Thursday, May 28, 2009

Exports And Investment Drag German GDP Down In First Quarter

German exports and investment spending plunged in the first quarter, dragging Europe’s largest economy into its deepest economic slump on record.

Exports were down 9.7 percent from the fourth quarter and company investment declined 7.9 percent, according to the Federal Statistics Office. The Office reported that gross domestic product fell a seasonally adjusted 3.8 percent from the previous three months, confirming an initial estimate from May 15. That’s the largest drop since quarterly data were first compiled in 1970.

From October to December 2008, the German economy had already contracted by 2.2%, and by 0.5% in each of the the second and third quarters.

According to the statistics office, the decline in economic performance was mainly due to movements in the balance between exports and imports of both goods and services. As in the fourth quarter of 2008, German exports fell much more than German imports in the first three months of this year. While exports declined 9.7 % year on year, imports were down 5.4%, so that the chnaged balance of exports and imports contributed minus 2.2 percentage points to the decline of GDP.

The negative first quarter evolution was also characterised by a notable decline in investments (– 7.9%, quarter on quarter). Capital formation in machinery and equipment, in particular, was much lower than in the last quarter of 2008. Companies invested 16.2% less in machinery, equipment and vehicles than in the last quarter of 2008.

The decline in capital formation in construction was small in comparison with a drop of 2.6% on the quarter. Inventories were also run down considerably during the quarter, thus reducing growth by 0.5 percentage points. Growth was positive only only for household consumption and government consumption, which up by 0.5% and 0.3% respectively.

Year on year, German GDP was down by 6.7% in the first quarter of 2009. After calendar-adjusted, the figure is 6.9% , since there was half a working day more in the first quarter of 2009 than there was in 2008 (easter impact minus the leap year effect).

39.9 million people were employed in Germany during the first quarter, an increase by 48 000 persons (or 0.1%) on a year earlier. The number of unemployed (ILO definition) was just under 3.4 million, 7.8% of the entire economically active population.

The recession in Germany has hit industrial activity (including energy) particularly hard, and output was down 20.2% over the first quarter of 2008. Marked declines in real gross value added were recorded also by construction (– 8.9%) and by trade, transport and communications (– 6.4%). Financial, real estate, renting and business activities fell much less - by 0.9% compared with the first quarter of 2008.

In contrast to the bleak picture for investment, fixed capital formation and German exports, final consumption expenditure was ever so slightly up quarter on quarter - by 0.1% - and even did slightly better than in the last quarter of 2008 (– 0.0%).

On a year on year basis, household consumption was marginally down though - by 0.1% (following a 0.5% drop in the fourth quarter of 2008), but general government consumption expenditure was up by 0.8%.

The Long Term Outlook

The first-quarter drop in GDP marked an unprecedented fourth successive quarterly contraction for Germany’s economy. The government expects the economy to contract 6 percent this year, while ECB council member Axel Weber said earlier that while “rays of light” are positive, there’s “no reliable indication that the global economy is past the worst.” The euro-region economy may only “gradually stabilize during the latter part of 2009.”

The longer term decline in German GDP performance is now pretty clear (see chart below).

According to the Federal Statistics Office:

Measured in terms of gross domestic product changes at 1995 prices, the rates of economic growth in the former territory of the Federal Republic of Germany and - since 1991 - in Germany have continuously declined since 1970. While the average annual change was 2.8% between 1970 and 1980, it amounted to 2.6% between 1980 and 1991 and to 1.5% between 1991 and 2001.

Since 2001 the performance of the German economy has in fact been worse rather than better, much to the consternation of those who hoped that many years of sacrifice in the form of wage deflation and structural reform would lead to a rebirth of the country's former economic prowess. In reality the German economy shrank (0.2%) in 2003, and grew by only around 1% in both 2004 and 2005. And while the German economy picked up notably in 2006 and 2007 (with growth rates of 3.2% and 2.6% respectively) and many talking in terms of such grandiose notions as global uncoupling and "Goldilocks" type sustainable recoveries, the most striking feature of the recent German dynamic has been the way that internal demand failed to respond to the externally driven export stimulus. Of course, all the speculation came to an abrupt end in 2008 when the German economy once more entered recession as world trade expansion slowed and exports collapsed (with GDP only growing by 1% over the year), while 2009 looks set to be a lot worse (with the IMF currently forecasting a contraction somewhere in the region of 5%, and forecasts of up to minus 7% not seeming exaggerated).

What we seem to have here is "engine faliure" rather than mere "magneto problems" (using Claus Vistesen's memorable phrase for a very similar situation in the Japanese economy, and it would be nice if the current crisis could serve as the stimulus for an open, and "in the real world" debate about why this is. So some part of the traditional mechanism of economic transmission seems to have been broken, and the "second leg" of the economic cycle, the domestic consumtion driven one, seems no longer to work. Long term GDP growth rates in the German economy are clearly falling, and the decline looks clearly set to continue. Now falling and ageing population couldn't have anything to do with it, could it?

Seeing is Believing, But Stabilising is NOT Recovering

This is one of the key points I have been hammering here on this blog for some weeks now. There is clear evidence of most economies globally "stabilising" at this point, you could even stretch it to say that the "worst is over" - since I doubt we will go back to the dreadful days of December and January (see German manufacturing PMI chart below) - when it was like someone had given a very sharp knock to the whole industrial sector with a large sledgehammer, and of course ultimately the vibrations settle down even if the damage remains.

But to go from this evident fact to drawing the conclusion that a full recovery is now in the works would be a very fast and loose use of both logic and economic theory. Production is falling less slowly (on an annual basis) and even increasing slightly (on a monthly basis) in some countries as orders can no longer simply be met from what are now very depleted inventories.

But as I suggest in this post, upping output to meet current orders is not a recovery, for the win-win dynamic to move us back into a new cycle investment activity has to increase. And on this front there is precious little actual evidence to back the more positive discourse, and indeed the data we are seeing indicate rather the contrary.

When I last wrote we did not have detailed data for Q1 GDP for the eurozone economies , so I took a look at the evidence from Japan, where investment activity slumped massively between January and March (pointing out that there was no good reason why we should expect the situation to be very different in Europe). Japanese business investment was down a record 10.4 percent year on year in the first three months, and a massive 35.5% over the last quarter.

But now we have detailed German Q1 GDP results from the Federal Statistics Office, and we find a very similar picture. Total investment was strongly down (– 7.9% quarter on quarter), while capital formation in machinery and equipment, was 16.2% lower than in the last quarter of 2008, and 19.6% lower than in the first three months of last year.

But all of that is to some extent history. Much more preoccupying - certainly for the "onward-annd-upward-we-go" thesis - is that German plant and machinery orders declined the most on record in April from a year earlier. Orders dropped an annual 58 percent, the most since data collection started in 1950, after falling an annual 35 percent in March, according to the Frankfurt-based VDMA machine makers association in a statement today. Export orders slumped 60 percent while domestic demand dropped 52 percent. So things actually seem to have deteriorated in April with respect to March. No good news this.

Especially when you read the same day an interview with Hans-Joachim Dübel - CEO of Berlin based FinPolConsult, one of the leading and few relatively independent voices in the German housing finance community - where he says: "My guess is that the Landesbanken alone will cause ultimate losses of 8-10% of German GDP, which is real money. Compare that sum with the 5% of GDP costs for the US S&L crisis".

