What Is The Real Level Of Unemployment In Germany And Japan?

With Japan having general elections today and Germany facing them next month, I though now might be as good a time as any to have a look at a topic which could turn out to be very important in the months to come: the real underlying rate of unemployment in both these countries.

While the present focus of most press attention is on the fact that GDP in Germany and Japan nudged upwards between April and June (over Q1), we should never forget that this increase follows substantial falls in output. Japan’s real GDP fell at a record pace in Q4 2008 and Q1 2009 (annualized declines of 13.5% and 14.2%, respectively), and German GDP fell by a quarterly 3.5 percent in Q1 and an annual 6.7% - making for the fourth consecutive quarter of negative growth. In both cases the fall in output was accompanied by only a much more moderate decline in employment.

Part of the explanation for this recent return of both economies to growth lies in the fact that both countries have very substantial stimulus and employment protection programmes in place, and these to some extent mask the extent of the output slump. At the same time both countries have been in run up periods to national elections, while both of them have rapidly ageing populations, rising health and welfare costs and steadily deteriorating gross debt to GDP positions. It is therefore highly likely that the positive stimulus programmes will wane somewhat after October as both governments are forced to move from very expansionary fiscal positions, to more or less "belt tightening" ones, and the big issue which lies in front is estimating just how far the respective labour markets can deteriorate in the two countries as a result. Fortunately analysts at Nomura (for Japan) and Societe Generale (for Germany) have recently produced what are very timely studies which help us get a better appreciation of the true underlying situation.


Japan's Sruggles To Raise Exports In The Face Of Tepid Domestic Demand

Apart from the temporary relief which came from a headline GDP growth reading in the second quarter, the news coming out of Japan at the moment is almost uniformly bad. The unemployment rate is now at a record high, raising even more doubts about the real sustainability of the recent economic recovery. The jobless rate rose to a worse than expected 5.7 per cent in July, up from 5.4 per cent in June. By Spanish or Latvian standards this may seem very tame, but if you take into account the extent of government subsidised "hidden unemployment" the true underlying rate may be nearer 12 or 13%, or at least this is what analysts at Nomura (see below) have recently been arguing.

In addition, Japanese core consumer prices fell at the fastest annual pace on record in again in July, potentially putting pressure on a reluctant Bank of Japan to rein in deepening deflation. Core consumer prices - the bank of Japan's preferred measure - which exclude volatile fresh food prices but include oil costs, fell 2.2% in the year to July.

Average monthly Japanese household spending fell in July by a price adjusted 2.0 percent from a year earlier to 285,078 yen, down for the first time in three months, while Japan’s July exports fell 1.3 per cent on a seasonally adjusted basis from June, a real big deal this in a country whose economy is almost entirely dependent on exports. Shipments in July fell 36.5 per cent by value year on year, outpacing the 35.7 per cent decline in June.




Under the Japanese employment protection scheme, the government pays two thirds of the wages of workers in certain specified situations. As of June 2009, some 2.383mn workers had applied for employment adjustment subsidies for 2009 onward (see chart). Although only 1.891mn had been approved as of June, Nomura expect this figure to eventually rise closer to the number of applicants.



In order to try to get a measure of the impact of this scheme on the unemployment level the Nomura analysts did a number of tests, and found that when indexing the number of those employed and real GDP to the output peak of Q4 2007 there was a considerable gap between the output adjustment and the employment one. Based on a simple calculation which assumed this "gap" to offer a good proxy for the amount of “hidden underemployment”, they arrived at a figure for “hidden jobless” in Q1 2009 of 4.7m. This number is far higher than the June unemployment figure of 3.48m. If the hidden jobless are included together with the registered “unemployed”, they calculate that the unemployment rate would have leapt from 5.4% to 12.2%.



This chart below shows estimates made by the Nomura analysts of the extent of hidden joblessness during previous economic downturns. In the majority of cases the number of hidden jobless did not rise at all, or employment fell by more than GDP did, suggesting that employment adjustments were quite swift. They did find, however that there was a comparatively large rise in the numbers of hidden jobless in Q4 1973, triggered by the first oil shock and in Q2 1997, following the Asian currency crisis, problems in the Japanese financial system and a consumption tax hike. The number of hidden jobless, estimated at about 4.7m in Q1 2009, seems to be well above the figures associated with these two earier downturns.



However, as the Nomura analysts point out, even if the difficult labour market conditions are not fully reflected in the unemployment figures, a deterioration in adjusted labor supply-demand could easily lead to major declines in wages even while companies keep the number of hidden jobless down by means of government support. In fact, according to Nomura it would be hard to explain the fact that the decline in wages (total cash earnings of full-time employees) in H1 2009, at 4.7% y-o-y, was far bigger than the equivalent declines in annual average wages of 2.3% in 2002 and 0.4% in 2003, when unemployment also reached new highs, if you don't take the hidden jobless factor into account (see chart). Thus the resulting pressure on wages and household income could easily become a serious impediment to any genuine fully fledged economic recovery.



As of June 2009, payments under the government's subsidy scheme for employment adjustment totalled ¥101.14bn. If the number of approvals grows to meet the number of applicants, Nomura estimate total payments will increase to ¥127.42bn, placing additional strain on fiscal finances. The Nomura analysts argue that dividing the cost of the hidden jobless and in-house unemployed between companies, households and government could well represent a major policy challenge for the new Japanese administration when it assumes office. Given the seriousness of the social and political problems that result from sharp rises in unemployment, it is quite possible the next Japanese government will strengthen the employment adjustment subsidy scheme by, for example, further relaxing its terms and conditions, and it is rather unlikely to try to limit the number of eligible cases by tightening conditions. The net upshot of this, will, of course, be a further deterioration in Japan's gross debt to GDP position.

Given this, and despite the distortions being produced by the huge number of hidden jobless, Nomura think the unemployment rate is unlikely to be allowed to rise too far beyond 6.0%. We will see.



And Germany Does The Same






Despite some small improvement in headline GDP numbers, the great German job machine effectively ran out of steam last autumn, and since that time the German economy has been adding jobs at an ever slower pace. Now the rate of job creation has turned negative, and less Germans are employed every month than they were a year earlier.



