What Are The Chances That We Just Hit The Second Great Depression Out In Ukraine?

Well, one good turn deserves another. So if, like Paul Krugman (and me, I think, though I hadn't gotten as far as thinking through all the implications of what was happening when I posted the original piece) you take the view the Ukraine industrial output chart I put up yesterday could be the smoking gun (or starter's pistol, or line judge flag, or whichever metaphor works for you) that tells us that the second great global depression in the history of modern industrial capitalism may now have begun, then here are some more of those tell-tale charts to put in you pipe and smoke - or if , like Huck Finn that is your preference, to chew on.


Of course, it is quite possible that Paul Krugman may only be saying that a Great Depression has broken out in Ukraine, and obviously only he can say what he really thinks, but as far as I am concerned, since one of the hallmarks of the original Great Depression was a sudden sharp drop in output, sustained over a number of years, and in a large group of countries, accompanied in several cases by outright price deflation, then I do think that what we now have on our hands is something that looks more like a depression than a recession (or slowdown) is what we now have on our hands, and what makes me more or less sure about that is looking not only at what is happening in Ukraine, but at neighbouring Russia, and China, and so on and so on. The point is that Ukraine is not an isolated case - if it were then we would simply be able to say that a large depression had broken out in Ukraine, and that would be that. But since part of the explanation for this sudden drop in output in Ukraine is a lack of working credit, and since this credit drought has now spread across most of Central and Eastern Europe (see Russia here, Poland here, and Romania here), and since the by-product of the Ukraine situation is likely to be a whole cycle of debt defaults, which will certainly spread well beyond Ukraine's frontiers, and since in the wake of those defaults banks will become even less enthusiastic to lend, well then it does seem to me that what is happening in Ukraine has some more general significance. I also certainly think all of this was not far from Krugman's mind when he made the post, since what he wasn't doing was simply (in true bloggie fashion) saying ha ha, look what's going on over there. What he was saying is "watch out, this can come back and give us all a kick" - which again is what he was doing with his Japan work in the late 1990s, and it did. My feeling, and it is only a feeling, is that what he wanted to do was move the debate on, and up a level. We can't address the kind of problems we are facing if we fail to recognise we are facing them, and one of our problems in responding to this crisis (and especially here in Europe), has been a consistent failure to recognise the importance of what was happening, and to take measures which were up to the challenge. What was it they used to say: Ninja mortgages, ha, ha, ha. I don't see these people laughing now.

Evidently, since history never exactly repeats itself, I am certainly not saying that the current crisis is going to last an entire decade, or end in a big war, or anything like that. What I am saying is that it has already made a place for itself in the history books, and already belongs to the class of large and unusual economic phenomena, and that we can learn a lot about how to handle our present problems by looking at the experience of 1930s. Of all of this I am absolutely convinced, and I have a pretty good idea that both Bernanke and Krugman are too, if you look at the constant references to those years in almost everything they say and do these days

Now Let's Look At Some Charts

Well, for those who missed it, here is the Ukraine chart that is causing all the fuss:



Japan industrial output isn't exactly falling at the same dramatic pace as Ukraine, but a 16.2% year on year fall isn't to be sniffed at either, and this is what they informed us today happened in November. Worse still, according to Japan's Economy Ministry output is expected to decrease by a further 8.0% between November and December, which, if accurate, will surely push the year on year decline in December over the 20% mark, not the great depression, but then again, not exactly enjoyable.




And exports, which drive the Japanese economy, were down by 26.7% in November. Even more to the point, deflation is baaack, or almost back, since "core" core prices hit zero (or 0.1% below current overnight BoJ interest rates) in November, and outright deflation surely isn't far behind.



You can find more detail on all today's Japan data over at the Japan Economy Watch Blog, and for those of you who want some more deflation background on Japan, well, Krugman has the goods here (extremely wonkish).

Moving nearer to home we have Germany. Here is the latest (flash) December manufacturing PMI for Germany, which is just about as point of the spear as you can get in terms of just in time data.



The slope of that line looks pretty telling doesn't it, especially if you are into depression economics. Then we have the November new orders chart, another shocker, and indicator of much worse to come, I think.



Now going back to this point:

“There is a burgeoning economic crisis in the European periphery,” Krugman said on the ABC network Dec. 14. “The money has dried up. That’s the new center, the center of this crisis has moved from the U.S. housing market to the European periphery.”

I think this is largely true, if we mean by the periphery the UK, Ireland, Eastern and Southern Europe, but the periphery in a very literal sense always ends up biting the hand that feeds it, since German industry depends on exports to that periphery perhaps more than to anywhere else, so it is not surprising that once the periphery folds, the shock wave moves on in towards the centre. I don't know if the blast which is about to hit Germany next year will count as a depression, but if it doesn't, it is going to be a damn close call. And the hard part for Germany is when you get to ask yourself where exactly the new demand will come from to drive the exports?

Moving off now towards the periphery, we have Spain to the south, where the money certainly has dried up, and with it internal demand for Spain's manufactured products. The November PMI showed Spanish industry contracting at an all time series maximum for any country.



Central Europe

The whole of central European manufacturing is now contracting rapidly. First off, the Czech Republic



Then Poland




And finally (for this little illustration) Hungary



Then There Is Russia

Moving on now to Russia, industrial output was down by 8.9% year on year in November, so it hasn't yet reached Ukraine levels, but at the rate of contraction they are experiencing I wouldn't be too confident that that state of affairs will last too long.




And Finally China

Where the November PMI also showed quite a strong contraction:



So where does that leave us? Well basically I'm not sure. We still need to see more data. (Do I sound horribly like Jean Claude Trichet at this point?). If we look at the chart for US industrial output which Krugman presents, the first thing which is pretty obvious is that the 1928-1930 boom-bust was a pretty rapid affair.



After that output dropped very sharply, going in the space of twelve months from a 20% expansion to a near 30% contraction, and the contraction continued at those levels until mid 1932, when the position started to improve - although all this year on year % contraction data is a bit misleading for non specialists, since to have a 30% contraction in mid 1932, following near 30% contraction in mid 1930 and (what) a 15% contraction in mid 1931 (taking into account base effects) then the drop is really massive, and I doubt even Ukraine (barring very worst case scenarios where the country simply disintegrates) will get this.

But where this current output slump (or call it what you will) in a number of key countries already does resemble the 1930s more than any other drop in activity since (remember, Japan's November fall in output is greater than anything that has happened in the entire lost decade-and-a-half - and the biggest since at least 1953) is in the sharpness of the drop, and in the sequencing of events. By sequencing I mean the fact that we have had a pretty dramatic financial crisis, which has lead to a generalised loss of confidence in the banking sector, and this in turn has produced a credit crunch, which is now working its way right through the real system. And nothing, but nothing, at this point, seems to be barring its pass. That is the worrying bit, and that is why I don't think we are going to see a generalised "turnaround" in activity in 2010, or even 2011, this show is going to run and run, at least in some of the worst affected countries. And we still don't know just how many icebergs there are lying out there for our convoy to hit. In particular, since we all just got the excess leveraging is bad, current account deficits are bad, exports are good religion, it isn't obvious at this point just who the customers are going to be to drive any new expansion when it does finally come. Life, as we know, is always full of surprises, and we should ever be ready for them, for good or for ill.

What Is The Level Of Deflation Risk In Germany?

Only one thing is really clear about the Germany economy at the present time, and that is that it is shrinking rapidly. In fact it contracted far more than most analysts and observers expected in the third quarter (although I, for one, was not especially surprised), entering what now appears to be its worst recession in at least 12 years as both exports and domestic spending continue to fall. German gross domestic product in Q3 dropped by a seasonally adjusted 0.5 percent from the second quarter, when it fell by a quarterly 0.4 percent, according to revised data from the Federal Statistics Office. The Germany economy last had a two quarter contraction of this magnitude back in 1996.

And all the signs are that the fourth quarter will be worse than the third one, so the situation may even surpass the 1996 recession.


What's more the 2009 outlook promises to be even worse. The International Monetary Fund are now forecasting outright GDP contractions for the U.S., Japan and the eurozone next year, with Germany's economy expected to shrink by at least 0.8 percent (this as we will see is one of the most optimistic forecasts currently on the table for German GDP next year). The European Commission declared the 15-nation eurozone to be in recession in November, and just over 40 percent of the exports from this highly export dependent economy go to other eurozone nations.

