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Thursday, May 29, 2014

Spain: The Land Where Incipient Deflation Becomes Good News For Headline GDP (Updated 29/05/2014).

The Spanish National Statistics Office (INE) today published the first detailed estimate of Spain's Q1 GDP. Basically they confirm the gist of the original Bank of Spain numbers (see my report of 25 March below) although there are some important nuances.

In my earlier report, I stressed that Spain's Q1 surge was as much a statistical artifact as anything else since:

a) Nominal GDP growth was virtually stagnant, and the application of the (negative) GDP price deflator (see explanation in earlier report below) explained most of the annual growth.
b) Spain's strong export drive has stalled, with exports being little changed in March 2014 from September 2013.
c) There was a major input from government spending. An important part of the explanation for the momentum behind Spain's recovery has been the relaxation of austerity, and the strong injection of government funded liquidity into the economy.

All these three trends are confirmed by the latest data, albeit, as I say, with significant nuances.

GDP deflator: Inter-annual real GDP growth was revised to 0.5% from the 0.6% in the INE flash estimate. More importantly we learnt today that nominal GDP fell 0.1% over the year, confirming the impression that despite the recovery people had less money in their pockets (this is what deflation means).

Export recovery: exports fell by less than originally estimated (by 0.4% quarter on quarter rather than by 0.6%) but the big change came in imports which moved from an estimated fall of 1.2% (q-o-q) to a rise of 1.5%. The net trade contribution to the final GDP number thus swang from being 0.2% positive to 0.2% negative. However the impression that this is no longer an export lead recovery was confirmed, as was the fear that as government-stimulus fed domestic demand imports would once more surge. This seems to confirm the idea that the economy is not as internationally competitive as the official sector claim it is.

Government spending: the big shocker in the latest report is the role played by government spending in arriving at the final number. The Bank of Spain only mentioned there had been an increase, giving no estimate for its magnitude. Today we learn that government spending was up 4.4% on a quarterly basis, following a 3.9% decline in the last quarter.This confirms the impression that there was a significant ending-the-budget-year-early effect (see original report below), as spending was transferred from Q4 2013 to Q1 2014. It also confirms the impression obtained from the Q1 labour force survey where we learnt that while private sector employment contracted during the first three months of the year, public sector employment rose by 11,100.  Naturally, if the government is to comply with this years reduced deficit target this momentum cannot be maintained, suggesting we will now see some weakening in the headline GDP number.

In fact in their latest report on the Spanish economy (published May 28) the Bank of Spain confirm this impression, saying that "Los indicadores coyunturales más recientes apuntan, en general, a una prolongación de la fase de recuperación de la actividad, si bien se aprecia distinta intensidad según se trate de información procedente de indicadores cualitativos o cuantitativos". Roughly translated this means that the recoverey phase has continued into the second quarter although the intensity may have reduced according to which indicator you look at (hard and soft). They cite the EU household confidence indicator, which continued to improve in April but less than in the previous three months. Also sales (both of goods and services) by large companies moderated their annual growth rates in March compared with earlier months. To me it looks like Q2 quarterly growth will be weaker than Q1. possibly in the order of 0.2%.
Construction activity is an interesting area. The INE Q1 report suggests a quarterly decline in construction activity of 2.6%, yet data supplied by the INE to Eurostat show a 9% rise during the quarter, an improvement that is consistent with other information available. Spain has something like 400,000 unfinished houses and bad bank Sareb and investment funds who have purchased distressed property loans appear to be finishing some of these housing units off in readiness to let.

All in all the argument I am pursuing here is not that Spain's economy isn't recovering - it is - but that the recovery is much weaker and much less well balanced than many think it is. Momentum going forward looks weaker than people expect, employment growth is tepid (except in the public sector), and the fall in unemployment is as much a product of people leaving the country or retiring as of anything else. Spain is already in deflation, house purchases continue to be postponed awaiting a further fall in prices, and the hard won rebalancing of the economy towards external trade is steadily being undermined.

Perhaps just one data point sums this whole problem up. According to seasonally adjusted data, nominal GDP rose by 1.432 billion euros during the quarter, while nominal government spending rose by 2.494 billion euros (or almost double). Not a very impressive bang for the buck. Go figure.

Spain: The Land Where Incipient Deflation Becomes Good News For Headline GDP - 25 April original review
 According to the bank of Spain, the Spanish economy continued to push forward with its recent expansion in the first quarter, and it do so at an accelerated rate, growing by 0.4% over the previous three months. This is certainly good news for everyone in Spain, and there is no doubt that this is the strongest expansion in economic activity (see PMI chart below) since the crisis started. The economy also grew by 0.5% over a year earlier, the first time it has done this in nine quarters.

Nonethless many of the old doubts about the durability and sustainability of the Spanish expansion remain. The labour market is still a huge problem, the housing market is gridlocked, credit is scarce and expensive, and the population is shrinking at nearly 1% a year as discouraged workers (both nationals and former migrants) pack their bags and leave. In addition, concerns are mounting that the current government, with low ratings in the polls and elections coming next year, has lost the appetite for reform. Here I will focus on  three issues that strike me in connection with the latest GDP numbers: the stagnation in the export boom, the difficulties being encountered in reducing the deficit and the ongoing deflation issue. The big question still remains: is this a balanced recovery, an export lead one, or simply a government financed one?

Composition of Growth

Here to help think about all this is the Bank of Spain breakdown of recent economic growth.