German unemployment rose again in July. The number of people out of work increased 52,000 to 3.46 million on an unadjusted basis. The seasonally adjusted total actually fell by 6,000, according to the statistics office due to statistical changes. Without the impact of the changes, the office estimates unemployment rose by 30,000. German unemployment began to increase in November after falling steadily for more than three years. The seasonally adjusted jobless rate was unchanged at 8.3 percent in July.



Analysts at Societe Generale, have examined the case of the German employment protection programme, and point out that while official unemployment in Germany has in fact only risen moderately in the current recession the underlying real effective rate is much higher. The unemployment rate (using the ILO measure) has risen by just 0.6ppt from its 7.1% low in Q4 2008, while in the euro area as a whole, the rate is up by 2.2ppt to 9.4% from its March 2008 low of 7.2%. As they say, it is also quite clear that this relative stability owes much to the widely-used practice of so called short-time working (Kurzarbeit).



The Societe Generale interpretation is broadly supported by survey evidence which suggests that the rate of contraction in employment has eased, suggesting there will be an even slower increase in unemployment in coming months. For example, the employment component of the PMI survey in manufacturing industry rose to 37.9 in July from a low of 32.9 in April, and in the services sector to 49.0 from a low of 45.2 in May. Employment intentions (in the European Commission survey) have also come off the lows in all sectors, but still remain in negative territory, implying further job losses. This evidence tallies with other recent evidence from official unemployment data, which show unemployment up by an average of 8,000 per month in May-July, a big shift downward from the average monthly increases of nearly 60,000 in Q1. This level of improvement will, according to Societe Generale not be sustained, although they do not expect to see a return to the pace of unemployment gains witnessed earlier this year. Of course, as SocGen point out, company employment intentions could easily deteriorate again if growth expectations get revised down, but for the nearer term, the evidence suggests that unemployment in Germany will rise at slower rates than observed earlier this year.




On the other hand they also underline that such short-time working arrangements evidently have a "sell by" date, and can't run forever. As a result there is some concern that a major increase in unemployment in Germany is merely a matter of time.

In fact the Societe Generale analysts are not that convinced by this line of argument, since they think that German legislation has already extended the period for which companies can run short-time working from 18 to 24 months. Examining in detail the evolution of the numbers on short-time working they find that the vast majority of companies only resorted to the programme in the very recent past, so that the 24 month limit will not bite until late-2010. Until the turn of the year 2008/09, the recourse to short-time working was very small indeed. Aside from the seasonal increases in the first quarters of 2007 and 2008, the numbers were small at around 50,000. To put the number in context, they point out that this represents 0.1% of the labour force and is equivalent to the monthly gains in unemployment that were recorded this year. Since then, the numbers resorting to the programme have indeed exploded and by March of this year (the latest available data), there were 1.3 million workers with shortened hours, and this number has probably now risen to around 1.4 million. These are clearly big numbers, amounting to about 3% of the labour force. If they were added to unemployment figures, total unemployment would rise to the previous historic peaks of around 5 million.


However, given that this increase only began in the final two months of 2008, these schemes could easily run for another 18 months, at least as far as the administrative rules are concerned. Whether the German fiscal position will allow this once the new government is installed is another question entirely. Indeed, according to an article in the Financial Times last week, Germany faces a potential wave of corporate restructurings just after the elections, restructurings which will involve substantial job losses and which have not been announced previously due to the existence of an implicit "pact" not to announce big job cuts ahead of the September 27 ballot. We will, as they say, see the proof of the pudding here in the ultimate eating, but levels of German fiscal support at the present level cannot run for that long unchecked after the election results are announced.

More Comedy From The Spanish Banking System

Going through the Variant Perception report on the parlous state of Spain's banking system, I couldn't help stopping and thinking hard about this point from the Spanish newspaper Expansion.

The valuation of the guarantees of the mortgage book of the cajas and banks and of its real estate gains importance. The thirteen companies tied to financial entities represented 47% of all real estate appraisals in 2007. The valuation of these real estate assets has taken on new importance for banks in the context of the current economic recession. The valuation of the mortgage guarantees and of the real estate assets they are taking on through the courts and debt for equity swaps is key to calibrate the solvency of the financial system. This situation has placed the focus once again on the links between banks and the real estate appraisers that goes beyond in many cases a mere commercial relationship.

And then scratching my head, and scratching my head.

Now to put all this in plain English, we are talking here about the valuation of properties that are repossesed by the banks, and that the banks then have as part of their asset side, as goods awaiting sale. Now, Expansion raises the question: "how can we know that these assets are being fairly valued (that is how can we assess the quality of part of the asset side in the bank balance sheet) when the banks themselves own (directly or indirectly) nearly half of the companies doing the valuing.

Well, this is an issue, but in fact the problem is much worse than the Expansion writer seems to realise, since there is a technical (matter of fact detail) that they seem to miss here, and that is how the valuation of property which is repossed by the bank actually takes place.

The issue is fairly complicated, but please bear with me, since if you follow me through to the end you will see why all the rigmorole is important. Basically Spanish “escrituras de hipoteca” (or mortgage agreements) require that the “valor de tasacion” as well as the amount secured is specified in the deed. The “valor de tasacion” is in effect the valuation of the property and it is put in the deed so that the amount of the debt can never actually exceed the value of the assets being mortgaged.


However since the bank don’t know when they might need to "exercise" (or recover) the mortgage, they don’t really want to compromise themselves in advance, and the typical way of handling the problem legally is to state in the "escritura" (or title deed) that it is agreed that the "valor de tasacion" for purposes of "exercising" the mortgage will be equal to the total amount of the debt outstanding plus the rolled-up interest.

This is a very convenient solution for the banks, since it gives outsiders the impression that there is what one might call a valuation in the UK or US sense, when what is really involved is simply a formula applied in order to structure legal documentation.

The same thing happens when it comes to the time to “ejecutar una hipoteca” by auction, there being no other way in Spain. Since judges tend to give banks a really hard time if the asset is valued below the amount of the mortgage debt (ie the individual who owes the money has a debt even after the auction) banks normally take the easy way out and value the property at the amount of the debt rather than have the judge cancel the auction. Banks then theoretically have to pay tax on the transfer price to the registry (assuming they end up “adjudicando” the asset to themselves, i.e. taking possession), and the tax office - Hacienda - won’t accept anything other than the price at which the asset has been “adjudicado”.