The only positive elements in the Q3 GDP data are to be found in the slight increases in both final household consumption and government expenditure. On a seasonal and calendar-adjusted basis, household consumption expenditure rose by a quarterly 0.3%, while government final consumption expenditure rose 0.8%. Gross fixed capital formation rose slightly (0.1%) due laregly to a sharp uptick in construction over the second quarter (+0.3%, following –3.4% in the second quarter and +5.5% in the first).

In addition there was a large increase in inventories, and inventories contributed a whopping 0.9 percentage points to Q3 growth (see chart below), and without this build-up the contraction would have been much sharper - so watch out since this inventory increase which will more than likely be unwound in the fourth quarter, with considerable downside impact. Imports were up significantly (largely due to the rise in oil prices - oil peaked around $147 a barrel in July), while exports dropped, as a consquence movements in the net trade balance had a negative impact on final GDP.




Capital formation in machinery and equipment (ie investment) was down sharply (–0.5%), after increasing for seven quarters in a row. Thus the entire positive impact of domestic consumption and increased inventories was more than offset by a very rapid and sharp deterioration in the net export position. Between July and September exports were down by 0.4% over the previous quarter, whereas imports were up 3.8%. This meant that net exports contributed a whopping minus 1.7 percentage points to q-o-q GDP, and headline German GDP is extraordinarily sensitive to changes in the net trade position (see chart below).

Deteriorating Short Term Outlook

Looking forward into Q4, the signs, as I said, are for deterioration, as can be seen from the fact that (according to the latest flash PMI) German services contracted for the third consecutive month in December, even if the rate of contraction was slightly less than that in November.



Worse still, the contraction in manufacturing accelerated, and sharply so, clocking up its fifth consecutive month of contraction according to the flash estimate. The data released by Markit Economics showed German manufacturing registering its lowest reading for manufacturing since the survey was started in April 1996, with the indicator falling to 33.5, down 2.2 points from the November result and significantly exceeding the 1.3 point decline expected by the analysts. If we break the figures down we find that output tumbled all the way to 29.9 (from 32.3 in November), while new orders slipped 3.3 points to a record low of 25.8. Meanwhile, the employment component reached its worse level in the history of the index, coming in at 40.9 for the month from November's 43.6.




October Industrial Output Down


The PMI data are obviously only survey-based forward-looking estimates, but when we come to the actual data we find they are normally pretty near to the mark, since German industrial output fell strongly in October - dropping a seasonally adjusted 2.1 percent from September - according to the latest data from the Economy Ministry. Year on year working day adjusted output fell 3.8 percent. And November’s drop was led by a 3.1 percent month-on-month slump in the demand for investment goods, which means that companies are anticipating a serious slowdown in final manufactured goods further on down the line.





And the PMI is Confirmed By New Orders Data

I think nothing gives us a clearer illustration the dramatic nature of the industrial slowdown the Germans are now experiencing than the chart reproduced below which shows changes in monthly orders (both domestic and for exports) for German manufacturing industry over the last decade. As you will see (to use one of my choice phrases of late) we just went careering off a cliff.


New manufacturing orders dropped 6.1% in October from September, and in September they fell 8.3% from August. The quarter on quarter drop is huge - in the order of 40%.

Export orders are falling faster than domestic ones in the longer term during Sepetmber even domestic orders started to contract sharply as well - a 6.1% drop as compared to 6.2% for exports. What this suggests that the "second round effects" on domestic consumption from the drop in export sales are now hitting domestic manufacturing order books.

Exports Up Only 1.4% In October


Now it is, I think, generally accepted that German domestic demand is lacklustre, and has been for some years, and the German economy lives (or dies) from exports, so it is not without importance that according to the most recent provisional data from the Federal Statistical Office, October German exports were worth up only 1.4% (non price adjusted) and imports up 5.4% from their respective October 2007 levels. After calendar and seasonal adjustment, exports in fact decreased by 0.5% (and imports by 3.5%) month on month when compared with September.

The foreign trade surplus was 16.4 billion euros in October 2008, down from the October 2007 surplus of 18.9 billion euros.




Growth Outlook

It is very hard to put precise numbers on where the German economy is likely to go from here. Certainly GDP growth next year is going to be a shocker on the downside - with or without those notorious calendar adjustments. The Essen-based RWI economic institute are forecasting what now seems to be a "low end" prediction of a 2 percent contraction for next year, but even this would already be the biggest annual contraction since World War II. The have been joined by the IFO institute, who foresee a contraction of 2.2%. At the present time everyone is moving on the downside and accepting the reality of what is happening, with the Berlin-based DIW economic institute also cutting its forecast for the final quarter of 2008 to a contraction of 0.3 percent - down from previously anticipated growth of 0.2 percent (citing in justification the declines in industrial output and construction). The Kiel-based IfW suggested this week that the German economy will shrink 2.7 percent next year - the most pessimistic assessment by any leading research institute. Worse they are suggesting that equipment investment will drop 7.4 percent in 2009 (following a 4.9 percent this year) and that exports will decline 9 percent, (compared with an estimated gain of 5.1 percent in 2008). If these last two guess-timates are anywhere near right, then the German 2009 contraction will be very significant indeed, since exports are the key to the functioning of the German economy.

According to a report in the Frankfurter Allgemeine Zeitung earlier this month the Germann Economy Ministry currently estimate that the economy may shrink by as much as 3 percent next year.

Even further along the scale there is Deutsche Bank, who are forecasting a contraction of as much as 4 percent next year. Deutsche Bank chief economist Norbert Walter makes his forecast based on the deteriorating economic situation in Russia and in the Middle East, countries which have been vital in sustaining demand for German exports in recent months. As a fair weather pessimist on the German front, I feel that Walter may be near the mark than most, and my reasoning would be based on the severity of the downturn both in Russian and Eastern Europe, as well as the slump in Southern Europe, lead by Spain's sharp and resonant housing crash. Since these regions collectively are customers for a very sizeable part of German exports, I expect a pretty horrendous H1 for German GDP in 2009 - and the bad news could go on a good deal longer, since I am sure the East and Southern European agonies are going to drag on at least int0 2010.

Business Confidence Plummets


Certainly the omens for Q4 2008 are now clear enough. German business confidence has been falling sharply since the summer, and dropped to its lowest level in more than of a quarter century in December. The Ifo institute business climate index, which is based on a survey of 7,000 executives, fell to 82.6 from 85.8 in November, giving the main index lowest reading since November 1982. The drop was largely a product of a significant fall in the current economic situation component - which fell to 88.8 from 94.9 in December. Expectations remained largely unchanged at a very low level.

The main sub components all remained very low in December,but what is most striking is the rapidity of the deterioration we have been seeing in the manufacturing sector.




German consumer confidence has held up rather better (possibly a function of the resilience of the labour market, and the drop in inflation) and has remained largely unchanged following a fairly sharp deterioration in August. In December growing pessimism about the short term economic outlook was offset by a stronger willingness to buy, and GfK AG’s forward looking index for January, based on a survey of about 2,000 people, held steady at 2.1.


Employment Resists The Downturn

German unemployment continued to drop in November, despite the scale of the recession that just hit the country, and employers continue to retain and even recruit staff while orders slump. The number of people out of work, adjusted for seasonal variations, dropped a further 10,000 in November to reach 3.15 million, following a 26,000 fall in October, according to data from the Federal Labor Agency. The seasonally adjusted unemployment rate held steady at 7.5 percent, a 16- year low.

Meanwhile separate data from the Federal Statistical Office show that in October 2008 there were 40.84 million Germans in employment, an increase of 538,000 (or 1.3%) over October 2007 . In facr this was the highest number of Germans employed ever. Month on month the number of those employed was up by 219,000 on an uncorrected basis, which was equivalent to an increase of 39,000 ( or 0.1%) on a seasonally adjusted basis. So the great German jobs machine is still working.




The big question which is puzzling many economists however is why this increase in employment does not feed though to private consumption. My own personal feeling is that you need to look at the age profile of the German workforce, and the low value added content of much of the new employment. Some reflection of this can be found in the fact that (on aggregate) labour productivity (price-adjusted gross domestic product per person in employment) in the third quarter of 2008 was down by 0.1% year-on-year in Q3 2008. When measured on a per hour worked basis labour productivity was down by 0.2%.


