Tuesday, August 14, 2012

In Search Of Lost Demand

So here's the 5 trillion dollar trick question. In an interesting article on the limitations of central bank monetary policy in the current environment, Reuter's Alan Wheatly made the following statement which caught my attention. "Central banks are rummaging through their toolkits because, despite slashing interest rates and buying vast quantities of bonds, they have signally failed to revive a global economy hamstrung by heavy debts and weak banks". But thinking about it for a couple of minutes, you could ask yourself why is this so?

Why is the global economy hamstrung by heavy debts and weak banks? Or put another way, why doesn't deleveraging happen, and the weight of debt reduce, and why doesn't the economy expand so the weak banks can once more become robust and healthy ones?

Short answer, it's the demand side stupid! The longer version was offered by Paul Krugman when he asked the ironic question, "To which planet are we all going to export?" Basically the demand needs to come from somewhere - unless of course you believe that "supply creates its own demand". What makes this crisis different from many of its predecessors is the global extension of the problem. If we were just talking about a few countries (as in the Asian crisis of 1998, which is so often mentioned in this context) then the answer would not be that hard, reduce currency values and export like mad to the non-affected countries. But in the current crisis, almost all developed economies are affected to one degree or another. The to one degree or another part is interesting, but it doesn't form part of what I am driving at here.

There are countries which are not so heavily in debt, and which do have a large growth capacity and a huge quantity of so called "pent up" demand - the so called Emerging Economies. But the simple math fails us. If we look at the first chart below the non "advanced" economies have been growing much more rapidly than the advanced ones since around 2002, so the potential is there.

But if we look at the second chart, these economies are still only around 40% of global GDP, so it is demand in 40% which is having to pull the other 60% with it. The interesting part is that in the space of a decade these economies have surged from 20% to 40% of the total. If the same trend continues by 2020 they could easily constitute 60%. Then things could be different, since we could have 40% of the total living from exporting to the other, faster growing, 60%. But we aren't there yet, which is why I think this decade will be a transitional one, one during which the developed economies (on aggregate) will struggle to find growth.

Nonetheless, emerging markets are growing fast, aided from time to time by an injection of liquidity from the developed world central banks. The IMF still expects the world economy to grow by 3.5% this year. Two issues cast something of a shadow over the immediate outlook. The first is the visible slowdown in Chinese growth, and the other is ongoing concern about the ultimate endpoint of the Eurozone drama in innumerable acts. The key point to appreciate about the second issue  is that with “risk off” due to the European Debt Crisis, even the Emerging Markets are unable to exploit their huge potential for growth. Capital is not flowing into these markets in the way it did following the various rounds of QE in the US and even the LTROs in Europe. These impacts can be seen in the JP Morgan Global Composite PMI chart below.

Both QE1 and QE2 were followed by large surges in global activity, and even last November's LTRO from the ECB produced an unexpected turnaround that some would argue has only been putting off the inevitable. Certainly, the force of the LTRO impact wrong footed many of us, since it produced a stabilization of global activity which lasted all through the first half of this year (see the latest German GDP results for additional evidence).

The China factor is also important. It was curious to watch a world which had just slumped following the collapse of an unsustainable debt orgy hoping to save itself by egging another country on to repeat the performance. Naturally, history isn't a mere repetition of the same, and the Chinese conundrum contains plot elements not seen elsewhere, including an ultra important export sector, but still it is hard to see how so many people could have remained silent in the face of what appears to have been a crazed investment boom. Still, China is a long way from having its back broken, even if the spinal column does need a lot of straightening out. The awkward part is that the "Chinese correction" comes just at the wrong time as far as global growth is concerned.

In any event, the BRIC concept was always far too general. It is just based on population size and the presence of underdevelopment. The key factor for growth dynamics, as I keep arguing,  is age structure, and in this sense India and Brazil look very different from Russia and China. Economic growth is partly about favourable demographics, and partly about institutional quality. Some EMs have favourable demographics, and some of these also are increasingly moving towards growth enhancing institutions. Others with favourable demographics are an institutional nightmare - Argentina is a good example, and others (like Ukraine or Belarus) have neither favourable demography nor positively evolving institutions, indeed in the two aforementioned cases it is unlikely they ever will.

What follows is a summary of my July manufacturing PMI report. The complete version can be found on Slideshare (here).

Manufacturing Visibly Slowing Across The Planet

We live in a globalised world. And what better illustration of this truism than the way in which manufacturing activity is steadily slowing across the planet. In theory the worsening conditions are a by-product of the Euro Debt Crisis, but in reality there are a multitude of factors at work – the slowdown in China, exhaustion of a credit boom in Brazil, a Japan which can’t export as much as it needs to due to the high value of the Yen, a United States where the various rounds of quantitative easing appear to have run out of steam.

But we also live in a world which is structurally in transition. The developed countries are overly in debt (especially when we consider health and pension liabilities looking forward) and ageing excessively. The emerging economies are experiencing a massive demographic, cultural and economic transition. The so called “Arab Spring” is just one example of this. Risk is being re evaluated, with developed world risk rising, at the same time as risk perception of Emerging Economies improves.

So the paths are crossing. Recessions in the developed world will now be more frequent and the recoveries shallower, while EMs will experience substantial catch up growth, while the recessions will be much more modest than previously.

Having said this, it is still impressive to note the diversity even among the EMs. This month I was struck by the way manufacturing sectors in some countries (like Indonesia and Vietnam) are now evidently having a hard time of it, while in others (India, Turkey) they are managing to keep their heads just above water. But in all cases what is most notable in the report summaries  that follow is the way in which exports are suffering, and export order books contracting, which suggests we have another six months or so of stagnation or worse staring us in the face.