The whole point here is that it ends up being very difficult for a bank to transfer an asset to itself in settlement of a debt at a figure which is substantially different from the amount of the debt unless there is a real possibility of getting the borrower to pay the balance.

So........ “valuations” in Spain effectively result from this complex and machine-like calculating process and are in no way comparable to what are known as valuations in - say - the UK market, nor does anyone involved in the process really think that such "values" really reflect what someone would pay for the property. Having got themselves into this position as a result of what is in the end for them a necessary procedure the banks basically just leave the figures exacty as they are. In simple Spanish a property valuation is an estimate of the property's “value”, whatever that might mean!

Which brings us right back to the Expansion article, and this quote:

"The valuation of the mortgage guarantees and of the real estate assets they are taking on through the courts and debt for equity swaps is key to calibrate the solvency of the financial system."

Well if this proces I have descibed above is the "key" to calibrating the solvency of the Spanish financial system, then the calibration process that results is going to be just as ad hoc and inadequate as the valuation process that gave rise to it. In a way all of this reminds me of the structured CDOs in the US case. Most of these got valued by computer programme simply because they were never traded. No-one ever really thought the valuations represented what they could be sold for even if that’s what hedge fund investors were told they were worth. Hence many were in the uncomfortable position of having them valued at 99.98 one minute and getting a bid at 30 the next.

Which again brings us back to Jonathan Tepper, and his Variant Perception report. As I undersand Jonathan, what he is arguing is that the situation in Spain now has certain structural similarities with the situation in the US before the sub-prime crisis broke out. The similarity is partly becuase there is little in the way of an early warning system available. The fact that the Bank of Spain's foreign exchange reserves are merely academic means that many professional bank analysts lack the early warning signs of an imminent balance of payments type crisis, and the mechanical and artificial system for valuing the growing number of homes accumulating in the banks' real estate portfolio means there may well be no small amber flashing light to watch for before all the dials suddenly luch over to red.

Has Spanish Unemployment Really Been Falling Recently?

In this post I would just like to ask a very simple question. What is the real rate of growth of unemployment in Spain? Are things improving, getting worse, or simply staying the same? Now, before you jump to too many conclusions on this it is important to remember that in the world of economic analysis there are lies, damn lies, and then there are press releases.

So if you read in the headlines in your paper recently that the number of jobless in Spain fell by 20,794 in July after a 55,250 decline in June (cutting the total number of unemployment benefit claimants to 3.54 million), you might like - bearing in mind what I have just said - to ask yourself what else could lie behind such statistics?



Well, if you look at some of the more informed commentary - say Reuters writer Paul Day - you will also note the little detail that "A huge public works programme in Spain slowed further layoffs in the beleaguered construction sector and helped unemployment claims to fall for the third straight month" - as a result of which the picture you have in your head may start change.

In fact, in the first six months of 2009, the Spanish government poured some 5 billion euros into local infrastructure projects as part of a total state-funded public works package worth up to 11 billion euros. Then you might notice the quote from PNB Paribas's Diego Fernandez -"'Keep in mind these figures are distorted by the fact that people taking state funded, back-to-work training courses are not counted"

But there is another little detail you should never forget, particularly in a country that has a lots of seasonally related employment, like construction, agricultur and tourism, and that is the lack of seasonal adjustment in the data. It is normal for unemployment to weaken somewhat in the summer. So if we look at the Eurostat data - scandalously Spain doesn't give a monthly unemployment rate to the public, and much less a seasonally adjusted one - we find that unemployment has gone up steadily from month to month, even if the rate of increase has weakened. The number of unemployed has now gone up every month since May 2007 in my Eurostat datasheet. That is 27 consecutive months of increase. And just wait till we get to the autumn!



All of this is very curious, since the way the Spanish National Statistics agency report data to Eurostat, and how they adjust it, remains something of a mystery to me. The June published rate of unemployment is 18.1%. In fact the unemployment number shot up rapidly in the employment survey in March - to a then published 17.4% (source Reuters). This surge surprised me greatly at the time, since I could see no reaon why it should exist looking at the underlying speed of the economic contraction. I even contacted reseachers in the Bank of Spain -via a friend - to ask whether there had been some seasonal correction or something, and received the following reply:

"Los datos de la EPA no se revisan. El INE hace una encuesta posterior para evaluar la calidad de la EPA, pero no hay revisiones. El incremento de las cifras del paro es muy preocupante, sobre todo porque pasaran varios trimestres hasta que se estabilicen. Y las cifras de paro registrado no contradicen en nada a las de la EPA." (Basically, the survey data is not subsequently revised).

Which is very very strange, since the data which are supplied monthly to Eurostat are being continually revised with every passing month at the moment (first up in March, and then down again, the current March reading is 17.2%), which is very acceptable, since seasonal corrections must be difficult at the moment, but it would be nice to have an explanation, since otherwise we might be lead to think that the EPA numbers shot up in March so the INEM numbers for April and May would come down, which they did. And those of us with really bad minds would remember that there were European elections in June. It would be ridiculous to suggest that these numbers were being massaged simply to give the impression unemployment was coming down, wouldn't it?



But as I say, the underlying seasonal trend as reported to Eurostat (but not revealed to voters in Spain) have continued to climb. Only in a country where the generally understanding of statistics is low could this happen, and pass un-noticed.

In this post I would just like to ask a very simple question. What is the real rate of growth of unemployment in Spain? Are things improving, getting worse, or simply staying the same? Now, before you jump to too many conclusions on this it is important to remember that in the world of economic analysis there are lies, damn lies, and then there are press releases.

So if you read in the headlines in your paper recently that the number of jobless in Spain fell by 20,794 in July after a 55,250 decline in June (cutting the total number of unemployment benefit claimants to 3.54 million), you might like - bearing in mind what I have just said - to ask yourself what else could lie behind such statistics?



Well, if you look at some of the more informed commentary - say Reuters writer Paul Day - you will also note the little detail that "A huge public works programme in Spain slowed further layoffs in the beleaguered construction sector and helped unemployment claims to fall for the third straight month" - as a result of which the picture you have in your head may start change.

