Export Dependency And Global Imbalances

With the timing of the latest G20 meeting set to coincide with the run-in to the German elections acrimonious debate has not been absent, but even as the passions generated by the arrival of voting day subside, it is clear that just beneath the surface their lie some simmering problems which simply will not go away. Despite the fact that nothing is really on the table that will make that much difference in the short run, I think the structural transformation that they are carrying out at G20 level is going to be very important in finding eventual solutions.

According to Bertrand Benoit in the Financial Times the G20:

"will endorse a report from the Financial Stability Board that calls for bonuses to be linked to the long-term success of financial companies and not excessive risk taking."

Well this of course sounds absolutely fine. I have absolutely no objection, but we need to understand that from a macro economic point of view it is virtually irrelevant, with the added detail that the implications are that a recovery in growth will be slower yet less risky. Evidently this issue of liquidity has little to do with bank bonuses and salaries. Having interest rates near zero in a significant part of the developed world for an extended period of time - the inevitable consequnece of having such a huge excess in global savings - means the money will be there, very cheaply, to do whatever people want with it. For example, people might like to buy Hungarian forint, and try to find out just how long it takes them to push the economy of that country off the edge of the precipice on which it is presently perched. This is not that risky for those who engage in the practice of Forex trading, and the banks who lend them the money will run little risk. The risk for the poor people who live in Hungary is, of course, massive.

The banks are also under pressure to raise their capital ratios. While this is well-advised in boom times, it makes matters worse in a downturn. "The current drive to make banks less leveraged and safer is having the perverse consequence of destroying money balances," he said. "It strengthens the deflationary forces in the world economy. That increases the risks of a double-dip recession in 2010."




This exhoratation is also fine.

"As far as policies to counter the economic and financial crisis, the G20 will call for extraordinary fiscal and monetary stimulus to be continued until “a durable recovery is secured”. It will call on countries to act together to ensure more balanced economic growth in future, with surplus countries – China, Germany, Japan and oil exporters – urged to raise domestic demand and deficit countries asked to reduce budget and trade deficits once the world has secured a recovery."

Unfortunately it will also be to noreal avail. It is like telling these countries, you know, you really should have had more children 30 years ago. Do people really think they can invent policies to get people who are worried about the stability of their pension system to spend more now, just becuase it is in the interest of the global economic system? And what policies exactly. Buy one and get another one for free from the central bank?

So what I think really matters here is that they have set up a problem, and they have set up a structure. Now we will try false solutions for two or three years, and then maybe, just maybe, they will all be ready to talk about what we really might do.



According to the current director of the US president’s National Economic Council, Larry Summers, writing in an academic paper published in 1990, the United States economy was set to run current account deficits for a period of 15 years, with the consequence that more than 6 percent of U.S. assets would be owned by foreigners by 2010. However, as he saw it, high saving during the subsequent 15 years would result in the generation of current account surpluses and a reduction in foreign capital ownership to 3.5 percent. After 2025, or so the analysis ran, the rapid increase in the number of elderly, would once again lead the United States to run current account deficits.

Since this forecast seems to come so near to describing a process we are now seeing unfolding before our very eyes – in a world where many hold economists can see nothing at all coming – we might like to ask ourselves how anyone could have known so much so far in advance? The answer to this strange questioin is Larry Summers used a very simple model to arrive at his “predictions”, a model based on the life cycle saving and borrowing mechanism, the description of which was to lead Italian economist Franco Modigliani to win a Nobel in 1995. Summers and his co-authors simple applied the individual Life Cycle model to a whole population, and as it appears came up with a fairly plausible outcome.

Everyone is evidently only too well aware that all developed societies are ageing (some, of course, more rapidly than others), but what many observers do not seem to grasp is that this ageing process has very concrete and forseeable economic consequences, consequences which have now been captured in a whole generation of economic models, and which are described in the accompanying chart prepared by my colleague Claus Vistesen.