GDP is a composite, derived by aggregating a number of components. Principal among these are private consumption and investment, public consumption and investment and net trade.  If we look at the composition of growth in Spain in the first three months of this year we find that private consumption grew, but less rapidly (0.3 vs 0.5) than in the preceding three months, government consumption and investment grew (vs contraction at the end of last year) but we don't know by how much because, unfortunately, the BoS don't tell us. Net trade was positive - despite the fact that both exports and imports were down (on a seasonally adjusted basis, by 0.6% and 1.2% respectively). Since imports were down by more than exports, net trade was positive and contributed an estimated 0.2 percentage points (or half) to growth. If imports had fallen by less, by say only 0.6%, then Spanish GDP would only have grown by half (0.2%), such are the quirks of GDP calculations. But it is surely not unequivocally good news if you have had to rely on a slump in imports to get that highest-growth-in-recent-years number.

Lastly Spain is officially in deflation, both of the falling expectations and purchases postponement kind - see this post yesterday - and this is recognised by the presence of a negative GDP deflator, which estimates a fall of 0.4% in GDP price inputs when compared with a year earlier. More on this later.

What is going on with exports?

Spanish exports have been an important part of the country's recovery story, no doubt about that. Services exports (mainly tourism) have been up consistently. But if Spain is to become "the new Germany", and this is what will be needed (current account surplus and all) if the country is to return to stable growth, goods exports need to grow and keep growing at a steady rate, and this is where the evidence we have to hand is a little less than convincing.

 The fact of the  matter is that - according to the latest bank of Spain estimates - goods and services exports ended March at the same level they reached at the end of last September. This is surely a strange result for a country during one of its best moments in an export driven recovery. True Spanish exports are up about 7% over where they were a year ago, but almost all this growth came in the second three months of 2013, just before the impact of Federal Reserve Tapering (which hit in May) was felt in the fast growing emerging markets. Sound familiar?

So in fact while the export story does continue on a modified basis, with growth in the Euro Area picking up some of the slack left by the demise of the EM customer base, it is a long way from being as vibrant as it was. This tendency is clearly revealed in the latest press release from the Economy Ministry covering exports (for February). While in the whole of 2013 export to the Euro Area were only up 0.1%, in January and February of 2014 they were up by 5.5% from a year earlier. Meanwhile exports to non EU destinations were only up by 0.4% over last year even though exports to the US, China and Japan all increased by significant percentages.

Not only are goods exports when compared with six months earlier rather stationary at the moment, the order books suggest the situation won't be improving radically in the coming months as the following chart from the national statistics office illustrates.

Overall new orders were down year on year by 1% in February, with orders from the domestic market - which were down by 2.2% - dragging the aggregate with it. Export orders were positive, but the composition changed, with demand from the Euro Area up 1.6%, while orders from outside the EA were down by 4.8%.

This division between improving export orders and weakening domestic ones is an ongoing story, as the following chart, again from the INE, illustrates. The interesting line is the seasonally adjusted one, and it shows that only in two months in the last two years - December 2013 and August 2012 - have industrial orders been above the level of a year earlier.

This phenomenon is due to the enduring weakness of domestic demand, and even with the recovery the pattern doesn't seem to have been radically altered. Industrial output is up, but only very very marginally, hardly noticeably even in the great scheme of things.

In the meantime, the fact that domestic demand is rising has been having a negative impact on the evolution of the goods trade balance, which after hitting a historic surplus high last March has been in deficit territory almost ever since.

Indeed if we look at the trend, after steadily reducing the deficit has once more stabilized well in negative territory. So while Spain's export sector has made considerable progress - more than most, but then the country's problems are greater than most - there is still a long road left to travel. Most importantly a net trade impact based on a sharp fall in imports is not what we should be seeing at a point where the recovery is gathering traction. It does not suggest a broadening out into steadily improving domestic consumer demand, but quite the contrary.

Deficit Difficulties

Spain, as is well known, was given extra time by the EU Commission - 2 additional years - to bring its fiscal deficit down below the 3% of GDP mark. In fact the country has made enormous efforts to reduce the deficit, but the results of such efforts have often been far less than had been hoped for. After hitting a peak of 11.2% of GDP in 2009, the deficit figure has meandered from 9.7% in 2010 to 9.6% in 2011 to 10.8% in 2012, to finally reach 6.6% in 2013. Not surprisingly this deficit record has produced a rather astonishing surge in the government debt level, from 36% of GDP at the onset of the crisis in 2007 to the current level of nearly 100%.

But even this 2013 6.6% number is not everything it seems to be, since the government was forced to draw down some 2% of GDP extra from the pension reserve fund (intended to help get the country through the difficult demographic moment that arrives at the end of the decade) and a further 1% of GDP from the Suppliers Fund (which is to pay suppliers previously unpaid bills). Neither of these liquidity injections affects the EDP deficit, but both certainly help the government square the difference between spending and income. Even so, in order to maintain the 6.6% number (actually it should have been 6.5%) the government was forced to draw the budget year to a close on November 25.

As reported in March in the Bloomberg article - Spanish Government Ended 2013 in November to Reduce Deficit - Spain brought forward the deadline for approving spending in the annual budget for the second straight year in 2013 following a 2012 decision to end the year on December 3. Previously the cut-off date had been the last working day of the year. Hence the enigmatic statement from the Bank of Spain that both government consumption and investment grew in Q1 following "their marked decline in the closing months of 2013". The marked decline was partly due to the cut-off date, so for deficit compliance reasons some of the spending was transferred to Q1 2014, giving a small boost to the headline GDP number.

In fact, the EDP accounting measure is becoming an increasingly blunt instrument for measuring the extent of Spain government spending and the dynamic of its debt obligations. According to Bank of Spain data there were something like 1.35 trillion euros of Spain government debt obligations in circulation at the close of 2013, as compared with the 961 billion euros worth which count as debt under EDP rules. I dealt with this issue at some length a couple of years back, but leaving aside the details - groso modo - it is clear that there is much more Spanish debt out there than many are assuming. Even more surprising is the fact that total debt obligations rose by some 14.5% during 2013, and that 56% of this increase came under headings which don't count towards the EDP measure.