So jobs are created, but household consumption expenditure hardly moves, and in fact it decreased by 0.3% year on year in Q3, despite the 0.3% increase quarter-on-quarter. So as unemployment has fallen German households have been spending less, especially on food, beverages and tobacco (–1.5%) and on transport and communications (–3.1%). The big factor in the latter decline was the marked decrease in private car purchases and the sharp drop in petrol consumption. As can be seen in the chart below, following the pre- VAT rise spike in Q4 2006, household consumption has remained decidedly lacklustre, despite the economy have had one of its most substantial expansions in over a decade.

If we look at the seasonally adjusted monthly retail sales chart (see below) we will see that these have been dropping steadily (stripping out the December 2006 spike) since mid 2006, and the decline continues.




Price Inflation Falls Dramatically


So to get back to the question I ask in the title to this post, we know that the German economy is going to contract sharply next year - by anything between 2 and 4 percentage points - so given the severity of this shock just what are the dangers that the sudden negative energy shock can push core inflation over into deflation mode?

Well, if we look at German producer prices - which can reasonably be considered a forward looking indicator for future prices, we find that they dropped sharply in November - in fact by the most since records began in 1949. This was of course a reflection pf the fact that the cost of oil declined drastically, but it is also an indicator of growing excess capacity as the global economic slowdown curbs demand. Producer prices fell 1.5 percent month on month, while the year on year rate fell back 5.3 percent. But if we look at the index itself (see chart) we will see that prices peaked in July (when oil prices were at a record), and have been falling steadily since.

And if we take a look at German consumer and producer price inflation together (see chart below), we will see that the energy price shock went in two waves. When the first wave petered out, consumer prices also fell, but they soon steadied, as the force of the expansionary momentum helped prices find a floor. But look what is happening after the second wave, producer prices are in virtual freefall, and these are dragging consumer prices along behind them, and when we think of the scale of contraction which we may well see in 2009, then it seems to me that the danger of opening up a deflationary dynamic behind the shock is a real and credible one.



In fact German consumer price growth slowed to 1.4 percent in Novermber according to the EU harmonized measure, down from 2.5 percent in October, falling significantly below the ECB’s price stability threshold of around two percent, and the lowest level in two years. Again this was the biggest decline since the federal statistics office started calculating German inflation using the HICP methodology in 1996. From a month earlier, prices were down 0.6 percent.

Again if we look at the index itself, we can see that prices have been falling since the summer, but if we dig a bit deeper, and take a look at the core index (that's the one to watch really, without energy, food, alchohol and tobacco, see chart below) then we will find that even on this measure prices have been stationary, and what we now need to watch out for is that the shock from the credit crunch driven GDP contraction addeded to the negative energy shock doesn't simply drive the core index into negative territory. It is impossible to say at the present time whether this will actually happen, but obviously the risk is real, and those over at the ECB would do well to remember this.

Fiscal Stimulus And Rising Deficit Pressure

Reactions to a problem of this magnitute will need to be on two fronts. The ECB obviously need to bring interest rates down rapidly and dramatically, and probably need to be thinking about how they can operate Japan and US style quantitative easing within a Eurosystem framework. On the other hand a fiscal response is essential, and Angela Merkel is reputedly considering a new package of measures in the early new year in addition to the stimulus package (estimated to have a net worth of about 31 billion euros in 2009) already announced.

The German Premier met the leaders of Germany's 16 states last Thursday to discuss additional measures, but no details of the package under discussionhave yet been announced. Angel Merkel did, however, suggest on Friday that the emphasis will be on infrastructure projects such as schools and roads - but since the areas of the Germany economy which are currently suffering most are the exports and capital goods sectors it isn't clear how much value this will really be.

But all of this has a downside, since it is now estimated that Germany will need to sell more debt next year than at any time since the end of World War II to finance the vaious measures being taken. Gross federal bond sales are set to expand by nearly 50 percent - to 323 billion euros ($471 billion) from 220 billion euros this year - according to the emissions calendar of the Federal Finance Agency. The 2009 issuance will be made up of 149 billion euros in bonds with a maturity of one year or more and 174 billion euros in shorter-dated money market securities.

The bond sales calendar is based on a budget that assumes economic growth of 0.2 percent next year, but as we have seen above this forecast is way out of line with what leading economic forecasters anticipate, thus the level of financing will likely be considerably greater at the end of the day, even without any additional stimulus packages.

Thus, following a 2008 budget which was basically balanced following a longer term strategy, Angela Merkel will now need to cope with a federal deficit which is certainly going to expand significantly as tax growth dwindles and spending rises. And bank rescue costs will come on top of the above, pushing the credit requirement up even further. Germany created a 480 billion-euro bank rescue fund in October comprising 400 billion euros in guarantees and as much as 80 billion euros in recapitalization steps, both of which will need to be financed in some form or other through the bond market. It is thought that around 200 billion euros will be approved in guarantees by the end of January and about 20 billion euros in capital measures. It seems however that bonds sold to boost banks’ capital reserves will be reported off budget, and thus not figure in accounts reported to the European Union's Eurostat office.

Germany plans to finance part of its 500 billion euro ($636 billion) bank rescue package by issuing bonds to banks in exchange for new preferred stock, according to Finance Agency head Carl Heinz Daube. ``The banks will not be allowed to sell the injected government bonds,'' Daube said in an interview in Tokyo today. ``So far there's obviously not a huge demand for any rescue measures, but this might change in the coming weeks.'' Germany's rescue plan, approved by lawmakers on Oct. 17, amounts to about 20 percent of the gross domestic product of Europe's biggest economy. Chancellor Angela Merkel's administration pledged 80 billion euros to recapitalize distressed banks, with the rest allocated to cover loanguarantees and losses.

Despite the changed dynamic in public finance, however, the German government is unlikely to experience any real difficulties selling its debt, and the country continues to enjoy a "stable'' outlook from Moody's Investors Service on its Aaa government bond ratings according to a report published earlier this month.

"Germany's public debt payment capacity is strong and Moody's anticipates no problems with regard to affordability or adverse debt dynamics, even with the impact of the economic slowdown likely to be felt on both sides of the government balance sheet,'' said Moody's analyst Alexander Kockerbeck.

It is not clear, however that things are going to remain quite so cut and dry in the future, as the government continues to expand net borrowing on the one hand while slower economic growth even after the recession, on the other, will continue to restrain revenue growth. And as Germany's population ages, health and pension costs are set to mount, and to some extent all this fiscal strain is going to undo a lot of the impact of the "good housekeeping" measures taken in earlier years, making another set of painful reforms more or less inevitable as and when the recovery comes. Angela Merkel is undoubtedly well aware of this harsh reality, and this is surely part of the explanation for why she has tried to keep debt growth under control as possible - much to the chagrin of her EU counterparts in London and Paris, where the demographic dynamics are, of course, much more favourable - even as her budget expands to pay for the emergency fiscal programs.

"A balanced budget remains our target because the demographic changes in Germany will increasingly have an effect from the middle of the coming decade. We must not overburden the younger ones," Merkel said.

Unicredit Shares Fall Again, Merrill Lynch Downgrades

At the present time the Achilles heel of the Italian economy has a name, and it is called Unicredit. In a number of posts on this blog (here, here, here, here) I have tried to draw attention to the potential problem the deteriorating balance sheet of what is now Italy's second bank by market capitalisation (after Intesa Sanpaolo) it used to be the first before the shares fell) and first bank by assets, and how this issue is exaccerbated by the fiscal embarassment of the Italian state.





The spread between Italian and German 10-year bonds hovered around 1.36 percentage points on Monday, more than four times its average over the euro's first eight years. Continuing social unrest in Greece has also pushed the gap between the yield on that country's 10-year bond and that of its German counterpart to a fresh high of more than two percentage points (see much more on Greece here).

At the same time, the cost of buying insurance on Spanish, Italian and Greek debt has more than tripled over the past six months, according to credit information firm Markit Group. Even as the market turmoil has eased in recent weeks, the price of such insurance on Southern European debt has continued to increase, touching highs earlier this month. The widening spreads and increasing insurance costs show opinions among investors about the short term outloook now vary considerably between one eurozone country and another.