Saturday, May 23, 2009

Don't Get Carried Away Now!

As Paul Krugman recently pointed out, one of the central points they made in the latest IMF World Economic Outlook was that recessions caused by financial crises tend to get resolved on the back of export-lead booms, with countries normally emerging from the crisis with a positive trade balance of over 3 percent of GDP. The reason for this is simple, since consumers are so laden-down with debt from the boom period, they are naturally more obsessed with saving than borrowing during the initial crisis aftermath. So much then for the typical crisis, and the typical exit. But musing on this point lead Krugman to an additional, rather disturbing, conclusion: since the present financial crisis is truly global in its reach, the habitual exit route to recovery will only work after we are able to identify another planet to send all those exports to (shades of Startreck IV). The joke may seem a rather exaggerated one, in poor taste even, but behind it there lies a little bit more than a grain of truth.

But not everywhere is gloom and doom at the moment, and on the other side of the world they woke up reeling from different kind of bounce last Monday morning, on learning that India’s outgoing government had been not only been re-elected, but had been thrust back into power on a much more stable basis. And that was not the only pleasant surprise in store for those reading their morning newspapers in London, Madrid or New York, since India's main stock index - the Sensex - shot up as much as 17% during early trading on receiving the news, while the rupee also surged sharply. So just one more time we find ourselves faced with the prospect of living in a rather divided world, where on one side we have growing and deepening pessimism, while on the other we see a burst of optimism, with someone, somewhere, getting a massive dose of that "let a thousand green shoots bloom" kinda feeling. Perhaps we should ask ourselves whether there is any connection?

Well, and to cut the long story short, yes there is, and the connection has a name, and it's called sentiment. Indeed sentiment is precisely why the recent (and highly controversial) US bank stress tests were so important. Their real significance was not for any relevance they may have from a US banking point of view (which was, of course, highly contested), but for the reassurance they can give market participants that there will not be another financial explosion in the United States (as opposed to a protracted recession, and long slow recovery), or put another way, to show the days of "safe haven" investing are now over. Risk is about to make a comeback, and the only question is where?

Which brings us straight back to all that earlier talk of coupling, recoupling, decoupling, and uncoupling which we saw so much of a year or so ago (or to Decoupling 2.0, as the Economist calls it). And to the world as we knew it before the the demise of Lehmann brothers, where commodity prices were booming like there was no tomorrow on the one hand, while credit- and housing-markets markets were steadily melting down in the developed economies on the other, where growth was being clocked up in many emerging economies at ever accelerating rates, while the only "shoots" we could see on the horizon in the US, Europe and Japan were those of burgeoining recessions.

The point to note here is not just that a significant group of investors and their fund managers spent the better part of 2008 busily adapting their behaviour to changed conditions in the US, Europe and Japan, but rather that a very novel set of conditions began to emerge, as the credit crunch worked its way forward and property markets drifted off into stagnation in one OECD economy after another. Just as they were finally announcing closing time in the gardens of the West almost overnight it started "raining money" in one emerging economy after another - as foreign exchange came flooding in, and the really hard problem for governments and central banks to solve seemed to be not how to attract funding, but rather how to avoid receiving an excess of it. Thailand even attained a certain notoriety by imposing capital controls with the explicit objective of discouraging funds not from leaving but from entering the country.

Then suddenly things moved on, and day became night just as quickly as night had become day as one fund flow after another reversed course, and the money disappeared just as quickly as it had arrived. Behind this second credit crunch lay an ongoing wave of emerging-market central bank tightening (during which Banco Central do Brasil deservedly earned its spurs as the Bundesbank of Latin America) with the consequence that one emerging economy after another began to wilt under the twin strain of stringent monetary policy and sharply rising inflation. Thus the boom "peaked" in July (when oil prices were at their highest), and momentum was already disapearing when the hammer blow was finally dealt by the decision to let Lehman Brothers fall in late September. By November all those previous positive expectations were being sharply revised down, with the IMF making an initial cut in its global growth estimate for 2009 - to 2.2 percent from the 3.7 percent projected for 2008. The World Bank went even further, and by early December was projecting that world trade would fall in 2009 for the first time since 1982, with capital flows to developing countries being expected to plunge by around 50 percent. By March 2009 they were estimating that the volume of world trade, which had grown by 9.8 percent in 2006 and by 6.2 percent in 2007, was even likely to fall by 9 percent this year.

Having said this, and while fully recognising that the future is never an exact rerun of the past - and especially not the most recent past - given that emerging economies have been the key engines of global growth over the last five years, is there any really compelling reason for believing they won't continue to be over the next five? Could we not draw the conclusion that what was "unsustainable" was not the solid trend growth which we were observing between 2002 and 2007, but rather the excess pressure and overheating to which the key EM economies were subjected after the summer of 2007? And if that is the case, might it not be that the "planet" we need to find to do all that much needed exporting to isn't so far away after all, but right here on this earth, and directly under our noses, in the shape of a growing band of successful emerging economies.

According to IMF data, the so called BRIC countries actually accounted for nearly half of global growth in 2008 - China alone accounted for a quarter, and Brazil, India and Russia were responsible for another quarter. All-in-all, the emerging and developing countries combined accounted for about two-thirds of global growth (as measured using PPP adjusted exchange rates) . Furthermore, and most significantly, the IMF notes that these economies “account for more than 90 per cent of the rise in consumption of oil products and metals and 80 per cent of the rise in consumption of grains since 2002”.

But behind the recent emerging market phenomenon what we have is not only a newly emerging growth rate differential, since alongside this there is also alarge scale and ongoing currency re-alignment taking place, a realignment driven, as it happens, by those very same growth rate differentials. The consequential rapid and dramatic rise in dollar GDP values (produced by the combination of strong growth and a declining dollar) has meant that a slow but steady convergence in global living standards - at least in the cases of those economies who have been experiencing the strongest acceleration - has been taking place, and at a much more rapid pace than anyone could possibly have dreamed of back in the 1990s, even if the long term strategic importance of this has been masked by the recent collapse in commodity prices and the downward slide in emerging stocks and currencies associated with the post-Lehman risk appetite hangover. Which is why, yet one more time, that simple issue of sentiment is all important, or using the expession popularised by Keynes "animal spirits".

Carry On Trading

But now we have a new factor entering the scene. The US Federal Reserve, along with many of the world's key central banks, has so reduced interest rates that they are now running only marginally above the zero percent "lower bound", and the Fed is far more concerned with boosting money supply growth to fend of deflation than it is with restraining it to combat inflation. Not only that, Chairman Ben Bernanke looks set to commit the bank to maintain rates at the current level for a considerable period of time.

In this situation, and given the extremely limited rates of annual GDP growth we are likely to see in the US and other advanced economies in the coming years, all that liquidity provision is very likely to exit the first world looking for better yield prospects, and where better to go than to to look for it than those "high yield" emerging market economies.

The Federal Reserve could thus easily find itself in the rather unusual situation of underwriting the nascent recovery in emergent economies like India and Brazil , just as Japan pumped massive liquidity straight into countries like New Zealand and Australia during its experiment with quantitative easing between 2001 and 2006. And the mechanisms through which the money will arrive? Well, they are several, but perhaps the best known and easiest to understand of them is the so called carry trade, which basically works as follows.

