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Friday, August 6, 2010

Too Soon To Cry Victory?

Confidence Has Returned To Europe’s Financial Markets, But Lasting Economic Growth May Not Be So Easy To Achieve

by Edward Hugh: Barcelona

ECB president Jean-Claude Trichet was in rather optimistic, one might even say jovial, mood at the press conference which followed this week's central bank rate-setting meeting. Second-quarter GDP growth in the 16-nation euro zone would prove "really exceptional," he stated, while the July bank stress tests marked “an important step forward in restoring market confidence.”

And it wasn't only that pre-holiday bonhomie - as Ralph Atkins also reports M. Trichet was about to head off for some well earned rest in the Brittany seaport of Saint-Malo - which was lifting M. Trichet's spirits, recent data - especially from France and Germany - has been reasonably encouraging. Indeed, M. Trichet’s comments came just hours after Germany reported a stronger-than-expected 3.2 per cent rise in industrial orders in June, which came hot on the heels of some pretty strong PMI readings and a further rise in confidence among those living in the Euro Area about the immediate economic outlook, which hit its highest level in more than two years in July according to the EU economic sentiment indicator. Nevertheless, as the EU Commission itself points out, a substantial part of the most recent improvement is due to the improved mood in Germany.

But this is still very much a tale of two Europes, with German industry receiving a large boost from growth in emerging markets, and France consumers taking advantage of the ultra low interest rates on offer to go on a spending boom, while, on the other hand, the overindebted peripheral economies - Greece, Ireland, Portugal, Spain and Italy - still struggle to find growth.

The German July manufacturing PMI showed strong growth

as did the French services one:

while Spanish services registered only feeble growth:

and Greek manufacturing continued to contract:

And despite attempts by IMF and EU representatives to put a positive note on this growing divergence, nothing here is going to be easy. Despite the important progress being made by Greece in implementing its emergency economic restructuring programme, it is still widely anticipated that the Greek economy will shrink by anything up to 4% this year, and possibly by another 2% next year, making for the worst recession in the country's history.

Although the IMF recently lowered its 2011 growth forecast for the Spanish economy to 0.6% – down from the 0.9% it predicted in April - and warned the any recovery in Spain "is likely to be weak and fragile" their medium term forecasts still look rather optimistic, especially given the heavy levels of indebtedness in the private sector, and the underlying weaknesses in export competitiveness.

Not unrealistically, the IMF predicts the Spanish economy will contract by 0.4% this year, but looking farther ahead it goes on to forecast growth of 1.7% in 2012, of 1.9% in both 2013 and 2014 and a 1.8% expansion in 2015. Certainly the numbers look very nice, but it is hard to see the Spanish economy enjoying trend growth of just under 2% in the coming years, given the size of the correction which is still to occur, and the concern is that these numbers may spur complacency, rather than acting as a call to action.

It's The Export Share Silly!

To offer just one example of the problems which lie ahead, while Spain's exports have grown more or less as fast as German ones in recent months (on an interannual basis), Spain's exports only amount to around 16% of GDP, while German exports account for more like 40%. Now that Spain's economy depends much more on exports than it did (construction activity is not coming back as a growth driver), the rate of growth in exports in Spain needs to be much more rapid than in Germany.

Does this seem like an extremely difficult task? Then this is exactly why it is hard to be optimistic about trend growth for Spain in the coming years. Put another way a 17% increase in Spanish exports (more or less the interannual rate in May) is an increase over 16% of GDP, or has an impact of around 2.7% on headline GDP, whereas a 17% increase in German imports is an increase over 40% of GDP, which exerts a 6.8% upward push on GDP. Of course, what matters is the net trade impact, but in any event the point holds, Spain is trying to leverage over a much smaller part of her economy, and in doing so cannot hope to equal the results obtained in Germany.

All this worked for as long as it did, and for as long as international markets were willing to fund an internal consumption boom in Spain. This is now no longer the case, and Spain is thus forced to rely on its export sector to drive the economy, and this is going to be difficult given how small it is (even allowing for the role of the important tourism sector). What is even more difficult is to see how expansion in this sector is going to give the kinds of rates of growth the IMF are assuming over the time frame in question. Spain's export sector needs to expand to occupy between 25% and 30% of economic activity if the economy is to expand fast enough to enable the debts to be paid down, and I don't see how there is any real way round that reality.

So while the export charts don't look that different, there is a huge difference in the industrial output ones.

This evident difference is due to the fact that Spanish industry is far more geared to the domestic market than it is to the external one, and the domestic market is Spain is weak, and will remain so for years to come, while in Germany, even though the internal market is weak, the export orientation of the economy means that growth elsewhere pulls it along. I don't think the different current growth performances need any further explanation at the macro economic level. What I think someone somewhere needs to explain is how - other than via what is, in reality, a rather tepid labour market reform - Spain is conceivably going to arrive at the sort of rates of growth between now and 2015 that many seem to be assuming. The Standard and Poor's estimate of an average of 0.7% between now and 2017 seems much more realistic, and even that only assuming that nothing seriously untoward happens between now and then (which it easily might).