Global manufacturing downturn gathers pace in July

The global manufacturing sector slid further into contraction territory at the start of the third quarter. At 48.4 in July, the JPMorgan Global Manufacturing PMI posted its lowest level since June 2009. The PMI remained below the neutral 50.0 mark for the second straight month, signalling back-to-back contractions for the first time since mid-2009.

Europe remained the main source of weakness during July, while the performances of the US, Brazil and much of Asia were at best only sluggish. Manufacturing PMIs for the Eurozone and the UK sank to their lowest levels for over three years. Within the euro area, the big-four nations fell deeper into recession, while Greece continued to contract at a substantial pace. Eastern Europe fared little better, with downturns continuing in Poland and the Czech Republic.

The ISM US PMI posted a sub-50.0 reading for the second successive month in July. Rates of contraction accelerated in Japan, South Korea, Taiwan and Vietnam, but eased slightly in Brazil and China. Brighter spots were Canada, India, Indonesia, Ireland, Mexico, Russia and South Africa, which all signalled expansion during the latest survey period. Manufacturing production and new orders both fell for the second month running in July, with rates of contraction gathering pace. International trade volumes, meanwhile, declined to the greatest extent since April 2009. Job losses were reported for the first time November 2009. With demand still weak and a sharp drop in backlogs suggesting spare capacity is still available, staffing levels could fall further in coming months.

Commenting on the PMI survey, David Hensley, Director of Global Economics Coordination at JPMorgan, said:
"Weak demand and the ongoing period of inventory adjustment pushed the global manufacturing sector into deeper contraction at the start of Q3 2012. Job losses were also recorded for the first time in over two-and-a-half years. Recent cost reductions are providing some respite, but this will be of little long-term benefit if underlying demand fails to pick up.”

Viewed as a continent, it is very hard to make generalitzacions about Asia. Japan is among the oldest countries on the planet. Domestic demand is congenitally weak, and exports struggle against the weight of an overvalued yen. The important point to notice is that all last years predictions about Tsunami reconstruction bring a new lease of life to the country have proven to be ill founded. All the associated damage has done is produce more debt. And still the economy struggles to grow. This issue will doubtless become worse after the government introduces the long promised increase in consumption tax.

China is suffering from a real estate adjustment which influences internal demand, while the global trade slowdown harms the export sector. In addition, the country’s potential growth rate, after hitting double digits at one point, is now slowing steadily as China steadily moves from emerging economy to mature economy status. India continues to advance at rates which are not seen in most Asian economies these days, but the country has an endemic inflation problem which remains unresolved, and growth is also hampered by poor infrastructure and widespread corruption. The semi developed economies like South Korea and Singapore still struggle to overcome weak export demand, and even new emergers like Vietnam and Indonesia remain challenged to find growth at this point.


The Japanese economy slowed more sharply than expected in the April-June quarter as exports and consumer spending lost steam, raising the specter of further deceleration for the rest of this year. Japan's economy grew strongly in the first quarter on increased government spending to aid in the rebuilding of areas battered by the March 2011 earthquake and incentives to boost sales of fuel-efficient vehicles. But fiscal policy appears no longer enough to offset the growing impact of the high yen coupled with Europe's persistent debt crisis and the resulting global slowdown on Japan's export-reliant economy.

July data from the Markit/JMMA manufacturing PMI survey confirmed the continuation of the April-June trend since it showed manufacturing output falling at the sharpest rate in 15 months, with  both new orders and new export business decreasing at accelerated rates.

Commenting on the Japanese Manufacturing PMI survey data, Alex Hamilton, economist at Markit and author of the report said:
“Business conditions in Japan’s manufacturing sector took a turn for the worse in July, according to latest PMI survey findings. Factory output, new orders and exports all decreased at the fastest rates since April 2011, while input buying and backlogs also decreased markedly. These are worrying developments given the weakness of global demand at present.

In China the HSBC Purchasing Managers’ Index posted 49.3 in July, up from 48.2 in June, signalling Chinese manufacturing sector operating conditions only deteriorated marginally. Indeed, the month-on-month increase in the index, though small,  was the largest in 21 months.

So while the Chinese economy is holding up far better than most of the hard landing people thought, the expectation was that it would be doing more than just holding up at this point in time. It was supposed to be both in the midst of a full-fledged recovery and driving the global demand chain. Chinese economic growth slowed to an annualised 7.6 per cent in the second quarter, its slowest pace since the height of the global financial crisis in 2009. And further data published last week indicated that it may need to do more to stop the rot which has now set in. Industrial production growth dipped to 9.2 per cent from 9.5 per cent in June, defying many analysts expectations for a rebound. Retail sales growth fell to 13.1 per cent from 13.7 per cent, while investment only managed to hold steady at a 20.4 per cent year-to-date pace. These are still large numbers, but for China, incredibly, they represent a slowdown. The fear is there may be worse to come.
Commenting on the China Manufacturing PMI™ survey, Hongbin Qu, Chief Economist, China & Co-Head of Asian Economic Research at HSBC said:

“Final manufacturing PMI confirmed only a modest improvement of manufacturing conditions thanks to the initial effect of the earlier easing measures. But this is far from inspiring, as China’s growth slowdown has not been reversed meaningfully and downside pressures persist with external markets continuing to deteriorate. We still expect Beijing to step up policy easing in the coming months to support growth and employment.”


In India the HSBC Purchasing Managers’ Index posted 52.9 in July, down from the reading of 55.0 recorded in June and pointing to a continuing slowdown in the manufacturing sector. In fact Indian industrial production slid in June for the third time in four months, with output of capital goods plunging the most on record. Production at factories, utilities and mines declined 1.8 percent from a year earlier, after a revised 2.5 percent rise in May. Capital goods output, an indication of investment in plants and machinery, fell 27.9 percent.

