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Friday, July 18, 2008

What Is The Risk Of A Serious Melt-Down In The Spanish Economy?

Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past, the ocean is flat again
John Maynard Keynes

'As far as I am concerned, this is ... the most complex crisis we've ever seen due to the number of factors in play'
Spanish Economy Minister Pedro Solbes speaking this week to Spanish radio station Punto Radio

Jose Luis Borges tells a story about two rascally villains, eternal rivals, who - under sentence of death - are offered one last bet: rather than accepting a conventional execution they can agree to have their throats slit simultaneously, just to see who is a able to run the farthest. Immortality, rather than fame, in an instant. Now I mention this since tale I can readily anticipate the immediate feelings many will have on reading what follows (I am at the end of the day going to argue that it is necessary to inject money - and I do mean rather a lot of money - into a banking and construction system which many will want to argue is largely responsible for Spain's present distress, and indeed, that having made a good deal of money out of the operation, these are the very people who should now be forced to don that sackcloth and ashes costume which so behoves them (actually the way things stand they are much more likely to find themselves reduced to a sporting a loincloth, but still). I understand why many ordinary Spanish people may have such feeling, but I do think this is a time for cool heads, and that what is most needed here is an extreme dose of pragmatism coupled with a lot of emotional intelligence. There is no point in agreeing to have your own throat slit just to see people you don't like have their's slit first.

Martinsa Fadesa The First To Go

This week's filing by the Spanish property developer Martinsa-Fadesa for protection from its creditors has brought Spain's ongoing economic agony back to the headlines. The decision follows a request from Martinsa Fadesa last Friday to its creditor banks for a postponement of the deadline on their requirement that the company obtain a 150 million euro ($235.7 million) loan. The banks refused the request and the rest is now, as they say, history. The failure of Martinsa - Fadesa whose debts are in the region of 5 billion euros - is not only the largest corporate bankruptcy in Spanish history, it is also a reflection of the pain which must now be being felt in Spain's troubled banking and construction sectors, and a harbinger of what is, in all probability, going to be much worse to come.

Spain At Risk

So to come directly to the matter which has provided me with the header to this post, just what is the risk that the present recession in Spain is something a bit more than a mere recession? What is the risk of a real and serious economic melt down just across France's Southern border, a mere stone's throw away (by plane) from Brussels or Frankfurt, yet still on the other side of that intellectual and cultural divide which seems to be formed by that ever so picturesque natural barrier known as the Pyrennees? Well it is a non-negligable one, in my view. Let me explain a bit.

First, as background it would be worth reading my Artemio Cruz Syndrome post, since all the main macroeconomic arguments are presented there (and those who seriously want to know what is going on should definitely read the excellent "Spain:Bubble Bursting - We now expect a full-blown recession" desknote from PNB Paribas).

Secondly, we need a bit of vocabulary clarification, since the terminology being used has become somewhat confusing of late. We could reasonably break things down as follows I think:

i) Soft Landing
ii) Hard Landing
iii) Melt Down

Now, in terms of the available semantic space, why don't we allow that "soft landing" means a recession of the more or less garden variety (as Portugal or Italy have at this moment, or as say France may anticipate, or Denmark) and not consider this to mean avoiding recession completely, which is how some seem to have used the term in recent times (I think it is hard to imagine any EU 15 economy avoiding recession completely between now and Q2 2009). Possibly Hungary up to this point could also be said to have had a comparatively soft landing.

"Hard Landing", on the other hand would be what they are currently experiencing over in the Baltics, what they may well soon experience in Romania, Bulgaria, the UK, and Ireland, and what is now most certainly taking place in Spain. Thus by "hard landing" I mean a very sharp slowdown in growth, a medium sized contraction in consumption, financial distress and bankruptcy in some areas, and a recession which drags itself on for more than a mere two quarters (in and out of negative growth) and probably results in annualised negative growth for a period of at least 12 consecutive months. What happened in Turkey in 2000 was certainly a hard landing in this sense.

iii) "Melt Down", following such definitions, would then be a Hard Landing plus, a Hard Landing plus a shock (or in Hungary's case, where the shock would be a run on the forint, you could imagine what initially is only a Soft Landing being converted into a melt down, but arguably Hungary's case is very special given the very high level of exposure of household balance sheets to CHF denominated forex loans).

Such a shock could be a banking crisis, a run on the currency, a sovereign default (this is where Italy's series of perpetual soft landings could move decisively into meltdown mode one of these fine days if something isn't done to correct the low growth/high sovereign debt to GDP dynamic while there is still time).

Now in this sense, Spain's economy is at some significant level in danger of having a melt down - lets define this as more than two years of negative GDP growth with a magnitude of more than one percentage point, coupled with (in the case of countries which have their own currency) very sharp devaluations, and in the case of those that don't severe and extended price deflation (ie a mini version of what happened in the USA in 1930).

Now the recession in Spain is, I think, more or less most certainly already served. The Spanish press were talking earlier in the week about a quarter on quarter contraction of 0.3% in Q2, and it is hard to see any acceleration of the economy in Q3. Pedro Solbes, when questioned explicitly by Punto Radio on the possibility that whole year growth for 2008 could turn negative replied diplomatically "It's not my feeling at the moment", which means basically that it might well turn out to be the case.

If this expectation if fulfilled then Paribas may have to revise their latest forecast slightly (see above link) since - in what is really an excellent general analysis - they pencil-in the recession to start in Q3 2008 and then move on to anticipate a contraction in the Spanish economy of 0.75% in 2009 (although as they freely admit all the risks here are skewed to the downside). My own personal call at this point is that the recession may well have started in Q2 (we will soon know) and that the contraction in whole year 2009 will be over 1 percentage point. Further than that I am not willing to go at this stage, since it all depends, and in particular it depends on whether or not we get a nasty "event" or series of events which send the economy hurtling out of the "hard landing" bracket and into the "melt down" one. It is because I strongly believe we be should doing everything we possibly can to avoid that eventuality that (and not continue to languish under our blankets with a heavy dose of the Artemio Cruz syndrome) that I am writing this post now.

Before continuing, however, I should point out that even the Paribas idea of negative growth in 2009 is still very nonconsensual, despite the widespread pessimism which currently surrounds the Spanish economy. The consensus economic survey for June gives a median 2009 growth forecast of 1.5%. The lowest forecast in the survey is 0.4% but most are grouped in the range 1.0-1.8%. Maybe the consensus will catch up with the curve in due course.

Structural Unwind

So what would be my justification for making such an apparently gloomy forecast? Well as I argue in my Artemio Cruz piece, and as Paribas re-iterate in their study, this is no ordinary crisis. It is taking place against a background of a severe credit crunch which affects the entire financial sector, in a country with an enormous external deficit (CA deficit over 1o% of GDP and rising), which has a strong external energy dependence, and at a time when food and energy prices have been rising sharply. All of this is bound to exert a very strong downward pressure on internal consumer demand, and as a knock-on impact on investment spending. At the same time slowing growth globally, and in the EU and eurozone economies in particular, makes for a very difficult external environment where increasing exports (even assuming Spanish export prices were currently competitive, which they aren't) becomes difficult, if not well nigh impossible.

Serious Structural Distortions

So let's take a quick look at some of the underlying structural issues. In the first place both Spanish households and corporates are extremely highly leveraged at this point in terms of their outstanding debt obligations. The levels of debt to GDP are really extraordinarily high when compared with their eurozone peers.

So how did Spain get into this rather precarious situation? Well I don't think you need to look too far to discover the answer. As can be seen in the chart below, Spain effectively had negative interest rates throughout the entire period between the start of 2002 and the autumn of 2006. That this state of affairs was produced in the very earliest years of the history of the eurozone was indeed, in my opinion, truly unfortunate, since it meant that inflation expectations had not had time to be "steered down" by a central bank track record. Thus a very widespread reaction on the part of ordinary Spaniards to what were generally perceived to be derisory interest rates for savers was to withdraw money from longer term deposit accounts and to place it in what was considered to be the safest of safe inflation hedges: property. Thus began what may well turn out to have been one of the most serious property bubbles in recent history.

The situation was also doubly unfortunate, since the ECB along with other central banks had lowered interest rates in an attempt to support economic weakness produced by a drop in stock market values following the collapse of the internet boom. In Spain's case however, the excesses caused by the internet boom never really had the opportunity to unwind, since as one boom ended, another one simply got going in its place. This effect can be clearly seen in the chart for long term quarterly GDP growth produced below, where we can see that following the 1992/93 recession (and up to Q2 2008) Spain simply hasn't had one single quarter of negative growth - that is during 15 years. Hence the legend of the Spanish economic miracle was born. But as with all legends, we should also really be asking ourselves what the reality was which lay behind it, since as we can now see, the absence of recession - and in particular the absence of recession in 2002/03 - simply means that we now have a lot of extra "distortion" lying out there and waiting to be "corrected" (the waste-pipes were effectively never flushed, which is why we are now faced with such a peculiar smell emmanating from the sewage system). This would be the main reason why I would argue that what we cannot now expect is a relatively smooth "return to trend" in 12 to 18 months time, since Spain has effectively been "off trend" for some six or seven years now, and the magnitude of the excesses (10%+ CA deficit, 5 million immigrants in eight years, corporate indebtedness pushing the 120% of GDP mark etc etc) is prima facie evidence for this. So even in the best of cases we are almost certainly now facing a significant period of negative and then very low headline GDP growth. But we may not be lucky enough to get away from all this with a simple best case scenario.

The last piece of structural evidence I would offer in this post refers to the CA deficit situation. Since I deal with that reasonably exhaustively in the Artemio Cruz piece, I will only refer to one item here: the deteriorating balance on the income account.

Now this is important in my opinion. It is important since obviously any of the remedies to Spain's short term financing problems imply borrowing money (in some way, shape or form via the support which is offered by belonging to the eurosystem). Spain needs one of those proverbial "bailouts", even though since Spain does not have its own idependent currency this position is somewhat masked by the fact that everything is denominated in euros. But debts incur interest, and the more you borrow, the more you effectively have to pay, not only in capital, but also in interest. And if Spain country risk rises sharply in any way - as some analysts are suggesting it may have to - well then what is already a serious problem is only going to become a more serious one.