Stimulus plans and near-zero interest rates in developed economies boost investor confidence in emerging markets and commodity-rich nations whose interest rates are often in double figures. Using dollars, euros and yen these investors then buy instruments denominated in currencies from countries like India, Brazil, Hungary, Indonesia, South Africa, Turkey, Chile and Peru - which collectively rose around 8% from March 20 to April 10, the biggest three-week gain for such trades since at least 1999 . A straightforward and simple carry-trade transaction would run like this: you borrow U.S. dollars at the three-month London interbank offered rate of (say) 1.13% and use the proceeds to simply buy Brazilian real, leaving the proceeds in a bank to earn Brazil’s three-month deposit rate of 10.51%. That would net anannualized 9.38% - under the assumption that the exchange rate between the two currencies remains stable, but the real, of course, is appreciating against the dollar.

Other options which immediately spring to mind are Turkey, where the key interest rate is currently 9.25 percent, Hungary (9.5 percent) or Russia (12 percent). And the cost of borrowing is steadily falling - overnight euro denominated inter-bank loans hit 0.56 percent last week, down from 3.05 percent six months ago after recent moves by the European Central Bank to cut interest rates and pump liquidity into the banking system. The London interbank offered rate, or Libor, for overnight loans in dollars is thus down to 0.22 percent from 0.4 percent in November. And while the ECB provides the liquidity, the EU Commission and the IMF provide the institutional guarantees which - in the cases of countries like Hungary or Romania - mean that even is such lending is not completely free from default risk, they are at least very well hedged.

Indeed Deustche Bank last week specifically recommended buying Hungarian forint denominated assets, and according to the bank the Russian ruble, the Hungarian forint and the Turkish lira are among the trades which offeri investors the best returns over the next two to three months. Deutsche Bank recommends investors sell the euro against the forint on bets the rate difference will help the Hungarian currency gain around 10 percent over the next three months (rising to 260 from around 285 to the euro when they wrote). Investors should also sell the dollar against the Turkish lira and buy the ruble against the dollar-euro basket, according to their recommendations.

And it isn't only Deutsche Bank who are actively promoting the trade at the moment, at the start of April Goldman Sachs also recommended investors to use euros, dollars and yen to buy Mexican pesos, real, rupiah, rand and Russia rubles. John Normand, head of global currency strategy at JPMorgan, is forecasting a strong surge in long term carry trading as the recovery gains traction. Long trading, he says, is decidedly "underweight" at this point. Long carry trade positions held by Japanese margin traders, betting on gains in the higher-yielding currencies, peaked at $60 billion last July, according to Normand. They were liquidated completely by February, and have subsequently increased to around one third of the previous value (or $20 billion). “Only Japanese margin traders and dedicated currency managers appear to have reinstated longs in carry,” Normand says. “Their exposures are only near long-term averages.”

And Barclays joined the pack this week stating that Brazil’s real, South Africa’s rand and Turkey’s lira offer the “largest upside” for investors returning to the carry trade. A global pickup in investor demand for higher-yielding assets and signs the worst of the global recession is over “bode very well for the comeback of the emerging-market carry trade,” according to analyst Anfrea Kiguel in a recent report from New York. In part as a result of the surge in carry activity the US dollar declined beyond $1.40 against the euro on Friday for the first time since January. Evidently the USD may now be headed down a path which is already well-trodden by the Japanese yen.

India on The Up and Up.

But some of these trades are much riskier than others. Many of the countries in Eastern Europe who currently offer the highest yields are also subject to IMF bailout programmes, so they are with good reason called "risky assets". But others look a lot safer. Take India for example. As Reserve Bank of Indian Governor Duvvuri Subbarao stressed only last week, India’s “modest” dependence on exports will certainly help the economy weather the current global recession and even stage a modest recovery later this year. Of course, "modest" is a relative term, since even during the depths of the crisis India managed to maintain a year on year growth rate of 5.3 percent (Q4 2008), and indeed as Duvvuri stresses, apart from the limited export dependence, India's financial system had virtually no exposure to any kind of "toxic asset".

As mentioned above, the rupee rose 4.9 percent this week to 47.125 per dollar in Mumbai, its biggest weekly advance since March 1996, while the Sensex index rallied 14 percent for its biggest weekly gain since 1992.

And, just to add to the collective joy, even as Indian Prime Minister Manmohan Singh began his second term, and stock markets soared, analysts were busy rubbing their hands with enthusiasm at the prospect that the new government might set a record for selling off state assets, and thus begin to address what everyone is agreed is now India's outsanding challenge: reducing the fiscal deficit.

Singh, it seems, could sell-off anything up to $20 billion of state assets over the next five years as he tries to reduce the central govenment budget shortfall which is currently running at more than double the government target - it reached 6 percent of gross domestic product in the year ended March 31, well beyond the 2.5 percent government target. The prospect of a wider budget gap prompted Standard & Poor’s to say in February that India’s spending plans were “not sustainable” and threaten that the country's credit rating could be cut again if finances worsen. But just by raising 100 billion rupees from share sales and initial public offerings in the current financial year would reduce the fiscal deficit by an estimated quarter-point, at the stroke of a pen, as it were. And there is evidently plenty more to come from this department.

As a result of the changed perception that the new Indian government will now - and especially with the elections and the worst of the global crisis behind it - seriously start to address the fiscal deficit situation, both S&P and Moody’s Investors Service, have busied themselves emphasising just how the outcome gives India's government a chance to improve its fiscal situation. The poll result gives the government more “political space” to sell stakes in state-run companies and improve revenue, according to Moody’s senior analyst Aninda Mitra, while S&P’s director of sovereign ratings Takahira Ogawa commented that the result means “there is a possibility for the government to implement various measures to reform for further expansion of the economy and for the fiscal consolidation.”

So off and up we go, towards that ever so virtuous circle of better credit ratings, lower interest rates, rising currency values, and ever higher headline GDP growth, which of course helps bring down the fiscal deficit, which helps improve the credit rateing outlook, which helps... oh, well, you know.

And it isn't only India which is exciting investors at the moment. Brazil's central bank President Henrique Meirelles went so far as to warn this week against an “excess of euphoria” in the currency market, implicitly suggesting the bank may engage in renewed dollar purchases to try to slow down the latest three-month rally in the real. The central bank began buying dollars on May 8, and Meirelles’s latest are evidently upping the level of verbal intervention. The real has now climbed 20.5 percent since March 2, the biggest advance among the six most-traded currencies in Latin America, as prices on the country’s commodity exports rebounded and investor demand for emerging-market assets has grown. The currency is up 14 percent this year, more than any other of the 16 major currencies except for South Africa’s rand, reversing the 33 percent drop in the last five months of 2008.

Carry Me Home

Despite a number of outsanding worries about the emerging economies in Eastern Europe, the general idea that countries like India, Brazil, Turkey, Chile, Peru etc are firmly at the top of the list of the economies where current growth conditions are generally favorable seems essentially sound. Additionally, if this sort of argument has any validity at all it is bound to have implications for what is sure to be one of the key problems we will face during the next global upturn: what to do with the financial architecture which we have inherited from the original Bretton Woods agreement (or Bretton Woods II as some like to call it).