As can be seen from the chart, as the demographic transition – identified in age bands following the nomenclature of the Swedish deomgrapher Bo Malmberg - advances median population ages move steadily upwards, producing in their wake a whole series of economic phenomena, phenomena which tend to impact directly on the domestic consumption and the current account balance of a national economy. The thick blue line shows what happens to the current account as a given country moves through the age bands. Initially there is a tendency to sharp deficits and severe economic crises, such as are very characteristic of low income, high fertility, developing economies like Ecuador or Pakistan. Then, as societies develop socially and economically the tendency toward deficit remains, only this time on a more mature, and seemingly more stable, basis as seen most evidently in recent years in countries like the United States, the United Kingdom, Spain and France, who all have population median ages in the 35 to 40 range.

But then something strange happens as population median ages rise past the 40 mark, and especially as they age past 42. The current account suddenly swings into the positive zone, and this can be seen in the real world in countries like Germany, Japan and Sweden, where the ageing population effect means that domestic consumption becomes steadily weaker, and if we look at the second (purple) line in the chart, which illustrates the level of export dependency, we can see that while this is weak at the lower median age ranges (due to the momentum derived from stronger domestic-credit boom dynamics), it steadily grows at the higher median ages.

So, is there any empirical evidence for this phenomenon you may ask? Well just look at Germany, Japan and Sweden, and how the recent collapse in demand for their exports produced by the global crisis sent the economies in these countries spiralling downwards. On the other hand, during periods of economic boom, strong surplus countries need to find an outlet for the savings they accumulate. Hence the large current account deficit countries in the East of Europe, for example, were funded by Austrian, Swedish and German banks. The question we should be asking is not why banks in these countries were so stupid as to lose so much money, rather it is why they had so much money to lose in the first place. That is, why were their populations saving so much, and why were profitable domestic outlets for such savings insufficient? Once we can get hold of this, we can start to see one of the reasons why there have been such large global imbalances in the first place.

One of the problematic aspects of this situation, looking at the chart, is there there is no steady state (or cyclical correction) mechanism at work here, since there is not, to use the jargon, homeostatis, and the need to export (the export dependency purple line) simple heads off exponentially towards infinity, while the level of deficit does the same in the opposite direction. The reason that the need to export moves exponentially upwards is that median age doesn’t just move up from one level to another, and sit there, but keeps climbing steadily upwards, and the more it rises, the less “bang for the buck” in GDP growth you get from any given level of exports. This is the situation we are seeing now in Germany and Japan, and this is why they will struggle mightily to pull themselves out of the present recession, and why the whole situation is evidently not sustainable. So, if the countries in question don’t do something, and do something now, to stop median ages rising too rapidly, more crises like the one we are presently living through are evidently guaranteed.

This way of thinking about things is sure to form, in my opinion, one piece in the new, post-crisis, macro mindset that will emerge. Of this I have no doubt, since the present crisis is all about imbalances, and this is one simple and straightforward model for thinking about and understanding them. Basically one group of people - the current account surplus countries (China, Japan, Germany, Sweden) - were afloat with money, and spent their time rather recklessly lending it to another group of people - the current account deficit crowd ( the United States, Iceland, Ireland, the UK, Spain, Portugal, Greece, Romania, Bulgaria, the Baltics, Hungary and New Zealand etc, etc) - who needed to fund their deficit habit, and who did so by equally recklessly borrowing the money. So if you want to understand the banking crisis, you need, as the US economist Brad Setser would say, to follow the money and find source of all those surpluses and deficits.

And all of this helps us understand not only the crisis, but also the problems we are going to have getting out of it, since as Larry Summers noted over lunch with the FT’s Chrystia Freeland “‘The global imbalances have to add up to zero and so, if the US is going to be less the consumer importer of last resort, then other countries are going to need to be in different positions as well.’

As Freeland highlighted, on this possibility, Summers was absolutely bullish, and understandably so. “The very great enthusiasm for accumulating reserves that one saw globally is likely to be a smaller factor over the next decade than it has been in recent years” he predicts this time. And so too is economic growth (going to be a smaller factor over the next decade), Edward Hugh rapidly adds, since with everyone looking to export their way out of trouble, we have to ask, as Nobel Economist Paul Krugman pointed out, the tricky question about just who the customers with the current account deficits are now going to be to enable all those much needed exports. The current talk of a simple and straightforward recovery for the global economy is misleading, and a long hard road lies ahead for all of us.