Land Prices

So where are the risks? Well I think it is no simple accident that Martinsa-Fadesa has been the first major developer to go, since a very large part of their portfolio is composed of land. According to press reports Martinsa Fadesa had land totalling 28.67 million square metres, 41 percent of which is outside Spain (and 50% of which is not "zoned", that is it is without the necessary premission to build). They also have a stock of more than 173,000 newly-built and unsold properties (again by no means all of these are in Spain). Now land is going to be a very important component in this whole "correction", since a lot of land (as we can see) has been accumulated with intent to build, and much of this land may now become virtually worthless. And land prices are already falling faster than house prices. Data from the Ministry of Housing shows that land for building fell to 251 Euros/m2 in March, a 7.7% drop when compared with March 2007. Land prices had fallen for 3 consecutive months by March with the average cost of land in Spain now being back somewhere around where it was at the end of 2004.

So I would say this is one of the first issues the Spanish government needs to tackle, and quite urgently. Frankly I can see little alternative to having the government intervene and take this land off the books of those who are holding it - not at market prices, they can handle some sort of "haircut" - but I don't think the government should be sitting idly back and watch one developer after another simply fold, since the end result of this is that the problem then moves over into an already overstretched banking sector.

Which brings me to my exhibit one: Japan land prices.

One of the key features in Japan's ongoing battle against deflation has been the way in which land prices were simply allowed to fall after the property bubble burst in 1991. The above chart shows the sharp rise in Japanese land prices from 1986 to 1990 - a period during which they more than doubled - and how they subsequently fell - albeit more gradually — by roughly two thirds from 1990-91 to 2005. Although urban land prices started to turn up slightly post 2006, land prices still continue to fall elsewhere, and of course we still haven't seen how the latest construction "bust" in Japan is going to leave things. Unsurprisingly, residential construction has remained virtually dormant in Japan over this entire deflationary period.So the question is, what is to stop this happening in Spain. I would be grateful to anyone who can present me with a reasoned argument as to why what happened in Japan won't happen here. Meanwhile the risk is evidently there.

The Builders In General

Obviously even if the most immediate and pressing problem in Spain is arising in the area of land prices, the rest of the housing related construction sector will not be far behind. This is a problem that is simply waiting to happen. According to the latest data from the Spanish housing ministry, average Spanish property prices fell by 0.3% in the 3 months to the end of June, but they were still 2% up on prices in Q2 2007, a factor which is leading many to question the reliability of the Spanish data (one more time Artemio Cruz strikes, since Spanish institutions are far from swift in responding to problems, and would seem to prefer denying that they exist). One explanation for the present situation may be that prices are being measured in terms of the initial asking price and not the final selling price. Whatever the explanation prices are certainly set to tumble, and even the the G-14 developers’ association, traditionally a staunch upholder of the immobility of property values, has had to admit that new-build prices have fallen by 15% in the last 6 months alone, while Cue Mariano Miguel, ex-president and present board member of the much troubled developer Colonial, is already predicting a fall in the region of 25% to 30% over the next two years. And new property in Barcelona (which is where I live) is now taking ten times longer to sell than it was only a year ago, according to real estate consultancy Aguirre Newman.

Meanwhile we learn from Jose Luis Malo de Molina, director general at the Bank of Spain (speaking at a recent conference in Valencia) that the number of new homes which will be completed in Spain in 2008 will beat all previous records (I said this was a system which was slow to react), simply piling one more house after another in order to add to that glut of newly completed homes that is already idly languishing and casting its long shadow over the Spanish property market. Muñoz's explanation for this phenomenon is simply that “the real estate sector can’t turn around quickly, it works in the medium and long term, so this year the properties started at the end of 2005 and beginning of 2006 will be completed, which means the number of new properties on the market will hit an all time high.” As I say, "just in time" may be an idea that has entered the heads of the more agile companies like the textile consortium Inditex, but most of Spain is a very, very long way from being able to offer an agile response. On the anecdotal front, a friend of mine recently went to visit family homes in the North West of Spain. In Vigo he spoke to the owner of a brick factory, and in Leon someone who had a quarry. In both cases production was continuing (there is simply no on/off switch here) but the inventory already had piled up to the extent of being now prepared to satisfy normal requirements for the whole of 2009 (in both cases), and of course, in 2009 requirements will not be normal, since housing starts in 2008 have collapsed to a forecast of below 200,000 (down from 600,000 plus in 2007).

At this point estimating the volume of unsold housing in Spain is really a question of "its anyone's guess" rather than a matter of scientific fact. The number 1 million is popular, but I suspect this is more a question of serving up an easily managed factoid than one of accurately measuring empty houses one by one. The same applies to the estimates for the size of the likely fall in property values. All we can safely say at this point, I think, is that the number in both cases is large.

The big question for our current concerns is who is exposed to the risk on all this, and the answer to that question is a lot simpler: Spain's already cash-strapped banking system.

One common estimate of the exposure of the banks to the builders would be somthing of the order of 300 billion euros - this is the opinion of Spanish analyst Inigo Vega at Iberian Securities (and it is one I more or less share). So we could say we have something in the region of 20% to 25% (or more) of Spanish annual GDP in play here.

Bank Exposure Through Mortgage Backed Securites

To this second order exposure of the banking system to the construction sector alone (and remember, through the negative impact of all this on the real economy, we should never lose sight of those non-construction corporates, you remember, the ones who had all that indebtedness we saw in the first chart) we need to add the exposure of the banks to the cedulas hipotecarias, which alone run to something in the 250 to 300 billion euro range (to which we need to add, of course, other classes of more conventional mortgage backed-securities ). If we add these two together - the builders and the cedulas - then we are obviously talking about a potential injection into something of over half of one years GDP in Spain.

According to Celine Choulet of PNB Paribas mortgage-backed securities in the broader sense of the term (ie including cedulas and MBS) now add up to around 37% of outstanding mortgage loans in Spain. She also estimates that asset backed securities held by non-residents may amount to as much as 81% of the total securities issued.

Outstanding home loans (for purchases and refis) represent a substantial percentage of the Spanish banking institutions’ balance sheets (21.5% of total assets and 35.6% of total loans to the non-financial private sector in the second quarter of 2007). In the second quarter of 2007, outstanding home loans amounted to 589 billion euros, 56.4% of which were distributed by cajas (29.8% of their assets), 37.2% by commercial banks (15.4%) and 6.4% by mutual institutions (30.9%).

If we add together home loans and the financing of real estate sector (construction and property services), the overall exposure of Spanish credit institutions has increased significantly over the last decade (37% of assets in the second quarter of 2007, 61.5% of total loans to the non-financial private sector). Exposure of Spanish banks to the real estate sector has exceeded, both in level and in growth rate, that of US, Japanese and British banks. In total, in the second quarter of 2007, cajas (49.7% of assets, 70.5% of loans) and mutual institutions (46% and 56.3% respectively) were almost twice as exposed as commercial banks (28% and 55.2% respectively).

According to Choulet - and just to take one example - in 2006 total new funding to the Spanish mortgage market reached 201.3 billion euros, of which 88.3 billion took the form of covered bonds (representing 43.9% of the total of mortgage securities market) and 113 billion was in mortgage-backed securities (56.1%).

And remember the cedulas all need to be "rolled over" in the next few years (with a big chunk coming up between now and 2012). And the problem starts this autumn. According to an article in the Spanish daily El Pais at the end of June the Spanish banking sector needs to raise 62 billion Euros before the end of this year just to rollover what they have coming up on the immediate horizon.

So what does all this add up to? Well, to do some simple rule of thumb arithmetic, just to soak up the builders debts and handle the cedulas mess, we are talking of quantities in the region of 500 to 600 billion euros, or more than half of one years Spanish GDP. Of course, not every builder is going to go bust, and not every cedula cannot be refinanced, but the weight of all this on the Spanish banking system is going to be enormous. Banco Popular is the most visible sign of the pressure, and their shares have already dropped by 44% this year, and by 7.9% on Tuesday alone (they were the listed bank which was most exposed to Mrtinsa Fadesa).

So it is either inject a lot of money now - more than Spain itslelf can afford alone - or have several percentage points of GDP contraction over several years and very large price deflation - ie a rather big slump - in my very humble opinion. And it is just at this point that we hit a major structural, and hitherto I think, unforeseen problem in the eurosystem (although Marty Feldstein was scratching around in the right area from the start). The question really we need an answer to is this one: if there is to be a massive cash injection into Spain's economy, who is going to do the injecting? Spain alone will surely simply crumble under the weight, and it is evident that the problem has arisen not as the result of bad decisions on the part of the Spanish government, but as a result of institutional policies administered in Brussels and monetary policy formulated over at the ECB. And yet, the Commission and the ECB are not the United States Treasury and the Federal Reserve, no amount of talk about European countries being similar to Florida and Nebraska is going to get us out of this one: and it is going to be step up to the plate and put your money where your mouth is time soon enough. Yet, cor blimey, we are still busying ourselves arguing about the small print on the Lisbon Treaty.

Demographics and Construction

The third major area of risk I would like to highlight today relates to the problem of demographics and their impact on the construction outlook. PNB Paribas (see initial link) see demography as one of the principal downside risks to their forecast. They put it like this:

"With United Nations population projections pointing to growth of only 300k per year on a ‘high-population’ variant for 2010-15, housing starts could fall considerably further. Hence the risks to our central forecast of 30% off housing investment by end-2009 are to the downside. The correction could be more rapid than expected. If not, it is likely to persist into 2010. ...........Our forecast has housing investment converging to levels consistent with relatively strong population growth. A weaker population assumption or some undershoot of the ‘equilibrium’ level would lead to a worse outcome."