The limitations of the current financial architecture have become only too apparent during the present recession, since with both the Eurozone and the US economies contracting at the same time, the currency see-saw between the dollar and the euro has failed to provide any adequate form of automatic stabiliser. And since Japan's economy is in an even more parlous state -deep in recession, and desperate for exports - having to live with a yen-dollar parity which is at levels not seen since the mid 1990s can hardly be fun. This has lead some analysts to start to talk of a new and enhanced role for China's currency, the yuan, in any architectural reform we may initiate. But obviously, beyond the yuan we should also be thinking about the real and the rupee. However,I would like to suggest the problem we now face is a much broader one than simply deciding which currencies should be in the central bank reserve basket, and it concerns the central issue of how to conduct monetary policy in an age of global capital flows. During the last boom, comparatively small open economies like Iceland and New Zealand were on this receiving end, but this time round we face the truly daunting prospect of having global giants thrust into the same position, while the USD gets pinned to the floor, just as the Japanese yen was previously.

The problem is evidenty a structural one. The euro hit 1:40 to the USD on Friday (at a time when Europe's economies are in deeper recession than the US one is), while - as I said - the Brazilian central bank President felt the need to come out and warn against an “excess of euphoria” in the local currency market following an 18% rise in the real over 3 months. Officially, the euro surged as a result of news that the US might receive a downgrade on its AAA credit rating, but this justification hardly bears examination, given that around half of the eurozone economies could be in the same situation. Obviously currency traders live in a world where the most important thing is to "best guess" what the guy next to you is liable to do next, and in this sense the rumour could have played its part, but the real underlying reason for the sudden shift in parities is the return in sentiment we have been seeing since early May, and the massive and cheap liquidity which is on offer in New York.

Of course, the impact spreads far beyond Delhi and Rio. Turkey’s lira is also well up - and has now advanced 10 percent over the last three months - while South Africa’s rand is up 22 percent, making it the best performing emerging-market currency during the same period.

All good "carry" punts these, with Turkey’s benchmark interest rate standing at 9.25 percent, and Brazil’s rate of 10.25 percent. Even the ruble is up sharply, just as Russia's economy struggles to handle the rapidly growing loan default rates. The currency climbed to a four-month high against the dollar on Friday, making for its longest run of weekly gains in almost two years, hitting 31.0887 per dollar at one point, its strongest level since Jan. 12. The ruble was up 3.2 percent on the week - closing with its sixth weekly advance and extending its longest rally since September 2007 - and has risen 16 percent since the end of January. Russia's central bank has cut base interest rates twice since April 24 in an attempt to revive the economy, but the refinancing rate is still 12 percent - well above rates in the EU, the U.S., Japan and even quite attractive in comparison with those on offer in other emerging markets. The basic point here is that carry trade players can leverage interest rate differentials and benefit from the changes in currency valuation that these very trades (along with those made by other participants) produce. So all of this is truly win-win for those who play the game, until, that is, it isn't.

Not all of this is preoccupying - far from it, since the issues arising are in many ways related to the problem I started this article with: namely, who it is who will run the trade and current account deficits and do the necessary consuming, to make all those export-lead recoveries (even in China, please note) possible. Evidently the core problem generated during the last business cycle was associated with the size of the imbalances it threw up, and the impact on liquidity and asset prices that these imbalances had. If I am right in the analysis presented here, then we are all on the point of generating a further, and certainly much larger, set of such imbalances as we let the process rip in the uncordinated and unrestrained fashion we are doing. As you set the problem up, so it will fall. Floating Brazil and India is a very attractive and very desireable proposition. Consumers in those countries can certainly take on and sustain more leveraging. The two countries can even to some extent support external deficits as they develop. But they need to do this in a balanced way, an they do not need distortions. The world does not need more Latvias, Estonias, Irelands or Spains (let alone Icelands, and let alone of the size of a Brazil or an India). So policy decisions are now urgently needed to impose measures and structures which help avoid a repeat of the same in what is now a very imminent future. And despite all the talk of reform, very little has been done in practice. Talk of "tax havens" and the like sounds nice, and is attractive to voters, but all this is on the margin of things. What we need is global architectural reform, and policy coordination at the central bank, and bank regulation level, not to stop the capital flows, but to find a more sophistocated way of managing them.

Thursday, May 21, 2009

Europe’s Economic Activity Looks Up (a bit) In May

Well the eurozone outlook is certainly deteriorating less rapidly at this point than it was, at least this is the impression given by the May flash Purchasing Managers Indexes (PMIs) - which show the pace of economic contraction slowing markedly from April. PMI readings for the 16-country euro area rose significantly this month, and hit their highest level for the last eight. It is, however, important to bear in mind that the index still registered contracting economic activity, even if the rate of decline fell for a third consecutive month. Chris Williamson, chief economist at Markit, who compile the indexes, said the latest readings were consistent with second quarter GDP falling about 0.5 per cent quarter on quarter (or by a 2% annual rate), well down from the 2.5% quarter on quarter GDP outcome (or 10% annual rate) in the first three months of the year. That being said, we are still in the realm of contraction, and organisations such as the International Monetary Fund, the European Commission and European Central Bank continue forecast a return to positive growth only in 2010.

In fact, May’s eurozone “composite” index, covering manufacturing and services, stood at 43.9 in May, up from 41.1 in April, the highest since September.

The eurozone economies, especially the export-led German one, showed themselves to be particularly vulnerable to the collapse in global demand after the failure of the Lehman Brothers investment bank. Most hopes for short term recovery are based on the idea that since companies have now substantially reduced inventories they will need to step up production to meet future orders. And this, it is true, will give a short-term uplift to output (which is what we are seeing). But for this short term uplift to translate into a full-blown expansion, the demand for inventory renewal has to provoke an increase in investment to fuel an anticipated future increase in demand, and it is far from clear that we are seeing this at this stage.

We do not have detailed data for Q1 GDP for the eurozone economies yet, so evidence for investment behaviour is scanty, but if we look at the evidence from Japan, investment activity slumped massively in between January and March, and there is no reason why the situation should be very different in Europe. Japanese business investment was down a record 10.4 percent year on year in the first three months, and a massive 35.5% over the last quarter.

On the other hand, eurozone economic activity will continue to come under pressure in the months to come as the impact of the sharp contraction in activity feeds through into the labour market. And companies are likely to keep cutting spending because the decline in external demand has left factories operating well below capacity level, and semi-idle workforces can only be retained for so long. Markit said that the pace of job losses had eased this month – but only slightly compared with the record pace reported in April.

The flash reading only gives details for two of the euro area's big four. The rate of decline in Germany's private sector eased to its slowest in seven months in May, and the composite index rose to 44.4 from 40.1 in April, suggesting the contraction in the second quarter will be much slower than the 3.8% slump (15.2% annualised) in the first. Markit estimated that we may be looking at something like a 0.6 decline (-2.4% annualised). The outcome may be a bit worse than this, but still a significant improvement seem certain.

The German manufacturing PMI index rose to 39.1 from 35.4 in April, while the services sector index rose to 46.0 from 43.8. The manufacturing index was dragged down by major job losses in the sector, and according to Markit "Manufacturing employment in Germany is falling at a far, far faster rate still than services...Manufacturing has really been hammered even though there was some easing in the rate of job losses in May."

The French services PMI was up at 47.6 in May from 46.5 in April, while the manufacturing sector also rose to an above expected level of 43.1 from 40.1.