Indian manufacturing has been struggling in recent months as inflation hovering above 7 percent has been eating into domestic demand and Europe’s debt crisis restricts exports. Price pressures from a drop in the rupee and the impact of a weak monsoon on crops forced the central bank to leave interest rates unchanged in July, breaking a trend towards reduced borrowing costs which extends from China to Brazil to Europe. The rupee has now slumped about 18 percent against the dollar in the past 12 month.

Headline inflation, which  was 7.25 percent in June (the fastest pace among the world’s largest emerging markets) fell unexpectedly to the slowest pace in nearly three years in July following a sharp drop in fuel prices, but risks of a revival in price pressures may still discourage the central bank from lowering interest rates to spur economic growth. The wholesale price index rose 6.87% in July from a year earlier.

Indian GDP rose 5.3 percent in the first quarter from a year earlier, the slowest pace since 2003, and both Standard & Poor’s and Fitch Ratings have warned they may strip the country of its investment- grade credit rating, citing risks including fiscal and current- account deficits.

Commenting on the India Manufacturing PMI™ survey, Leif Eskesen, Chief Economist for India & ASEAN at HSBC said:

"Manufacturing activity grew at a slower clip in July on the back of power outages and a moderation in new order inflows, with the weak global economic conditions dragging down export orders. Moreover, orders decelerated faster than inventory accumulation suggesting that the more moderate expansion in output will continue in the months ahead. The slowdown in order growth allowed manufacturers to reduce backlogs of work. Moreover, input and output prices decelerated, but inflation remains above historical averages."

Europe Heads Into Its Next Recession

The eurozone  economy shrank in the second quarter, having flatlined in the first, despite continued German growth which looks increasingly fragile with every passing day out. Bailed-out Portugal saw its recession deepening with GDP diving by 1.2 percent on the quarter and 3.3% on the year, meaning that the threat of missing its deficit target this year is becoming increasingly real.

Figures released earlier had already showed deficit-cutting measures helped to shrink Greece's economy 6.2 percent year-on-year in the second quarter. Italian data last week showed the economy contracted 0.7 percent quarter-on-quarter, compounding the difficulties for Mario Monti's technocrat government as it tries to avoid a bailout. Spain's economy shrank 0.4 percent over the same period, pushing it deeper into recession.

As a result the currency bloc contracted by a quarterly  0.2 percent despite Germany eking out  0.3 percent growth. The storm cloud don't cease to gather, though, and just today the forward-looking ZEW sentiment index slid for a fourth month running. All the leading indicators for Germany now suggest looming contraction.

Thus, even as Europe’s leaders continue to fiddle around with the debt crisis, the economies of the Euro Area sink deeper into the mire. The latest round of PMIs suggest that the recession will become official in the third quarter, and at the present time there is  no let up in sight.

Certainly progress is being made in terms of the liquidity and capital needs of Euro Area banks, and further moves to ease sovereign financing difficulties seem to be at hand, But competitiveness issues are still a long way from finding solution. There is no evidence to back the idea of a surge in German inflation, while VAT hikes in country’s like Spain continue to damage their relative cost position.

The ECB has raised market expectations considerably in recent days. In the short run such expectations have foundered on disappointment. In the longer run, however, the ECB is likely to have few unbreachable limits to its freedom of action. Movement by the EU and the ECB will require formal requests for aid and involve conditionality. When this happens the most likely policy move with be SMP reactivation by the ECB in the secondary market and EFSF purchases in the primary one. Finally a reminder: it is important to remember the Greek problem has not gone away, it is simply in limbo. The Troika have gone home for now, but they did leave a message, courtesy of the Ramones, “see you in September”.

Eurozone manufacturing recession deepens at start of third quarter

The final Markit Eurozone Manufacturing PMI fell to a 37-month low of 44.0, down from 45.1 in June. The PMI has now signalled contraction for 12 consecutive months. Widespread weakness was seen across the region, with almost all of the national PMIs at sub-50.0 levels. Only Ireland bucked the trend, seeing improved business conditions as its PMI hit a 15-month high. Rates of decline in Germany, France and Spain were either at or close to the steepest since mid-2009. Italy recorded the worst overall performance in three months, while Austria slipped back into contraction and business conditions in the Netherlands continued to deteriorate. Greece stayed rooted to the bottom of the PMI league table.

Casting a long shadow over the future, total new orders contracted for the fourteenth straight month, with the rate of decline the third-fastest for over three years. Greece and Spain recorded the steepest falls, while the big-three of Germany, France and Italy all posted sharp contractions. Declines in the Netherlands and Austria were much weaker in comparison, while Ireland saw new order growth hit a 15-month high. New export orders fell at the fastest pace for eight months, with intra-Eurozone trade particularly subdued. Only Ireland and the Netherlands reported increases in new exports. The German export machine remained firmly in reverse during July, recording the steepest drop in new orders of all countries and the fastest rate of decline since May 2009.

Chris Williamson, Chief Economist at Markit said:
“The Eurozone manufacturing sector’s woes intensified again in July. Output fell at the fastest rate since mid-2009, consistent with the official measure of production falling at a quarterly rate in excess of 1%. Manufacturing therefore looks to be on course to act as a major drag on economic growth in the third quarter, as the Eurozone faces a deepening slide back into recession.


The performance of the German manufacturing sector took another turn for the worse in July, with output and new orders both declining at the sharpest rates since April 2009. This led to a further drop in the Markit/BME Germany Purchasing Managers’ Index from 45.0 to 43.0 in July, its lowest level since June 2009.