Basically, I think the big topic in this context is the coming rate of new household formation. And here it is worth remembering that while the countries most affected by the property-driven credit crunch in the EU would appear to be Spain, Ireland and the UK, the UK is rather different from the other two, since while housebuilding grew by 187% in Spain between 1996 and 2006 (and by 177% in Ireland), the equivalent increase in the UK was just 12%. Planning restrictions in Britain meant fewer homes were built and the resulting relative scarcity may provide one part of the explanation for why house prices have almost doubled, in real terms, in the UK since 1999 despite the comparatively low percentage of new builds (this would bring us back to the huge zoned and un-zoned lang overhang in Spain, and what the dynamics are that produced it). That is, while the UK can to some extent offset the impact of the crisis in the longer term by increasing homebuilding (to house, for example, all those extra people from Poland and other parts of Eastern Europe), in Spain and Ireland the problem is going to be very different, since they both have to sharply reduce housebuilding capacity.

So what are the main sources of new household formation in Spain? Well basically they are threefold: natural population development, migration, and second homeowners from the north of Europe. Now if we start with the question of natural population evolution in Spain, ex-migration the Spanish population is virtually stationary at this point - with an average annual increase of a mere 30,000. But what matters in housing terms is not so much the size of the population as its age structure, and here we don't need to go to the level of refinement involved in looking at longer term UN population projections (high, median or otherwise) because in terms of Spanish property from now to 2020 (at least in terms of natural population drift) the deal is now done (or rather the goose is now cooked), and a quick glance at the US Census Bureau IDB population pyramid for 2000 should make this abundantly clear (see below).

What we can effectively see is that in 2000 (and please click on the image if you want a better look) Spain's three historically largest 5 year cohorts constituted the 25 to 40 age group. But if we mentally fast forward as far as 2015 we will see that the aggregate size of the cohorts in this age range is very significantly smaller, and if we fast forward again to 2020, we will see that what we have are the three smallest cohorts in the last forty years. And from here on in we only go down and down - talk about absence of sustainability!

So we are left with North Europeans is search of second homes and migrants to offer some support to Spain's rapidly crumbling housing sector in the coming years. Well on the North Europeans front the picture doesn't look exactly promising either, since the bulk of the buyers in recent years have been British (Britons own an estimated 500,000 to 700,000 properties in Spain), and they are already having their own problems, plus the fact that changes in the value of the GBP and interest rates mean that affordability is becoming an issue, an issue to which you have to add the drop in attraction of properties whose prices may now be set to seriously deflate, and over a significant number of years.

Indeed, according to Manuel Gandarias, president of the ‘Live in Spain’ holiday-home developers’ association, sales of holiday homes in Spain are now down by 50% from the peak “In recent years between 120,000 and 125,000 holiday homes were sold each year, this year it will be half that,” he is quoted as saying. And of course it isn't only the cost of buying the home that has been going up, it is also the cost of servicing the debt that buying the home brings with it. Josep Suárez, director at Solbank in London estimates that the combined impact of rising Euribor rates and the appreciation of the Euro against the pound (15% in the last 9 months) means that mortgage payments for Britons with mortgages in Spain are now 25% higher than they were a year ago.

So the outlook on the North European second home market doesn't exactly look bright either, which leaves us with the migrants. As is now generally well known, Spain's population has increased dramatically in recent years - from around 40 million in 2000 to around 45 million in 2008 - and this increase has been almost exclusively (natural increase is no more than a quarter of a million) the result of huge inward migration.

Basically the future of all these migrants is now deeply uncertain. I would even say that losing the migrants constitutes the most important of all the downside risks to the Spanish economic crisis for the impact it will have on urban rents and mortgage delinquency in the short term (since many of the migrants have bought flats), and for the consequences for Spain's housing market and pensions system in the mid term. Evidently, since most of the migrants are economic migrants the inward flow must surely be about to dry up (since there are few if any jobs for them) and thus our attention should be focused on the need to hold onto those we already have.

Is There A Rescue Plan Available?

Basically, and on the basis of all the above, I would like to now put forward a five point "rescue" plan for the Spanish economy. It would look something like this:

1/ Set up a national land agency, to buy up land and to irrevocably convert it to other uses (agriculture wouldn't be a bad bet where possible given present food prices). This to include the proviso that such land could never again be zoned.
2/ Buy out and close down the bankrupt builders as part of a general restructuring programme such as the one which was developed for the shipyards and the mines.
3/ Buy up and burn immediately ALL outstanding cedulas hipotecarias. Well, I'm exaggerating here, but something very decisive needs to be done to take these things out of circulation in the longer term, or we will never ease Spain out from under this.
4/ Establish a programme to help immigrants in difficult circumstances, and offer training etc to prepare for the future. Abasic focus of policy needs to be on trying to persuade migrants to stay.
5/ Restructure all existing mortgage contracts - which will involve every one paying more - in order to put mortgage financing in Spain back on a sound footing. This will obviously require legislative intervention, and will equally obviously involve breaking the direct tie with one year euribor. It has been following euribor up and down which has gotten the Spanish mortgage market into this mess in the first place.

OK, I warned you. I said none of this was going to be popular. And none of these propsals should be consider as carved in stone. Better ones could well, I am sure, be put forward, but in the absence of anything credible in the way of alternatives I am putting them forward now. As I said at the start, there is no point in agreeing to have your own throat slit just to see people you don't like have their's slit first.

It is very, very important that some form of "corta fuegos" (fire break) is put in place, and put in place now, otherwise the whole of Spain could very easily burn down in just the same way the Liceu opera house did here in Barcelona, simply because some chump decided to do on-stage soldering repairs with the safety curtain up! Risk sir, there's no risk here. It's all as safe as houses.

Saturday, July 12, 2008

Russia's Consumption-Driven Inflation: Will It All End In Tears?

Russia's inflation rate remained tantalisingly frozen at its highest in more than five years in June as energy and food prices continued to move on upwards. Russian consumer prices were up 15.1 percent from a year ago - matching the rate in May- according to data released earlier this week by the Federal Statistics Service.

As a result he Russian government is struggling to bring inflation down towards it's 10.5 percent target after increased income from rising global energy prices boosted domestic demand and made possible 300 billion rubles ($13 billion) of extra government spending on items like pensions and state wages in the run up to last December's elections. The result has been a massive surge in consumer spending and construction activity which has pushed the rate of expansion in the Russian economy above its long term "comfort" capacity level.

In this post we will look at the general macro economic situation of the Russian economy, and we will see that, with output in the resource sector effectively at or near its peak, the main drivers of Russian growth are now construction and domestic consumption. Since long term labour supply issues mean that Russia is unable to comfortably grow at its current rate of expansion the end product is rising inflation and structural distortions in the development of the manufacturing sector. Policy limitations at the level of fiscal demand management and exchange rate adjustment mean that this whole process is only being accelerated rather than contained and as a result the living standards improving boom could easily, under unfavourable circumstances, be converted into precisely its opposite: an impoverishing bust.

Inflation Hits the Poor Hardest

Welcome as the current rises in living standards are in a comparatively poor country like Russia (see dollar wage chart below), inflation running at the rate Russia now has is certainly not to be sniffed at.

The price of bread has risen 41 percent since June last year, pasta is up 51.3 percent, and milk 35.3 percent. Month on month, petrol costs rose 4.3 percent compared to a gain of 3.5in May. World Bank research suggests that the impact of the world food price shock on Russia has been significant, and has greatly complicated disinflation efforts. In particular the poor (and the poorest regions) have been disproportionately affected. Over the past 5 years, food prices in the Russian Federation have grown much faster than non-food prices. Food price rises accounted for some 82 percent of the overall rise in CPI between July 2007-March 2008, with food prices rising, on average, almost 15 percent (see chart below).

(Please click on image for better viewing)

Contrary to a widespread perception that food inflation mainly affects the more prosperous regions, data from the World Bank shows that food priceshave increased the most in the Volga region, and least in the Far East Federal Okrug. In general, food inflation in western Russia has been higher than in the eastern regions. But the World Bank’s preliminary simulations of the poverty impact of this food inflation shock (based on the international poverty line of $2.15 per day) suggests that, other things being equal, the food price spike could raise Russia’s overall national poverty and vulnerability rates by 1.2 and 4.3 percentage points respectively—resulting potentially in 1.7 million more people in poverty and an additional 6 million vulnerable to poverty, respectively.

Overheating A Problem

At the same time there is now extensive evidence that the Russian economy is overheating. The IMF in their June 2008 Article IV Consultation Report mention three factors: i) the fact that inflation has almost doubled over the past year and now extends well beyond food and energy price increases; ii) domestic demand is increasing at an annual rate of 15 percent in real terms, while GDP is growing at 8 percent, a rate which is somewhat above the level that can be maintained without causing accelerating inflation, according to estimates by both Russian and IMF experts; iii) resource constraints have now become strikingly evident in labor markets, where shortages are causing real wage increases of about 16 percent annually, well above growth in labor productivity (see chart below), and unit labor costs are now rising steadily. Domestic resource constraints are also evident in the rise in import volume growth to almost 30 percent annually.

The World Bank basically take a similar view, and point out that the Russian Economic Barometer index of industrial capacity utilization has risen from 69 in 2001 to 81 in March 2008 (with 42 percent of the firms surveyed for the index reporting utilization of over 90 percent). Also, an index of labor utilization has increased from 87 to 94 with three quarters of firms showing utilization rates of over 90 percent. Meanwhile unemployment was running at 6.1 percent at end of 2007 - its lowest level since 1994.

Systematic Labour Market Tightening

Unemployment has been falling steadily since 2003, while real wage growth has been accelerating beyond labour productivity growth since 2004. Aggregate unemployment statistics for the first quarter of 2008 present a picture of continued tightening in the labor market. The average unemployment rate (using the ILO definition) was estimated at 6.6 percent for the quarter. This compares with 7.0 percent during the first quater of 2007 (see chart below for a month by month breakdown).

The level of unemployment, however, varies significantly from region to region, and reflects the large differences which exist in the underlying levels of economic activity. In 2006, for example, the lowest unemployment was registered in the Central Federal Okrug (4.1 percent), and the highest in the Southern Federal Okrug (13.7 percent).