So it would be very premature to draw the conclusion that we are out of the woods yet. The euro hit 1:40 to the dollar on Friday, and with this level it is hard to see how German exports are going to stage a recovery with currencies like the Swedish Krona and the UK pound down something like 20% over the last year. And remember, with Italy and Spain themselves in deep recessions German companies are now going to have to look well beyond the eurozone to find those much needed customers.

Friday, May 15, 2009

Slovakia Takes The Biscuit - GDP Drops 11.2% In Three Months

I've been trying to draw attention to what is happening to Slovakian GDP for some months now, since I felt the consensus has been missing something (see this post, and this one). The Economist, for example, has been arguing some sort of version of Baltic and Hungarian exceptionalism in Eastern Europe, and even pointing to Slovakia as a positive example to be followed.

“Most other countries in the region are faring much better, though….Like Slovenia, which joined two years ago, Slovakia can enjoy the full protection of rich Europe’s currency union, rather than just the indirect benefit of being due to join it some day.”
This example is far from isolated, yet, as I have already indicated in this post, the April EU sentiment indicator showed that business and consumer confidence in Slovakia was doing rather worse than the even that in the Baltics, so something relatively unpleasant was obviously happening.

And now we know for sure that it was, since according to last Friday's flash data release from the national stats office Slovakia's economy contracted by 5.4 percent year on year during the first three months of 2009. By way of comparison we could note that the economy expanded by 8.7 percent year on year in the first quarter of 2008. The latest results simply confirm what most Slovak economy watchers, the central bank, the European Commission and others already knew: the country is set to enter recession and remain there throughout 2009.

While the sharpness of the contraction in the first three months is pretty eyebrow raising, it does not come as a total shock, since in its revised GDP estimate released on April 7, the National Bank of Slovakia had already forecast that Slovakia’s economy would contract by 2.4 percent over the course of 2009. At the end of 2008 the bank was projecting growth of 2.1 percent for 2009, so the turnround is pretty sharp. And while the local stats office haven't yet given us a seasonally adjusted quarterly figure for the contraction, last Friday's Eurostat EU GDP release gave the figure of 11.2% for Slovakia q-o-q (which may well not be seasonally corrected, so I am evidently not suggesting they were dropping at a 44.8% rate in the quarter, which would obviously be ridiculous).

Total employment is also also down, falling in the first quarter of 2009 by 0.4 percent year-on-year, so that at the end of March there were 2,199,900 persons employed, according to the stats office.

In presenting the data, František Palko, state secretary of the Economy Ministry, argued that a year-on-year drop in GDP by as much as 5 percent had been expected in the first quarter due to impacts of the Russian gas crisis - which affected Slovakia at the beginning of the year - and the decline in external demand for Slovakia's products.

Certainly this decline is evident, since Slovak industrial output fell 22.9 percent in the first three months of the year, led unsurprisingly by the car industry, which had previously been the growth motor. In fact Slovak industrial output contracted at a slower inter-annual pace in March following a record plunge in February since European government incentives helped with car production and the electronics industry continued to expand. Output was down an annual 18 percent, making March the sixth consecutive month when production has contracted, a figure which compares with the revised 25.6 percent decline in February. Car production was down 30.1 percent year on year, compared with a 44 percent drop in the previous month.

The lions share of the fall in industrial output was due to a fall in demand for exports - Slovakia is a small, trade-dependent economy, and March exports decreased by 20,1 % compared with March 2008. Imports were down even more, by 23,1 %, and as a result the trade balance was in surplus (EUR 81,9 million). Over the first three months, as compared with the corresponding period last year, total goods exports were down by 28,6 % and total goods imports by 28,2 %. The quarterly trade balance registered a deficit of EUR 51,2 million (up by EUR 45,6 million compared with the same period in 2008).

Inflation Heading To Zero

The net result of the collapse in demand is an increase in the output gap and strong downward price pressure - in particular since as a member of the eurozone Slovakia no longer has its own currency to devalue. So it is hardly surprising to find the country's EU harmonized annual inflation rate falling back to 1.4 percent in April, its lowest level since August 2007, and down from 1.8 percent in March. Month on month, prices fell by 0.1 percent following a 0.3 percent decline in March.

Indeed Slovakia is on the threshold of negative year on year inflation since consumer price indexes (both the general index and the core one) have actually been flat now since the start of the year (see chart below).

Waning demand is also leading companies to cut back on their workforces, pushing the March unemployment rate to 10.33 percent, the highest in almost three years. The rate, which is the highest since June 2006, was up from from 9.72 percent in February, according to the Bratislava based National Labor Office. The number of unemployed available for work in the country of 5.4 million people increased to 273,779 from 257,564. The unemployment rate has now been rising steadily from a record-low of 7.36 percent achieved in August last year. The EU harmonised rate published by Eurostat was up at 10.5% in March, from 10% in February.

Despite all the talk of Slovakia having a "fexible" labour market, 7.36% is still a very high rate of employment to run when the economy is experiencing a massive boom, so it will be very interesting to see the actual rate of downward movement in wages (and prices) as the recession moves forward (another kind of "stress testing").

Pressure On Public Finances

Slovakia’s central budget deficit widened to 347.4 million euros at the end of April as the economic slowdown cut into tax revenue, according to the Finance Ministry. Revenue for the first four months of the year was 3.32 billion euros, lower than expenditure which amounted to 3.67 billion euros. The shortfall compares with a 204.6 million-euro difference in March and a surplus of 257 million euros at the end of April 2008. Slovakia originally targeted a central government budget deficit of 1 billion euros in 2009, or a shortfall of 2.1 percent of gross domestic product.

The Finance Ministry now estimates tax revenue will be about 1 billion euros short of the original projection, which was based on an expectation for GDP growth of 2.4 percent this year. The central bank now forecasts the economy will shrink 2.4 percent.

In 2008, the general government deficit increased to around 2.25% of GDP. The better-than expected budget outcome was the result of a number of the revenue-increasing measures (e.g. broadening of the corporate and personal income tax base, increase in the maximum ceiling on social contributions), which offset the revenue shortfall due to the deteriorating economic situation.

The 2009 general government deficit is forecast by the EU Commission to increase to 4.75% of GDP. On the revenue side, the anti-crisis packages include measures such as a temporary increase in the tax-free part of income from €3,435 to €4,027, an in-work benefit for low-income employees (negative income tax), as well as a decrease in social contributions for mandatorily insured self-employed. On the expenditure side, the bulk of the measures with budgetary impact are related to the subsidies for R&D activities, for programmes aiming at increasing energy efficiency and supporting existing or newly established SMEs as well as for the Slovak cargo and railway company.

The EU Commission expect the general government deficit to rise to 5½% of GDP in 2010, with the debt-to-GDP ratio increasing from 27.5% of GDP in 2008 to some 36% in 2010. Despite the deficit in excess of 3% of GDP, gross public debt is still very low, and ratings agency Standard & Poors were generally pretty positive in their most recent Slovakia outlook. They did however see two significant challenges lying ahead for Slovakia.

1) Firstly the rather obvious point that here is an increasing risk to the economy from Slovakia's high exposure to the auto sector.

2) And secondly, the rather more important point that since conversion to the euro was undertaken when the Slovak Koruna was trading at a short term peak - the government were using currency appreciation to soak up inflation and stay withing the Maastricht euro limits (see this post here) - Slovak exports are now somewhat penalised compared with those coming from some of their neighbours (the Czech Republic, Poland and Hungary) - in terms of competitiveness, since while they were also using currency appreciation as an anti inflation posture during the height of the commodities surge, they have since been able to "correct" and allow their currencies to devalue. Personally I can't stress too strongly how important an issue I think this is.