In fact, in the first six months of 2009, the Spanish government poured some 5 billion euros into local infrastructure projects as part of a total state-funded public works package worth up to 11 billion euros. Then you might notice the quote from PNB Paribas's Diego Fernandez -"'Keep in mind these figures are distorted by the fact that people taking state funded, back-to-work training courses are not counted"

But there is another little detail you should never forget, particularly in a country that has a lots of seasonally related employment, like construction, agricultur and tourism, and that is the lack of seasonal adjustment in the data. It is normal for unemployment to weaken somewhat in the summer. So if we look at the Eurostat data - scandalously Spain doesn't give a monthly unemployment rate to the public, and much less a seasonally adjusted one - we find that unemployment has gone up steadily from month to month, even if the rate of increase has weakened. The number of unemployed has now gone up every month since May 2007 in my Eurostat datasheet. That is 27 consecutive months of increase. And just wait till we get to the autumn!



All of this is very curious, since the way the Spanish National Statistics agency report data to Eurostat, and how they adjust it, remains something of a mystery to me. The June published rate of unemployment is 18.1%. In fact the unemployment number shot up rapidly in the employment survey in March - to a then published 17.4% (source Reuters). This surge surprised me greatly at the time, since I could see no reaon why it should exist looking at the underlying speed of the economic contraction. I even contacted reseachers in the Bank of Spain -via a friend - to ask whether there had been some seasonal correction or something, and received the following reply:

"Los datos de la EPA no se revisan. El INE hace una encuesta posterior para evaluar la calidad de la EPA, pero no hay revisiones. El incremento de las cifras del paro es muy preocupante, sobre todo porque pasaran varios trimestres hasta que se estabilicen. Y las cifras de paro registrado no contradicen en nada a las de la EPA." (Basically, the survey data is not subsequently revised).

Which is very very strange, since the data which are supplied monthly to Eurostat are being continually revised with every passing month at the moment (first up in March, and then down again, the current March reading is 17.2%), which is very acceptable, since seasonal corrections must be difficult at the moment, but it would be nice to have an explanation, since otherwise we might be lead to think that the EPA numbers shot up in March so the INEM numbers for April and May would come down, which they did. And those of us with really bad minds would remember that there were European elections in June. It would be ridiculous to suggest that these numbers were being massaged simply to give the impression unemployment was coming down, wouldn't it?



But as I say, the underlying seasonal trend as reported to Eurostat (but not revealed to voters in Spain) have continued to climb. Only in a country where the generally understanding of statistics is low could this happen, and pass un-noticed.

On the other hand, the rate of annual increase in the INEM numbers is definitely slowing - or if you prefer the second derivative has turned south, and the annual rate of increase has fallen back from a peak of 56.69 in March to 46% in July - which is hardly surprising since unemployment cannot go up exponentiallly (or there would soon be no one left working) and is also what you would expect to find when manufacturing is contracting less slowly, and significant numbers of people are being employed on public works or going on training courses.



So the fact of the matter is, that the latest good data we have for Spain are the June unemployment data (supplied to Eurostat based on the EPA) which showed 4.186 million out of work, and an unemployment rate of 18.1%. And unemployment is rising every month, and that is the sorry and woeful tale of Spanish unemployment at the moment. That and my forecast that, if nothing is done to stop the runaway contraction, unemployment could be up and hitting the 30% mark come December 2010. 25% before Easter 2010 is now a done deal as far as I am concerned, and we will probably break the 20% psychological threshold in October or November of this year.

Raising Taxes In Spain Is Not A Solution!

Victor Mallet had a piece on public works minister José Blanco's Thursday speech in the FT yesterday. My feeling is that the Spain of Zapatero looks more and more like the Hungary of Gyurcsany with every passing day, and I say this more from the point of view of the twin deficit problem, and the impression the administration gives of things being totally out of control and no one knowing what to do, than anything else.

I am not at all party political, and my observation should in no way be read in that sense. The situation has only deteriorated since Solbes and Vergara were ousted, and the only mystery for me is why exactly they were replaced with a team who have no understanding of macro economics whatsoever. For the record, I predict the IMF will have a permanent delegation in Madrid before 2011 is out. My long promised piece on the current situation will finally appear this weekend and will attempt to justify this view.

As the following chart - from Dominic Bryant at PNB Paribas - makes clear, while Spain's households and corporates are busily deleveraging, government finances are deteriorating in a totally unsustainable fashion.



On the details of Blanco's statement, I would simply make three points.

Firstly, it is far from clear that this is a serious proposal. There must be a battle royal going on inside the PSOE even as I write, and this proposal may well have more to do with internal party debates than anything more substantial. Economy Minister Elena Salgado has been notably silent, so one possibility is that Blanco made the speech simply to "test the ground".

Basically, the current Spanish administration want to hear nothing of internal devaluation, and will try anything to avoid that going down road. The biggest issue they have is growing deflation, and falling revenue as prices drop. This has been a common picture across Eastern Europe, it is just that the states in the South of Europe are rather richer, so there was more flesh on the bone when the crisis broke. They have a salary increase for public servants pencilled in for next year, and this, of course, is a commitment which it will be impossible to honour in the present climate.

Secondly, the biggest unspoken issue we are seeing in one economy after another is the retreat of a lot of activity back into the informal sector. So called economic "greying". Just look what is happening to revenue in Italy. Again, we have seen this happening throughout the East. The contractions in the Baltics are nowhere near 20% in my view (although they are, of course, very large), people simply are declaring less and less. This is a problem the IMF are struggling with day in and day out in Latvia. But this whole process makes things very difficult for government finances, as we are seeing. More tax increases on the very rich and professional middle classes will be entirely unproductive as they will only accelerate this process.

Lastly, increases in VAT. These are again very counterproductive, since they hit consumption directly, at a time when consumption is declining anyway. All such increases do is accelerate the contraction (IMHO the IMF is wrong to be advocating this in the East, but undoubtedly they feel they have little alternative if they wish to preserve some minimal semblance of social services, which they need to do to get the population to agree to their packages in the first place). I wouldn't even mind betting that a VAT hike would be nearly revenue negative, for the consumption drop it would produce and the retreat into the informal economy it would accelerate.

Is Germany's Economy Really Powering Ahead?