July data also saw the thirteenth successive monthly contraction of incoming new business in the German manufacturing sector. This is the longest continuous period of falling new orders since the survey began in April 1996. Survey respondents frequently reorted an unwillingness among clients to commit to new spending, largely in response to the uncertain global economic outlook. New export work continued to decline at a steeper pace than total new business receipts in July. Manufacturers noted shrinking sales in Western Europe, alongside softer demand in Asia and the US. The overall decline in new export work was the steepest since May 2009.

Commenting on the final Markit/BME Germany Manufacturing PMI® survey data, Tim Moore, senior economist at Markit and author of the report said:

The German manufacturing PMI number slipped to bronze position in the ranking of the ‘big four’ eurozone economies during July, its lowest position for three years and indicative of a sharp deterioration in business conditions over the month. Manufacturers linked the latest setback to shrinking export sales and a general shortage of new work to replace completed projects. Output dropped at the steepest pace for over three years and job shedding was the most marked since the start of 2010.


Manufacturers in Italy continued to face a challenging operating environment at the start of the third quarter. A further contraction in demand led to lower output levels and the sharpest reduction in employment for 33 months, with a sharp and accelerated decrease in backlogs of work underlining the degree of excess capacity in the sector.

The Markit/ADACI Purchasing Managers’ Index dipped to a three month low of 44.3 in July, down from June’s reading of 44.6. The headline index has posted below the neutral mark of 50.0 throughout the past year, and was below the average recorded over the second quarter as a whole giving the impression that the recession may even be deepening.

Phil Smith, economist at Markit and author of the Italian Manufacturing PMI said:

“July saw the recession in the Italian manufacturing sector extend to a year. Moreover, the downturn was shown to have deepened as the PMI sank to its lowest level in three months, primarily reflecting a sharper reduction in staffing levels. A solid and accelerated decrease in stocks of purchases also dragged the headline index lower, and suggested that firms had grown more concerned about cash flow and were not anticipating a rise in production requirements in the near term.

Central and Eastern Europe

Czech manufacturing business conditions deteriorate further

The latest HSBC PMI report confirmed the ongoing weak downturn in the Czech manufacturing economy at the start of the third quarter. New orders and purchases of inputs by manufacturers both fell for the fourth successive month, while output remained stagnant. This is all in line with the fact that Czech GDP has now been falling for three successive quarters.  The PMI remained below the no-change mark of 50.0 in July, continuing the pattern seen since April. The deterioration in overall business conditions signalled by the headline figure remained modest, however, as the PMI was little-changed at 49.5 from June’s 49.4.

Commenting on the Czech Republic Manufacturing PMI survey, Agata Urbanska, Economist, Central & Eastern Europe at HSBC, said:
“The PMI index changed little in July compared to June and still points to a slight deterioration of business conditions in the manufacturing sector. Among the index components, the suppliers’ delivery times improved (lengthened), offsetting worsening output, new orders and employment indices. We assess this combination as negative and remain cautious of downside risks. This is particularly the case in face of weaker than expected leading indicators in July like IFO and PMI in Germany. The PMI’s input and output prices indices show a further decline of inflationary pressures, and leave room for the central bank to cut its policy rate to a new record low later this year.”
Contraction of Polish manufacturing sector slows in July

HSBC survey data compiled by Markit indicated a near-stabilisation of business conditions facing Polish manufacturers in July. New orders declined at the weakest rate since March, while output fell only marginally since June and firms raised headcounts at the fastest rate since February 2011. The PMI recovered from June’s 35-month low of 48.0, posting 49.7 in July. That signalled a fourth successive overall deterioration in the business climate, but at only a marginal pace that was the weakest in that sequence.

Commenting on the Poland Manufacturing PMI® survey, Agata Urbanska, Economist, Central & Eastern Europe at HSBC, said: “The recovery of the PMI index, despite the fact that it still remains in contraction territory, is a positive following a month of activity data releases all surprising on the downside. The PMI still points to a marginal deterioration in business conditions in the manufacturing sector, but the pace of deterioration has slowed compared to previous months.

Turkish manufacturing output falls for first time in four months

The seasonally adjusted HSBC Turkey Manufacturing PMI dropped below the 50.0 no-change mark in July, posting 49.4. This followed a reading of 51.4 in June and signalled the first deterioration in business conditions since March. That said, the decline was only marginal. Both output and new orders decreased in July. New business fell for the fourth month in 2012 so far, following stagnation in June.

Commenting on the Turkey Manufacturing PMI® survey, Melis Metiner, Economist at HSBC, said:

“Turkish manufacturing conditions deteriorated in July, falling into contraction territory for the first time since March. Both output and new orders fell, while new export orders recovered after a sharp decline in June. The pace of improvement was marginal, however.
United States

US PMI indicates slowest manufacturing expansion for nearly three years

Growth of the U.S. manufacturing sector slowed to its weakest pace in nearly three years in July, according to the Markit U.S. Manufacturing Purchasing Managers’ Index. At 51.4, down from the flash estimate of 51.8 and below June’s reading of 52.5, the PMI hit a 34-month low and signalled only a modest expansion during the month.

The volume of new orders received by manufacturers increased in July. The increase in total new work largely came from the domestic market, however, as new export orders fell for the second consecutive month, partly reflecting the ongoing economic crisis in Europe. Overall, new orders (both domestic and exports) rose only modestly, with the rate of increase weaker than the earlier flash estimate and the second-slowest since orders began rising almost three years ago.