The argument here is not to suggest that Spanish gross sovereign debt is 132% of GDP (which a superficial reading of the headline number would suggest) - the reality is more complicated - but that it is certainly significantly higher than the 93.9% of GDP reported to Brussels under the  EDP criteria. But even more importantly - and this is really the argument I want to get across - in order to achieve a positive GDP quarterly growth figure at this point it is almost impossible to really reduce the scale of the fiscal deficit, whatever Herculean efforts you make. The rest is simply smoke and mirrors.

The Role of the GDP Deflator

Finally we come to what may well be the most important doubt that enters my head when I look at that Bank of Spain table I reproduce above: the role played by the magnitude of the GDP deflator in arriving at the headline GDP number. The GDP deflator is the measure that is used to convert nominal (current prices) GDP into real (comparing apples with apples and not with pears) GDP, since it is an attempt to remove the impact of price movements (inflation or deflation) from the final benchmark GDP reading. Let's take an example. If nominal GDP grows 5% and inflation is 3% then real GDP has grown by 2%. If inflation is then re-estimated at 2% then real GDP growth turns out to have been 3%, and so on. Compensating for deflation is when things start to get more complicated, and doing so when nominal GDP is either stationary or negative is when the world gets really wonky.

Lets take the case where nominal GDP grows by 2%, and deflation is 1% - then real GDP grows by no less than 3% (you have to add the deflation number, not subtract the inflation one, if in difficulty ask the Japanese for help, they have been doing this for years). Now lets imagine a case where quarterly nominal GDP growth is zero, but the GDP deflator is estimated at minus 0.4% (aha, now you see where I am going). Then in this case real GDP grows on the quarter by 0.4% (precisely the current Spanish result). Supposing that later you revise this estimate to minus 0.2%, then GDP growth is halved at a stroke, since it also becomes 0.2%.

I am not the first person in the world to to think about this issue, and especially not in connection with Spanish GDP data. Back in August last year the UK economist Shaun Richards wrote a blog post - What is happening with the national accounts and GDP of Spain? - which dealt with a number of similar issues. Shaun examines the impact of a series of data revisions carried out at the end of Q2 2013 and draws some thought provoking conclusions.

In particular he examines the impact of a number of statistics office revisions to the GDP deflator estimates. As he tells us,
"we get a new view on Spain by observing that it (the estimated GDP deflator) has been effectively zero since the end of 2008. I am slightly exaggerating as in fact it adds up to 0.17% but I hope that you get the point. The revisions here have been large as the number was previously 1.58%! Now consider GDP numbers which are sometimes poured over for 0.1% and we see one more time that such behaviour is bizarre as they are by no means that accurate. Indeed 2011 seems to be a troubled year for Spain’s accounts as implied deflator inflation was 0.96% and is now 0.02% which is much more like 1% than 0.1%."
 Certainly then the GDP deflator plays a very central role in final Spanish GDP outcomes, and the sensitivity of the early GDP estimates to errors in the deflator value is striking. As I am suggesting here the value attributed for Q1 2014  effectively accounts for 100% of the estimated GDP growth, and the probability of subsequent revision is, going by past experience, large. Indeed in the Spanish context could it be said to be the loop which finally squares any unfortunate circular gaps in the national accounts?

And when I said when nominal GDP is close to zero things get wonky, I meant it. According to data from the Spanish national statistics office, seasonally adjusted nominal quarterly GDP hasn't budged more than a decimal point from 255 billion euros since Q2 2013 (see chart below), and even then the decimal movement has been downwards. We don't have an estimate for the first quarter of this year yet, but if the 0.4% real growth and the minus 0.4% GDP deflator estimates are confirmed, then it should be just about where it was during Q4 2013.

I was surprised to find this, but then maybe I shouldn't have been since shopkeepers have been telling me for months that the takings in their tills hadn't improved. Now we know why. There has been an improvement in output VOLUME and COMPOSITION, since prices have been falling and the economy has reorientated somewhat, but not in overall turnover. Looking at these numbers one of two things are true. Either Spain has been sliding steadily into deflation over the last year, or there has been no recovery. There would seem to be no available third reading. The most probable interpretation of the data we have to date would be the former, that Spain is sinking steadily into deflation. I assume the statisticians at the economy ministry understand GDP calculations sufficiently to get this. In which case the constant denials, and references to early Easter "one offs" etc would seem to be totally irresponsible.

So, the ability of the Bank of Spain to offer an early estimate (normally confirmed by the INE first estimate) of GDP growth - based on the variables included in the economy ministry's synthetic indicator - comes at a price: you need to wait 12 or 18 months to get a much more precise measure of what is going on. As Shaun says:
One of the issues with Gross Domestic Product numbers is that they are revised over time sometimes significantly. This does not fit well with the short attention span of modern media and so leads to an obvious temptation to publish relatively optimistic figures and then revise them later once the hue and cry of the pack has died down.  


As I state at the outset, I have no doubt whatsoever that Spain's economy is undergoing a modest recovery. Even economy minister Luis de Guindos calls it weak, fragile and uneven. Serious doubts exist about the extent to which we are going to see anything resembling a "classic recovery" in Spain, a recovery where solid export growth eventually broadens out into a wider improvement in domestic consumption and investment, even though this is what financial markets increasingly seem to be pricing in. Press headlines have trumpeted the country's new found growth, but when you dig under the surface and find that most of the latest growth is either accounted for by a sharp DROP IN IMPORTS, or by a CALENDAR ADJUSTMENT IN GOVERNMENT ACCOUNTING, or by the ESTIMATED ARRIVAL OF DEFLATION then the conclusions you draw are hardly reassuring ones.

