, and as the spread rises the market value of these bonds falls, so - given that another important part of the banks capital base is composed of land and property assets of uncertain value - the prospect of a slide in the value of the bonds they hold leaves Spain's government with little alternative but to be seen to be taking "serious" measures, whatever the cost. But quite how Spain's citizens will react to the news that their government's policy is now being driven by the need to "calm market fears", and that the country's leaders are actively considering asking them to retire at 67, still remains to be seen. Yesterday's warning shot from political rivals and unions alike may leave their mark in the short term, but it is now clear that things have, in fact, changed, and Spain's politicians (and the bankers who influence them) are now likely to be much more sensitive to market sentiment than they are to public protest.

The Economic Slide Continues

While eurozone manufacturing sector grew at its fastest pace in two years in January, the divergence between laggard Spain and the rest of the big four economies simply widened, according to yesterday's Global Manufacturing PMI report. Spain was actually (and just one more time) the worst performer among the 26 countries surveyed. Here in Europe the Markit eurozone manufacturing purchasing managers’ index for January rose to 52.4 from 51.6 in December, but while the data showed activity in Germany, France and Italy continued to expand it was a different story in Spain, where the reading did edge up slightly to 45.3, from 45.2 in December in a move that offered little more than token consolation, since the changes is marginal, and simply confirmed that business conditions in manufacturing deteriorated for the twenty-sixth successive month.

“The recovery is becoming two-track, with Spain and Greece in particular falling further into recession when growth in most of the other nations, led by France and Germany, is accelerating,” said Rob Dobson at data provider Markit.

Commenting on the Spanish Manufacturing PMI survey data, Andrew Harker, economist at Markit, said:

“The Spanish manufacturing sector began the new year with output, new orders and employment all continuing to fall. The steepest decline in input buying for seven months highlights the lack of confidence in the sector, with firms reluctant to invest in new stock until sales have been secured. Manufacturers were again forced to cut prices in January as weak demand made it difficult to pass on higher raw material costs to clients.”

Again,Spanish car sales rose 18.1 percent in January comp.ared with the same month of last year, but these sales are destined to fall back sharply in the second half of this year as government subsidies are withdrawn. According to car makers' association ANFAC the January sales increase followed a rise of 25.1 percent in December and 37.3 percent in November. Year on year car sales fell 17.9 percent in 2009 (over 2008) to 952,772 vehicles.

The Spanish government began offering 2,000 euro subsidies to new car buyers last May, in addition to a 700 million euro subsidy to replace old cars with energy-efficient models, but this kind of spending is simply likely to disappear as the government moves forward with its austerity programme.

As ANFAC noted, "The continuation of government subsidies is having a positive influence on car the second half of the year sales will benegative, with falls over 18 percent as a result of the 2 percentage point rise in VAT and an end to government subsidies."

Unemployment Still Heading Onwards And Upwards

As the PMI report points out, Spanish manufacturers continued to adjust their workforces in response to extensive spare capacity during January, resulting in further substantial job cuts. Employment in manufacting has in fact now declined in each and every month since September 2007.

Not unexpectedly, the number of workers registered as unemployed in Spain increased by 124,890 in the month of December, and is now over the 4 million mark (4.05 million), according to Labour Ministry data out today (Tuesday). Since January last year, the number of registered jobless has risen by 720,692.

According to Maravillas Rojo, head of the Labour Ministry's employment department, "January is traditionally a bad month for unemployment. Historically it rises in that month even when the economy is growing". She added that "The rise in joblessness is a very bad figure, but the tendency for the rise to slow, which began about a year ago in March, continues, although we have yet to hit the ceiling". And the rate of increase is slowing (see chart below), although there is a marked increase in people who are not registering, and the government deficit adjustment plan will surely start to add to the queues again.

In addition to the rising unemployment figure, the number of taxpayers to the Social Security system has also fallen starkly: there are 257,828 less of them (more than doubling the unemployment figure increase). Such a number implies that, apart from the expected people retiring and in retraining courses, there are many entrepreneurs that are shutting down their businesses. Let us recall that on January 2008, even though the fall in unemployment was similar (132,378), the number of taxpayers affiliated to Social Security was only reduced by 84,697.

The psicological threshold of 4 milion people unemployed has now been broken, with a grand total of 4,048,493. Let us recall the Minister Corbacho asserted repeatedly last year he "did not believe" Spain would reach the figure of four milion people unemployed.

Today's unemployment figures illustrate we are now in the second phase of the current crisis, since we have gone beyomd the first credit-shock part (which induced layoffs mainly in the construction sector) and are into the second, provoked by the sharp reduction in global output, and now continued by an ongoing drop in internal consumption. The evidence for this is the fact that most of the new unemployed belong to the services sector (102,130 (a monthly increase of 4.5%) and the industrial sector (8,873, monthly increase of 1.7%). Construction "only" added 7,036 layoffs (0.9% monthlyincrease).
Jordi Molins, independent Catalan economist.