At the same time Russia's robust economic growth has been accompanied by double-digit increases in real incomes and wages. According to Rosstat, average real wages and real disposable incomes increased by 13.1 and 11.8 percent, respectively, during the first four months of 2008.

This growth in real wages and incomes, however, significantly exceeda real GDP and productivity growth, giving yet one more sign of the presence of overheating, and indicating the possibility of producing long term structural damage. Almost all sectors of the economy have been reporting increases in real wages well above 10 percent level, with the largest gains taking place in the public sector, and in retail trade and construction (16-17 percent). The average monthly dollar wage was standing at 649.4$ in the first four months of 2008, an increase of 41 percent over the same period of 2007. This massive rise partly reflects real wage increases, partly inflation and partly nominal appreciation of the ruble against the dollar.

Russians have by now become accustomed to very rapid real income growth - of the order of 15% a year. This is more than twice the recent growth rate in labour productivity (see chart above). In one respect, this disparity has been sustainable: since oil prices have risen strongly, rapidly improving terms of trade have allowed real aggregate demand to outpace the growth of domestic production. However, this does not negate or ameliorate the problem of rapidly rising unit labour costs, or the knock on consequences for the real effective exchange rate, or the difficulty presented by distorting Russia's economic development towards resource extraction and away from the development of a healthy manufacturing industrial base. Also Russians, as I say, are becoming accustomed (and ill accustomed) to such ongoing increases, irrespective of whether they are sustainable, or justified by rising productivity, and this "detach" from the underlying reality in the mind of the average worker is in and of itself a worrying development. Thus reports of strikes and other worker protests indicate increasing worker activism in pursuit of higher pay or other benefits are now becoming commonplace. This is not surprising, as shortages of skilled labour are now becoming quite general, and the overall pool of manpower is on the verge of shrinking as Russia's population enters long term decline.

Meanwhile Russia’s short-term economic growth has been steadily accelerating above its long term trend. In 2007, the economy grew by 8.1 percent on the back of higher global oil prices, robust domestic demand and strong macroeconomic fundamentals. Preliminary data indicate an even faster real growth in GDP (8.7%) and industrial production rising by an annual 6.2 percent in the first quarter of 2008. Again the monthly Key Economic Activities index prepared by the Bank of Russia gives us a pretty clear snapshot.

Fiscal Concerns

One of the problems which both the World Bank and the IMF draw attention to is the way in which domestic demand pressures are being exacerbated by the presence of a procyclical fiscal policy. Ideally, with inflation roaring away, the economy showing strong signs of overheating and monetary policy having inherent limitations, fiscal surpluses are the only effective bulkhead available for restricting the long term damage that an extended period of over-capacity growth might cause.

Recent experience, however, raises serious doubts about the ability of those administering the Russian economy to appreciate the importance of this point. Primary expenditures by the Russian federal government were up by 15 percent in real terms in 2007, while the non-oil deficit - excluding a one-off collection of tax arrears from Yukos - rose by 0.8 percent of GDP. And a further relaxation in the fiscal stance is underway this year.

While it might be argued that the relaxation is limited in comparison with the size of the share of taxes from the oil and gas sector that are being saved as reserves against the future, there is little justification for any kind of fiscal loosening at a time when strong private demand and rapidly raising food and energy prices are already sending inflation through the roof.

The general government surplus declined to 6.1 percent of GDP in 2007, from over 8 percent in 2005-2006. There is also a growing vulnerability of the budget with respect to oil revenues. The fiscal surpluses continue in 2008, but they are coming down fast, making any disinflation process much harder. According to preliminary estimates for the first quarter of 2008, the Federal Budget generated a surplus of 549 billion rubles, or 6.6 percent of GDP on a cash basis, compared to 7.3 percept surplus during the same period of 2007. Record high oil prices helped the Russsian government generate 1.932 billion rubles (or 23.4 percent of GDP) in Q1, and these exceeded by a considerable margin the revenue target stipulated in 2008 Budget Law (20.7 percent). Federal Government spending has so far totaled 1.383 billion rubles, or 16.7 percent of GDP on a cash basis, compared to 17.7 percent stipulated in the Budget Law for 2008, but pressures are building up to spend additional windfalls on the oil account without paying too much attention to the likely impact on inflation of doing so.

The recent revision to the 2008-2010 three-year federal budget envisages further relaxation in the fiscal stance. In February 2008, the government approved the amendment to the 2008 Budget Law that foresees an increase in noninterest expenditures by 310 billion rubles and a further decline in projected fiscal surpluses to 3.0 percent of GDP in 2008, and to only 1.0 percent in 2009-2010. Non-oil deficit is projected to be about 6 percent of GDP in 2008-2009, and 5.1 percent in 2010, and this will mostly need to be covered by transfers from the oil and gas account.

Structural Distortions In the Economy?

The structure of Russian real GDP growth has shifted significantly towards non-tradeable sectors in recent quarters, partly reflecting booming domestic demand and the appreciating real effective exchange rate of the ruble. There has decline in the relative importance of resource extraction - oil output has stopped rising, and was 1% down year on year in June - and an increasing dependence on imports and construction. In the earlier years of this century, and in particular during 2003-2004, oil and some industrial sectors were the key engines of economic growth. From 2005 onwards, however, the expansion has largely been driven by non-tradable services and goods production for the domestic market, including manufacturing goods. In 2007 the wholesale and retail trade alone accounted for almost a third of the overall economic growth. Booming construction and manufacturing contributed another 30 percent. Within the industrial sector, manufacturing - which is largely directed towards the domestic market - was a key driver, expanding by 7.4 percent in 2007, compared to only 2.9 percent in the previous year. In contrast growth in the resource extraction industry has virtually ground to a halt, reflecting binding capacity constraints and the comparative remoteness (and cost) of new deposits.

The World Bank in a 2007 study entitled “Unleashing Prosperity: Productivity Growth in Eastern Europe and the former Soviet Union” documented how Russia had experienced a strong productivity surge over the period 1999-2005, a surge which significantly increased headline economic growth at the same time as raising living standards. Total factor productivity growth of 5.8 percent was the motive force behind annual average GDP growth in the region of 6.5 percent. In part this productivity surge is explained by the utilization of excess capacity, but it is also attributable to major structural shifts in the economy and the reallocation of labor and capital to more productive sectors. In addition, efficiency gains within firms were found to have accounted for 30 percent of the total growth in manufacturing productivity over the period 2001-2004. Firm turnover (entry of new firms and exit of obsolete ones) accounted for 46 percent of manufacturing productivity growth. The main contribution to manufacturing productivity growth came from the exit of obsolete firms, releasing resources that could be used more effectively by new or existing firms. However, as we have seen, this minor productivity revolution has been steadily losing steam since 2005, and the new growth drivers in the non-tradeable sector are by no means as forthcoming in terms of productivity benefits.

Changes in the output indices by sector paint a similar picture, with the non-tradable sectors - construction and retail trade - growing particularly rapidly. During 2003-2007 construction and the retail trade reported very high average annual growth rates of 14.5 and 13.0 percent, respectively. This tendency accelerated further in the first four months of 2008. The rate of annual increase slowed slightly in April to a provisional 13.2%, but the January to April average is 15.7% (see chart below).

Growth in these two sectors - construction and retailing - have been increasingly outpacing the rest of the economy, and as the tightening capacity constraint factor has locked-in industrial expansion has become less and less driven by extraction industries, with new growth now being almost entirely a product of the manufacturing sector.

The detailed manufacturing data for the first four months of 2008 show robust growth across a whole range of manufacturing subsectors. The leading manufacturing sectors were rubber and plastics, both of which are products that feed directly into the domestic construction and durable goods boom. Rubber and plastics were growing by more than 30 percent per annum in the first four months of 2008, compared to 13 percent a year earlier. The production of machines and equipment also continued to expand rapidy, in this case by more than 20 percent. Some manufacturing industries, however, have been reporting lower growth rates. The production of electro-technical equipment, the food industry and chemical products, for example. While the overall picture shows dynamic manufacturing growth, the World Bank concludes that rising unit labor costs and an appreciating real effective exchange rate may well be behind the lower growth in some manufacturing subsectors, and indeed it would be surprising if they weren't in cases where import substitution is a viable alternative.

Foreign Direct Investment Remains Strong But Excessively Concentrated

Fixed capital investment in Russia has been growing in recent years (see chart below) although investment as a proportion of GDP (21% in 2007) remains relatively low in comparison with those sustained in other emerging market economies. For example, Korea (38 percent), China (42 percent) and India (34 percent) have all maintained significantly higher rates of investment over quite long periods of time (1980-2007). In addition the bulk of investment activity continues to take place in resource industries, and transportation and communication services. The share of the resource sector rose to 17.3 percent of the total in 2007 (up from 15.2 percent in 2005), while manufacturing industries have reduced their share to 15.7 percent in 2007 (from 17.6 percent in 2005).

Simply put Russia does not appear to be investing in industries that could eventually lead to a more diversified economic structure. On the back of the rapid increase in energy prices Russia has received large quantities of direct foreign investment, but the composition of Russia’s FDI has, over the past three years, shifted towards extraction industries. In 2007, for example, extraction industries received around 50 percent of total FDI inflows, while manufacturing received only 15 percent. Recent estimates from Rosstat show FDIs in the first quarter of 2008 running at only USD 5.6 billion, more than 50 percent down on the corresponding period of 2007. The structure of FDI also changed in the first quarter of 2008 with investments in the electricity, gas and water supply sectors shooting forward to receive a third of the FDI inflow (USD 1.9 billion) - reflecting new investments into TGK (teretorialnaya generiruushaya kompania) and OGKs (optovaya generiruushaya kompania) electricity generating companies - while the manufacturing share of FDI continued to decline (falling to 13.1 percent of the total in Q1 2008).