Such widening spreads mean more expensive bond auctions for the Italian government in the future, and this is just where the trouble comes, since Italy has a very hefty accumulated debt to continually refinance (around 105% of GDP), and it is partly because investors don't see clearly how a government with a damaged banking system and an economy which looks set to shrink for at least two years can continue shoulder the weight of this debt let alone increase it, especially given the evident difficulty faced by the Italian government in enforcing measures to reduce it, that the widening is occuring.

And this is what makes Unicredit such a major headache for the Italian government, since any substantial increase in government borrowing needs could become completely counter productive if it precipitated an increase in the spread and thus an increase in the costs of borrowing over all those parts of the debt which fall due for refinancing.


Unicredit 2008 Earnings Won't Meet Target


Unicredit shares fell in Milan trading this morning after the bank admitted 2008 earnings won’t meet their target. Unicredit shares were down as much as 4.7 percent - to 1.52 euros at one point - their lowest price since 5 December, and were trading at 1.55 euros (down 2.6 percent) in Milan, giving it a market value of 20.7 billion euros. UniCredit said in a statement late yesterday that it expects net income of 4 billion euros in 2008, excluding a property sale that will be smaller than planned. The company in October forecast net income of 5.2 billion euros.

UniCredit recently reached an agreement with unions to offer early retirement to 3,700 workers in an attempt to cut costs amid the global financial crisis, and last week they bank pulled out of an option they had to buy the Polish government's remaining 3.95 percent stake in Bank Pekao in order to not put more strain on the bank's solvency ratios.


Merrill Lynch Downgrade

Unicredit was downgraded to "neutral" from "buy" by analysts at Merrill Lynch this morning. The bank cited “the fast deteriorating macro picture in Italy and Central Eastern Europe”

“The high exposure to Central Eastern Europe and to the corporate business result in UniCredit above average sensitivity to the poor macro environment and to asset quality deterioration,” London-based analysts Antonio Guglielmi and Andrea Filtri wrote in a note to investors today.

Ukraine Clients May Default On 60% Of Loans

A 44 percent slide so far this year in the Ukraine currency, the hryvnia, is threatening the repayment of loans and mortgages denominated in foreign currencies. Roman Zhukovskyi, head of the social and economic department in President Viktor Yushchenko’s office, estimated in a televised press conference in Kiev on Wednesday that if the hryvnia traded near 9 per dollar, some 60 percent of loans may not be repaid.

“A substantially weaker hryvnia is going to seriously hurt corporations since Ukrainian companies have massive external liabilities,” said Ozgur Yasar Guyuldar, a senior emerging markets strategist in Vienna at Raiffeisen Centrobank AG, who forecast the decline to below 9 per dollar in November. “It is inevitable to see dozens of corporate bankruptcies.”

In an attempt to soften the devaluation blow and bolster the currency Ukraine’s central bank raised its refinancing rates for the second time in two days today to 22% after the hryvnia fell as much as 16 percent in the past two days. But this is likely to be of little avail given that the economy is already headed for an estimated 5% GDP contraction in 2009, and these kind of interest rates make any softening of the economic slump impossible.

Ukraine is just one - at this point extreme - example of the kind of level of default we can see among holders of forex loans across Central and Eastern Europe in 2009, and Unicredit is in the forfront of the exposure to these defaults, which means, effectively, that the medium term future of the Italian economy at this point in the hands of the CEE countries. Which is why Italy's biggest economic headache has a name, and that name if Unicredit.

Why We All Need To Keep A Watchful Eye On What Is Happening In Greece

In view of Greece's EMU membership, the availability of external financing is not a concern, but the correction of cumulating indebtedness could weigh appreciably on growth going forward. While the risk of transmitting vulnerabilities to the euro area is very small reflecting Greece’s small relative size, large persistent current account deficits would increase the vulnerabilities to a reversal in market sentiment, leading to a corrective retrenchment of private sector balance-sheets in the face of rising indebtedness, and a possible appreciable rise in the cost of funding over time. These developments would have significant negative implications for growth.
Greece: 2007 Article IV Consultation - IMF Staff Report

The above quited paragraph from the IMF is a very good example of what used to be the orthodox wisdom about Greece's economic imbalances - that given EMU membership the availability of external financing should not be a concern, and that the Greek economy is effectively too small for it to constitute a menace to the stability of the eurozone itself, even on a worst case scenario. Well, if we look at the growing yield spreads you can see in the chart above (please click for better viewing) the first premiss seems to be in real danger of falling, EMU membership no longer gives an automatic guarantee of oncost-free external financing, and if you look at the names of the other countries lining up in the queue behind Greece - Italy, Spain and Portugal in particular - you can begin to see the outline of a contagion mechanism whereby the coming to reality of the worst case Greek scenario might just extend itself into a problem of sufficient magnitude to transmit Greek vulnerabilities across and into the entire euro area. No one is too small to be a problem when it comes to financial crises, and if you think I am exaggerating just look at how the "pipsqueak" Baltic economies have paved the way and opened the door to much bigger problems right across Central and Eastern Europe even as I write.

But just what are the problems Greece faces, and just what are the risks of transmission of these elsewhere?

Bank Credit Downgrades

The first of the things which has changed since the IMF wrote the staff report I cite above (back in 2007) is the soundness and stability of what was then seen as being a very well funded and liquid banking system. Only last Friday Moody's Investors Service announced they had changed the outlook on the bank financial strength ratings (BFSRs) and long-term deposit and debt ratings of four Greek banks - to negative from stable. The banks in question are National Bank of Greece, EFG Eurobank, Alpha Bank and Piraeus Bank. This move follows decisions earlier in the week by EFG Eurobank and Piraeus Bank to participate in the Greek government's 28 billion euro (about 12% of GDP) bank bailout scheme the aim of which is to provide capital injections to the participating banks via the sale of preferred shares to the state, guarantees on debt issuance, and liquidity support. The decision by these two banks now brings to six the number of Greek banks who have decided to seek refuge in the government scheme, with the other banks being National Bank, Alpha Bank and the smaller ATEbank and Proton Bank.

Piraeus Bank has said it will hold a shareholders' meeting on January 23 to seek approval for a 370 million euro issue of preferred shares to be sold to the state. Under the terms of the bailout plan, the Greek government may spend up to 5.0 billion euros (of the 28 billion euros total, or a little over 2% of GDP) on boosting bank capital ratios via the purchase of preferred shares. These shares will pay the government a 10 percent dividend, and banks using the facility will need to accept a state representative with a right to veto dividend policy and executive pay on their boards. Banks will also have the right to buy back the preferred shares no sooner than July 1, 2009.

In addition to the evident weaknesses which have now come to light in the Greek financial system, the other worrying development we are seeing in Greece at the present time - apart that is from the largescale social conflict that has been hitting the headlines in recent weeks - is the movement in what is know as the yield spreads. These spreads are the interest rate difference a national government has to pay for borrowing money (over ten years say) when compared with that paid by the (benchmark) German government. What this means is Greek government bonds are sold cheaper (ie the government receives less for them) than their German counterparts, but their yields are higher and this is because external investors increasingly see Greece as a less creditworthy country. If Greece itself was fully self sufficient in finance (like say Japan is) then this wouldn't present a problem for bond yields (as we can see in the case of an equally indebted Japanese govenment) since domestic investors could be relied on to buy up the bonds (in a process known as "home bias"), but Greece is not self sufficient, and has to depend on external finance to fund a current account deficit of around 15% of GDP. Thus the opening up in these spreads over the last two months most now constitute the biggest headache those responsible for managing European Monetary Union have had to face since the creation of the eurozone, since according to the well know neo-classical theory of contingent convergence they should be disappearing, and not increasing.

But increasing they are, in what is only the latest example of reality defying received theory, and the Greek 10-year bond, for example, was yielding 4.89% at the close of European trading last Tuesday, while the 10-year German issue returned just 3.23%. The spread between Greek and German bonds has now more than doubled since October and indeed hit its highest level ever since the launch of the euro last Thursday - reaching 190 basis points, up from 168 before the rioting began.