Another interesting detail about the German differential performance is the way in which German industry has sidestepped the apparent weaknesses in demand in Southern and Eastern Europe by expanding its markets elsewhere. Thats what competitiveness means, agility and the ability to adapt to changed circumstances. As Unicredit's Alexander Koch points out (see chart below), a glance at the recent German foreign trade figures reveals that while the most important export market by far remains the European Union, growth has been coming from elsewhere. In the first five months of this year, more than 60% of all merchandise exports were shipped to neighboring countries. Asia (including Japan) had a 12% share, the US a 7% one and Latin America a "measly" 2.5%. But recent reports from German export firms suggest that these weights are shifting drastically. Above all in the key vehicle manufacturing sector, additional demand from emerging markets currently plays a decisive role. Vehicle exports to China have jumped by as much as 170% so far this year (over the equivalent period last year). Koch's chart shows us the difference between current export levels and those which existed in 2007. Over this time frame Emerging Asia has gained more than 3 percentage points – of which the vast majority is accounted for by China (2.5 percentage points). Also Latin America recorded a significant increase, a rise which more or less compensates for the decline in the US share. In fact Central and Eastern Europe was the only emerging country region which didn't increase its importance - a reflection of the serious economic crisis which still pertains in most of the region.

The sizeable drop in the export share going to the Euro Area (down by 2.5 percentage points) is largely accounted for by the periphery countries. Greece, Ireland, Portugal, Spain and Italy together currently make up 11.5% of German exports down from almost 14% in 2007.

Differential Credit Impacts

More evidence of the disparities that exist within the Euro Area can be found in the lending data for house purchases which on an aggregate level rose at an annual rate of 3.4 per cent in June – the fastest since September 2008. But while in France such lending was up by 5.3%, in Spain the change was only 0.9%.

Much as expected M. Trichet continued to brush aside concerns expressed about this kind of disaggregated data, along with the apparent credit tightening revealed in the second quarter bank lending survey, by arguing (not altogether unreasonably) that the survey had been conducted at the height of the European sovereign debt crisis, and before the publication of those famous stress tests. But still, credit seems to be flowing in some countries, and not in others.

Still Under Stress?

As for the stress tests themselves, are they working? Well the evidence is mixed. Certainly the atmosphere in the short-term European interbank market has improved, and there is some evidence that, little by little, things are improving. On the other hand we also have the recent surge in 3 month Euribor rates, which rose above the 0.9% threshold for the first time in over a year on Thursday. Twelve month Euribor is also on the rise, and stood at 1.373% in June, up from 1.281% in May. Still it remained 0.039% below the level of June 2009, but the rise seems relentless, and this is not without significance, since it is the benchmark from which over 85% of Spanish mortgages are set.

So, are these movements, as some claim evidence that the market is finally functioning, and that demands for loans are on the rise? Or do they, as others claim, reflect continuing nervousness about the decisions the ECB will eventually take in connection with its short term liquidity provision to banks? Remember, borrowing by Spanish banks from the ECB shot up in June, and September will see the final bout of three month tenders, which were introduced by the ECB in June to ease the pressure on Europe's banks given the tensions in the interbank market. Seeing whether the level of dependency of Spain's banks on the ECB can be substantially reduced will offer us one measure of the degree of success of the confidence raising exercise which lay behind the stress tests.

Whichever version of the story has it right, there can be no doubt about the consequence of this inching upwards in rates, the interest rate differential with the US Federal Reserve continues to rise, and with it the parity of the Euro, which is now being valued at over 130 to the dollar, following hitting a low of 119 back in May. What this will do for the Eurozone’s export-lead recovery remains to be seen. M Trichet is probably right to be nervous about the kind of slowdown we could see in the third and fourth quarters of the year.

In fact the ECB President effectively denied that the higher market borrowing costs and recent rise in the euro constituted an effective tightening of monetary policy, one which would ultimately slow the recovery. Indeed, he saw “exactly the contrary”, arguing that such developments reflected growing confidence and thus boosted Euro Area growth prospects. Let’s hope, like Nelson before him, he wasn’t holding his telescope up to a blind eye when he was looking.

At this point in time the differences in posture between the ECB and the Federal Reserve remain marked, and while the European bank left its main rate unchanged at the record low of 1 per cent for the 15th consecutive month, its President continued to emphasise the process of policy normalisation, resisting all questions which invited him to speculate about future decisions either on interest rates or on liquidity provision. The difference in tone with a US central bank manifestly concerned with perceived weaknesses in the recovery and the deflation danger could not be greater at this point.

Yet, as M Trichet acknowledged, while some of the worst of the financial crisis has now abated it is definitely far too soon to “cry victory” in the battle against Europe’s sovereign debt woes, and the second half of 2010 may well not be anything like as positive as the first half has been in terms of the real economy. Still, as Europe’s citizens lie outstreched on their beaches of preference, or search for the cooler climes of those mountain peaks, maybe it would be better for them to contemplate the recent performance of some of the continent’s key football teams, and leave the dreary task of preparing for their autumn “belt tightening” until their return to the fray in September. As I say at the start of this post, Jean Claude Trichet, for his part, informed us that after the meeting he was headed straight for Saint-Malo, and I wish him a very restful “time-out” there, recovering all that energy that he is most certainly going to need for the difficult decisions he will have to take in the months to come.

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