So 4.05 million is just the number of people who are signing on at the labour offices, on other measures the level of unemployment is even higher. According to Eurostat data (ILO comparable methodology) there are around 4.5 million unemployed already, not counting those who have already left Spain in the search for work elsewhere (the so called "discouraged" workers). According to the latest Eurostat data the seasonally adjusted unemployment rate for European Union member states (EU-27) was 9.6 percent in December 2009, compared with 9.5 percent in November.

Among member states, the lowest unemployment rates were recorded in the Netherlands at four percent and in Austria at 5.4 percent, and the highest rates were seen in Latvia at 22.8 percent and in Spain at 19.5 percent (see chart). Spain thus ended 2009 with the highest jobless rate in the Eurozone, and by a large margin.

Elena Salgado Fails To Convince

According to the FT's Victor Mallet Elena Salgado was unable to conceal her discomfort last week, when she met the press to announce her austerity plan designed to slash successive budget deficits and restore the country’s credibility on international markets. Ms Salgado "had good reason to be uneasy. The table of figures she presented on Friday showing Spain’s “fiscal consolidation path” through €50bn of savings over four years had some embarrassingly blank spaces for the projected budget deficits in 2010, 2011 and 2012".

Spain, as Mallet points out, wants to reduce its total public sector deficit from 11.4 per cent of gross domestic product in 2009 to the European Union target of 3 per cent of GDP in 2013, but - as the empty boxes show - is not sure either if it can, or how to do it. Alfredo Pastor, a professor at IESE business school in Madrid and former deputy finance minister, shares the same doubts: Spain will also struggle to reach the EU deficit ceiling by the 2013 deadline, “We would have to have very high and fast growth, higher than what we can expect,” he told Bloomberg in an interview last week.

"It's a plan that is essential after our most recent deficit figures," Finance Minister Elena Salgado told journalists at the meeting which followed the government's weekly cabinet meeting. But the main problem facing the Spanish government now is credibility. Spain announced an annual deficit of 11.4% for 2009 after previously (even two weeks ago) forecasting the deficit would come in at 9.5% of GDP. In fact it is rather surprising that as recently as last September (when the government first presented its budget plans for 2010) the deficit was still being forecast to come in as low as 5.2% of GDP (52 billion euros), while by November the forecast had already risen to 8.5% of GDP (85 billion euros) and now (just two months later) we are told that it was 11.4% (over 110 billion euros). A number of questions automatatically arise, like just what level of control the Spanish government actually has over its deficit, and just how convincing is the government's plan to make a three year, 50 billion euro reduction in a deficit which has just shot up in four months by more or less exactly the same amount without anyone (officially) forseeing it!

And Elena Salgado's still incomplete deficit reduction plans critically depend on economic growth forecasts – which rise to about 3 per cent a year in 2012 – that many independent economists regard as totally unrealistic. Even the IMF, with whom Ms Salgado recently took issue, are not convinced by her numbers and forecast a 0.6% (and not a 0.3%) contraction this year. The government now projects a 1.8% gain in GDP in 2011, with growth in 2012 up as high as 2.9%, from a prior 2.7%. Of course, you can pull numbers (like rabbits) out of any hat you like, but that won't bring you growth, and certainly not nearly 3% growth in 2012.

"We are moderately optimistic for 2010 and 2011," Elena Salgado said "If you recall, in June, international agencies also forecast the worst, ultimately, convergence has been to our data" she added.

How she has the temerity to say this is really beyond me.

So even after Friday’s announcement serious doubts remained about Spain’s ability to control its budget spending, particularly since a fifth of the proposed adjustment is supposed to come from the autonomous regions and local authorities that account for more than half of spending. The central government, furthermore, specifically ruled out cuts in pensions, unemployment and social security payments, education spending, research and development or foreign aid. Half the deficit reduction is to come from spending cuts, including a near-freeze on hiring for the civil service (only one in every ten who leave is to be replaced). This means central government, which will bear the load of the austerity plan, about 40 billion euros of it, or 5.2% of GDP.

As is well known Spain is currently grappling with the collapse of a decade-long housing boom that has pitched the wider economy into a deep recession, sent tax revenues plummeting and social welfare costs soaring. Furthermore, in the aftermath of the housing bust, even the government doesn't expect the economy to return to pre-crisis growth rates anytime soon, making it impossible to meet spending commitments taken on during the boom years. Even more worryingly, despite the fact that the pension reform is needed, and the austerity programme to rein-in the deficit essential, Spain has not one measure currently on the table which is able to restore growth and employment in the short term.

And time is running out. As Victor Mallet puts it - the recent austerity announcement does little answer the one question which is now uppermost in the minds of all those investors and economists who are busy worrying themselves about the future of Europe: can Spain control its budgets and once more become competitive within the constraints of the single European currency?

Mr Zapatero insists it can – “We are a serious country and we fulfil our promises,” he said in Davos – but he and Ms Salgado have yet to prove it, and today's news that the retirement plans may well be substantially modified only serves to reinforce the doubts.