Well, euphoria in Germany is certainly on the rebound, with a sudden surge in the ZEW investor confidence index and newspaper articles all over the place predicting the imminent renaissance of European economic growth, despite the fact that in 3 of the 5 big European economies - the UK, Italy and Spain - there is little in the way of evidence to back this view up.

The French economy is certainly holding up reasonably well, but the situation in Germany still remains deeply problematic due to the complete dependence of the economy on exports. Despite this we have a shower of articles (Below I present an extract from Frank Atkins writing in the Financial Times) explaining how "Europe's Economic Recovery is Gaining Steam" and the "German economic recovery powers ahead". I have already written up a an extensive summary of the actual state of play in the German economy, which is largely supported by a strong government stimulus programme, and a recovery in industrial output for export to levels which are more in line with the actual current level of demand than were the extremely low levels seen at the turn of the year (which were the product of demand being met from inventory run downs).

German economic recovery powers ahead
By Ralph Atkins in Frankfurt

Germany’s economic recovery has leapt into a higher gear, according to a closely watched survey that showed private sector activity expanding this month at the fastest rate for 15 months and lifting the overall eurozone economy’s performance

The purchasing managers’ index for Europe’s largest economy jumped to 54.2 in August, from 49.0 in July, signalling an unexpectedly brisk pace of expansion. The growth was driven by the service sector, where employment actually rose, but manufacturing also showed a further rebound.

The figures were the latest economic data from continental Europe to surprise on the upside and suggested the region had overtaken the US and UK in the pace of its recovery. France’s economy is also now expanding clearly, according to a separate purchasing managers’ index for the eurozone’s second largest economy.

The euro gained 0.5 per cent on the dollar to $1.43 and 0.2 per cent on the pound to £0.86

Germany’s rebound appears to have been powered by the country’s pioneering “cash-for-clunkers” incentives for new cars purchases and a pick-up in global demand for its exports. Earlier this week, the Bundesbank reported that consumer spending was likely to have risen further in the second quarter and described German shoppers as “remarkable in continuing to defy the negative effects of the global economic and financial crisis”.

The Bundesbank argued that a “further marked pick-up in overall economic output is possible in the third quarter”.

However, Axel Weber, Bundesbank president, has sought to rein in expectations, warning in a German newspaper interview this week that “the economy is not yet standing on its own feet, and the financial markets are still reliant on central bank help”. Other European Central Bank policymakers have also warned that a self-sustaining recovery may take longer to emerge – which also suggested the ECB will be in no rush to reverse the exceptional steps it took to combat the eurozone’s recession.

Evidently Frank Atkins is right up to a point (and his position may indeed even seem more extreme than it is due to poor headline writing). It is certainly the case Europe's economies continued to show signs of improvement in August - following a better than anticipated perforemance in Q2 - with the Markit Flash Eurozone Composite Output Index rising to 50 from 47 in July, thus ending a fourteen-month sequence below the no-change mark of 50. The Flash Purchasing Managers Index for the manufacturing sector stood at a 14-month high of 47.9 in August compared to 46.3 in July, while the services PMI rose to a 15-month high of 49.5 versus 45.7 in July. Markit only publishes flash readings for two eurozone economies, France and Germany. PMI readings give us the best up to the moment snapshot of where activity is at at any given point.



The Markit Flash Germany Composite Output Index stood at 54.2 in August, which was the highest reading for fifteen months, following an index reading of 49 for July. The German Flash services PMI rose to 54.1 in August from 48.1 last month. A very strong rebound for a single month, but do watch out, since elections are coming, and beyond that tricky little data point there is no evident explanation for this impressive rebound. It is suspicious for its strength, in what is an otherwise tepid environment.



Whilet he Flash Manufacturing PMI moved up to 49 from 45.7. A solid improvement, but we are still just short of expansion.



So obviously we should also take into account the latest PMI readings for the Eurozone, which were certainly positive, but hardly sufficient to start uncorking the champagne bottles. Basically, I would note two more things about the recent German performance.

i) We are in the direct run up to an election. This phenomenon has well known side effects for public spending etc. Certainly every project which can be will be being brought forward at this point. We need to wait and see what things look like in October before drawing too many conclusions.

Indeed, on this point, note what the Federal Statistics Office said in their latest press release on German public debt:

"As reported by the Federal Statistical Office (Destatis), the core budgets of the Federation and the Länder – as defined in public finance statistics – recorded a considerable financial deficit in cash terms in the first half of 2009. For the Länder, the financial deficit totalled EUR 15.4 billion, while in the first half of 2008 a financial surplus of EUR 3.1 billion was recorded. In the core budget of the Federation, the financial deficit rose to EUR 14.7 billion compared to EUR 13.1 billion in the first half of 2008. It should be noted, however, that the financial burdens of the Federation caused by the financial and economic crisis become obvious mainly in its extra budgets “Financial Market Stabilisation Fund” and “Investment and Redemption Fund”. Relevant statistical data will not be available until the end of September."

Please note that last little line - "Relevant statistical data will not be available until the end of September." - ie after the elections which will be held on 27 September.


ii) Bundesbank president Axel Weber may be over optimistic when it comes to the deflation threat, but he is far from being full of "irrational exhuberance" about the present timid bout of growth. This kind of view, however, is seldom reflected in those attention grabbing headlines. It would be a pity if all this new found German growth, like those famous wave of babies who were supposed to have been being born in Dussledorf last year, should turn out just to be a blip, undetectable when the annual figures are counted up.

Indeed the present situation (even down to the headlines) is very reminiscent of the reaction after the first quarter of 2008, when that famous decoupling thesis was first launched in all its splendour, which is why I am reproducing extracts from an article by Karl Zawadzky written at the time. He said then "the indicators suggest that the German government is on the safe side with its growth prediction of 1.7 percent. Some economic experts are already speaking of 2 percent or more." In fact German GDP started shrinking almost immediately after the words were written and 2008 whole year growth came in at only 1.3% according to the Federal Statistics Office (and more like 1% on a calendar adjusted basis, allowing for the extra day in February) as I was already more or less forecasting in July 2008 (just for those of you who think economists never get anything right).

My feeling is that by the time we get to the end of the third quarter of 2009 we will all be back to reality, including those among us who write newspaper headlines.