Monetary Policy and Ruble Appreciation

Russia registered record net capital inflows into both banking and non-banking sectors throughout 2007, significantly raising liquidity in the domestic economy. These flows reflected a mixture of comparatively strong fundamentals, an appreciating ruble, and a low perceived external vulnerability. The also helped maintain dynamic growth in the banking sector, while facilitating an ongoing rise in consumer credit. Despite continuing accumulation by the oil Reserve and National Welfare funds the Russian central bank was unable to fully sterilize the domestic monetary impact of the oil revenues and the capital inflows and there was a rapid growth in the money supply (up 44 percent in 2007) - this is way above the levels of nominal income growth and this has obviously contributed significantly to inflationary pressures.

Russian monetary policy effectively remains hamstrung by an excessive focus on stabilizing the ruble in terms of a euro-dollar basket. At the present time the ruble is allowed to trade within a given band versus the basket - which is made up by 55 percent dollars and 45 percent euros - with the objective of avoiding gains which are thought liable to hurt the interests of Russian exporters. But this policy is now under tremendous strain the rapid rise in the money suppy which this is producing fuels an inflation process which is now increasingly out of control. Indeed it is partly the feeling that the non-sustainability of this position will eventually lead to ruble revaluation which is encouraging some of the inflows - which amounted to a total of $82 billion in 2007 alone.

In order to maintain the trading band the Russian central banks buys and sells the ruble on a daily basis, as a result ruble appreciation has been fairly limited, and the currncy only gained 0.2 percent against the dollar and 0.4 percent against the euro in the second quarter.

The pressure is obviously now on, and central bank Deputy Chairman Konstantin Korishchenko indicated at the end of June that Russia may expand the ruble trading band by as much as 5 in the near future. The aim is explicitly to deter speculation, since Korishchenko's main argument was that the wider range would make it costlier for traders to limit losses should bets go the wrong way.

It is evident that the Russian authorities need to find some way to tighten monetary policy. One route to achieving this object can be to allow for greater exchange rate flexibility, although it is important that this is done sooner rather than later, since the longer the present rate of inflation is allowed to continue the greater the risk of a sharp downward correction in a free floating ruble should we see an easing in the currently very high level of energy prices (which if maintained will almost certainly slow global growth considerably in 2009) and the Russian external balance deteriorate on the back of a non-competitive manufacturing export sector. At that point the win-win dynamic of capital inflows driven by appreciation expèctations could turn into its opposite.

The recent increases in policy rates and reserve requirements does not constitute significant tightening. The commitment on the part of the Russian central bank to move to formal inflation targeting, once it believes the conditions for such a framework are in place, is a positive step (if one fraught with risk in terms of central bank crredibility) under current inflation conditions, but this does not imply there is not an urgent need to refocus monetary policy on immediate inflation reduction. For the sort of structural reasons outlined in this article a major reduction in credit growth and higher real interest rates are essential - and unavoidable - at the present time.

Oil Dependence and An Ageing Population - The Long Term Risk

In the short term the Russian economy only seems to go from strength to strength. Russia's trade surplus is estimated to have expanded again in May (results due out this week) from April as the world's largest energy exporter benefited yet one more time from record oil prices. The surplus is likely to be in the region of $18.6 billion, compared with $15.5 billion in April and $12.2 billion in May, 2007.

At the same time the price of Russia's Urals crude continues to touch all time highs (it averaged $106 a barrel in the year through July 2, compared with $60 a barrel in the same period a year earlier). Russia produced 9.77 million barrels of oil a day in June, more than Saudi Arabia did, thus becoming the biggest exporter of the fuel. Russia also produces the energy equivalent of about 11 million barrels a day of gas. As a result of such factors Russia's trade surplus hit a record $130.92 billion in 2007. So what could possibly go wrong?

Well the central point would be that the strong rise in oil prices we have seen since the start of the century has only served to increase Russia’s dependence on oil and gas revenue and has not been used to facilitate the kind of diversification which could allow for a more stable development path. As such the Russian economy - despite the outward semblance of "you've never had it so good" boom times - has never been more vulnerable to sudden falls in oil and gas prices.

The share of oil income in total fiscal revenue has increased substantially – from 10 to about 30 percent of GDP. Instead of diversifying, Russia has, de facto, been specializing in oil. Oil now also accounts for about 60 percent of total exports. Higher oil revenues allow for additional spending room, but they also complicate macroeconomic management and lead to an increased dependence on a highly volatile and uncertain source of income. While this has not been a problem during the period of high oil prices, it would be a major source of vulnerability if oil prices suffer any kind of rapid descent from the recent levels, and it does put in place a "ceiling" on Russia inflation-free level of growth capacity given the fact that the resources sector seem to have now reached its "peak output" level.

Soaring oil prices, large capital inflows, and high credit growth are all providing the impetus for a virtuous circle of robust growth in investment, real incomes and consumption but such growth has been producing manifest signs of overheating. The situation is only being made worse by a procyclical fiscal policywhich is stimulating rather than easing demand pressures, while the fixed exchange rate policy in the face of rising oil prices and large capital inflows is leading to very high levels of money and credit growth.

And as we move forward the problems identified here are only likely to get worse. Russia’s well documented demographic trends—declining population, aging, and increasing demand for pension and health services and the changing structure of demand for education are likely to become key drivers of major social expenditures such as pensions, health and education expenditures in the years to come. The net effect of these trends is that under any long-term economic scenario, public expenditures on pensions, health and education are likely to increase significantly. The World Bank estimate that the main social expenditure items are likely to increase by 3 percentage points of GDP - from 14.1% in 2008-10 to about 17.3% by 2016-20. Given this situation stable sources of long-term fiscal revenue and moderation in total public expenditure commitments are essential, as is the development of a growth model to make all the numbers add up.

And sustainability of pensions and health spending isn't the only issue that Russia's demography presents us with. Declining levels of productivity growth mean that it is very likely that increases in headline GDP will only be possible via sustained increases in labour inputs, yet Russia now has, as we have seen, a declining working age population. Long term very low fertility (TFR 1.3-1.4 range, see chart above) means that this problem is set to continue at least over the next twenty years (and probably a good deal longer) which means a Russian economy which is increasingly immigrant dependent (the World Bank estimates Russia currently need a million migrants a year) and which suffers from the almost permament inflationary pressure of running a very tight labour market. Under these circumstances it is impossible to contemplate the present very high levels of GDP growth being sustained in the longer term, indeed, if we have any kind of "adverse event" which precipitates an unwind, precisely the opposite might well occur.

Thursday, July 10, 2008

What Is The Recession Risk For The German Economy?

Christian Menegatti in his Global Recession Watch post on RGE Monitor last week strang together an impressive list of countries which might be at risk of entering recession during 2008. One name which was conspicuously absent from the list was that of Germany. Yet the situation here is not as self evident as some may assume, and one of the aims of this post is to pose the question: just how realistic it is to expect an export dependent German economy to avoid recession when so many of its most important customers - the UK, the US, Spain, Italy... - are either skirting or entering recession even as I write? Indeed Sebastain Dullien implicitly asks this same question in his most recent post here on Europe EconMonitor.

As Sebastian points out there are now a growing number of indicators which suggest that the German economy is not only slowing, but slowing comparatively rapidly. And maybe one indicator here says it all: industrial output. Increasing industrial output to fuel rapid growth in export demand has been at the heart of Germany's most recent expansion, and, as can be seen from the seasonally adjusted output index in the chart below, industrial output has now been declining for three consecutive months (as of May data, released 07/07/2008).

In addition all the main sentiment indicators are now down (including the EU Composite Economic Sentiment Indicator, which came in at 101.5 in June, its lowest level since January 2006). The latest Ifo institute business climate index fell to 101.3 in June (again its lowest level since January 2006) down from 103.5 in May, and the Sentix institute index (released this morning) fell to minus 9.3 from a positive 5.2 in June. That's the lowest since June 2005 and the biggest one-month drop since the start of the index in February 2001.

The GFK consumer confidence index was also down this month, with the forward looking index for July dropping to 3.9 from a revised 4.7 in June. Again this is the lowest reading in quite some time. In particular in their monthly report GFK highlighted how continuing high inflation was eroding income expectations and the consumer propensity to buy. According to the latest flash estimate from the German federal statistics office, inflation is thought to have hit 3.3% annually in June, and if confirmed this will be the largest price increase since December 1993.

German manufacturing orders declined in May, the sixth straight month that orders have been down. Orders, adjusted for seasonal changes and inflation, fell 0.9 percent from April, according to data from the Economy Ministry last week.

And The Real Economy Is Faltering

So much for the sentiment indexes, but what about the real economy? Well if we look at retail sales these were up by 0.7% in real terms in May over May 2007. However, if we look at a longer term time series, we can see that, despite the comparatively positive general economic environment, sales have not been strong for some time now, and in fact they have only registered monthly year on year increases five times since January 2007.

Despite the fact that May saw quite a sharp increse over April - 1.3% in real terms m-o-m sales seem to have contracted again markedly in June according to the last Bloomberg retail PMI reading. The index slumped from May's eighteen-month high of 56.6 to the low level of 44.9 (remember that on the PMIs 50 marks the neutral point, with readings over that level indicating expansion, and below contraction. Looked at this way it would seem sales were contracting almost as fast in June as they were expanding in May).

If we look at the monthly (seasonally adjusted) sales index we find ouselves with a very clear before and after picture, with the sharp pre tax-increase spike in December 2006 being followed by a huge trough in January 2007 following the 3% VAT hike. After that retail sales have never really fully recovered, suggesting that raising consumer taxes may not be as harmless a move as many seem to have thought, and is certainly not the most advisable way to finance the fiscal liabilities presented by population ageing.

If we now turn to industrial production - which, as I say has really been at the heart of the current German expansion - we find that output declined for a third consecutive month in May. Seasonal and inflation adjusted output was down 2.4 percent from April, when it fell 0.2 percent, according to data from the Economy Ministry in Berlin this morning. That is the larges month on month fall since February 1999. Output was up 0.8 percent on May 2007, on a working day adjusted basis.

Manufacturing output was down 2.6% month on month, while construction was up 1% from April, but construction in April was already at a very low level. The seasonally adjusted index peaked in February, and has since been declining, as can be seen in the chart below.