And the first evidence of this can be found in the latest quarterly US current account data. The deficit narrowed in the second quarter to $98.8 billion, the least since 2001, reflecting a smaller shortfall in trade of goods as imports and exports both decreased. followed a revised $104.5 billion deficit in the previous three months, the Commerce Department said today in Washington. exports were up 1.6 percent, while imports were down 0.6 percent resulting in the smallest trade deficit since November 1999. The U.S. trade deficit widened by 16.3% in July to $32.0 billion, the Commerce Department said Thursday. This is the biggest percentage increase in the deficit since February 1999. The trade deficit was well above the consensus forecast of Wall Street economists of a deficit of $27.5 billion. Imports rose at a record pace in July, outpacing a further gain in exports. Trade activity is still well below last year's level. The U.S. trade deficit with China was $20.42 billion in July compared with $25.01 billion in the same month last year. Excluding petroleum, the deficit rose 18.3% to $23.46 billion. Real imports, which exclude prices, rose 5.3%. Real exports rose 3.9%



Further US bank loans have fallen at an annual pace of almost 14pc in the three months to August (from $7,147bn to $6,886bn). The M3 "broad" money supply, watched as an early warning signal for the economy a year or so later, has been falling at a 5pc annual rate. Well, this is what the world wanted, and this is what it is now going to get. So everyone should be happy, I guess.


(1) An Aging Society: Opportunityor Challenge? - written with David M. Cutler (Massachusetts Institute of Technology), James M. Poterba (Massachusetts Institute of Technology), and Loise M. Sheiner (Harvard University) and published in Brookings Papers On Economic Activity, 1990.

Economic Realism in Germany

Germany’s recovery from recession came in time to give a boost to Chancellor Angela Merkel’s re- election bid in the Sept. 27 vote. It may not last much longer.

Unemployment is set to jump and consumer spending to fall in 2010 as government stimulus runs out, according to the Halle- based IWH institute, an adviser to the government. Companies are warning of a credit crunch, and debt at a post-World War II high leaves policy makers with few options to counter a double dip.

“The pace of the upswing can’t be maintained,” said Klaus Baader, co-chief European economist at Societe Generale SA in London. “Next year is going to be more difficult, with unemployment rising and government stimulus petering out.”

Exceptional measures of 85 billion euros ($124 billion) lifted spending and subsidized jobs, helping keep unemployment below levels in the U.S. and France, even as the economy suffered its worst post-World War II recession.

The return to growth in the second quarter enabled Merkel, 55, to “exploit” the issue in her campaign, Laurent Bilke, an economist at Nomura International, said in an interview.

Five polls last week gave Merkel’s Christian Democratic Union a lead of between nine and 13 percentage points over her main challenger, Social Democratic Foreign Minister Frank-Walter Steinmeier, 53.

“We’re through the worst,” Laurenz Meyer, economic spokesman in parliament for the CDU, said in an interview. “But the second wave of this crisis has yet to hit us.”

Economic Forecasts

Germany, the world’s biggest exporter, was hammered by the global contraction as sales of Wolfsburg-based Volkswagen AG cars and Munich-based Siemens AG equipment slumped. The government has forecast a 2009 economic contraction of as much as 6 percent.

Spurred by extra spending equal to 1.6 percent of gross domestic product in 2009, the economy grew 0.3 percent in the second quarter, confounding economists’ forecasts. It may expand another 0.8 percent in this quarter. Growth may reach 0.9 percent in 2010, the IWH institute says.

Reflecting the rebound, the benchmark DAX stock index has rallied 56 percent since March 6. Still, German government bonds have outperformed U.S. Treasuries this year on expectations the U.S. economy will grow more strongly.

Germany, Europe’s biggest economy “isn’t out of the woods yet,” Finance Minister Peer Steinbrueck said Sept. 1.

Candidates’ Pledges

The Christian Democrats have pledged across-the-board tax cuts worth about 15 billion euros and looser labor-market rules making it easier to fire employees. Steinmeier said during a televised debate on Sept. 13 that Merkel has a “credibility problem” over her plan to lower taxes even as debt soars. The Social Democrats propose tax cuts for the lowest incomes and want a universal minimum wage of 7.50 euros an hour.

“The chancellor is not to be envied,” Ulrich Kater, chief economist at Dekabank in Frankfurt, said in an interview. “Having rescued the economy through large government aid programs will soon be forgotten and what’s left is cleaning up the mess.”