Opinion: German Economy Powers Ahead
by Karl Zawadzky: business editor Deutsche Welt Radio

The German economy surged in the first quarter of this year, defying a global slowdown. DW's Karl Zawadzky remains optimistic about Germany's ability of maintaining its current financial boom.

Experts are predicting that economic growth will slip this year. They cite the financial crisis, high oil and gas prices and the expensive euro.

But the German economy is currently quite robust -- perhaps even more robust than many experts think. The surprisingly strong jump in economic activity during the first quarter is evidence of this. While gross domestic product increased by only 0.3 percent in October, November and December, it rose by 1.5 percent in the first three months of 2008.

Domestic markets get attention

For years, business activity has been fuelled by ever increasing export records. But now, focus has shifted to domestic markets. There were few impulses from abroad that spurred the German economy during the first quarter. The rising prices of key imports crude oil and gas, but also the expensive euro, which put the breaks on German exports, played a decisive role.

Little reason for pessimism

But the German economy is still on track for growth. Even in the first quarter, personal consumption rose after many weak years. Employment was up 1.8 percent compared to spring 2007 and the rise in wages in some sectors promises the biggest increase in buying power in years. That will boost consumption. The German economy is powering ahead, propelled by its own strength.

The indicators suggest that the German government is on the safe side with its growth prediction of 1.7 percent. Some economic experts are already speaking of 2 percent or more.

Compared to other countries in the EU, Germany is proving to be the bloc's economic engine and is powering through the current financial crisis quite well. While the German economy grew by 1.5 percent in the first quarter, the EU reported an average growth rate of only 0.7 percent.

Certainly German analyst and investor sentiment rose sharply in August to its highest level in over three years. The ZEW economic think tank's closely-watched monthly survey, said rising industrial orders and a pick-up in exports had brightened the outlook for Germany. The Mannheim-based institute's economic expectations index for Germany rose to 56.1 in August from 39.5 in July, taking the indicator to its highest level since April 2006.



But we should never forget that while German exports swang back to solid growth in June, surging by 7 per cent in June, optimism was also boosted by a 4.5 per cent rise in industrial orders in June - powered almost entirely by export orders - they are still significantly down on the level they attained one year ago.



While industrial production output numbers for June, tempered hopes for a further rebound, since they fell back 0.1 per cent compared with the May’s figures which showed a 4.3 per cent rise over April.



And in terms of domestic consumption it really is difficult to see any powering ahead in German retail sales, since while the rate of decline may have eased somewhat in July as only a marginal drop was shown in month-on-month sales (the index rose from 46.0 in June to 49.8) the index has now been registering contraction since sales began falling in June of last year. And I doubt things are going to get much better on this front anytime soon.



Oh, and one last little detail. Germany's economy is not - as Frank Atkins again had it in last Friday's FT - offering a ray of hope for the global economy, since Germany is running a current account and trade surplus, which is to say that, on aggregate it is actually draining demand from the rest of the world, rather like those famous energy inefficient solar panels, it uses up more energy producing itself than it actually supplies.

Twenty Percent of Spanish Mortgages Now Considered To Be High Risk

Well officially I am still half on holiday, but I am breaking "radio silence" this morning to cover a story which appeared today in the Spanish newspaper Expansion. According to that article, one in five Spanish mortgages is now considered as being high risk and liable to become "non performing".

The mortgages at greatest risk are naturally those contracted after 2005 where the loan to valuation was over 80% of the total. In 2006 and 2007, according to data from the bank of Spain, LtVs were over 80% in 17.7% of the mortgages granted.

Prior to 2006, the main source of data comes from a study by Genworth Financial, who show that loans with +80% LtV rose from 12.2% in 1996 to 26.4% in 2005 (see chart below which comes from Expansion). These loans were especially popular between 2003 and 2006, but then started to decline as the decision of the ECB to raise interest rates made the likelihood of a price correction rise sharply.



The other key indicator for risk of mortgage default is, of course, the proportion of income devoted to servicing the loan. This has risen, according to Bank of Spain data for the second quarter of 2009 to an average of 38.6% of disposable income.

This figure is down sharply from the 46% reached between 2006 and 2008 largely as a result of the drop in interest rates. This is the plus side of over 90% of Spanish mortgages being variable interest. The boost to families with mortgages has been significant, and this is evident in the consumer confidence surveys.

But there is a downside here. Spanish households are now extraordinarily vulnerable to any rise in interest rates.

Secondly, people feel better because of the improved cash flow situation, but are probably not looking at the capital account side of their personal balance sheet. People with large mortgages and very high LtVs may well be better off by a few hundred euros a month, but the capital value of their investment may be sinking like a stone. In other words they are bleeding out money through the rear window. One day they will wake up to this, and find they are paying interest on a loan which is worth far more than the property they hold. Then, if there is no change in the bankruptcy law it is off to Australia, Canada or Brazil for many highly educated but heaviliy indebted young people, since as the Spanish law stands there is simply no way out from underneath this for them, ever. That is what those awkward little words "full recovery" mean.

Thirdly, Spain is now in deflation. This means that incomes will go down (over several year probably, if there is not one dramatic year of fall), and property values (which will remember correct against the general price index, that is they will also be further sucked down by the general level of prices) will also continue to fall. So the LtV will rise even as the proportion of income which needs to be paid to service a debt of which so many people were once so proud, but which they now find the be a millstone round their necks, will go up and up an up.


Meanwhile Bad loans as a proportion of total credit at Spanish lenders fell the first time in two years in June as savings banks reported a decline in defaults. The ratio fell to 4.6 percent from 4.66 percent in May and compared with a rate of 1.7 percent a year ago, the Bank of Spain said today on its Web site. Bad loans at Spain's banks slipped to 85.6 billion euros in June from 86.7 billion euros in May and 31.2 billion euros a year earlier.

But to put this in perspective, the ratio of bad loans to the total has still tripled to 4.6% over the past 12 months. And the situation is worse than it seems, since according to a study by UBS Spanish commercial banks have clawed back about €10 billion in debt-for-property swaps. And this number does not include Spain’s savings banks who do not disclose the relevant figure. If the position is similar to their commercial peers and we reclassify all these property purchases as bad loans, then the non-performing loan ratio would be 5.7% (before making any further adjustments for the loan restructuring which has been going on thanks to the availability of generous government and ECB funding).