If in addition these highly-subject-to-later-revision initial estimates are used by the incumbent government to try to shore up its wobbly position, and also used as an justification for not carrying out deeper reform - especially in the labour market where unemployment remains over 25% - then  beyond not being reassuring they start to become preoccupying.

Tuesday, May 20, 2014

Mario Draghi's Ongoing Faustian Pact

Word has it that Mario Draghi is busily working up a new version of his "whatever it takes" methodology. This time the objective is not saving the Eurozone, but maintaining the region's inflation at or near the ECBs official 2% inflation objective. The first time round the President of the Euro Area's central bank had it easy, since market participants took him at his word and he effectively needed to do nothing to comply. This time though, as they say, it will be different.

Its getting towards two years now since Mario Draghi made that first famous "whatever it takes" promise for which he will either be feted eternally in the central bankers' heaven or cursed perpetually in whatever their equivalent of hell is. During that time the tide of the Euro Area debt financing crisis has steadily been turned - perhaps the turning point came when Spain's prime minister Mariano Rajoy decided not to apply for a full Troika bailout and got away with it, sometime around November 2012.

During the time since that first Draghi promise Spanish (and other periphery) yields have come down dramatically, from around 7% (in Spain's case) to the current rate of just over 3%. Perhaps the steepest, and most surprising, part of that drop was between January and April 2014, a period in which speculation - often fueled by the ECB itself - was rife that a programme of quantitative easing was in preparation and likely to be launched in order to fend off the threat to Euro recovery presented by low inflation/deflation.

The threat of outright deflation across the entire Euro Area is slight at the moment but, as Mario Draghi himself recognizes, very low aggregate inflation is itself a problem since several countries are bound to have below average inflation, especially those indebted countries on the periphery where domestic demand is weak, capacity slack is large, and there is an ongoing need to recover relative price competitiveness.

Countries like Greece, Portugal, Ireland, Italy and Spain.

Or if you prefer Eastern Europe, Slovakia, Slovenia, or Estonia.

In most of these countries household demand is weak and the economies only grow slowly, leading to a structural demand deficiency. In addition many have enacted labour market reforms whose ongoing impact will be lower average hourly wages. Low inflation is a fact and, if you accept at least some of the above arguments, there is some sort of theoretical backing for the idea that it could weaken further and even fall into deflation in the above countries.

As a result many in the financial markets now assume that Mario Draghi will do "whatever it takes" to restore more robust inflation to the Euro Area, and that this "whatever" will include some version of Quantitative Easing probably including sovereign bond purchases.

The key part of the background here, as Wolfgang Munchau pointed out at the time, is that the recent German Constitutional Court ruling effectively left OMT – which only ever had a virtual existence and was increasingly seen as an empty bluff since it was clear no one was going to accept the conditionality side – deader than that infamous dead duck. Karlsruhe’s objection to Draghi's original bond buying programme was that it went beyond the ECBs mandate since directly financing government debt is prohibited under Maastricht, and the objective of OMT was to help governments finance at an affordable price. Since break-up risk – which could have offered an alternative justification for OMT – is for the moment off the table, OMT lacks definitive legal justification and in practical terms the emperor visibly has no clothes.

The FT's David Oakley (February 18) was the first to my knowledge to really join up the dots.

“At last, after resisting for so long, the European Central Bank looks closer to implementing its own version of quantitative easing to spark growth across the eurozone……………… Investors and strategists expect about 30 per cent of the bond buying will be in German Bunds in a €400bn programme. The ECB would then likely buy about 20 per cent in French Oats, 18 per cent in Italian BTPs, 12 per cent in Spanish Bonos, with the rest being bought in the other much smaller debt markets……”

“The German constitutional court has asked the European Court of Justice to make a ruling on outright monetary transactions, which Mr Draghi introduced as a backstop to the eurozone in the summer of 2012. Although outright monetary transactions would involve buying government bonds, it is not the same as QE as it would be introduced in the event of a run on one or more of the debt markets. The ECB could successfully argue that QE, which involves buying a range of bonds to lift inflation, was within its remit as it is designed to bring about price stability…..” 
Naturally this debate was a trigger to bring down periphery spreads much further since a blanket sovereign bond purchasing programme (with no conditionality) would be equivalent to some kind of implicit uniform debt guarantee. In addition, a large scale QE programme would - as has been seen in the US and Japan - be supportive of financial assets generally, hence the rush to buy Greek and other bank bonds and shares.

Then there is something called the spread compression trade. Fund managers can make money out of this when bond offer yields that are deemed to be trading substantially out of line with the real risk involved in holding them. I first started becoming aware of this in Europe in the summer of 2012 when investor interest in buying bonds issued by the Catalan regional government (which is effectively locked out of financial markets) surged since the 10 years ones were trading at around 13% in the secondary market. The issue that concerned them was, not the underlying health of the economy, but whether the central government would be able (constitutionally) to rescue the regional ones. At the time there was some doubt among investors, hence the high yield demanded to hold the bonds. But the first to realize that in fact Madrid would rescue the regions (via the Fondo de Liquidez Autonómica, created in the autumn of 2012) could safely buy the bonds sin the full knowledge they were effectively guaranteed. This is what happened, and yields came down, not because the Catalan economy had had a miracle recovery, but because someone else was guaranteeing the debt. At this level its all about perceived risk, not about potential GDP growth or anything like that.

The point to "get" about bonds is that their value moves inversely with yields, so a bond bought with an effective yield of 13% increases its value considerably when the market trades at 6.5%. The gain is conditioned by a variety of factors - maturity, coupon, coupon frequency, starting yield - but a move of these proportions might produce a capital gain of around 50% depending on the modified duration function. This kind of trade effectively involves riding the "spread compression" to make capital gains. It is a trade practiced by more risk prone investors, who then sell the bonds on to more risk averse ones (and take their profits) once the yields are trading at more realistic levels, and the risk is perceived to be reduced.