These widening spreads mean more expensive bond auctions for the Greek government, and this is just where the trouble comes, since Greece has a very hefty accumulated debt to continually refinance (around 90% GDP), and it is partly because investors don't see how a government with a damaged banking system and an economy which may soon start shrinking as the recession bites can shoulder the weight of this debt, especially given the evident difficulty faced by the Greek government in enforcing measures to reduce it, that the widening is occuring.

Twin Deficit To Beat All Twin Deficits?


Basically, if I could sum all this up in a nutshell I would ask, just why are we seeing rioting out on the streets of Greece, and calm placidity down there on the Spanish highway. Well, apart from the evident differences in national cultures (which I am certainly not in any way equipped to get into) I would say there is one single fact that marks out the difference: Spanish Prime Minister Jose Luis Rodriguez Zapatero can still sign any cheque he wants to to try to fend off the worst of the Spanish crisis, while Greek Prime Minister Kostas Karamanlis no longer can. Words of warnings left unheard are now coming home to roost and the Greek government's room for fiscal manoeuvre is very very limited indeed at this point. Undoubtedly time will also run out on the Spanish Prime Minister too if we continue on the present course (as I argue in this post) but my point here is that we should be aware that events in Greece, depending on how badly things go, or how quickly they go bad, could end up cutting the available time for Spain even further, via a nasty little process which is ferquently known to go to work during financial crises: regional contagion.

We have already seen just a process at work in Eastern Europe, following the ill-advised excursion of Russia's tanks through the Roki tunnel in early August, are we now about to see something similar happen in Southern Europe following the course of the ill-gotten police bullet which ripped life and lung out of a poor young 15 year old schoolboy in Athen's Exarcheia district this week? Actually I doubt it, that is I doubt we are likely to see a similar chain reaction process just yet, but the severity of the social backdraft we have scene following the incident should serve as a warning to us all of just how delicate this situation now is, and just how easily things could be knocked off balance.

The core of the problem we have before us lies in the Greek twin defict - Greece has a very large and continuing current account defcit (around 15% of GDP, see chart below) and a very large accumulated government debt (around 90% of GDP, see second chart below).



Part of the reason for the recent surge in Greek external debt has been a rapid rise in domestic investment which was not matched by a similar increase in national saving - in fact household savings have been more or less stagnant - and this has meant that the gap between national saving and investment has been steadily growing since 2001 - increasing from 10.5% of GDP in 2001 to nearly 15% in 2006. Most of the additional gap has been due to a rise in net indebtedness by the household sector. To a large extent the decline in household saving and the increased demand for housing as a private investment vehicle can be explained by the increased access to and demand for credit in the context of financial liberalization and the lower interest rates which have followed from Greece's euro participation. Undoubtedly during the years in which Greece "enjoyed" negative real interest rates, it seem a much more attractive proposition to buy a piece of property whose price it was imagined would "never fall" rather then watch savings steadily lose their value in time deposits which were effectively being ravaged by infaltion attrition. On the other hand it is worth bearing in mind that gross Greek household debt - at a little over 40% of GDP - never reached the heady levels attained in Spain of around 90% of GDP.

In contrast, the Greek corporate sector has been running a net savings surplus throughout the entire period (and this of course is another big difference from Spain), with rising saving repeatedly exceeding investment. This notable increase in corporate saving has largely been the result of the strong profitability in the shipping and financial sectors, and it is this profitability which is now, suddenly, under threat in the current downturn.

Greek government debt, on the other hand is somewhere in the region of 90% of GDP, while the deficit is currently somewhere around 3% of GDP, but none of us (including the European statistics agency Eurostat or the EU Commission) can really be too sure of all this, since the goalposts seem to be being constantly moved in more than the football stadia down in Greece, and while it would be an exaggeration to say the data changes on a weekly basis, sometimes it seems we are not so far away from that point. Such shortcomings in Greek public finance statistics (and economic data from Greece generally I would say, if you look at all the regular omissions in the Eurostat short term data relases) are by now a reasonably well-known problem - the general government deficit for 2007 has only in the last month been revised upwards yet one more time - from 2.8% to 3.5% of GDP (much to the furor and chagrin of the EU Commission, since this put Greece in technical breach of its committments to the Commission, yet one more time), while for 2008, the official public deficit target has already been revised up by 0.75% of GDP, compared with the initial budgetary target of 1.6% of GDP, and of course with the historic record to go by and bank bailouts and the economic slowdown to think about, it hardly seems to be credible that this year will be the year, the year we finally make it back under the 3% deficit limit on a consolidated basis. The latest upward adjustment in the forecast reflects expenditure overruns of 1% of GDP and revenue shortfalls of 0.5% of GDP, although at the present time these are supposedly being partially compensated for by a series of measures implemented in September (with unknown outcome at the time of writing, but with an evident adverse impact on Greek public opinion if the images on our TV screens are anything to go by).

The September package consisted of both revenue enhancing and public consumption cutting measures with a projected budgetary impact of some 0.75% of GDP - and hence in part of course the recent furor on the Greek street. If the intended outcome were to be achieved - something which is, as I say, very unlikely under the present economic circumstances and given the government's track record - then the Greek government deficit for 2009 would be somehwere in the region of 2.5% of GDP. But the point about all this rigmorole, is that the end result of all this coming and going, and too-ing and frowing down the years is that Greece is still not completely out of its EU excess deficit procedure, and this at the end of what has been one hell of a "good times" boom, so what can we seriously expect now that the bad time have most definitely come?

Greek consolidated debt has been steadily coming down, as can be seen in the above chart (the brown line, right hand scale, please click on image for better viewing) but the problem that is facing decision makers is, will getting to grips with the heart of the financial problem imply measures which once more reverse this trend, and if it does, just how will the ratings agencies respond, and assuming we already know the answer to the last question, what will this mean for the yield spread?

Greek Economic Performance

The Greek economy has been buoyant for several years, and the gap in real per capita income between Greece and the EU–15 has narrowed significantly. Real GDP growth averaged 4.25 percent during 2000–06, and is estimated at 4 percent in 2007. Solid gains in employment and handsome real wage increases have underpinned strong consumption growth. Rapid credit expansion that followed financial sector liberalization and the drop in interest rates associated with euro adoption have fostered rising residential investment by households, while strong profitability has fueled corporate sector investment. However, the external sector has been a drag on growth; external imbalances have remained large throughout and widened.
Greece: 2007 Article IV Consultation - IMF Staff Report

Recent Greece economic performance, as measured in terms of growth in per capita income and GDP (see chart below) has been - as the IMF indicate - strong, with average annual growth running at a little over 4%, but looking at the macro imbalances which have been accumulating, we need to ask ourselves, as in the case of Spain, will there be a payback to be made for all of this good news?

If we examine the inflation chart (see below), we will find that Greek annual inflation has also been hovering around the 4% mark since the start of the century, a clear two percentage points above the ECB inflation target, and also two percentage points over the ECB policy rate during the key period from June 2003 and December 2005 (when the rate was held at 2% offering monetary conditions which were far too loose for several key members of the eurozone and in the process fuelling housing bubbles in a number of zone member states). Thus with GDP running way above what might be considered a reasonable trend level, interest rates were being adminstered at what was a real rate of minus 2%, despite the evident inflationary symptoms that there was significant "overheating" going on. Thus the Greek economy was given a pretty significant monetary stimulus during what could only have been perceived as the height boom, and at a time when the fiscal stance was also very expansionary. If any of this could work, then we would have to admit that most of what we claim to know in terms of economic theory was simply wrong - although the ECB at the point may simply have taken the IMF view that "the risk of transmitting vulnerabilities to the euro area is very small reflecting Greece’s small relative size". However since I certainly do not think that Greece is "too small to matter" and since I also think the part of our current body of economic knowledge about what you should and shouldn't do during overheating episodes is among the most tried and tested portions of our theoretical heritage,the Greek economy now seems likely to suffer from some rather severe macro problems in the course of the unwind of this particular binge, and I doubt the knock-on effects from the unwind for the rest of the eurozone will simply be too benign to notice.