The Slovak economy is very open, and indeed has become impressively more so in recent years. It is in fact the third most open economy in the EU after Luxembourg and Malta, according to Eurostat data (in the sense of a “small open economy”). In terms of trade in goods, Slovakia is even the most open economy in the EU. This situation in part reflects the country's small size - Slovak GDP represents only 0.6% of eurozone GDP, or some 2.4% of German GDP. Given Slovakia is so small and so open, a high proportion of domestic demand will now be met by imports from “cheaper” neighbours (notably Hungary and Poland). So Slovakian growth will have to rely more on investments in productive capacity and exports.

As I said above in this sense a shift in emphaisis is called for, since the economy is incredibly vulnerable to the automotive sector, and this in a situation where European car sales have slumpled, is, as weak can see, a lethal flaw. In fact the situation has been made worse by the recent wave of government-backed incentives, since they have only exacerbated the slump in demand for luxury models - like the Cayenne, the Audi Q7 and the Volkswagen-brand Touareg SUVs - which are over-represented in the Slovak sector ((in contrast, theCzech car industry is strongly profiting from car scrapping subsidies). These subsidies together with accompanying environmental incentives have shifted Europe’s shrinking car demand toward smaller and more fuel-efficient models, and hence global No.1 luxury carmaker Bayerische Motoren Werke AG’s registrations dropped by almost one-third in April (to 55,633) even as the German market as a whole expanded 19 percent. Daimler recorded a 26 percent sales decline to 60,214 cars, led by its Mercedes luxury brand.

The Slovak government has been having some success in diversifying the economy, for instance by attracting Sony and Samsung production facilities. Production of cars was down 30.1 percent in March, while output in the electronics industry rose an annual 50.3 percent.

More worryingly, the amount of foreign-investment pledged to Slovakia slumped 92 percent in the first quarter of the year as the global slowdown prompted companies to delay expansion. The only two projects brokered by the state SARIO investment agency in the first three months represent a total investment of 8 million euros, with the potential to create 220 jobs, according to spokeswoman Jana Murinova. In the same period last year, the agency negotiated nine projects worth 103 million euros and creating 1,455 jobs.

Slovakia adopted the euro last January, is now feeling the pressure of price competitiveness from neighbours who have retained an autonomous capacity to devalue their currency as investors as scale back expansion plans during the slowdown. During 2008 Slovakia attracted investment projects worth 538 million euros, less than a half of the 2007 total of 1.28 billion euros.

The Slovak case raises important questions, not least about the rigid application of the Maastricht criteria in a situation where they may not only have lost much of their original relevance, but even where they may lead to distortions - as in the Slovak case - which may mean a painful period of internal wage and price deflation is necessary to overcome the loss of competitiveness produced by entering the common currency at an unrealistically high parity .

Slovakia may now face a difficult period (like Portugal - see this post) of internal price adjustment having entered the euro at too high a rate. The openness of the economy will require more price and wage flexibility. Slovakia joined EMU with a relative strong exchange rate. Currencies of neighbouring countries have been depreciating significantly against the euro. So we are seeing strong deflationary pressures, and average industrial wages fell an annual 0.6 percent in March, following a 1.9 percent fall in February. In nominal terms, average monthly wages rose to 718 euros from 687 euros in February. However, for now these are nowhere near on the same scale as, for example, the impact of the drop in sterling on Ireland.

On a side issue Slovakia issued a 2 billion euro, 2015-dated bond yesterday at 170 basis points over mid swaps. So this can give you some idea what new eurozone members can expect in the future, somewhere up there in the spreads with Greece and Ireland. Slovakia is rated A1 by Moody's Investors Service, A+ by Standard & Poor's Corp. and A+ by Fitch Ratings.

So, while Hungary is still the worst performer among CEE EU member economies the two recent members of the Eurozone - Slovenia and Slovakia - are doing worse than anyone would have imagined, and this should lead to some serious questions being asked in Brussels and Frankfurt. Why is it that, for example, participants in a crisis racked economy like Latvia (whose economy is contracting at an 18% annual rate, and whose bankers and politicians are moving heaven and earth to try to scrape through the qualifying hurdle for eurozone membership) are still feeling better than many economic agents in the Eastern two countries who have actually managed to access the zone according to the latest reading of the EU Economic Sentiment Index. Eurozone membership is not a one way street, far from it. So what are the benefits, and what are the dangers, and how do we optimise the membership process?


Portugal Sustains - what are the lessons of Portugal's membership of the Eurozone (12 January 2009)

Slovakia’s Euro Membership Bid (April 21 2008)

Let The East Into The Eurozone Now! (22 February 2009)

German GDP Falls At An Incredible 15.2% Annualised Rate

“I believe there are some grounds for being optimistic that the pace of decline in economic activity will decelerate markedly in the months ahead,” was the view being expressed by Bundesbank President Axel Weber earlier this week. And we'd better hope he's right, since with figures from the Federal Statistics Office this morning showing that Germany's recession worsened considerably in the first quarter, with the economy shrinking by 3.8 percent compared with the previous three-month period I would hate to see it accelerating. Basically a 3.8 percent contraction in three months is equivalent to a 15.2% contraction as an annualised rate, so the chances are he is right, this is a breathtaking pace, and is unlikely to be maintained. But slowing down the rate of contraction is hardly equivalent to recovery, a point weber was quick to reinforce. “However, it is certainly not advisable to be overly optimistic that the recovery process is safely on track. This will most likely be a gradual process," he added.

This is, in fact, the fourth consecutive quarter of contraction, and is the worst performance by the German economy since at least 1970 - when the German statistics office started the present time series. It is also the first time since reunification in 1990 that the German economy has experienced so many quarters of negative growth. GDP has was dragged down by the drop in export and and the consequent weakness in investment.

Year on year GDP fell by 6.7%, following a 1.7% reading in the fourth quarter of last year. Corrected for working days, GDP fell by 6.9% year on year. Last month the government revised its forecasts and is now expecting an annual contraction of 6%.

The 16-nation euro zone also slumped by a record of 2.5 percent quarter on quarter in the first there months. This is worse most analysts had been predicting as recently as a few days ago, when forecasts were pointing to a decline of around 2 percent. While Germany, Europe's largest economy saw the deepest slump, Austria was not far behind with a drop of 2.8 percent and Italy with its 2.4 percent contraction in the first quarter. Meanwhile, Europe's second largest economy, France, also saw negative growth, sliding by 1.2 percent. The 27 member European Union shrank by a quarterly 2.5 percent.

The sharpness of the German GDP contraction in the first quarter of this year is unlikely to be repeated during the rest of 2009, according to German government spokesman Thomas Steg, and given the ferocity of the downturn he is surely likely to be right. But not shrinking so fast is not the same as growing, and there is evidently a lot more pain in the works yet.

There are a number of signs of just this slowing down in the contraction already emerging. Retailer slaes in Germany fell at the slowest pace in the current 11-month sequence of decline in April, according to the Bloomberg retail PMI. Sales were down only modestly in marked contrast to the steep declines recorded at the start of the year. Month-on-month the index for Germany picked up from 44.4 in March to 48.9.