Commenting on the final PMI data, Chris Williamson, Chief Economist at Markit said: “The final reading of Markit’s U.S. Manufacturing PMI was even weaker than the flash estimate, indicating that manufacturers are currently reporting the weakest growth since September 2009.
“Producers are being hit by the ongoing euro zone crisis, slower global economic growth and increasing unease about demand in the home market as elections loom closer and uncertainty hangs over fiscal and monetary policies.“With order books barely growing in July as export orders fell for the second month in a row, the survey signals a real risk of manufacturing production falling in the third quarter unless demand picks up soon.


Further declines in both output and new orders in Brazilian Manufacturing in July

July data signalled a further deterioration in manufacturing business conditions in Brazil, with survey respondents largely citing weak client demand. Both output and new orders fell for the fourth month running, albeit at slightly weaker rates than those registered in June, and firms reduced their workforces to the greatest extent in three years.

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

“The HSBC Manufacturing PMI stabilized in July, rising from 48.5 last month to 48.7. On the whole, the headline index and its key components remained below the 50 threshold, suggesting that the industrial sector in Brazil continued to contract in July. But at least this decline in economic activity appears to be losing momentum, with the very modest rise in the headline PMI index being led by improvements in both the output and new orders indices.”

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

Sunday, August 12, 2012

The Owl Of Minerva

Last week was the fifth anniversary of the outbreak of the global financial crisis. Not uncoincidentally it was also the fifth anniversary of continually rising unemployment in Spain , since it was in early summer 2007 that seasonally adjusted Spanish unemployment embarked on its steady upward path. And after it started climbing, naturally it hasn't stopped since. Indeed we seem to have at least another year of growing unemployment before us, maybe more.

Anyway, as if to celebrate this uncanny anniversary the Spanish government has decided to take the bold step of officially requesting an EU loan to recapitalise the country’s banking system. In addition, part of the money will be used to set up some form of bad bank with the objective of cleaning up some of the toxic property and other assets off the bank balance sheets. Smart moves both of them. Pity the people responsible weren't prepared to accept the need to do this five years ago, when unemployment was only running at 8%, and when the economy and Spain's citizens were better placed to accept the kind of burdens that are now about to be imposed upon them.

Just to round the commemorations off, in the August edition of their monthly bulletin the ECB finally let out that dirty little secret than every insider in the know has already discounted.  The Bank have finally accepted that the much heralded Spanish labour reform isn't going to work. At least not as planned. As the Financial Times put it, the Spanish labour market reform approved in February was “far-reaching and comprehensive” but came too late, the ECB implied, saying it “could have proved very beneficial” in avoiding job cuts if the measure had been passed some years ago.

Exactly. But once we recognise this point, isn’t that rather leaving the Spanish economy adrift in stormy seas without a rudder? Simply cutting the deficit back and cleaning up bank balance sheets won’t get the economy back to growth.

Indeed this habit of continually getting behind the curve, and trying vainly now that the economy is spiralling almost out of control to introduce measures which should have been brought in a decade ago extends well beyond the issue of labour reform. Take reducing the generosity of unemployment benefits. This is also something that should have been done years ago, since the two year allotment really did encourage people to refrain from actively seeking work in times of relatively full employment. But cutting benefits now, as the Rajoy government has just done, when unemployment stands at 25% and rising seems insensitive and even cruel. A government’s job is to introduce policies to create employment, not to cut benefits going to those who cannot find work in an environment where total employment is falling and has been doing so for five years. Quite frankly, if cuts have to be made, better to reduce pensions, but that is political dynamite, so it doesn't happen.

Again, reducing the fiscal advantages of home ownership made mountains of sense during the years of the property bubble, but it didn't happen. Now, with around two million housing units (between finished and uncompleted) needing to be found purchasers removing tax benefits on mortgages, increasing VAT rates on property transactions and raising the local property taxes - all of which make buying a homea lot  less desirable - looks very much like trying to shoot yourself in the foot. There is a lot of merit behind the desire to stabilise Spain's public accounts, but shouldn't we also try to remember why the country has this crisis in the first place?

Anyway, having recognised that the labour reform comes to late to really change course decisively this deep into the crisis - something incidentally which we much maligned macroeconomists have been arguing all along - what does the ECB propose to supplement it? Well, according to the bulletin "countries with high unemployment also needed to abolish wage indexation, relax job protection and cut minimum wages." Indeed the bank went beyond its usual practice of avoiding country specific commentaries to issue a direct prescription, saying it expected a “strong decline” in wages in Greece and Spain, countries which have the highest levels of youth unemployment in the eurozone, with more than 40 per cent of under-25-year-olds in the labour force out of work.

This strong decline in wages does not, mark you, form part of the kind of "internal devaluation" some of us have been arguing in favour of  for some years now, whereby a battery of measures are introduced to try and bring down both prices and wages at one and the same time. Not at all. July inflation in Spain was running at 2.2% compared to 1.7% in Germany. Prices in Spain are going up, largely due to all those tax increases laid down in the adjustment measures. Annual inflation will probably surge by around two percentage points in September as the new consumption tax rates fall into place. So it is only wages which are likely to be coming down, and this makes it all feel much more like 1930s type wage deflation than the sort of internal devaluation that has been being advocated (see my January 2009 piece "The Long And Difficult Road To Wage Cuts As An Alternative To Devaluation" as a harbinger of all this).

Well, if you let things go to hell for the best part of five years, naturally the patient is in a poor state and in need of radical surgery. I won't say "I hope they know what they are doing," since I am pretty sure they don't. Perhaps I would rather say I hope Mariano Rajoy knows what he is letting himself in for when he asks for help from the ECB.