We might, of course like to ask ourselves whether it wasn't a pragmatic case of "simply nothing to be done"? I would argue that there most certainly was something to be done, and it was on the fiscal side, since interest rate policy was effectively under ECB control. The Greek government, on noting the signs of overheating should have moved to a restrictive fiscal stance - in other words it should have been running a surplus, and a big one, of possibly 2% or 3% of GDP - but as we have seen, just the opposite was the case, and at the same time as monetary policy was excessively accommodative fiscal policy was busy pumping in even more juice.

And so it went on, until it simply couldn't go on any more, which is where we are now, and why Prime Minister Karamanlis cannot simply keep signing the cheques to buy social peace and satve off the downturn, although it is quite clear that this evident reality still hasn't been gotten across to Greece's two largest union federations who last week held a nationwide general strike to protest a set of government's remedial policies which, if they are anything, are already too little and too late. To give you a flavour of what is involved, here is a selection of some of the reforms that are currently causing so many problems.

The Much Needed Pension Reform

Unless the social security system is fundamentally reformed, the long-term costs of population aging are expected to threaten the sustainability of the public finances. The completion of the actuarial studies of the major pension funds has been further delayed, and the authorities are proceeding with a narrowly focused reform agenda which is nonetheless already drawing considerable protest. They have ruled out reduction of the replacement rate and increases in the contribution rates. Instead, the focus is on obtaining efficiency gains through the merger of pension funds, tightening provisions for early retirement (the list of “heavy and unhealthy” occupations and the disability pension code would be reformed toward this end), increasing the incentives for people to stay employed longer, and tackling contribution evasion. In the absence of an assessment of the cost savings, it was not clear to what extent the current reform proposals would suffice to restore the pension fund to financial viability.
Greece: 2007 Article IV Consultation - IMF Staff Report

Despite strong opposition from the main trade organisation unions, the Greek parliament last March approved a law which aimed at a long overdue overhaul of the country's ailing social security system whose longer run actuarial deficits are now estimated to be running at more than twice Greece's 240 billion euro GDP. Experts predict a collapse of the system in 15 years unless something is done to prevent this and have warned that even the current reforms may not be enough to guarantee the system. We should remember that Greece has long running low fertility (around 1.3tfr) and has a rapidly rising population median age. The working age population is soon set to start declining as a proportion of the total population. Many of Greec's working population, however, simply do not understand this rather harsh and complex reality, and are angry about being asked to increase pension contributions for what they feel may well be reduced pension entitlements later, especially at the present time as they are already feeling the pinch of the global economic downturn. The changes included merging the country's myriad 133 pension funds to form a mere 13, raising retirement ages, eliminating special and supplementary pensions, and introducing incentives to encourage people to work additional years.

Privatisations To Pay Down Some Of The Debt

Greece's New Democracy government has already auctioned stakes in Greece's largest ports in Piraeus and Thessaloniki, and sold a stake in telecoms company OTE. It has also pledged to push ahead with the privatization of several state-owned companies, such as Olympic Airways and Postal Savings Bank. Other assets to go on the auction block may include Athens International Airport. These sales have been pushed forward despite strong opposition by unions who fear job losses and wage reductions, but really - apart from the competitiveness arguments which underpin such moves - the government really have little alternative since something or other has to be sold here.

Wages and Salaries

Wage moderation and enhancing wage flexibility are important challenges. The authorities will continue with the policy of containing increases in basic wages of government employees and are hoping for a favorable signaling effect on private sector wage settlements. However, in recent years, wage increases in the private sector have been relatively large and often exceeded productivity growth.
Greece: 2007 Article IV Consultation - IMF Staff Report

One of the key areas of controversy in recent weeks has been a law which effectively ends the employees' right to collective wage contracts (Spain, be warned) and which won approval in the Greek parliament last August. The government said it wanted to clean-up debt-ridden state companies and overhaul protective employment laws in an attempt to attract more foreign investment. The Finance Minister Alogoskoufis recently told parliament the reform should be pushed ahead "for the sake of the Greek economy and society," since higher wages have added to state companies' debts, which ordinary Greeks had to cover with their taxes.

Are We A Bunch Of Hypocrites In Southern Europe?


One question I often ask myself when speaking with Spanish government employees who timidly ask me the predictable "crisis, what crisis? Can't you see, all the bars are still full!" question is just what is meant by that much used and little understood word "solidarity". We are proud to note down here in Southern Europe that we have a complex set of collective institutions which are driven by objectives of "social solidarity", not like those nasty little anglo saxon types (you know, the "neo-liberals") who live up north. But why is it, I ask myself, that I don't here this "crisis, what crisis" stuff from those working in the private sector, who spend the best part of the day at the present time looking across the factory or office floor at their colleagues and asking themselves who it is who will find themself going out of the door this week?

Solidarity means, if it means anything, that everyone shoulders some part of the burden in difficult times, and that people behave responsibily with their national resources and heritage, and accepting that when there is no money to pay for something, then there simply is no money to pay for it. If you find yourself having to depend on the stringent demands of others from outside your country, then the best thing you can do is to get your country out of the debt which is the cause of the problem, and then you can freely decide your own future for yourself. But while I can well understand how a relatively poor country like Ecuador gets itself into such a dependence-based mess, I am at a loss to understand how comparatively rich countries like Spain, Greece and Portugal have allowed things to come to the pass they have now come to, or how their citizens have let them get to the point they are at now.

One good example of the ways you get into such difficulty comes from Spain where the government now wants power companies to pay off one third of the latest tranche of a multi-billion euro deficit which has been created by utilities charging small consumers less than the cost of generation. At the present time, and following the partial deregulation of Spain's electricity sector, the government continues to set tariffs for small consumers. This deficit is estimated by the Spanish energy regulator CNE to be running at 5 billion euros for 2008 alone.
The government has no immediate plans to oblige utilities to pay for a further third of the 11.2 billion euros of tariff deficit accumulated pre 2008, since this deficit is provided for in Spansih law and appears on the companies' books as a long term credit which they are expected to eventually claw back gradually through their customers. The government has been trying to finance this deficit through quarterly debt auctions, but these have met with mixed results, and the government had to declare null and void an attempted sale of 3.85 billion euros of debt amid market turbulence in back in September. The scandalous part about all this isn't that the government could use any funds it could raise at auction for other and better purposes right now, rather it is the fact that this 5 billion euro debt which has been incurred in 2008 by selling energy to customers below cost has only been adding to the hole in the current account deficit, since the energy it pays for effectively needs to be imported.

One key feature in all this woe has to be a political process that is extremely ineffective, and driven by the fact that no one likes to hear bad news, and that the last thing a politician is able to say is tighten-up your belts now lads and lasses, we are in for a rough ride. But isn't this just how the IMF gets such a bad name for itself, since the IMF doctors get called in just where the domestic political process breaks down, and where local politicians haven't the ability to stand up in front of their citizens and say, it's going to have to be like this, I'm afraid. Isn't this what just happened in Ukraine, Hungary and Latvia? And then people say, those "nasty folk" at the IMF, they cut pensions everywhere they go, and wages are down 8% in Hungary, and 15% in Latvia once the IMF get to run the show. That is the IMF make for a convenient scapegoat, but people seldom ask themselves why wages needed reducing, or why there is no money to pay the pensions. Oh, I know.................

The Greek Economy Is Slowing Rapidly

Greek economic growth is now slowing rapidly. Quarter on quarter growth in Q3 2008 was 0.4%, and almost all the growth the economy has been getting this year (including that sharp spike you can see in Q2 in the chart below) comes from earnings from shipping services, earnings which are now falling dramatically as global trade starts to contract. The economy is expected to decelerate further in Q4, and may even contract slightly, with a best case scenario of remaining around the stationary level. Thus the Greek economy should start contracting - and thus formally enter recession in Q1 2009, at the latest.

Given the difficulties Greek banks are having in raising finance in the global financial and capital markets, the ensuing tightening credit conditions are bound to lead to a further slowdown in private consumption. Government consumption is expected to move more or less in line with GDP, while public investment is expected to rebound in 2009, largely reflecting an accelerating pace in the implementation of EU Structural Funds. Household borrowing has - as we have noted - increased at a rapid rate between 2003 and 2007, but during 2008 the rate of increase has been slowing steadily (see chart below).