Coming to employment, German unemployment declined in again in June, pushing the jobless rate to its lowest level in almost 16 years. The number of people out of work, adjusted for seasonal changes, fell 38,000 from May to 3.27 million.

And employment is still increasing. There were a total of 40.19 million people employed in Germany in May, an increase of 619,000 (or 1.6%) on May 2007. Compared with April 2008, the number of persons in employment was by 111,000 ( or 0.3%).

Thus the German job creation machine continued to function in May, although at a slightly slower pace than in previous months. From January to March this year, the number of persons in employment each month was by 1.8% higher than in the corresponding month of the previous year, while in April and May 2008 the increase had dropped slightly to 1.6% on April and May 2007. It is too early at this point to decide definitevely whether the current trend can be considered to mark a general slowdown on the labour market. At least part of the slowdown can probably be explained by the fact that the winter months had been unusually employment-friendly because of the mild weather, so that the usual upturn in spring was smaller, although of course this also means that growth in the earlier months of the year was not as stong as appears at first sight.

When looking at the unemployment numbers it is also important to bear in mind that the German labour force is now near its historic peak, and will now steadily decline. An indication of this can be found in the chart below where it can be seen that the rapid growth in the population available for work which characterised the years between 1997 and 2005 has now come to an end, and since 2005 the numbers have been stagnating.

This stagnation in the potential labour force (before an eventual decline if immigration is not leveraged to facilitate growth) is also a reflection of the fact that Gernamy's population is now, slowly but steadly, declining, and has been declining since Q4 2004, as can be seen in the chart below.

The only way to really swim against the stream in these conditions and to continue to achieve sustained GDP growth is by raising labour productivity, but this has been one of the weak spots in the current expansion. Overall labour productivity (price-adjusted gross domestic product per person in employment) rose only very slightly - by 0.1% - in Q1 2008 as compared with a year earlier, although as measured per hour worked, there was an increase by 0.8% (this is because the number of hours worked by those in employment rose much less than the number of persons in employment). The bootom line here is that a lot of the new jobs Germany has been creating are part time and temporary work, often in relatively low value activities.


The core of the German economy, and the principal driver of its GDP growth, is its export sector. Basically, as a crude first approximation, when German exports do well, the German economy grows, and when they don't it falters. In part this is simply the natural corrolary of the fact that German household consumption has remained congenitally weak. The chart below should make this relative co-movement reasonably clear.

Now in April, which is the latest month for which we have data, German exports continued to grow on a year on year basis, led by demand from countries outside the 27-member European Union. Sales abroad, on a seasonal and working day adjusted basis were up 1.2 percent in April over March, when they had fallen back 0.8 percent on February. April exports rose 14 percent on a year on year basis.

One interesting data point is that during the period January to April exports to countries outside the EU increased 11.6 percent from a year earlier (and by 18% April on April) while exports to EU countries rose 5.8% percent, and to the eurozone alone only 4.6%.

If we go back to 2007, which is the last period for which we really have a detailed breakdown of the export data, about three quarters of German exports went to European countries, and 65% went to the member states of the European Union. The second market after Europe was Asia with a share of about 11%, followed closely followed by the United States, with a share of approximately 10%.

So Europe (whether inside the EU or not) is the key to German growth, and this, of course, is one of the reasons why German exports have been so resilient to the rising value of the euro, since (at least until the problems of the property slowdown started to hit the value of the pound sterling) even those coutries who did not share the common currency (like the UK or most of Eastern Europe) had currencies which had by and large appreciated side by side with the euro itself. Of course all of this has now started to change, the UK has its own problems, and inside the eurozone, Spain and Italy are no longer increasing the volume of German products they buy in the way they were even six months ago.

On the other hand, even as some of the traditional customers have begun to falter, new ones have arrived to take their place to some extent, and in particular here new members of the European Union and Russia. To put things in perspective a little, in 2007, and despite all the talk about the "China factor", Germany exported roughly the same quantity of products to the Czech Republic ( 26,026.6 million euro) - population circa 10 million - as it did to China (29,922.7) - population circa 1.3 billion.

A detailed comparison of relative performance between 2006 and 2007 is even more revealing. Of particular interest is, for example, the fact that exports to China only increased by 8.7% in 2007 while exports to the Czech Republic rose at almost double the Chinese rate ( 16.9%). The importance of United States as an export destination, on the other hand, declined, since exports to the US were down from 78 billion euro in 2006 to 73.3 billion euro in 2007, a decrease of 6%. Exports to Poland (another important destination for German exports with 36 billion euro in 2007) were up 25.2%. Spain was also up considerably (as was Italy), rising from 42 billion euro in 2006 to 48 billion euro in 2007 (up 14.2%). The Russian Federation also stands out outside the EU, with exports there rising from 23 billion euro in 2006 to 28 billion euro in 2007, that is an increase of 20.6%. It is clear that the rate of increase of German exports to Russia has accelerated even further during 2008.

Now the list I have just gone through is scarecly a randomly chosen one. The decline in importance of the United States as an export destination for both Germany and Japan - which are the world's No 3 and No2 economies respectively (and both are CA surplus export-driven economies) - surely has some implications for the whole decoupling-recoupling debate.

Also, the dependence of the German economy for exports growth on Poland, the Czech Republic, Russia, Italy and Spain - all of which may find themselves with economic issues in 2008 of greater or lesser importance - is surely more than a minor detail, and the evolution of the east european and latin economies needs to be closely monitored for what they can tell us about the future path of the German one. At this point it is clear that German exports have been labouring in recent months more under the difficulties produced by the slowdown in Spain, Ireland and the UK than they have been suffering the direct consequences of reduced demand in the US.

Q1 2008 GDP

As I reported in detail here, the German economy started 2008 with what seemed on the face of it to be considerable momentum, since on a price, seasonal and calendar adjusted basis gross domestic product (GDP) was up by a very large 1.5% in the first quarter of 2008 over Q4 2007.

Perhaps rather surprisingly, economic growth in the first quarter of 2008 was primarily supported, not by exports, but by gross fixed capital formation. Compared with the fourth quarter of 2007, investment in machinery and equipment was up by 4%, and capital formation in construction by 4.5%. The latter, it has been suggested, being partly the result of a comparatively mild winter. Overall final consumption expenditure increased by 0.5% q-o-q, the first such rise in over a year, however breaking this down we find that government final consumption expenditure was up markedly (+1.3% q-o-q), while the final consumption expenditure of households showed a rather smaller increase (+0.3% q-o-q). But the big "little secret" of the German Q1 2008 data is that inventory levels were up sharply, and inventory building added a substantial 0.7% points (of the 1.5% total) to growth in the first quarter. Obviously this situation is most likely to be corrected in Q2, and this, together with the steady slowing of general economic momentum, is undoubtedly the reason Deputy Economy Minister Walther Otremba is predicting a contraction in Q2.

Exports continued to grow (+2.4%) but since imports rose even more strongly (+3.5%), foreign trade actually had a downward effect on gross domestic product in Q1 2008 when compared with the preceding quarter. So whatever else the Q1 headline number was about, for once this was not an exports story.

So we can draw two conclusions from all this rigmorole: firstly it would be far from in order to announce the Q1 2008 result as strong evidence for anything very important about the Germany economy or its future trajectory, and secondly, given that the inventory correction is virtually bound to take place (and that early construction momentum has almost certainly not been maintained - construction output was down 2.9% in April over March and by 2.3% over April 2007, and only bounced back 1% in May over April, so was still under the March level) we should not interpret a negative number in Q2 as meaning that Germany is actually entering recession at this point. Global trade is still growing (not as fast as previously, but still growing) and German exports are still sufficiently resilient at this point for this eventuality to be very likely.

For the German economy to enter recession the global economy will need to slow further - which all the signs are that it most probably will do, as country after country falls into the grip of higher inflation and increased central bank monetary tightening.

The important point to understand about the export sensitivity of the German economy is that this is a by-product of permanently weak household demand, which is, in my opinion, associated with the progressiving ageing and numerical stagnation of the German population.

Government Debt

Among the sources of support for the German economy in the coming quarters we should not count on the possibility of fiscal loosening. Germans debt to GDP ratio was 65% in 2007, down significantly from the 67.8% peak hit in 2005, and Germany has been gradually move the fiscal books back into balance (0% deficit in 2007) after four years of breaching the EU's 3% deficit limit (2002-2005). We should not expect any enthusiasm from the German government for hitting reverse gear at this point.

Indeed Finance Minister Peer Steinbrück is forecast this week to unveil a even tighter-than-expected 2009 budget in an attempt to stay on track with the target of completely eradicating the federal deficit by 2011. The draft budget will be put to the German cabinet on Wednesday and is thought to envision total federal spending in 2009 of €288.4bn, up 1.8 per cent from this year. The deficit is forecast to fall by €1.4bn to €10.5bn. The finance ministry’s four-year fiscal plan is said to be little changed from earlier versions and foresees a fall in the deficit to €6bn in 2010 and zero from 2011 onwards despite an average yearly increase in spending of 1.5 per cent.


There seems to be a general consenus at the present time that the German economy is slowing. Where there is no real consensus is over the rate at which it is slowing and where and when the slowdown will settle. It is already clear, however, that GDP growth in 2008 will be below the heady 2.9% annual rate achieved in 2006, or the 2.5% clocked up in 2007.

The median of five forecasts published in June by the major German economic institutes sees growth in the German economy this year of 2.2%. This really now seems a highly optimistic number, especially bearing in mind the economy may in fact have shrunk in the second quarter after expanding 1.5 percent in the first three months, according to the recent statement of Deputy Economy Minister Walther Otremba.

I personally will be very surprised if we see growth at or near the 2.2% the institutes are forecasting (and much less the 2.5% put forward in the now somewhat dated EU commission April forecast, although Eurostat now have a 1.8% forecast pencilled into their database). I even consider the 1.7% from the OECD and 1.9% from Morgan Stanley to be still on the high side given the extent of downside risk and the sort of real economy data we are now seeing.

At the start of the year the German government was reckoning on a growth rate of 1.7 per cent, while Peer Steinbrück is basing himself on 1.2% for the draft budget.