Manufacturing Contraction Eases

German manufacturing contracted for the ninth month running in April, though the pace of the downturn eased to its slowest since last November. The headline manufacturing PMI in Europe's largest economy registered 35.4, still a very low level, but nonetheless up significantly from March's reading of 32.4.

"April's survey provides hope that the German manufacturing downturn has passed its nadir, as the PMI moved further above January's record low," according to Tim Moore, economist at Markit Economics. "However, output still fell at a rate unprecedented prior to the fourth quarter of 2008, prompting firms to trim employment and inventories to the greatest extent in the survey history," he added.

New orders declined for the tenth successive month but at a much slower pace than in March, with the sub-index rising to 37.0 from 28.9 - a series record month-on-month rise. The improvement in the PMI results fits in with other recent sentiment indicator readings in German, with the Ifo institute's business climate index improving in April to its best level in five months, while the ZEW investor sentiment gauge rose to its highest level in almost two years. However, we are still a far cry from a return to output growth in Germany, with most observers anticipating a GDP contraction of between 5% and 7% for 2009, and given the export dependence we should be looking for an increase in imports in main customer economies before we start thinking about any expansion in German manufacturing output.

Industrial Output

German industrial production held more or less steady in March, for the first time in six months. Output was unchanged from February, when it dropped 3.4 percent, according to the latest data from the Economy Ministry in Berlin. Manufacturing industry continued to contract however, and was down 0.4% on the month, and by 22.8% year on year.

That being said, German industrial output levels are now very low (see chart below), and are roughly comparable with those registered in 1999/2000.

Exports Recover Slightly In March

German exports were up for the first time in six months in March, adding to signs that the pace of the economic contraction slowed slighly as we entered the spring. Exports, adjusted for working days and seasonal changes, were 0.7 percent from February, when they fell 1.3 percent, according to the latest data from the Federal Statistics Office. Year on year exports were down 15.8% following a 23.5% drop in February and a 23.2% drop in January.

German imports increased 0.8 percent in March from the previous month, when they dropped 4.8 percent. The trade surplus widened to 11.3 billion euros from 8.6 billion euros in February. The surplus in the current account, the measure of all trade including services, was 10.2 billion euros, up from 6.8 billion euros. On a seasonally adjusted basis exports were up by 0.4 billion euros from February, which means you can just barely notice the change on the chart below: ie there is still a very long way to go here.

Services Contraction Also Slows

Activity in Germany's private sector shrank for the eighth month running in April, though as elsewhere the pace of the contraction eased, in the German case to the slowest rate since last October. The services sector PMI edged up to 43.8 from 42.3 in March, while the business expectations sub index jumped to 44.4 from 39.0, and the headline composite PMI reading rose to 40.1 from 38.3 in March.

Markit reported that "Pessimism about the year ahead outlook for activity was the least marked since June 2008. This partly reflected the support given to business sentiment from the government's economic stimulus plans, as well as hopes that overall market conditions will begin to stabilise". These firmer expectations are consistent with the rise in the April Ifo reading for German corporate sentiment, which hit its strongest level in five months.

However, despite the more positive business expectations, the German government has slashed its forecast for the economy, projecting a record 6-percent contraction this year. Previously it had not shrunk by more than 1 percent in any year since the second world war.

In harmony with this more sober assessment, the sub-index on employment fell to 40.6 from 42.3 in March. "We are now seeing the labour market feel the full force of the economic downturn, with the latest wave of private sector job losses the steepest for at least 11 years," according to Tim Moore, economist at Markit Economics. "This provides advance warning that April's spike in official unemployment numbers will be repeated during the months ahead ... firms are likely to make further substantial job cuts even after the worst of the recession has passed," he added. German unemployment rose for the sixth month running in April to hit its highest level since late 2007 despite government subsidies designed to prevent mass layoffs.

Consumer Confidence Holds Steady

German consumer confidence remained steady for a third consecutive month in April as slower inflation boosted household purchasing power and the pace of the economic contraction slowed slightly. GfK AG’s forward looking confidence index for May, based on a survey of about 2,000 people, remained unchanged from April's revised 2.5 percent reading.

Investor Sentiment Continues To Rise

The ZEW Indicator of Investor Sentiment continued to improve in April, and rose by 16.5 points to stands at 13.0 following a reading of minus 3.5 in March. For the first time since July 2007, The indicator was positive for the first time since July 2007, although it is still well below its long term historical average of 26.1.

According to ZEW the indicator has been positively affected by the German government stimulus packages. Furthermore, investors seem to be taking the view that low inflation rates may give some support private consumption. They also felt that the economic outlook for the United States has improved, and responded to some vaguely positive signals emanating from China.

“Along with other indicators, the ZEW sentiment indicator reveals that there are well-founded expectations that the downward dynamics of the business cycle are bottoming out. It is even becoming more likely that the economy will slowly recover in the second half of this year.”, says ZEW President Prof. Wolfgang Franz.

Whether Franz is right in this very upbeat assessment really does remain to be seen, since I personally am far convinced that we have the bottom of this anywhere in sight yet, especially given German export dependence and the fact that year on year contractions in imports are still very strong in nearly all the major customers.

But Unemployment Is Headed Steadily Upwards

German unemployment rose for the sixth straight month in April. The number of people out of work increased a seasonally adjusted 58,000 to 3.46 million, according to the Federal Labor Agency. The seasonally adjusted unemployment rate rose to 8.3 percent from 8.1 percent in March.

So while an increasing volume of data suggest confidence across Europe is stabilizing and the recession slowing, the continued increase in unemployment may well weaken consumer spending and help prolong the recession. And with PMI surveys showing the employment output as bleak both in the service and manufacturing industries further increases in unemployment now seem inevitable.

Job Creation Turns Negative In March

The number of those employed in Germany was down year on year in March for the first time in several years. According to provisional results from the Federal Statistical Office total March employment in Germany was 39.89 million - a decrease of 46,000 (–0.1%) on a year earlier. The last time the number of persons in employment decreased from the same month a year earlier was in February 2006.

Generally employment increases in March due to the usual spring rebound in economic activity. Over the last three years employment was up by an average 138,000 persons from February. This March, however, the increase was only 53,000 (+0.1%). The Federal Statistics Office noted that the significant extension of the short-time work probably rescued the numbers from being even worse.

Seasonally adjusted the total number of employed was 40.18 million in March, a seasonally adjusted decrease by 27,000 persons (–0.1%) on February.

While Deflation Dangers Remain

German producer prices fell for the first time in five years in March, suggesting that the deflation risks are increasing in Europe’s largest economy. Prices were down 0.5 percent from a year earlier following an annual 0.9 percent gain in February, according to data from the Federal Statistics Office. That’s the first annual decline since February 2004 and the biggest drop since September 2002.

Plenty More Downside To Come

Perhaps the worst casualty of all this will be German public finances. German tax revenue for 2009 is now projected to decline by more than an additional 300 billion euros as compared with previous estimates. Germany’s finance minster Peer Steinbruck is reportedly pretty depressed by the estimate, since it makes him the finance minister who presided over the highest borrowing requirement in history (as opposed to the finance minister who balanced the budget, which is what he set out to do). The economics minister, meanwhile, said that the loss in tax revenues was no reason not to cut taxes. The EU Commission now forecast Germany will have a deficit of 3.9% of GDP this year and 5.9% in 2010. As a result gross government debt is projected to climb from 65.9% of GDP in 2008 to 73.4% in 2009 and 78.7% in 2010.