This reality is reflected in the recent statement by central bank govenor George Provopoulos that he hoped the bank bailout plan would be able to keep the country's credit expansion pace at 10 percent next year (down from around 18.1 percent currently). Even were this to be achieved (which is far from clear), as we have seen in Spain it will lead to a sharp contraction in an economy which had grown accustomed to new credit generation at twice that rate, and especially given the governments inability to step in and offer any fiscal support.



In addition, the Greek construction sector - which, it should be noted, never became so bloated as a share of GDP as it did in Spain and Ireland (where it hit around 11%) - has now been slowing since Q3 2007, when it hit around 7.5% of GDP, and was down to 5.4% in Q3 2008, and was dropping year on year at an annual 6.7% rate in September 2008 according to the latest data from the national statistics office.

Industrial output is also now falling, by 4.5% in October, and the November manufacturing PMI registered a series low of 42.3 indicating even faster contractions in the pipeline. Greek industry has been getting some uplift from the economic boom in South Eastern Europe, and since that is now well and truly over, we should expect the manufacturing downturn to be sharp and sustained.


In the shipping sector, a significant jump in world freight rates and a rise in shipping volumes on the back of a hefty increase in world demand for oil and other minerals both boosted the sector’s profitability, and increased it's importance in GDP growth (indeed growth in the last couple of quarters has been virtually all about shipping). This favourable position has now very much turned. George Economou, Greek shipping billionaire and Chairman and CEO of DryShips recently characterized the current collpase in the Baltic Dry Index (of bulk charter cargo rates) as something like "a nuclear explosion" for those in the shipping industry. The index, which measures world shipping charges for raw materials, has plummeted from a high of 11,793 in May to 672 (see chart below), its lowest level since soon after the index was established, back in 1985. Daily-rental rates for the largest Capesize category of carrier have plunged from $234,000 just two months ago to $2,320, a fall of a staggering 99%.



Even more worrying for the mid-term outlook is the rush to cancel orders of new ships. In November, New York–based Genco Shipping and Trading willingly agreed to say adios to a $53 million deposit simply to get out of a half-a-billion-dollar deal to buy six new vessels. Clarkson Plc, the world's largest shipbroker, announced that while 378 ships were ordered during October 2007, only 37 were ordered in October 2008. And back in Greece Kriton Lendoudis, managing director of Athens-based Evalend Shipping Co., estiamets that in Greece there are currently some 100 applications by shipowners to lay up their vessels. Lendoudis concludes, "The next 24 months do not look very optimistic." It's hard to disagree.

So my feeling is that - taking all the above elements into account - we should expect Greek economic performance to deteriorate at a rate and to an extent which may surprise the casual observer of economic events. Those who have already been following closely what has happened in countries like Spain, Latvia and Romania should, however, be fully prepared for what is now to come. The first signs are there, in the EU confidence chart I close with (below). As can be observed, a slow and steady deterioration has suddenly, after the summer, changed course, and become a sharp downturn. I fully expect that we will now see this general shift in confidence find its reflection in the real economy data that comes rolling in over the next three or four months.

So Just When Does Spain's Twin Deficit Problem Become Unsustainable?

This, it seems, is the question of the day. According to the IMF Spain’s economy faces a contraction of at least one percent next year. And the IMF stress that the risks to this forecast “remain on the downside” since the country’s real-estate market is “in full correction,”. Also, horror of horrors (and we will return to this). The government’s budget deficit will exceed five percent of gross domestic product next year, the Fund forecast.

While the IMF seem to be more aware of the scale of the problem than the Spanish government currently are, they do seem to be putting all of the emphasis for recovery on some much needed labour market reforms, but personally I don't think even these are playing in the right ball park, we need a big picture "breakout" escape plan, to cut loose from the pincers of cash drought, corporate bankruptcy, construction dependency, large scale contraction and price deflation. It's a big mess, and will need an equally bold and ambitious plan to get to grips with it.

One point which is obvious at this stage is that Spanish government forecasting - which has currently built a 1% expansion into the 2009 budget - is getting ever more out of line with the economic dynamic. Really this is the first thing which has to change. Spain urgently needs someone leading the country who is able to turn the page, put some realistic numbers on the table, and try to work to meet objectives, instead of simply failing to achieve them time after time. What do I mean by this, well, if you seriously think that the contraction next year will be of 2% of GDP then it is better to say 3%, and beat your target, than say its going to be 1% growth and come in with a 2% contraction. Not only will your citizens be getting more and more fed up with all of this (and the impact on morale should not be treated lightly) but much more to the point, since Spain is heavily dependent on foreign finance to buy the debt that the government is going to need to issue (see more below) to finance the fiscal deficit, then each and every failure to achieve target is likely to be punished with a higher cost of financing debt (as the yield spread on the risk rises). So as well as the credibility cost, this kind of playing fast and loose with the forecast is now likely to carry a real financial cost.

Of course, in true wooden-bureaucrat style (where are we here, back in the old USSR?) a spokeswoman who declined to be named in line with ministry policy informed Bloomberg that while the Finance Ministry shares the IMF’s analysis of the economic situation, it doesn’t back the specific IMF forecasts on growth and the budget deficit. Obviously the spokeswoman not only decline to be named, she also declined to enter the Byzantine discussion of how it is possible to share the analysis without sharing the conclusions. On the other hand the man who is hotly rumoured to be pencilled in as Pedro Solbes successor in the next facelift - Economy Secretary David Vegara - was rather more elegant when questioned about the estimate by reporters "To me it's reasonable, I always think the IMF and OECD do their work with first class technical groups,". Exactly, although of course, in the forecasting game even the best of technical teams can get it wrong, which is what the IMF allow for when they talk about "downside risk".

Vergara was also of interest yesterday insofar as he specifically denied that Spain faced a deflation problem, although he did admit that inflation was likely to reach a very low level. I think, yet one more time, this is "ostrichism" (avestruzeria), since the drop in prices is now so evident, and the contraction in Spain is going to be so sharp, that Spain has to be the one developed economy where price deflation is now a near certainty, and you can quote me on that. As I go to my local bar for the morning coffee, I always take a look to see whether the 1.15 euros they currently charge for a cafe con leche has been brought down to 1.10 euros. Not yet of course, but when will that happen? In March? In June? I bet it happens before August next year (and I will report). And when it goes down to 1.10 euros, the next move will be 1.05 euros, and so on..... depending on just how long the deflation continues.

So Just How Much Will The Spanish Economy Contract In 2009?

Well, I think this is a very hard question to answer. I think a 1% contraction is a done deal, and my own previous best guess was in the 3% to 5% contraction range, which is, of course, very strong indeed. And there I was happy to leave it, until that is Deutsche Bank came out with their latest 2009 forecast for the German economy, where chief economist Norbert Walter has said that Germany's gross domestic product could contract by as much as 4 percent next year. This has to be "bottom of the range" estimate, but then, it might happen, I mean these are not just numbers spun out of thin air, they are backed by analysis, German manufacturing is contracting very rapidly at the moment (but not as rapidly as Spanish manufacturing). The German government itself is forecasting a 1% contraction, and the IFO institute came out today with 2% contraction for 2009 estimate (the median forecast?). At this point I won't go so far as to modify my original forecast for Spain, but what I will say is that if German GDP contracts by 4% in 2009, then Spain's will contract in the 5% to 7% range, since on every important reading Spain is contracting more rapidly than Germany at this point, and there really is no bottom in sight, just what appears to be a "black hole", sucking us down.

But what About The Sovereign Debt? What Is Going On With All That Government Spending?

This I think is the big point.

At the risk of boring to tears all my regular readers I would first like to stress that what we have in Spain is not a simple garden-variety housing correction. Spain is a country which was allowed across the 2000-2007 period to develop massive macroeconomic imbalances, which to some extent were reflected in a huge housing boom. But the imbalances (current account deficit of 10% of GDP, massive migrant flows - 5 million people in 8 years, rapidly rising household and corporate debt - rising at 20% pa, and reaching around 90% and 120% of GDP in 2008 respectively) and not the housing are the key to the problem. Thus Spain's economy is not reeling under the weight of the unwinding of the property boom, but rather Spain's property boom is reeling under the impact of the unwinding of the macro imbalances, and this unwinding became more or less inevitable once the US sub prime crisis broke out in August 2007. I think it is no accident that the two countries who noticed most the shell shock from the sub prime turmoil were Spain and Kazakhstan, since these two countries were the most dependent on selling some type of paper or other in the wholsale money markets to finance their imbalances, and the doors to these markets effectively closed in September 2007.