“Now the president of the Bundesbank told the cabinet it might be 2 per cent, to my surprise,” Peer Steinbrück informed the Financial Times in an interview this week. “For my 2009 budget, I estimated growth at around 1.2 per cent, which accounts for all the downside risk ... Some people say it might be 1.4 or 1.5.”

Obviously I am one of the people in question, since I would go much nearer to the 1.4% rate forecast by the IMF in its April World Economic Outlook forecast, and my reasoning would be as follows. We have already had 1.5% growth in the first quarter, but we may have a negative number to put next to it in Q2. Lets make a guess: -0.2%. That brings us back to around 1.3% (its not as simple as this in practice, but bear with me for a second). So then, what if we get, say, a reasonably positive Q3: 0.4% expansion, say. But what then if we get a contraction in Q4? Then everything would depend on the rate of contraction.

Well, there's a lot of guessing going on here, and we will be a little clearer when we get the Q2 number, but the basic structure of the situation is, I think, the one I am suggesting here. Very weak (and possibly negative) growth in Q2 followed by a "bounce back" in Q3, and then a second negative quarter in Q4, a quarter which could well by that point be the first of two consecutive quarters of negative growth, that is the first part of a recession.

In addition all the indications suggest that German consumption will continue to be weak throughout 2008. So if consumer consumption is at best flat, government consumption equally so, and investment and construction weakening, we are simply lefy with export growth, and here the outlook is definitely more negative in 2008 than it was in 2007. So I would say that, based on current data, 1.4% growth in Germany in 2008 looks to be a reasonable estimate at this point, and if there is risk to this call, then I would say that it was mainly downside.

Tuesday, July 1, 2008

Italy's Economy On The Ropes (Again)

"Italy’s per-capita GDP growth was 5.4% in the 1950s, 5.1% in the 1960s, 3.1% in the 1970s, 2.2% in the 1980s and 1.4% in the 1990s. A rough-and-ready extrapolation of this decade-long continued slowdown would lead to expect no more than 0.5% in the 2000s."

Altogether, the long-run data suggest that the bad performance of the Italian economy is not the figment of the currently unfortunate business cycle contingency. This is why speaking of decline may not be totally unwarranted. With one caveat to add, though: given that the rest of Europe has been and is still growing at a positive pace, Italy’s alleged decline is of a relative, not an absolute type. Italy’s per-capita GDP has simply grown not as fast as Europe’s GDP, but has not diminished over time (yet)"

Francesco Daveri and C. Jona-Lasinio,
Italy's Economic Decline, Getting the Facts Right

The Swiss writer Frederich Dürrenmatt tells a joke somewhere. It relates to the tragically flawed expedition that Scott lead to the Antartic in the early years of of the last century. There are various possible approaches to the fictional treatment of this topic. Shakespeare might perhaps have Scott fail due to problems which are deeply rooted in his character. Brecht on the other hand would probably have explained the failure as being rooted in some kind of turmoil produced by the class struggle. Samuel Beckett would more than likely have reduced the whole thing to some sort of "endgame", with Scott being frozen in a block of ice surrounded by his crew members equally trapped in other blocks of ice to which Scott speaks without ever receiving any kind of response or answer. Then there is Dürenmatt's own version: Scott's expedition simply failed due to one stupid mistake made right at the outset - Scott accidentally locks himself inside a refrigeration chamber whilst purchasing provisions for the expedition.

Very amusing you might say, but what has this exactly got to do with Italy? Well Italy's economic expedition, like Scott's naval one, is, it seems, essentially flawed. And we have various explanations going the rounds to help us to understand why this is. The Shakesperian version would have it that the whole thing is down to character, you know, all that excessive interest in under the table money and things like that. Then, of course, you have the Brechtian account. Italy's longstanding love/hate relationship with the latter day heirs of former fascist and communist movements, and the veto power vested in the extremes when you have a badly fragmented political system. Then you have the more intellectualised Brussels/Brechtian account, which would put the whole problem down to Italy's failure to really enter into the spirit of the Lisbon Reform and Dialogue Process. Then of course there would be the accidental spanner in the historical works account ,whereby Italy simply got locked out of modernity before it even got started. I think the smart name for this would be "path dependence", with Italy, say, being forced out of ERM in 1992 by one very smart decision by one very well known investor, and the rest, as they say, now being history.

Curiously, with or without the plethora of would-be explanations we have on offer, there is a least consensus on one thing: something is wrong with the Italian economy, badly wrong. But before getting into my own "scripting" of what is actually going on Italy, lets start from the ground floor and take a look at some of the basic facts of the case.

Italy's Growth Decline

The first thing to notice about Italy's economy is its more or less endemic weakness. If we look at the chart for quarter on quarter growth since 2000 (see below), what is evident - and regardless of whether or not Italy is actually (technically speaking) in recession right now - is the fact that Italy has already been in recession three times so far this century (and sometime this year it will almost certainly be in for a fourth, and in 2009 a fifth?) - in Q2/Q3 2001, Q1/Q2 2004 and in Q4 2004/Q1 2005. It is the fragility of this situation which is so noteworthy I beg to suggest.

If we look at the long term GDP growth chart the position becomes even clearer, since after pretty strong - if rather volatile - growth in the (1950s, 1960s - see Davieri and Jona-Losinio, and) 1970s, Italian headline GDP growth has been more like a flame which is steadily going out - the proverbial candle in the wind. Just one hefty puff and it is gone, it seems to me. And the current combination of the ongoing credit crunch (tighter lending conditions) and the global food and energy "shock" may well constitute just the strong puff that was needed. (Although I'm not sure that "shock" is quite the right term here, since normally shocks are considered to be exogenous, while looked at from the perspective of the global economic system rather from that of individual national economies, what is happening might well be though to be endogenous. I think this argument will have to await another occasion, although I do have a shot at putting an initial case here).

Basically if we look at the trend here, and in particular if we think about how frequently the Italian economy has been dipping in and out of recession over the last seven years, we ought at least be prepared to ask ourselves the question whether a point might not arrive when Italy enters what appears to be a recession and then never comes out, in the sense that we don't get to see sustained positive headline growth again, and the economy simply contracts and contracts. Of course, if this were to be the case we would need to revise our historic vocabulary, since what we would be facing would certainly be far more than a mere recession, while at the same time it is quite unlikely that what we will have could be described as a slump, in the sense that after a slump we normally get a rebound). Rather, and in similar fashion to the emblematic Venice itself, the Italian economy may slowly but surely be simply sinking into the sea.

Certainly the theoretical possibility of such an eventuality does exist, and the far from hypothetical possibility of such a state of affairs actually coming to pass in reality should not be simply discounted, since with the coming decline in the labour force as the Italian population ages and shrinks, and the decline in things like retail sales which may accompany an ever reducing number of consumers, it isn't hard to see how this might happen. If we simply take the issue from the supply side for the moment it is plain tha, barring immigration, raising productivity is just about the only way Italy can hope to sustain growth momentum in the future, and productivity growth is precisely what Italy hasn't been delivering in recent years. As we can see in the chart below, output per hour worked in Italy has been steadily losing ground vis-a-vis the other members of the EU 15 since the mid 1990s.

And if we look at the annual rates of change in GDP per hour we get a chart (see below) which looks remarkably similar to the one we saw above for long term GDP growth.

Viewed From The Supply Side

Now this comparative performance vis-a-vis the EU 15 is the exact opposite of the one we should be seeing, given the fact that Italy is in the short term the most challenged of the EU economies in terms of potentially labour supply (see chart below). Between 2010 and 2020 the working age population is set to decline by around 1.5 million. So, given the supply side constraints on labour, if Italy is to avoid slipping into long term economic contraction then the whole productivity trend has to be reversed, and this is no easy matter and something, frankly, which it is hard to see actually happening after so many years of talking so much and doing so little. (In this regard it is far from clear whether eurozone membership has provided Italy with sufficient incentive for change, or whether - by guaranteeing cheap liquidity - membership has simply allowed Italy's problems to continue and the underlying stituation to deteriorate as argued by OECD economists Romain Duval and Jørgen Elmeskov in their well known paper " The Effects of EMU on Structural Reforms in Labour and Product Markets" presented at the ECB Conference "What effects is EMU having on the euro area and its member countries?" held in June 2005).

Obviously this labour supply constraint can be circumvented in the short term by raising participation rates and immigration (although in the longer run sustainability implies that something serious needs to be done about the underlying low fertility issue). However it needs to be said that progress so far in this direction has certainly been far from satisfactory. As can be seen from the next chart, Italy has had quite a dramatic surge in immigration in recent years.

Employment in Italy has risen from 20.617 million in Q1 2000 to 23.170 million in Q1 2008. That is there has been an increase of about 2.5 million (or 12.4%) in the number of those employed, so Italy has been creating jobs, but this has largely been in labour-intensive, low-value activities, and hence the productivity result. More to the point, since Q1 2005 Italy has generated 800,000 extra jobs, and 500,000 of these positions have been filled by immigrants. That is, the Italian labour force itself is nearly stationary at this point.

And Then From The Demand Side

What little economic growth Italy gets these days largely comes from two things: exports and government spending. Since the prowess of the former continually shows evidence of ongoing weakness (see here), while the latter is already responsible for the second largest debt to GDP ratio on the planet (or the third, depending on whose version of the Greek accounts you accept), it is plain that demand side elements in the Italian case are inherently weak. If we take Q1 2008 as an example, GDP was up by a seasonally adjusted 0.5% on Q4 2007, which seems to be a relatively positive result. But when we come to examine the details things don't seem to be so rosy at all. Imports were down 0.5% on the quarter (due to weak internal demand), while exports were up 1.4% (this was the positive part). As a result the balance between imports and exports changed substantially, and this is undoubtedly one of the main factors in the "bounce back" in the first quarter from the 0.4% q-o-q contraction registered in Q4 2007.