Talking of which, and turning to another of the "troubled" countries, Italy, I see Finance Minister Vittorio Grilli has come out today and confirmed two issues I was conjecturing about in my blog post only yesterday. In the first place he admitted in an interview in the newspaper La Repubblica that it was unlikely the country would meet this years deficit target due to the depth of the recession, and in the second one he confirmed my fear that getting agreement to ask for EU help would be much more difficult than Mario Monti recognised during the press conference he held with Mariano Rajoy at Spain's Moncloa Palace. Italy plans to wait for the ECB to act, and see what the measures look like, despite the fact that Mario Draghi has made it quite clear he will only do so after a request for assistance goes to the EU.

So instead of preparing a “battery of measures” to go to the root of Italy’s problems it looks like we what we may well face is protracted debate about how to avoid making any kind of formal  request. The latest idea to surface is that of trying to get ECB agreement for the Cassa Depositi e Prestiti, a state-financing agency controlled by the Treasury and managing some €220bn in postal savings deposits, to be allowed to use its banking licence to secure loans from the central bank in order to explicitly buy government debt. As the saying goes, this one can run and run.

Which all brings me to the main point I have been thinking about all weekend, which is why it is that policymakers find it so incredibly hard to see situations coming, and to take corrective action before the train crash occurs?

"One more word about giving instruction as to what the world ought to be. Philosophy in any case always comes on the scene too late to give it... When philosophy paints its gloomy picture then a form of life has grown old. It cannot be rejuvenated by the gloomy picture, but only understood. Only when the dusk starts to fall does the owl of Minerva spread its wings and fly".
G.W.F. Hegel, Preface to the Philosophy of Right

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

Saturday, August 11, 2012

Is The Italian Elephant About To Break Loose Again?

Market nervousness about Italy has been growing in recent weeks, with the Moody's credit downgrade of the country being only  one of the reasons. A bailout is clearly in the offing, with the only real questions being how and when. While the situation inside his country appears to be deteriorating, Mario Monti has been doing the rounds of European capitals in an attempt to drum up support. While in Helsinki he raised an eyebrow or two when he warned that without a serious plan to bring down interest rates disaffection with the euro in his country could easily grow to dangerous proportions. Crying wolf, or a piece of insider information? Probably a bit of both.

Italy is in a deepening recession which has now lasted for over a year. Monti himself  has ruled out the possibility that he could continue in office after next spring's general elections, while at the same time Silvio Berlusconi is constantly hinting that he would not be averse to accepting prime ministerial office again, should his country need him. All of which makes me ask myself just over a year after my "Is Italy, Not Spain, the Real Elephant in the Euro Room?" post, whether in fact the currently chained beast is not about to break its tethers and go for a crockery breaking rumble round the Euro living room.

What follows is a summary of a revised version of a presentation I gave in Cortona last autumn. I have put the presentation online here.

Low Growth And High Debt, A Highly Combustible Cocktail

Just as I highlighted in the case of Portugal in my recent post, Italy's problem is long term growth. This is not a passing phenomenon, but one which has been getting steadily worse over decades. Italy has lost growth at a pace of about one percent a year over the last four decades. If the pattern continues Italy GDP will drop over this decade and continue to do so for as far ahead as the eye can see.

To give us an idea of what this means, Italian GDP at the end of June was at the same level it first reached in the second quarter of 2003. If the current recession continues as forecast by the Italian government during this year, by December we will be below the GDP level of December 2000, which is another way of saying that it will be below the level first attained some 12 years earlier. If the recession is slightly deeper that the current government forecast, and continues throughout 2013 (certainly not an excluded scenario) we might even arrive at levels first seen in the late 1990s.  In the meantime the country's population will have risen from 57 million to 61 million, hence GDP per capita will have fallen substantially. This is not a situation either to be taken lightly, or one which it will be easy to turn around.

There are a variety of reasons for this sharp drop in growth momentum. Some of the reasons are undoubtedly, as I will argue demographic. Others are associated with the loss of international competitiveness experienced by the  Italian economy since entering the European monetary union.

Once clear indication of the extent to which the deteriorating growth outlook is associated with cometitiveness loss is to be seen in the correlation between worsening growth performance and the deteriorating current account balance.

Double Dip Recession

Italy first fell into recession at the end of 2007 – some months before the other Euro Area countries - and didn’t come out of it again till the start of 2010 , so the economy contracted for two full years. GDP fell by 1.2% in 2008, and by 5.5% in 2009.

After an 18 month recovery, the economy again fell into a second “double dip” recession around the middle of 2011, after a surge in borrowing costs forced the government to apply stringent austerity cuts in an attempt to recover investor confidence.

In the three months up to June GDP contracted for a fourth straight quarter, falling by 0.7 percent over the previous quarter. We don't have the detailed breakdown from the statistics office yet, but it seems clear the contraction was again led by sharp falls in consumption and investment as concerns about the fiscal outlook and the euro area crisis depressed confidence and tightened credit conditions.

It is quite possible that Italy will experience a deeper recession this year and next than most forecasters predict (IMF current 2012 -1.9%), reflecting headwinds from the sovereign debt crisis compounded by Italy’s large planned fiscal adjustment. The government will likely miss its deficit targets and even in the absence of any major shocks to yields, the country’s debt to GDP ratio is surely going to increase significantly over the next few years.

Part of the problem is that Italy's fiscal spending has assumed the importance it has in the country's economy due to the loss of international competitiveness. Reducing the government contribution to GDP in this context only makes the economy fold in on itself. More urgent competitiveness raising issues are needed, ones which will bring quicker results than the ongoing programme of long term structural reforms.

So Just What Do We Mean By International Competitiveness?