This is what has just happened with the Greek bond yield.

In July 2013 Greek ten year bonds were trading at something over 11%. For reasons I explain in this post Greece is now something of a special case, since Greek excess debt (anything over 110% GDP in 2022) is effectively guaranteed by the other Euro Area partners. This already meant that Greek yields were trading much higher than the risk warranted, so lots of people started buying simply to squeeze the lemon juice out of the yield compression. Add to this the risk of deflation - Greece is the prime example - and the possibility of QE in the context of  Draghi's "whatever it takes" commitment and Greek bond yields end up having a lot more to fall - 10 year Japanese bonds are currently trading around 0.6% and it is clear the ECB could do the same with Euro Area yields  if it really had the will so to do. Lots of gravy swimming on the plate to mop up with some bread  then.

The devil is, as always however, in the details. It is not hard for a bright fund manager to convince himself that the governing council of the ECB will one day be forced to implement QE. It is again not that hard for that same fund manager to convince himself that even though the ECB has been toying with a 1 trillion euro asset purchasing program biased towards the private sector, that the market in ABS in Europe is just too small for this to be realistic. But it is pretty hard indeed for him (or her) to decide when the ECB will finally get round to doing it.

Which brings us to the small recent spikes upward to be seen in both the above bond yield charts. Mario Draghi has committed his governing council to doing something at the June meeting, but that something is not likely to be QE. More plausible are things like a small refi rate cut (to 0.1%?) and negative deposit rates. Maybe even some sort of small business lending scheme. But not QE.

Indeed, it isn't hard to reach the conclusion that what there is consensus on at the ECB governing council at the moment is more akin to the need to lower the value of the Euro than any outright anti deflation policy. Given everything which is happening in Ukraine and the existence of sanctions against Russia German exporters are more than normally squeezed at the moment, so it isn't that hard to get the Bundesbank on board for some sort of Euro weakening move. But as Reuters' Ross Finley points out in his "Strong euro may be monster Dragi can't tame" having at least partially pegged monetary policy to  the exchange rate he may now face the prospect of both short-term and long-term investors buying the euro thus making any move he makes somewhat counterproductive.

Finlay's argument is that if the euro zone economy relapses from its broadening recovery (and there were some signs of this in the Q1 numbers), or inflation remains dangerously low, short term investors may be tempted to try their luck and see how far they can push the euro and peripheral bonds and assets up before a reluctant ECB is forced to step in with a powerful policy response. But if the euro zone economy picks up, and presumably pricing power and inflation with it, flows into euro zone assets naturally will increase and with these the euro will rise. This is why buying Greek bonds isn't such a foolish think as many conventional analysts thought it was. It could even have been seen (and still be seen) as a kind of one way bet. If things turn out badly then Draghi will do QE, and if they turn out well, well where's the problem? Either way, these sort of "bets" will keep an upward pressure on the Euro. Once more Draghi is damned if he does and damned if he doesn't.

Which brings us to another of the wonders of the investment world, the disappointment trade. Those in markets who still expect QE to be introduced in June (is there really anyone out there who still thinks that??) are likely to be disappointed. The result of that disappointment could be a small bond sell-off after the announcement, driving yields temporarily higher. So the savvy investor is now selling some of his/her bonds (take some profits) in order to then buy them back again cheaper sometime after the announcement, and surprise, surprise the euro is (temporarily??) weakening. Could be called the chronicle of a disappointment foretold.

But what then happens? The reason the ECB won't introduce QE in June, not that there isn't a need - Wolfgang Munchau has just argued it could already be too late to avoid falling into deflation - but because the Governing Council can't agree on the need to do it. Indeed with the euro now slipping a bit for the sort of reasons discussed above the Governing Council may even surprise on the downside and do less than expected. But meanwhile that same bright fund manager we spoke of above will conclude that they will get there eventually, that it is only a matter of time (September or December perhaps, depending on the inflation data) and start to buy into the dip in bond values in order to get ready to ride yet another round of yield compression. Naturally when this happens back up the euro will go, confounding policymakers yet one more time.

Wolfgang Munchau suggests that Mario Draghi made a mistake with his original promise. When he said he would save the Euro whatever it takes. Munchau thinks he should have said "Inflation of 2 per cent – whatever it takes". In a certain sense I beg to differ. The need to eventually implement full blown QE was always implicit, even in the original promise - or at least it was already read this way by a number of very influential investors. Certainly this was the reading Bridgewater's Ray Dalio put on the promise at the time. The euro "will now 'likely' stay together because existing growth-constraining austerity measures will henceforth be balanced by money printing over at the European Central Bank", he told Bloomberg at the time. (See my "Taking A Man At His Word" post of October 2012 for much more on this).

So now Draghi is about to discover just what it means to enter into an open-ended Faustian pact with people whose motives may be different from yours. All those nice people who helped him hold the Euro together virtually for free now want the other part of the deal. The bond buying/money printing part. Really after these dramatic declines in bond spreads the ECB simply cannot afford NOT to do QE. Opening up the spreads again would be like opening up all those recently healed wounds from the earlier stage of the crisis, and doing it at a time when sovereign debt burdens are much higher. There is simply no way he can do that, and the markets are likely to bet strongly enough that he can't that this will become a self-fulfilling prophecy.

Oh, yes, there's just one last question. Will QE work as intended? To get a hold on that problem perhaps it might be worth taking a glance at this piece of mine on Japan - The Real Experiment That Is Being Carried Out In Japan.