Total consumption was up q-o-q 0.2% (all data seasonally adjusted), but it is the composition of the consumption that matters here, since private household consumption was only up 0.1% (after falling 0.4% q-o-q in Q4 2007) while government consumption and transfers were up 0.4% (that's a 1.6% annual rate in an economy that is hardly growing). It is hard to see how this rate of increase in government consumption can be maintained and the deficit be reduced at one and the same time.

Investment is basically a second order factor here, since this will rise and fall as either exports or domestic demand generate the impetus to justify the invesment. Gross Fixed Capital Formation was down q-o-q by 0.2% in the first quarter, of which equipment was stationary, transport equipment down 3.4% and construction up 0.3%. However when we come to look at year on year machinery and equipment (ie investment and renewal) spending, we find it was down 0.9% following an annual 2.5% drop in the previous quarter. That's why all those business confidence readings are so important, since in many ways the bottom has all but fallen out of Italian investment in machinery and equipment over the last nine months, and to get this item moving again we are going to need to see a revival in confidence, something which is unlikely to appear over any immediate horizon. Italian business confidence dropped to its lowest level in almost three years in June under the impact of slowing economic growth, rising energy costs and a stronger euro. The Isae Institute's business confidence index dropped to 87.1 from a revised 89.4 in May. That is the lowest reading since July 2005.

On the export side Italy is no Germany or Japan, and struggles to sustain a trade balance, there is often a goods trade surplus, but a significant deficit on services (especially in transport and business services) means that Italy normally runs a trade deficit these days.However the fortunate combination of reduced imports and increased exports sometimes means that the trade impact on headline GDP is positive, and we see economic growth. The dynamic can be seen to some extent in the chart below - which shows movements in GDP, investment in machinery and equipment and exports. The uptick starts with a movement in investment, which is presumeably a response to changes in the order books, then exports surge, and in their wake headline GDP moves up. Then the rate of increase in exports starts to weaken, investment hits a downward path, and some quarters later GDP folds. Now investment in capital and equipment, while still falling year on year, did bottom in Q1, but here comes the rub, with the external environment worsening, and the storm clouds gathering this may well not have been sustained into an uptick. And viewed in this light the fact that the June business confidence reading fell back again might be thought to be rather ominous.

Returning now to consumption we can see in the chart (below) that the dynamic behind Italian household consumption has steadily faded in recent years (in a way which reproduces the pattern seen in the long term GDP growth and productivity charts). This is why I say the only real possible first order drivers of growth for the Italian economy are exports and government spending, since both investment and consumer spending tend to be derivitives of these.

As far as retail sales go, these were down by 5.9% in real terms in April (the latest month for which we have ISTAT data), while the retail PMI has now been registering contraction for 16 consecutive months. The June figure suggests another strong contraction (36.3) but not as rapid as the April one (31.4). Again, we could ask ourselves whether Italian retail sales will ever grow again, especially since they were mainly contracting in real terms though most of 2006/07 which was one of Italy's best growth spurts in the century so far.

As far as housing booms go Italy has not had a real boom since the one which took place between 1985 and 1992. The housing market does however continue to limp along, and construction activity is a GDP positive. Nationally, prices in 2007 rose by around 4% in nominal terms, much the same as the previous year, while the number of sales dipped by 4% falling to roughly 16% below their 2004 peak.

Prices in the major cities have been growing somewhat faster than the national estimates in recent years but are considered by both Nomura and Scenari to have grown by at less than 5% in 2007. Over the past decade, house prices have not risen at anything like the rate seen in many other EU countries, and only grew by about 30 to 40% in real terms between 1996 and 2006.

Pensions Retirement and Debt

So to tie all this up (neatly if possible) where does my analysis leave us? Well Italy badly needs to turn the productivity problem around, and there are, naturally, as many suggestions around about how to do this as there are explanations for her plight. Unfortunately most of the suggestions have been on the table for rather a long time now, and nothing noticeable has happened. So what confidence can we have that things will be any different this time round? Very little I would say.

In Chapter Two of its Italy country note "Economic Policy Reforms: Going for Growth 2008" the OECD did outline a long list of priorities for Italy. In order increase productivity, the OECD recommend that: divesture programmes be accelerated in public utilities, transportation and media; golden shares be replaced with arm’s length regulation; and regulators be strengthened further: planned liberalisation of market and local government services be fully implemented, and statutory and official authorisations giving anti-competitive powers to professional associations be removed. The OECD also advocate a decisive push to boost tertiary education graduation rates and improve university teaching and research quality. All such measures are doubtless very worthy, and will produce some results if implemented. But it is not at all clear that, even with decisive government action (which is not at guaranteed at this point, indeed interest seems rather to be focused on "Robin Hood" taxes and other such like) they will go deep enough and take effect rapidly enough to stave off what is likely to become the number one issue of the day: the sustainability of Italy's fiscal debt.

In order to appreciate the depth of the problem here, we might just take one area: pensions reform. As we have seen, after many years of very low fertility, fewer and fewer young Italians are now joining the workforce to replace the older Italians who are retiring. Instead their places are now being taken by a steady stream of newly arrived immigrants. In fact two-thirds of the annual increase of 308,000 new workers in the fourth quarter of 2007 were immigrants, with the other third being effectively accounted for by an increase in employment rates in the 55 to 64 age group. At the same time Italy has the highest proportion of over 65 year olds in the European Union and the second highest in the OECD (after Japan).

Italian civil society is effectively in denial, however, about the importance of this problem, and the best illustration of this is the ongoing failure to reach agreement on substantial increases in the retirement age - indeed despite all the recent "anti-immigrant" rhetoric we have been hearing coming out of Italy the fact of the matter is that a very large share of the new employment has gone to immigrants, and these immigrants are effectively working to pay a significant chunk of the pensions bill being run up by all those Italians who are still taking their retirement at 58 (only to live and claim their pensions a lot longer than most other Europeans to boot). Yet one more time Italy is more or less at the head of the list (see chart below) in terms of early exit from the labour force.

In fact one of the big problems for the Italian political system in its attempts to do something to address the downward drift in the economy is all the political horse trading that is needed to move even the smallest change forward. Last November Prodi only finally managed to get the support of Italy's labour unions for the 2008 budget (which was of course an attempt to keep the fiscal deficit under control) by accepting that there would be a much more gradual pace of increase in Italy's pension and retirement age as a trade off. The agreement he reached involved a staggered increase in the minimum retirement age, which at that point was set at 57. The change in fact involved supplanting (or going back on) a previously agreed reform law - one which would have boosted the retirement age to 60 from as early as January 2008 - and an effective slowing down of the reform process. The law which was put aside was agreed to in 2004, by one of Silvio Berlusconi's governments, and the decision taken then had been to raise the minimum retirement age— from 57 to 60 - as of January 2008. Under the new Prodi plan the retirement age was raised by one year, to 58, in 2008. In July 2009 the retirement age will again go up, this time to 60 for those with 35 years of contributions, or remain the same for those workers who can muster 36 years of pension payments. From 2011, the retirement age for everyone will rise to 60, and then to the astronomic age of 61 by 2013.

This decision, apart from being an astonishing one for outside observers, raises a number of important issues, especially since the ageing population problem is one which affects Italy in a very important way. Male life expectancy in Italy is now fast approaching 80, and is among the highest in the EU. At the same time Italy currently has the third-lowest birth rate in the EU (TFR around 1.3). Without raising the retirement age, contributions simply won't keep pace with pension payments (which are already running at approximately 15% of GDP see chart below) over the coming years, even assuming there is no ageing impact on the overall economic growth rate, which as we are seeing is far from clear.

Of course doing things in this way is not only ridiculous, it is also totally unsustainable. Italy undoubtedly needs migrant labour, but as a complement to, and not a replacement for, a very substantial and swift increase in the retirement age and in employment participation rates among the over 60s. The consequence of not addressing the retirement question is obvious: Italy's debt - which did fall back slightly in 2007 (to 104 percent of GDP from 106.5 percent in 2006) will start to rise again.

Interest payments alone on the national debt currently run at some 70 billion euros a year, or about 1,200 euros for each Italian, and any serious slippage in fiscal "clean up" is going to be closely watch by the financial markets, where, it will be remembered, the difference in yield between Italian 10-year bonds and the benchmark German bunds tends to increase notably at the first sign of risk aversion in the global financial markets. The spread between German and Italian bonds widened to 52 basis points in mid March, the most since October 1998, when it was as by much as 61 basis points. Any repetitions of this incident will surely cost the Italian government dear, since spending programmes - like the pension system that already eats up a full 15 percent of GDP - will almost certainly become more expensive to fund, leading to cuts in other - less protected and less structural - areas.

Any mention of rising Italian government debt only piles on the risk to Italy's credit rating. Both Standard & Poor's and Fitch Ratings reduced Italy's creditworthiness in October 2006. Fitch now rates Italy's long-term debt AA-, while S&P gives it A+. Italy's debt is rated 'Aa2' with a stable outlook by Moody's. Italy's issue with the ratings agencies is liable to prove no mean one, as the ECB made clear back in November 2005, when it took the decision not to accept government paper (bonds) in the future from any country which has not maintained at least an A- rating from one or more of the principal debt assesment agencies.

Only this week the Italian employers association, Confindustria, cut their forecast on the Italian economy for 2008, suggesting it will effectively grind to a halt this year economy and grow by the miniscule 0.1 percent this year, the slowest pace since 2003. Even more importantly they suggested that the slowdown in growth will simply add to the strain on Italy's public finances. They forecast Italy's budget deficit in 2008 will rise to 2.5 percent of gross domestic product compared with its previous forecast in December of 2.2 percent. This is really the number of all numbers to watch, since Italy desperately needs to avoid a deficit of over 3% if it wants to stay out of trouble with the debt ratings agencies. Confindustria predicts that Italy's deficit will increase to 2.6 percent in 2009, in the process casting doubt on the government's ability to balance the budget by 2011 as required by EU agreements. So I guess this is our "risk barometer" on Italy. Each tenth of a percentage point the Italian deficit climbs over that 2.5% forecast will represent one more nail in the coffin of S&P's A+ rating, and will put Italy one small step nearer having the doors of the vaults over at the ECB slammed firmly shut in the face of Italian government paper.