In addition the central bank recently circulated new guidance relaxing the provisioning rules on risky mortgages. Until now, banks had to make provision for the full value of high-risk loans - those above 80% of the property’s value—after two years of arrears. That was obviously far too demanding, since property values rarely fall to zero. However the timing of the change was far from inpeccable, and the new rules, which mean banks only have to allow for the difference between the value of the loan and 70% of the property’s market value, give the impression of massaging rend results.

Iñigo Vega, an analyst at Iberian Equities, estimates that the new rules would relieve banks of the need to make provisions of about €22 billion in coming months (assuming non-performing loans only reach 8% by the end of 2010). To put that into context, Spain’s savings banks, which are heavily exposed to developers, are expected to make profits of only €16 billion before provisions this year.

As the Economist said, deferring losses to mañana doesn't change the extent of the difficulties facing Spain’s financial system.

And just to confirm that Spain really is different, surreal almost, this article (in Catalan) explains that the majority of the long term unemployed who have gone to the employment offices to claim the 420 euro monthly payment they thought they had been promised have discovered ...... that they are not in fact entitled. Apparently, according to the small print, you need to have run out of benefit and been declared unemployed AFTER 1 August 2009. This is Monty Python stuff, isn't it?

From Original Sin To The Eternal Triangle - Lessons From Central Europe

The non-biblical concept of original sin, as Claus Vistesen notes in this post, when propounded in its standard Obstfeld & Krugman textbook version refers to the situation where many developing economies who are not able to borrow in their own currencies feel forced to denominate large parts of their sovereign and private sector debt in non-domestic currencies in order to attract capital from foreign investors - as evidenced most recently in the countries of Central and Eastern Europe. Well, piling insult upon injury, I'd like to take Claus's point a little further, and do so by drawing on another well tried and tested weapon from the Krugman armoury, the idea of the "eternal triangle".

As is evident, the reality which lies behind the current crisis in the EU10 is complex, and has its origin in a variety of causes. But one key factor has undoubtedly been the decisions the various countries took when thinking about their monetary policy and currency regimes. The case of the legendary euro "peggers" - the three Baltic countries and Bulgaria - has been receiving plenty of media attention on late, and two of the remaining six (Slovenia and Slovakia) are now members of the Eurozone, but what of the other four, Romania, Hungary, Poland and The Czech Republic? What can be learnt from the experience of these countries in the present crisis.

Well, one convenient way of thinking about what just happened could be to use Nobel Economist Paul Krugman’s Eternal Triangle” model (see his summary here), which postulates that when it comes to tensions within the strategic trio formed by exchange rate policy, monetary policy, and international liquidity flows, maintaining control over any one implies a loss of control in one of the other two.

In the case of the Central Europe "four", Poland and the Czech Republic opted for maintaining their grip on monetary policy, thus accepting the need for their currency to "freefloat" and move according to the ebbs and flows of market sentiment. As it turns out this decision has served them remarkably well, since the real appreciation in their currencies which accompanied the good times helped take some of the sting out of inflation, while their ability to rapidly reduce interest rates into the downturn has lead to currency depreciation, helping to sustain exports and avoid deflation related issues.

The other two countries (Hungary and Romania), to a greater or lesser degree prioritised currency stability, and as a result had to sacrifice a lot of control over monetary policy, in the process exposing themselves to the risk of much more violent swings in market sentiment when it comes to capital flows. Having been pushed by the logic of their currency decision towards tolerating higher inflation, they have seen the competitiveness of their home industries gradually undermined, and as a consequence found themselves pushed into large current account deficits for just as long the market was prepared to support them, and into sharp domestic contractions once they were no longer disposed so to do.

A second problem which stems from this "initial decision" has been the tendency for households in the latter two countries to overload themselves with unhedged forex loans, a move which stems to some considerable extent from the currency decision, since in order to stabilise the currency, the central banks have had to maintain higher than desireable interest rates, which only reinforced the attractiveness of borrowing in forex, which in turn produced lock-in at the central bank, since it can no longer afford to let the currency slide due to the balance sheet impact on households. Significantly the forex borrowing problem is much less in Poland than it is in Hungary or Romania, and in the Czech Republic it is nearly non-existent.

The third consequence of the decision to loosen control on domestic monetary policy has been the need to tolerate higher than desireable inflation, a necessity which was also accompanied by a predisposition to do so (which had its origin in the erroneous belief that the lions share of the wage differential between West and Eastern Europe is an “unfair” reflection of the region’s earlier history, and essentially a market distortion). The result has been, since 2005, a steady increase in unit wage costs with an accompanying loss of competitiveness, and an increasing dependence on external borrowing to fuel domestic consumption.

So, if we look at the current state of economic play in the four countries, we find two of them (Hungary and Romania) undergoing very severe economic contractions - to such a degree that in both cases the IMF has had to be called in. At the same time both of them are still having to "grin and bear" higher than desireable inflation and interest rates. In the other two countries the contraction is milder, the financial instability less dramatic, and both inflation and domestic interest rates are much lower. Really, looked at in this light, I think there can be little doubt who made the best decision.


Appendix

Here for comparative purposes are charts illustrating the varying degrees of economic contraction, inflation, and interest rates. GDP contraction rates actually present a little problem at the moment, since one of the relevant countries - Poland - still has to report. However Michal Boni, chief adviser to the Prime Minister, told the newspaper Dziennik this week that the economy expanded at an annual rate of between 0.5% and 1% in Q1. So lets take the lower bound as good, it is still an expansion.

The economy in the Czech Republic contracted by an estimated 4.9% year on year in the second quarter.

The Hungarian economy contracted by an estimated 7.4% year on year in Q2.



While the Romanian economy contracted by an estimated 8.8% year on year.


Inflation Rates

Poland's CPI rose by an annual 4.2% in July.


The CPI in the Czech Republic rose by an annual 0.3% in July.



Romania's CPI rose by an annual 5.1% in July.


Polands CPI rose by an annual 5.1% in July.


Interest Rates

The benchmark central bank interest rate in Poland is currently 3.5%.

The benchmark central bank interest rate in the Czech Republic is currently 1.25%.


The benchmark central bank interest rate in Romania is currently 8.5%.



The benchmark central bank interest rate in Hungary is currently 8.5%.