For instance, Germany’s 5 billion-euro “cash-for- clunkers” program, the world’s largest, ended this month, removing support that shoppers have depended upon.

The car-scrapping premium, which was emulated from the U.K. to the U.S., led to a 23 percent increase on spending for vehicles in the first six months. The Federal Statistics Office attributed the second-quarter rebound to those purchases.

There are no signs consumer spending overall has stabilized, the Kiel-based IfW economic institute said in a Sept. 9 report. The results are already being felt.

Opel Job Cuts

General Motors Co.’s German Opel unit, one of the main beneficiaries of the subsidy, may shed 4,000 jobs in Germany as part of a plan to cut 10,500 jobs across Europe to return to profitability. As many as 50 auto suppliers face insolvency by the end of this year, according to a study by Roland Berger Strategy Consultants.

Insolvent retailer Arcandor AG, which failed in its quest for government aid this year, will cut 3,700 mail-order jobs and close 19 Karstadt department stores under plans unveiled last month by the company’s administrator.

The unemployment rate will jump to 10.3 percent in 2010 from 8.1 percent this year, the IWH institute forecast on Sept. 15. Consumer spending will drop 0.7 percent in 2010 after growing 0.5 percent this year, it said.

Subsidized Jobs

Jobs have been subsidized by the Federal Labor Agency, which pays 60 percent of the net wage that’s lost due to reduced working hours. The program, extended to 24 months in May from 18 months, supported about 1.4 million employees at some 50,000 companies as of June.

Holding on to workers with little to do may prove too expensive. Labor costs per working hour rose 4.8 percent in the second quarter from a year earlier, the second-biggest increase after a record 5.3 percent jump in the first three months, the statistics office said Sept. 15.

“It would be a mistake to underestimate the longer-term consequences of the past 18 months,” the BDB association of German banks said in a report on Sept. 9. “It will take three to four years until production is back at a pre-crisis level.”

Adding to the burden, the BGA association of wholesalers and exporters said Sept. 15 that 42 percent of its members expect credit to tighten. Small and mid-sized companies, which provide 70 percent of jobs, will face tougher loan conditions in the first half of 2010, Deputy Economy Minister Hartmut Schauerte said last month.

Increased Borrowing

Faced with such gloom, the next chancellor will have few tools to deploy. Net new borrowing will almost double next year to 86.1 billion euros from a record 47.6 billion euros this year, according to the government budget.

“There’s quite a bit of bad news left to digest,” Elga Bartsch, chief European economist at Morgan Stanley in London, said in an interview. “The challenge for the next government is that its fortunes hinge on economic indicators that trail the business cycle.”

German recovery loses momentum
By Ralph Atkins in Frankfurt

Published: September 24 2009 11:13 | Last updated: September 24 2009 11:13

http://www.ft.com/cms/s/0/4e1cb3e2-a8ee-11de-b8bd-00144feabdc0.html

Germany’s economic recovery is losing momentum, with business confidence rising less than expected this month, according to a closely watched survey that highlights the fragility of continental Europe’s return to growth.

The Munich-based Ifo institute reported its business climate index rose from 90.5 in August to 91.3 in September. That was the highest reading since September last year, when Lehman Brothers collapsed in the US. But it fell short of economists’ expectations, suggesting some of the recent optimism about Europe’s largest economy may have been overdone.

The Ifo index, which is regarded as offering a good guide to future activity, plunged dramatically late last year as global demand for German products slumped, and in March reached its lowest level since the pan-German survey started in 1991. It has since staged a “v-shaped” revival, pointing to a robust recovery. That fitted with other economic evidence showing industrial orders picking up as German exporters benefited from the revival in global growth prospects. Germany exited recession in the second quarter, when gross domestic product rose 0.3 per cent.

However, the rate of increase in the Ifo index slowed markedly in September. Hans Werner Sinn, Ifo president, pointed out that most companies still regarded current business conditions as poor. Instead, the rise in the index had been driven largely by the component covering businesses’ expectations for the next six months – which has risen for nine consecutive months to the highest level since May 2008.