Greek Re-entry (or Grentry) Not The Game Changer Many Think It Is

There is no doubt that Greece's recent bond sale was an exciting and even invigorating moment for many people. The WSJ's Simon Nixon, for example, called it "a symbolically important moment for the euro crisis". Reuters' Marius Zaharia suggested the speed of the come back could even be a game-changer for the heavily indebted southern European country. Certainly there can be little doubt that, as Nixon puts it, the turn round in market fortunes was a remarkable achievement, illustrative of just "how far market sentiment toward Southern Europe has changed". 
 "For the country at the center of the crisis to draw €20 billion ($27.77 billion) of foreign demand for a five-year bond yielding under 5% shows that the market now believes Greece will stay in the euro zone, that it won't collapse into chaos and that any further debt relief will be provided by official rather than private lenders."

The pace of the fall in Greek bond yields has been little short of astonishing, and Nixon is surely right, market participants now believe that the country isn't about to collapse into chaos (although we'll have to wait and see just how far this belief survives any further evidence of increasing support for Syriza). Possibly more importantly, they are now convinced that future debt relief will come from the official and not the private sector. So swift has the turnaround been, that it is now quite probable that Antonis Samaras's promise the country would wind-up its bailout process in 2014 may well be fulfilled.

In fact, it is hard to understand the present turnaround in Greek financial fortunes outside of the context of (i) the widespread belief that the ECB will eventually be forced into a sovereign bond buying QE programme; and (ii)  the agreement by the country's Euro Area partners (pressurized by the IMF - see this post) to meet any shortfall on the country's debt reduction programme over and above 110% in 2022 provided it fulfills ongoing EU Commission reform  requirements. Following publicaton of the latest EU report in April the FT put it like this:
Under a hard-fought deal reached in November 2012, Greece’s lenders agreed to provide additional debt relief after Athens achieved a primary budget surplus – which excludes interest payments. Jeroen Dijsselbloem, head of the eurogroup of finance ministers, said these talks were set to begin after the summer. The EU official declined to speculate on how eurozone governments would help to lower Greece’s debt levels, insisting this discussion was not part of the just-completed review. 
What this basically means is that the Greek headline Eurostat sovereign debt figure of 175% of GDP is a very misleading one. 40% of this debt is in the hands of the European Stability Mechanism (ESM) on very favourable terms -  capital repayments are not due for 25 years while interest payments have a waver till 2023. As Klaus Regling, head of the  (ESM) put it in an interview with the Greek newspaper To Vima, "There's no debt sustainability problem for the next 10 years. This is very good news for investors."
Greece's public debt currently stands at about 320 billion euros, or 175 percent of GDP. About 80 percent of it is in the hands of the European Union and the International Monetary Fund, at very low interest rates and on a long repayment schedule.
Regling's ESM, which holds about 40 percent of Greece's debt, is charging Athens about 1.5 percent to cover its own financing costs. ESM rescue loans to Greece have a 25-year repayment schedule and Athens starts paying interest on them 10 years after they are disbursed. The EU and the IMF have so far extended 218 billion euros of bailout loans to Greece over the past four years and Athens stands to get 19 billion euros more by the end of the year.
In other words, investors, irrespective of whether or not the ECB introduce QE, can safely buy new Greek debt without worrying too much about whether they are going to be paid back. Between now and 2023 there is no real problem in that department given the de facto Euro Partners guarantee. As I point out elsewhere (On The Trail of Italian Debt) Greek and Portuguese sovereign debt issues are comparatively small beer, and will not threaten the common currency, but the same cannot be said for Italian, or ultimately Spanish, debt. So Greek debt, even at current interest rates looks, frankly, attractive. Doesn't Mario Draghi constantly advise investors not to underestimate the determination of EU politicians to hold the Euro together. Well, there you are.

Real Economy Hits Bottom But Muted Rebound Ahead

Life is rather different, though, within the typical Greek "oikos" (or household). While Greece's economic slump is now hitting the bottom and while, following a pattern seen elsewhere on the periphery, there has been a great boost for the financial sector, there has been relatively little in the way of real gains for the country's hard pressed population at large. Bond yields have fallen sharply, shares are up (or here), and banks are even able to sell bonds (for an example of what they then do with the money see this NYT piece from Landon Thomas), but little of this has trickled through to participants in the real economy.

The economy was down by 1.1% in the first three months of the year when compared with 2013,  the lowest inter-annual  Q1 drop since 2010. The economy is now something like 25% than it was at the q1 peak in 2009. Since the Greek statistics office STILL don't produce quarterly seasonably adjusted data (is that a measure of the progress they have made?) we don't know for sure, but it does look like the economy actually grew from December to March on an sa basis.

But there is little improvement visible in either retail sales or industrial output.

Unemployment has clearly peaked, but so far only fallen marginally.

A lot of the external correction has now taken place, and the current account balance was positive in  2013.

Exports turned positive on a year on year basis in March, but the country country still runs a sizeable goods trade deficit.

Credit gowth remains negative.

So, it is important to bear constantly in mind that the fact the economy has stopped contracting is not at all the same thing as it returning to growth. On that front we will need to wait and see, but there is little that is especially encouraging to date. The problem with having the Euro as a currency was never how to stop the economy contracting. It was always the difficulty which would exist in subsequently returning the economy to growth. Italy and Portugal pre-crisis didn't see their economies shrink, but they did remain stuck in low growth.

The most serious problem facing Greece right now is evidently deflation.

Inter-annual inflation has now been negative for 14 months. Curiously, in the Greek case the main problem with deflation is not going to be that debt levels are pushed up, since as we have seen above excess Greek debt is now effectively guaranteed by the Euro Area partners. A deflationary debt spiral this isn't likely to become the problem it could be in non-debt-guaranteed countries like Spain or Italy.