The issue of international competitiveness is the one which has perhaps caused most theoretical controversy during the current Euro Area crisis, with one side arguing vehemently that some sort of devaluation is essential, while the other argues equally vehemently that it isn't. In the follwoing slides I propose a slightly new definition of international competitiveness, which is to do with having an export sector which is appropriately large given the median population age of the country concerned.

You can enlarge the slides for easier reading by clicking on them, or alternately you can view them via my slideshare version.

Bottom line:
• Median population age is an important economic indicator
• Populations with high median ages tend to be export dependent
• Export dependency gives a better, more precise measure of international competitiveness.
• An export dependent country is internationally competitive when it has a large enough export sector to drive economic growth.

Italy and The Eurozone Debt Crisis

Total Italian debt is not excessive in comparison with some other countries in the Eurozone, but public debt is the second highest.

Despite having normally run positive primary balances

Italy has run general budget deficits since the 1980s

The problem here is the weight of the debt, the burden of interest payments

Italy Is Now Poised On A Knife Edge

Italian gross government debt to GDP is currently perched just under 123% of GDP. The key factors which will influence the future trajectory are GDP growth, inflation and interest rates. With GDP falling, inflation low and interest rates rising the outlook seems quite problematic. Hence The Problem Of Market Pressure, and concerns about interest rates. Italy is currently paying around 6% for 10 year debt issues, and the average maturity of Italy’s debt is 6.7 years, the lowest level since 2005.

The IMF currently predicts that Gross Government Debt To GDP will peak at 124% in 2013. Any significant slippage on this and debt restructuring becomes inevitable. Investors are worried with good reason. Market responses are not just simple speculation. ECB support is critical, but so are radical measures to increase the growth rate.

Too Big To Rescue?

As stated above, Italy shrank further into recession in the second quarter with a 2.5 per cent annual decline. The 0.7 per cent quarterly fall in gross domestic product, only slightly better than the first quarter’s 0.8 per cent decline, means the economy has now been contracting for over a year, and there is at least another year of the same or worse to come as spending cuts steadily bite and the Euro debt crisis rocks its way forward. The recession will weaken tax revenues and hit jobs and consumer spending, a vicious circle which makes it harder for Mario Monti, who is aiming to cut the budget deficit to 0.1 per cent of GDP in 2014, to meet his public finance goals.

Consumer Confidence and PMI indicators suggest that the Italian government’s GDP growth estimates (of a contraction of 1.2% for 2012 and an expansion of 0.5% for 2013) are way too optimistic . The consumer confidence reading was only just up in July from June's 14 year low, and for the first time since the launch of the PMI services survey in January 1998 firms generally expected output to be lower in a year’s time than current levels.

The employers group Confindustria now forecast a contraction in GDP of 2.4% in 2012. A further fall of 2.0% is not unlikely in 2013 as the European debt crisis worsens. Compared to the other forecasters I would be more negative on the outlook for both private consumption and investment activity. In addition, with a more negative outlook for the euro area economy – destination for 43% of Italian exports — these are unlikely to put in an unexpected stellar performance in 2013.

Unemployment Rising Sharply

Italy's unemployment rate hit a record 10.8 percent in June, up from 10.6 percent in May. There were 2.79 million people looking for work in June, according to seasonally adjusted figures -- a rise of 37.5 percent compared to a year earlier. Youth unemployment dropped from 35.3 percent in May to 34.3 percent. These are not yet anything like Spanish numbers, but they are not to be sneezed at either.

The number of people living in absolute poverty in Italy rose to 3.4 million in 2011, or 5.7 percent of the population, up from 5.2 percent in 2010.Those living in relative poverty for Italian standards were roughly stable at 8.2 million, or 13.6 percent. But among families with no workers and no pensioners, the relative poverty rate rose to 51 percent from 40 percent.

Fiscal Targets Look Increasingly Out Of Reach

The implementation of austerity measures in Italy is likely to have a substantial negative impact on the economy in the coming years. Given its lack of competitiveness, the economy lived off constant demand stimulus from the government. Without this the growth problem is likely to become worse.

There have now been five fiscal packages introduced by Italian governments since July 2011, with the objective of a  cumulative fiscal consolidation of some 5.2% of annual GDP (€85.8bn) between 2011 and 2014. With the majority of the measures concentrated in 2012, there will inevitably be a large negative impact on the economy throughout this year.

Given the deep recession the country will be in over the next couple of years and poor potential growth prospects over the medium- and longer-term, Italy’s public sector balance sheet problems are likely to mount. Although the 2011 fiscal deficit of 3.9% was not particularly high in comparison with many Euro Area countries the governments projection of a close-to-balanced budget in 2014 looks hugely optimistic. A more realistic expectation would be for the deficit to be under the EU 3% level at that stage, but the danger is this could well mean gross debt to GDP will be over 130%. Above the danger mark.

The ECB's role in the crisis both helps and doesn't help, depending on how you look at it. They have been very tardy in acting, and normally when they have done so it is been via half measures which have not got to the heart of the problem. The LTROs are a good example. Italian banks have borrowed more than 283 billion euros from the ECB via the 3 year LTROs and other liquidity operations, but this liquidity is by and large used to either purchase government bonds or buy up their own expiring debt. Buying government bonds is attractive since they pay yields which are far above the ECB lending rates. This difference - the so called "carry" -  helps bank profitability and enables them to recapitalise, but it also means that interest rates charged to small business clients rises as they need to compete with the government for funds. Despite the fact that such practices make the banks more "joined at the hip" than ever with their sovereigns, and that their exposure to losses should the Italian sovereign eventually have to restructure rises, they remain attractive because the risk weighting and hence "capital consumption" of public sector lending under the Basle rules remains absurdly low. This is where the real private sector “crowding out” comes.