So what we need to think about is the impact Spain's financial system problem is having (due to difficulties in financing the current account deficit) on the housing bubble and the construction industry, since this I think is the way the causal arrow works in this case, and not the other way round. And it has been the failure to appreciate this causal chain, in my opinion, that has lead so many people to have had so much difficulty understanding the extent of the problem we have here in Spain.

Basically the housing boom had masked the enormous problem Spain had acculumlated in terms of its current account deficit, for the simple reason the funds which were happily flowing in to fuel the boom meant the books balanced easily enough each and every month. But once people became just a little bit nervous about what was happening to that boom, and how sustainable it was, the flow of funds suddenly dried up, just like that, in September 2007, and the size of the hole in the flagship side suddenly became apparent. Since that time the bilge pumps have been busily trying to drain all the water which has been flowing in, but alas without notable success.

When I say the bilge pumps have been working, I am talking about attempts by the ECB and others to provide liquidity to the Spanish banking system, but if we look at what has been happening to lending in Spain in recent months, we will see that this particular cocktail still isn't managing to reach the parts "the other beers cannot reach". Below we have a chart (based on Bank of Spain data) which shows net additional lending to households on a monthly basis.

What is clear from a quick glance is that lending since June has been virtually stationary, which means basically new funding is being provided for mortgages only at the same rate as old ones are paid up. This effectively means that if something can't be paid for in cash or with a credit card, then it really isn't being sold, and every time less so. To get things in perspective, new lending to households was running at the rate of about 10 billion euros a month up to the summer of 2007. It also means that a business sector which had become accustomed to having new business at the rate of 10 billion euros a month has no found itself with virtually nothing (as I say, simply the business you can do on the basis of recycling the old credits which are being paid off).

But there is new money every month, the CA deficit (which is reducing) is being squared, so where is the new money going. Well that's easy isn't it, it's going to the government to finance the growing deficit, and to Spain's corporates, who need to keep refinancing all that debt, debt which is only mounting, of course, because no one has money to buy the products they want to buy... and why, you may ask, don't they have money? Because the money needs to go to keep the companies afloat, or to fund government rescue plans, to help the firms (possibly via the banks) who can't sell becuse the customers don't have money to buy. Oh, I see.

Of course the solution to this macarbre vicious circle is not to lend the money to the customers who are in any event far to deep in debt, but to reduce the current account deficit which lies at the heart of the problem, possibly by encouraging some people abroad to borrow a bit more money, and then selling them something they need, at a price they may be interested in. It's called "export".

In fact Spanish corporates received a net 19 billion in additional lending over the three month July-September (while households received a net 800 million) but as we can see, all this extra debt isn't moving us forwards very fast, and indeed we are actually going backwards.



As I say, Spain's big problem is the current account deficit, which reached 10% of GDP last year (see chart above). At the present time this deficit is dropping slightly as imports collapse, but it is not falling as fast as it should be, and meantime, as I am saying, the Spanish government is raising its borrowing needs. Spain has movied in 2008 from having a 2% of GDP surplus in January to a 3% deficit in December (ie a shift of 5% of GDP), in 2009 we will move up to at least 5% (as the IMF suggest, and we could even move higher depending on what happens to GDP).

The fiscal response has been swift and large. The government has taken 4 percent of GDP in structural measures for 2008-09 to assist the economy-bigger than many EU partners and ahead in timing. Together with automatic stabilizers, this results in deficits of 3 percent of GDP in 2008 and over 5 percent in 2009-a swing of more than 7 percent of GDP in the headline balance (compared with an end-November 2008 estimate of 1¾ percent for the euro area as a whole). While the mission notes the focus in the 2009 package on spending for labor-intensive local public works, the authorities need to ensure that this is channeled to its most productive use. The mission sees this fiscal effort (with built-in unwinding as the exit strategy) as temporarily boosting demand.
IMF Article IV Consultation: December 2008

So in 2010 we could find ourselves with a CA deficit of around 8% of GDP and a government fiscal deficit rising up into the 5% to 7% region. If this does prove to be the case, then I think the financial markets are absolutely going to see red (there are already problems with the eurozone sovereign 10 year bond spreads, see the charts below - click on the image to see it better) and Spain could find itself just where Hungary was in 2006.

As ECB Council Member Jürgen Stark said in an article in yesterday's Wall Street Journal, the environment for conducting economic policies, and in particular monetary and fiscal policies, has now become extremely "challenging". One part of this challenge is going to be the funding of all the extra borrowing that euro-area governments will need to do to make good on all their promised support for the banking system, most notably the funds for recapitalization and guarantees for interbank loans. Stark estimate that to date, the envelope of funds for possible recapitalizations and guarantees amounts to some €2 trillion, or roughly 20% of euro-area GDP. This is a very large number.


As Stark also notes many euro-area governments failed to use the past boom times to consolidate their public finances (although this was not especially the Spanish case). As a consequence, many euro zone governments are now entering the current downturn with high deficit and debt ratios. Given the weak growth ahead and the costs of the bank bailouts, these ratios are inevitably set to rise. Stark estimates that in a year's time the deficits in many euro-area countries will be between 5% and 7%, up from around 3% now, while public debt may rise by 10 to 20 percentage points. Again these numbers are very large, and financing them is going to be, as Stark would say "challenging".

As can be seen from the chart above, interest-rate spreads for government bonds are already high (and rising) in a number euro-area countries, and I would draw special attention here to the cases of Greece and Italy, since they have been constantly warned about the danger of this kind of development. And governments are having growing difficulty selling paper, as both the Netherlands and Austria found out this week. The Dutch government failed to raise as much as it had targeted for three bonds - maturing over five, six and seven years, respectively - while the Austrian government saw one of the weakest auctions in years for 12-year paper. These difficulties highlight the potential problems that may be faced with the vast pipeline of government and government-backed debt following the announcements of big fiscal packages to stimulate economies and bail out banks.

And analysts are warning that while the problem isn't a big one right now, these early signs of stress, following so closely on the back of the announcement of big fiscal stimulus programmes, are a clear warning of potential problems next year when record volumes of debt are due to be issued. More than $1,000bn of government debt is expected to be raised in Europe in 2009, while close to $2,000bn is forecast in the US.

The Austrian government found itself forced to pay 13 basis points more than comparable 12-year bonds for its €1.1bn issue, while the Dutch government only managed to raise a total of €2.46bn for the three bonds being sold after indicating that it wanted between €2.5bn and €3.5bn. Since the Netherlands is normally considered one of the strongest and safest of credits,then frankly this does not augur well.

The thing is, Spain's downturn is now pushing the country's former fiscal rectitude into the distant past of historical memory. Worse, the debt is being levered up, not to buy a piece of the future for a country in the process of a thoroughgoing renewal, but rather to keep one group of already moribund and walking dead corporates alive, just as long as it remains possible to keep selling Spanish Sovereign debt at prices which don't swallow up most government revenue simply paying off the debt. But as those spreads move skywards that point will be reached, most probably in 2011. By which time Spain will be perfectly poised for one of those classic twin deficit national-bankruptcy scenarious financial crisis theorists like to write so much about.

Short-run fiscal policies need to be embedded in a long-run context to explain how the debt can be lowered once the economy stabilizes. Public debt, while still manageable, is poised to jump. To boost confidence in light of high aging costs, the authorities should present a plan how to lower the debt again once activity stabilizes, including with pension reform. The mission encourages the authorities to develop an intertemporal public sector balance sheet for publication in the annual budget. It would show the debt already incurred, and also the present value of the projected stream of future deficits (a forward-looking debt) under unchanged policies. This provides perspective on long-run fiscal sustainability.
IMF Article IV Consultation: December 2008

Keynes once recommended paying people to dig holes in the ground and fill them in again rather than leaving them languishing on the dole. The Spanish government seem to have gone one stage further, they are only paying us to dig the hole, there is no plan to fill it in again, unless that is they have a prepaid contract with Komatsu or Caterpillar to come over (in the eventuality this is needed, which it will be) with some earth moving equipment, and shove the soil back in to bury the lot of us.