Deflation will, most likely, push up the level of non performing loans in banks, but even these can be recapitalized and some of the cost passed on to the common currency partners. The real problem in the Greek case is that people will constantly feel that the amount of money in their pockets is shrinking, which it will be (turnover can be down while sales volume is up). This creates a very important mismatch between the positive discourse about  economic improvement coming from the government and the official sector generally and the amount of money people see in their tills and wage packets. Naturally, deflation in this sense is not conducive to political stability, and it is here the main risk to the Greek recovery is to be found. In the meantime, a two tier Euro divided between those who have acquired some sort of implicit debt guarantee and those who haven't has effectively been created, yet few have so far seen fit to notice the fact. As the IMF stated in their latest (eleventh) Portugal Program Review:
"While staff considers public debt to be sustainable over the medium term, this cannot be asserted with high probability. However, systemic risk from contagion to other vulnerable euro area countries, should the sovereign fail to service its debt, continues to justify exceptional access......Nevertheless, commitments by euro area leaders to support Portugal until full market access is regained—provided the authorities persevere with strict program implementation—give additional assurances that financing will be available to repay the Fund".

Sunday, May 18, 2014

On The Trail Of Italian Debt

Looking for trends and correlations in that landslide of economic data which arrives, day in and day out, on our desks is normally something akin to trying to find a needle in a very large and raggedy haystack. From time to time, however, some things are just to obvious not to be noticed, like the ever rising levels of debt on the EU periphery and the growing demand from political leaders there for some kind of QE type initiative from the European central bank, for example. Sure, there is no obvious causal connecting here - the missing "middle term" linking the two would probably be all that ongoing deflation risk - but the inability of governments to contain their debt levels is a consequence of having low growth and low inflation, as is the wish being ever more insistently expressed by Southern Europe's political leaders that the ECB were more like the Bank of Japan.

In this context the latest batch of Euro Area GDP numbers must have come like a bucket of ice cold water thrown across the luke warm recovery hopes of policymakers in Frankfurt, Brussels and Berlin. Only the German economy put in a really impressive performance (0.8% quarter on quarter). Spain's economy also did well, but the 0.4% quarterly growth failed to convince due to the fact that the main influences on the number were a 1.2% fall in imports and a 0.4% negative inflation calculation (see my analysis here).

France's economy stagnated, but more worryingly for policymakers core Europe countries like Finland (minus 0.4 q-o-q)  and the Netherlands (minus 1.4%) failed to shake off their long running recessionary drag, while periphery growth laggards like Portugal (minus 0.7%) and Italy (minus 0.1%) fell back again into negative growth territory. Clearly the Euro Area seems to be stuck in some form of secular stagnation, a feeling which is only confirmed by the very low inflation levels we are seeing and reinforced by the fact that both Portugal and Italy have suffered from chronically low growth rates since the start of the century.

Nothing which has happened since the crisis suggests this low trend growth rate is going to to improve radically, in fact there are good reasons to think that trend growth might even deteriorate further: both countries have higher debt loads (public and private combined) than when they entered the crisis, and in both cases working age populations have now started to decline. (See an excellent review of the Portugal situation by Valter Martins here and here).

Not only do we have a legacy then of high debt and low growth, a new problem has emerged: low inflation or even deflation. Italy's inflation has fallen to very low levels, while Portugal now has experienced 3 consecutive  months of negative annual inflation.

The combination of low inflation and low growth means that it is the evolution of nominal GDP that really matters now. Nominal GDP is non inflation corrected GDP (or GDP at current rather than constant prices). If inflation remains low or even becomes negative, then nominal GDP will hardly increase and may even contract (as has happened in Japan). This phenomenon has already started to make itself felt in Spain, as the following chart from the Spanish statistics office makes plain.

 We don't have any detailed data for Spain's Q1 2014 performance yet beyond the Bank of Spain initial estimates, but if this estimate is confirmed by the National Statistics Office then it is unlikely than nominal GDP at the end of March was much above the level it was at last June, despite the recovery in economic activity.  Which is one of the reasons that Spain's debt to GDP level has been rising so rapidly in the last 12 months. Naturally something similar has been happening to Italian debt, which rose from 127% of GDP in December 2012 to 132.6% GDP in December 2013, despite the fact the country only had an annual fiscal deficit of only 3% of GDP. Italy's nominal GDP fell in both 2012 and 2013, largely due to the sharp drop in economic activity. Nominal GDP may continue to fall in 2014, but this time because the GDP deflator is negative. If this happens the debt level will continue to rise confounding hopes for a turnaround in the dynamic.

Italy's situation is to some extent replicated in other countries on the periphery (Ireland sovereign debt to GDP 124%, Portugal 129%, Spain 93.9% and Greece 175%) since almost all official forecasts anticipate an imminent turnaround in the debt dynamic. If secular stagnation and ultra low inflation really set in this turnaround is going to be impossible to achieve and Europe's leaders will need to decide what to do about it. 

Italy is a good case in point here, since if debt were to climb towards 140% of GDP and beyond, then someone somewhere would surely have to officially recognize that it was not on a sustainable path. Cases like Greece and Portugal are to some extent manageable from an EU perspective since the economies are small enough for EU leaders to engage in some sort of extend and pretend via low coupons and long horizon maturities. But Italy's debt is simply too big to be manageable in this way.

So Italy's government faces a dilemma. Complying with its EU deficit and debt obligations may well mean that the deficit comes down but in all probability the debt level will go up (given the weak nominal GDP effect). Not complying with them opens the possibility to slightly more growth (and possibly stronger inflation) but naturally the debt level will rise. It's a sort of damned if I do and damned if I don't situation, since either way the debt burden rises.

From the point of view of the country's political leaders though, it is obvious that austerity today has costs (and few visible benefits) while deficit spending may bring some short term benefit at the price of hypothetical longer term debt issues. It shouldn't surprise us then if they go for the latter, especially since Japan's political leaders have been widely applauded for doing something similar.