Mr Sinn argued that “compared with the catastrophic developments of the past 12 months, this is good news”. Economists still expect a strong third quarter economic performance and Andreas Rees, economist at UniCredit in Munich, argued that the strength of business confidence about the months ahead meant “we do not expect any abrupt shift any time soon – momentum in major German export markets is simply too strong”.

However, the results are likely to add to policymakers’ concerns about the sustainability of Germany’s recovery. The country’s economy is still expected to shrink by about 5 per cent this year, with the under-utilisation of capacity to feed through into higher unemployment – which in turn will act as a further constraint on growth. Industrial associations have also warned that banks’ restrictions on credit provision will act as a brake on growth.

The Ifo results followed weaker-than-expected eurozone purchasing managers’ indices earlier this week, which also pointed to an improvement in prospects but at a slower pace. France, rather than Germany, appeared to have largely driven September’s improvement.

The European Central Bank has warned that the outlook for the eurozone – in which Germany is the largest economy – remains uncertain and that the recovery will be gradual. It is widely expected to keep its main interest rate unchanged at 1 per cent well into next year.


Merkel warns G20 against focus on imbalances
By Bertrand Benoit in Berlin

http://www.ft.com/cms/s/0/268529ce-a8ec-11de-b8bd-00144feabdc0.html

Published: September 24 2009 10:50 | Last updated: September 24 2009 10:50

Angela Merkel warned fellow world leaders on Thursday not to make the fight against global imbalances the central issue of a meeting of the world’s 20 largest economies, which kicks off in Pittsburgh on Thursday night.

Speaking in Berlin before boarding her flight, Ms Merkel came close to accusing the US and Britain of backtracking on the issues of financial market regulation and global limits on bonuses for bankers by shining the spotlight on the export-oriented economic policies of Germany and China.


“We should not start looking for ersatz issues and forget the topic of financial market regulation,” she said in her clearest comments to date. “We cannot afford to neglect this issue now.”

Ms Merkel turned on Washington, saying: “Imbalances are an issue, but we must look at all the factors . . . We must talk about imbalances and name the reasons why they came into being.”

“We should also look at imbalances between currency regions and not pick on specific countries within the eurozone,” she added, referring to criticism from the US that Germany is not doing enough to support its domestic demand.”

Germany, she said, had acted “as a stabilising force. Our trade surplus has become much smaller. We import more today because of our fiscal stimuli and our automatic stabilisers”.

Ms Merkel criticised London for neglecting to address the long-term fiscal impact of growth-boosting measures: “We should not – and this is a big issue in our talks with our British friends – push for higher growth and say we’re not interested in how we do it. This has to be sustainable growth.”

Berlin has grown concerned in the past few days that the US and the UK could use Pittsburgh – the third time G20 leaders will have met to forge a joint response to last year’s financial crisis – to put pressure on Germany and China to change their economic policies.

Early drafts of the meeting’s final communiqué sent by Michael Froman, economic advisor to US president Barack Obama, suggest Washington wants to make the discussion of global imbalances a centrepiece of the talks.

Speaking alongside Ms Merkel, Peer Steinbrück, the German finance minister, who will joint his G20 counterparts at the summit, was even clearer in his criticism.

In a clear jibe at London, he said he expected “all EU member states” present in Pittsburgh to back this week’s European Commission proposals on a tougher financial market rulebook “and to work towards their implementation.”

“We can talk about global imbalances,” Mr Steinbrück said, “but without pre-conditions. Let’s talk for instance about the US deficits and the enormous capital inflows needed to finance them . . . Let’s talk about the fact that the Chinese currency is still not convertible. Sure we can talk, but not selectively.”

Asked whether he thought the British government was softening its position on financial regulation under pressure from the City of London, Mr Steinbrück said: “It’s not just my perception. If you listen around, many think there is massive lobbying for hard-nosed regional interests going on.”

“Resistance from Wall Street and the City,” he said, was legitimate but should not be allowed to derail an international agreement on tougher financial market rules.