Banks increased their holdings of the country’s bonds by about 78 billion euros in the first six months of 2011. This forms part of the “nationalisation” of Europe’s sovereign debt markets. Foreign investors cut their holdings of Italian government securities by 18 percent in March from a year earlier, according to the Bank of Italy. In the same month Italian banks boosted them by 39 percent.

Meanwhile, as we can see in the chart above, the rate of new lending to the private sector has been falling steadily, to both households and corporates. As I say part of the problem is that as the recession deepens the credit risk perception of Italian households and companies deteriorates,as the ECB pointed out in their latest monthly report.

The report immediately produced criticism from the Italian consumers’ association Codacons, who complained that the ECB itself had not found a solution to this situation. “If companies are insolvent it’s because banks are strangling them, denying them credit,” Codacons said. Coldiretti, the Italian agricultural association, also estimates that 60 per cent of companies in the sector risk being starved of credit as they face interest rates that are 30 per cent higher than the average of other sectors.

This problem is more complex than it seems. It is not so much a question of credit being strangled, but of demand being strangled as austerity bites. Companies who cannot sell profitably are a high credit risk. There is demand globally, but as I am saying Italy is insufficiently competitive to take advantage of it. Bottom line, the high cost of financing Italian government bonds is pushing up longer term interest rates, and discouraging investment, and this is an issue the ECB could address, by directly buying commercial paper, for example.

Easing In The Bailout

The possible Italian bailout is fast becoming a tricky political issue. The technocratic government of Mario Monti would like to get an MoU agreed before handing the country back to the politicians.

The request for bond buying would involve ECB secondary market purchases as well as primary market purchases by the EFSF. It would also involve a Memorandum of Understanding which would undoubtedly contain strict conditions and an implementation supervision mechanism. The ECB would surely also have a say in those conditions if bank bond purchases were to form part of the package.  Indeed, the ECB has only this week in its August bulletin made clear what it thinks is required. The Bank suggests countries with high unemployment need to “abolish wage indexation, relax job protection and cut minimum wages”. The bank is not impressed with the Italian labour reform, which is too little too late, and thinks direct wage cuts are now the only workable remedy.

Unsurprisingly, many Italian politicians are highly reticent about being seen to hand over their country’s future to an institution with such views, which if implemented would be massively unpopular in the country, so pressure is mounting for Monti not to ask for help. That having been said, the country really has no alternative if it wants to stay in the Euro.

Is Italy Facing A period of Growing Political Instability?

But this is just it, exactly how committed is the Italian political class to staying in the Euro? Certainly it is the one country on Europe's periphery where you can hear speeches from politicians with serious followings questioning whether there are not alternatives. Indeed Mario Monti warned on just this point during his recent Helsinki visit. "I can assure you that if the (bond yield) spread in Italy remains at these levels for some time then you are going to see a non euro-oriented, non fiscal-discipline-orientated government taking power in Italy," he said.

He was, of course, referring to the ambivalence of Silvio Berlusconi on the Euro issue, and the outright hostility to the common currency displayed by the rising (5) star of Italian politics, Beppe Grillio. “After me the populists”, as Monti once said.

A lot of these statements can be read as brinksmanship, but as BofA Merrill Lynch foreign exchange strategists David Woo and Athanasios Vamvakidis warned in a July 10 report, investors “may be underpricing the possibility of voluntary exit of one or more countries” from the currency bloc. And these countries may not be the ones most widely talk about, like Greece or Spain. It was Italy, the euro area’s third-largest economy, which they found would enjoy a higher chance of achieving an orderly exit than others and would stand to benefit from improvements in competitiveness, economic growth and balance sheets.

Woo and Vamvakidis employed a variant of game theory and found that while Germany could “bribe” Italy to remain in the bloc and avoid the fallout from an exit, its ability to do so is limited. That’s because Italy has more reasons than Greece to leave so any compensation could become too expensive for Germany and Italians may be even more reluctant than the Greeks to accept the conditions for staying.

Interestingly enough in this connection Nomura's Jens Nordvig and Nick Firoozye (whose excellent work on Euro break up dynamics unfortunately did not win them the Wolfson Prize) argue in their afterthought essay (Wolfson: What we learned about the future of Europe, Nine specific lessons from the Wolfson Economics Prize competition) that one of the things they learnt from doing the spadework was the following.
"We have constructed a data base of the relevant liabilities for each Eurozone country, and our calculations show large relevant external liabilities in Greece, Portugal, Ireland and Spain. This analysis highlights that currency depreciation following exit from the Eurozone would substantially increase the external debt burden of these countries...."

"Meanwhile, we note that estimated balance sheet effects following exit in the case of Italy and France, are substantially smaller than in other peripheral countries, mainly as a function of the prevalence of local law obligations (which can be redenominated) within external liabilities. It follows that policy makers and investors should pay close attention to the size of balance sheet effect (not only to standard competitiveness and the trade effects) when thinking about the macro impact of specific exit scenarios".
So, summing up briefly, while the Monti Government’s structural reforms are obviously a step in the right direction it is unlikely they will go either far enough or fast enough to significantly lift the country’s potential growth rate from its present lamentable level.  Further, as the April 2013 election approaches  the growing  popularity of new political movements like Beppe Grillo's Five Star one could easily  lead to the kind of political fragmentation already seen in Greece - Italy has hardly been a model example of the two party system -  making the traditional political forces which back the Monti Government even more reluctant to accelerate the adoption of far-reaching reform.

And going beyond April, the political arithmetic of a post Monti government looks complicated, making the kind of stability needed to advance what the population may well see as "harsh" reforms unlikely. In other words, as Monti says, when I go watch out for the populists!

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".