Italian GDP Falls An Annualised 9.6% In The First Three Months Of 2009

Italy's recession deepened at the start of 2009, with first-quarter gross domestic product falling to its worst level since at least 1980, confirming the impression that Europe's fourth-largest economy is now headed for its worst downturn since World War II. Preliminary data from the national statistics office (Istat) show that Italian GDP fell 2.4% in the first quarter when compared with the last quarter of 2008. This follows a downwardly revised 2.1% contraction in the fourth quarter of last year. Annualised this means a 9.6% contraction rate during the three months, which is very high indeed.

Year on year GDP fell by 5.9%, which was also the sharpest drop since Istat's most recent data series starts in 1980 - or for at lest 29 years. The contraction was even worse than analysts were predicting, with the consensus having been for a 1.8% drop on the quarter and a 5% one on the year.

According to ISTAT, even if GDP stays flat for the remaining three quarters of the year, 2009 GDP will contract by 4.6%. According to my rough calculations, Italy's GDP was on about the same level this quarter as it was in the first three months of 2005, and from here we are travelling back in time.

But GDP is not remaining flat, even if the pace of contraction seems to have slowed in the present quarter.

PMIs Show Continuing Contraction - Although The Rate Eased In April

Italy continued to register the steepest overall fall in retail sales in the Eurozone in April according to the Bloomberg Retail PMI. The month-on-month sales index did however rise from 41.9 in March to 46.8 giving the slowest rate of decline since October 2007. Retail sales have now fallen for 26 months consecutively according to survey data.

Manufacturing Output Falls

Italy's manufacturing business shrank at its slowest rate for six months in April, with the latest Markit/ADACI survey producing a headline PMI reading of 37.2 - significantly above March's record low of 34.6 and beating the consensus forecast of 36.5.

In addition other recent data suggest that the lowest point may have been past with business confidence improving in April (following 10 consecutive monthly falls), and consumer morale hitting its highest level in 16 months. However Markit reported that about 40 percent of companies in the survey reported new order levels continued to fall during the month, even though at the slowest rate of decline in seven months. Output fell at its slowest rate since October, with the sub-index jumping to 35.9 in April from 32.8 in March. Overseas orders, even though they fell less sharply in April, still clocked up their 14th successive month of decline, with Markit noting that demand was particularly weak from Eastern Europe and Russia.

And job losses in Italy's manufacturing sector showed no signs of letting up and were running at the second fastest rate in almost 12 years of data collection following the record low hit by the employment index in March.

However, saying that the "darkest hour" in this contraction may be over is not the same thing as saying that recovery is anywhere in sight. Italy's manufacturing PMI has now not indicated growth since February 2008 and forecasts generally expect the economy to contract by around four percent this year, making for two straight years of continuous contraction for the first time since World War Two. Indeed, the Organisation for Economic Cooperation and Development has even already pencilled in a potential further contraction for 2010, which if realised will mean Italy's economy will have been shrinking for an almost unprecedented 3 years continuously.

As Does Services

Italian service sector activity contracted for the 17th consecutive month in April although at the slowest rate for six months. The Markit/ADACI Purchasing Managers' Index rose to 42.0 from 39.1 in March, but still is not that far above the record low of 37.9 recorded in February. Activity has now been stick below the 50 mark that separates growth from contraction since November 2007.

The survey showed new business shrinking for the eighteenth straight month in April, though the rate of decline eased for the second month running, while expectations of business in a year's time rose to an eight-month high. As elsewhere, while optimism is rising Markit did point to record job losses as a likely on consumer spending looking ahead, making hopes of a swift recovery extremely premature. The employment sub-index fell to 44.0 from 44.6, as firms cut jobs at a survey record rate in response to the ongoing loss of business. The survey is thus consistent with other recent indicators that have pointed to an economy still mired in the deep recession that began in spring of last year, but with some grounds for thinking that the lowest point may now have been passed.

Deflationary pressure remained evident with service firms cutting their prices for the seventh month running and at the fastest rate in the survey's history in response to weak demand, while input prices showed no monthly increase for the first time since the survey began. The Italian government slashed its economic forecasts last week, and now project gross domestic product to fall by 4.2 percent this year following last year's 1.0 percent decline. The International Monetary Fund is more pessimistic, forecasting a 4.4 percent fall this year and a further drop of 0.4 percent in 2010. Italy thus now possibly faces three years of economic contraction one after the other although previously the country had not posted two consecutive years of falling GDP in its entire post-war history.

Business and Consumer Confidence Rebound Slightly

Italian consumer confidence rebounded slightly in April and reached its highest level since December 2007 as the lure of slowing inflation seemed to offset concerns about rising unemployment. The Isae Institute’s consumer confidence index rose to 104.9 from 99.8 in March.

Italian business confidence also rose as companies saw signs of an increase in orders of goods and services following the sighting of green sprouts everywhere except under our noses. The Isae Institute’s business confidence index climbed to 64.2 from a revised 60.9 in March.

Industrial Output

Industrial output simply declined and declines, and fell in March for an 11th consecutive month. Output dropped a seasonally adjusted 4.6 percent from February, when it fell a revised 4.6 percent, according to data from the national statistics office. From a year earlier, adjusted production fell 23.8 percent. Fiat has laid off about half of its 78,000 national workforce in using temporary state-subsidized programs. Sales of their cars fell 16 percent in Italy in the first quarter, according to data from the trade association ANFIA.

Exports Remain Very Weak

Italy's trade deficit increased dramatically to 837 million euros in February, almost double the 449 million euros recorded in the same month in 2008. Istat said a fall in demand was recorded in all sectors, but the automobile sector was particularly hard hit with a fall in exports of 46 percent. Trade in the chemical sector was down 29.5 percent, electrical goods were down 27.3 percent and exports of other manufactured goods fell by 22.7 percent.

Imports were down by 25.3 percent at 24.3 billion euros while exports were down by 23.7 percent at 23.5 billion euros. The results, however, were slightly better than in January, when imports were 23.4 billion euros and exports 19.8 billion euros. This was effectively the worst decline in exports since these statistics were first compiled by ISTAT in 1993.

No End To The Recession In Sight
Italy effectively entered recession in third quarter of 2008, and the economy now looks bound to shrink the most in more than half a century this year. The International Monetary Fund forecast on April 22 that the jobless rate will reach 8.9 percent this year and 10.5 percent in 2010. At the same time, Italian inflation has been slowing and hit a record low of 1.1 % in March, so if the contraction continues the deflation threat is real and present.

According to the latest EU Commission forecast Italy’s gross domestic product will fall this year by 4.4 percent, more than twice the 2 percent it predicted three months ago. This is bound to have a substantial impact on government debt, and the Italian government already accepts that the budget deficit will rise this year and breach the European Union limit of 3 percent of GDP. Government spending climbed 21 percent in the first quarter from a year earlier, while revenue fell 4.8 percent, the Bank of Italy said on May 13. The EU Commission forecast a deficit of 4.5% of GDP this year and 4.8% in 2010. As a result gross government debt is projected to climb from 105.8% of GDP in 2008 to 113% in 2009 and 116.1% in 2010. A grim picture, and no easy solutions.