Germany's Economy Returns To (Timid) Growth In Q2

The German economy, Europe’s largest, unexpectedly returned to growth in the second quarter, technically bringing an end to its worst recession since World War II. The euro climbed 0.2 percent to $1.4248 on release of the report.

But don't get carried away just yet, since while gross domestic product rose a seasonally adjusted 0.3 percent from the first quarter, when it plunged 3.5 percent, the most since quarterly data were first compiled in 1970, compared with Q1 2008 Compared with the second quarter of 2008, the price-adjusted GDP product was down 7.1%, while after adjustment for calendar variations, economic performance decreased 5.9% on a year earlier as the quarter had three working days less than the same period of the previous year.



Household and government final consumption together with capital formation in construction (government infrastructure spending) all exerted a positive impact compared with the previous quarter. As price-adjusted imports declined far more sharply than exports (that is the trade surplus rose), the balance of exports and imports also had a positive effect on GDP growth. However, declining inventories continued a negative effect on growth, and this suggests that optimism is not that ebullient, since otherwise people would be stocking up getting ready to sell.

Employment continued to fall, and there were 40.2 million people in employment in Q2, which was a decrease of 25,000 persons or 0.1% on a year earlier.

The Federal Statistical Office will release detailed results for the second quarter of 2009 on 25 August 2009, and we will be able to see the complete picture a little better then.




PMIs Still Show Contraction

Germany's private sector contracted at its slowest pace in 11 months in July and was close to breaking through into growth.

Final figures for the Markit purchasing managers index (PMI) showed the headline composite measure of business activity rising five index points to 49.0 in July from 44.0 in June -- closing in on the 50 level that separates contraction from expansion.

The composite index covers both Germany's manufacturing and service sectors. The headline PMI for the service sector rose to 48.1 in July from 45.2, just below the flash estimate of 48.4.

However, it is clear there will be a before and after the German elections (next month) here, and my forecast is for a further contraction, possibly 0.5% q-o-q in Q3 (looking at the PMIs) as the impact of the stimulus wanes, and exports get stuck more or less around the present level. A long hard road lies ahead.



Germany's battered industrial sector contracted at its slowest pace in 10 months in July, and orders and output grew for the first time since last summer. The Markit purchasing managers' index (PMI) of activity in the German manufacturing sector rose for a sixth month running and by the biggest amount in the survey's history to hit 45.7. This is still, however some considerable distance from the 50 expansion threshold.



Exports Rebound

German exports swang backin to solid growth in June, surging by 7 per cent in June, optimism was also boosted by a 4.5 per cent rise in industrial orders in June - powered almost entirely by export orders.



On the other hand, industrial production output numbers for June, tempered hopes for a further rebound, since they fell back 0.1 per cent compared with the May’s figures which were revised up to show a 4.3 per cent rise in production over April. The strongest performing sectors in recent months have been those producing investment goods and “intermediate” products, shipped for completion elsewhere.



Consumer and Business Confidence On The Rise


German IFO business climate came in at 87.3, higher than the 86.6 expected and the 85.9 reading in June. IFO economists continue to be optimistic as the economy is gradually stabilizing. The expectations component rose for the eighth consecutive month to 90.4 from 89.5 in June. The current assessment component also increased to 84.3 from 82.4 and above market forecast of 82.8.



Consumer confidence also continued it upward trend in August with the GFK forward looking indicator forecasting a value of 3.5 points for August 2009, following a revised value of 3.0 points in July. Over a longer term comparison however, the consumer climate is still at a very low level.



German investor confidence on the other hand fell back in July, although since the impression has been that investors may have been getting ahead of themselves, then this correction is not entirely unexpected. The ZEW index of investor and analyst expectations, which aims to predict economic activity six months ahead, declined to 39.5 from 44.8 in June.



As Retail Sales Continue To Fall Domestic Demand Remains Weak


Domestic demand remains very weak, and retail sales dropped for a secondconsecutive month in June as rising unemployment prompted consumers to cut back their spending. Sales, adjusted for inflation and seasonal factors, decreased 1.8 percent from May when they fell 1.3 percent. From a year earlier, sales decreased 1.6 percent. As can be seen in the chart, German retail sales have been in decline since 2006.




Employment Falls And Unemployment On The Rise

The German job machine ran out of steam last autumn, and since that time has been adding jobs at an ever slower pace. Now it has turned negative, and less Germans are employed every month than they were a year earlier.



German unemployment rose again in July. The number of people out of work increased 52,000 to 3.46 million on an unadjusted basis. The seasonally adjusted total actually fell by 6,000, according to the statistics office due to statistical changes. Without the impact of the changes, the office estimates unemployment rose by 30,000. German unemployment began to increase in November after falling steadily for more than three years. The seasonally adjusted jobless rate was unchanged at 8.3 percent in July.



And Deflationary Pressures Mount

The German consumer price index declined by 0.5% in July 2009 over July 2008, raising new deflation concerns. Germany as a whole has never seen such a low inflation rate has not been seen since German reunification, while for the former territory of the Federal Republic, a similar rate was registered in spring 1987. In the preceding months of June and May 2009, the rates of price increase were +0.1% and ± 0.0%, respectively. Compared to June 2009, the consumer price index remained unchanged (±0.0%).

The harmonised consumer price index (HICP) for Germany, which is calculated for European purposes, declined 0.7% in July 2009 over July 2008.



The index of producer prices for industrial products (domestic sales) for Germany fell by 4.6% in June 2009 from the corresponding month of the preceding year. This was the lowest year-on-year-rate since December 1968 (–5.0%). In May 2009, the annual rate of change was –3.6%. Despite the fact that much of this fall in prices is due to falling food and energy costs, the ongoing excess capacity in the economy, and the mounting unemployment will maintain the deflationary pressure. My view: Germany has entered deflation, and it is far from clear when she will leave.



In fact the German economy will never recover on the back of domestic demand, which is weak, and tends to lag behind movements in exports and in GDP. So really a full fledged German recovery must await recovery elsewhere, and in the meantime we are left with simply marking time.




Bottom line, this is as much of a statistical recovery as anything else at this point. After the election the new German government will need to address fiscal deficit concerns, undermining the fragile growth, and my current forecast is for a further 0.5% contraction in the third quarter, and a 7% fall in 2009 as compared with 2008.