Naturally, since the difficulties the onset of secular stagnation will produce for heavily indebted countries with ageing and shrinking workforces are not widely understood, hints that deficit objective relaxation calls are growing have not been well received everywhere.  The FT published details recently of a document jointly issued by the German and Finnish finance ministries which strongly rebuked Brussels for easing austerity demands, citing in particular the additional  flexibility given to France and Spain for reducing their budgets to within EU deficit limits. Although given the latest performance results for the Dutch and especially the Finnish economy ("Once Europe's lead preacher of budget prudence, Finland loses righteousness"), Germany may find itself increasingly out on a limb if it maintains this posture.
“Since 2012, the commission has substantially changed the way it assesses whether a member state has taken ‘effective action’ to comply with [EU budget rules],” the memo states. “The recent methodological changes imply the risk of watering down the newly strengthened [rules] at its implementation stage.”
As might have been expected, Matteo Renzi  has not been slow in coming forward to seek similar treatment for his country (See "Italy request to push back budget targets dismays Brussels" FT April 17). According to the newspaper the country's finance minister, Pier Carlo Padoan, sent a formal written request to the commission on 16 April seeking authorisation for a change in objectives. Citing the “severe recession” that set Italy back in 2012 and 2013, Mr Padoan wrote that Italy wanted to “deviate temporarily from the budget targets” and that because of “exceptional circumstances” (my emphasis throughout) the government had decided to accelerate the payment of arrears owed by the public to the private sector by €13bn, which would increase the debt to GDP ratio in 2014. The trouble is that these "temporary factors" and "exceptional conditions" seem to arise with a predictable regularity in Italy's case. The country is currently aiming for a balanced structural budget in 2016 rather than 2015 as agreed with Mario Monti’s technocrat government in 2012. A year earlier, then prime minister Silvio Berlusconi had promised a balanced structural budget by 2013.

Naturally Brussels was not amused (“Brussels is very upset,” one senior Italian official told the FT) and issued a statement to the effect that Italy's economic woes continued to require strict monitoring and "strong policy action".Such findings form part of the EU's new system of economic policy coordination and are aimed at preventing a repeat of the euro zone's debt crisis. The system requires governments to undergo repeated scrutiny of their economic performance to determine if there are economic trends and policies that are sowing the seeds of future problems.

But as Mathew Dalton pointed out in an article in the WSJ (Italy's Plea for Leeway Puts Brussels in a Bind) the problem facing Berlin and the EU Commission is far from straightforward.
The problem of Italy's debt is shaping up to be a key test of the European Union's complicated new system for controlling the finances of its member states. 
 The new budget rules are proving to be a source of conflict, pitting harder-line countries such as Germany and the Netherlands against broad swaths of Southern Europe that want more leeway on their budgets. Standing in the middle is the European Commission, the EU's executive arm, which has gained stronger authority to enforce the new rules.

Now it faces a crucial decision: Does it insist on a tough enforcement of the rules that could potentially plunge the Italian economy back into recession? Or does it give Rome some flexibility and risk undermining the new system that Brussels fought hard to establish to prevent a repeat of the region's debt crisis?
As Dalton points out the Commission will be wary of enforcing any rule which may undermine Matteo Renzi's credibility, aware as they will be that most of the alternatives are likely to be (from their point of view) far worse. Further, aside from the likely strong performance of Beppe Grillo in the forthcoming EU parliament elections the country is becoming increasingly eurosceptic (Italy turns from one of the most pro-EU countries, to the most eurosceptic ).

Secular Stagnation or No Secular Stagnation, That Is The Question

Evidently members of the EU Commission, ECB governing council members, or senior political leaders in Berlin, Amsterdam or Paris are neither theoreticians nor intellectuals. Secular stagnation is at this point more akin to a theoretical research strategy than a template for policymaking, and policymakers are understandably reluctant to take decisions on the basis of what is still largely a hypothesis. But the risks here are far from evenly balanced. If countries like Japan, Italy and Portugal are suffering from some local variant of one common pathology, then normal solutions are unlikely to work, and matters can deteriorate fast.

Naturally the ECB can go down the Abenomics path, and institute large scale sovereign bond purchases even while the Commission turns an increasingly blind eye to higher deficit spending at the country level. But it is far from clear that Abenomics works (or here, or here) and if it doesn't what happens to all the accumulated debt?

Basically we are at the point where no easy answers are available, and where the best step we could take would be to try to start asking some of the right questions. Will, for example, unconventional Keynesian policy work as advertised in the case of declining-working-age-population induced secular stagnation? Paul Krugman seems to assume it can, when he asks himself whether there are "structural changes in Europe that arguably will lead to persistently lower demand unless offset by policy?" Exactly which policy/policies are we talking about here?

Larry Summers appears to take a similar view (Why stagnation might prove to be the new normal). But both economists are far from being unambiguous about the situation. Summers concludes his piece by saying that "the risk of financial instability" (being provoked by sustained non-conventional measures like Abenomics) "provides yet another reason why preempting structural stagnation is so profoundly important".

Europe, unfortunately has now been left to drift well  beyond that early "preemptive" stage. Paul Krugman concludes his review (Stagnation Without End, Amen) of what has to be the most substantial examination to date of the theoretical issues involved (Gauti Eggertsson and Neil Mehrotra's "A Model of Secular Stagnation") by asking himself "whether there is a possibility of sustaining the economy with permanent fiscal expansion". Naturally, the answer is important since if there isn't the validity of the whole Keynesian model which PK himself has been working with would be called into question. A point which is entirely lost on those who reject the secular stagnation hypothesis outright (I won't let mere facts get in my way) for inbuilt ideological reasons. As I say, finding a way forward to manage this problem is very much a matter of which questions you allow yourself to ask.