Dollar Diminishing Makes U.S. Favorite for High-Yield

Dollar Diminishing Makes U.S. Favorite for High-Yield
By Oliver Biggadike and Ron Harui
Sept. 14 (Bloomberg) --


Betting against the dollar is becoming the trade investors can’t afford to ignore. The U.S. Dollar Index fell last week to the lowest level in a year as price swings in foreign exchange declined, encouraging investors to borrow greenbacks at record low interest rates and buy assets in countries offering yields as much as 8.1 percentage points higher than U.S. deposit rates. Borrowing costs in dollars as measured by London interbank offered rates fell below those of yen and Swiss francs for an extended period for the first time since 1994 during the past three weeks. Those carry trades are the most profitable since before 2000, according to data compiled by Bloomberg. Borrowing dollars and then selling them is adding pressure on a currency that’s already weakened 14 percent since March as the budget deficit exceeded $1 trillion, the government sells a record amount of debt and the Federal Reserve floods the financial system with $1.75 trillion to pull the economy out of a recession.
“The dollar is the big funding currency,” said Jonathan
Clark, vice chairman of New York-based FX Concepts Inc., the
world’s largest currency hedge fund, with $9 billion in assets
under management. “The reason why people are borrowing the U.S.
dollar for carry trade is A: It’s very cheap to fund, and B: The
expectation is it’s going to go down.”

Risk Versus Returns

London-based Standard Chartered Plc, the most bearish of 45
firms in a Bloomberg survey, predicts the dollar will decline 6
percent versus the euro by year-end. Deutsche Bank AG in
Frankfurt, the most accurate forecaster of the dollar in the
first half of 2009 as measured by Bloomberg, is bullish, calling
for it to gain 11 percent by the start of 2010.
Using the world’s reserve currency to fund carry trades
became more profitable and less risky last month than with the
yen for the first time since March 2008, Bloomberg data show.
The difference in Sharpe ratios for dollars and yen, a measure
of performance versus risk, has averaged 1.35 since May,
compared with minus 0.37 since 2004. The higher the Sharpe ratio,
the higher the risk-adjusted return.
“The way everyone is funding their risky investments is by
using dollars,” said Bilal Hafeez, the head of foreign-exchange
strategy at Frankfurt-based Deutsche Bank, the world’s largest
currency trader. “Interest rates between Japan and the U.S. are
fairly comparable right now, which is incredibly unusual. Much
of the past 20 years or so, the yen has been the funding
currency of choice.”

29% Return

The three-month Libor for dollars, a benchmark for about
$360 trillion of financial products, fell last week to an all-
time low of 0.299 percent, compared with 0.366 percent for the
yen and 0.305 percent for the Swiss franc, another traditional
funding currency, according to the British Bankers’ Association
in London. Over the past 20 years dollar Libor has averaged
almost 3 percentage points more than yen Libor.
An investor who borrowed $10 million dollars in March to
fund the purchase of a basket of 10 currencies including the
Brazilian real and South African rand would have paid 1.27
percent initially. The trade would have delivered a 29 percent
return through last week as the offshore funding rate dropped to
0.53 percent, according to three-month deposit rates for the
currencies compiled by Bloomberg.
That same strategy funded in yen would have returned 19
percent with wider swings in daily returns, Bloomberg data show.
That trade funded in francs would have earned 16 percent.

Real, Rand

The basket comes from the most actively traded currencies
in the Bank for International Settlements’ triennial survey that
offer the highest three-month rates. Brazil’s benchmark is 8.6
percent and the real has appreciated 26.4 percent this year.
South Africa’s borrowing rates are 7.2 percent. The rand has
strengthened 28 percent compared with the U.S. currency.
Volatility, which can wipe out gains from carry trades,
also favors using the dollar over yen. Three-month euro-dollar
volatility fell to 10.2 percent on Sept. 11, while three-month
dollar-yen volatility declined to 11.9 percent. The difference
is the biggest since December.
Record low borrowing costs, designed to help pull the
economy out of the deepest slump since the Great Depression, may
be hurting the dollar more than supporting it. The Fed and
Chairman Ben S. Bernanke cut the target fed funds rate to a
range of zero to 0.25 percent in December, from 5.25 percent in
September 2007.

Dollar Index

The Dollar Index, which tracks the dollar against the euro,
yen, U.K. pound, Canadian dollar, Swiss franc and Swedish krona,
rose 17 percent from Sept. 15, 2008 to March 5, 2009, as
investors sought the safety of U.S. assets following the
collapse of Lehman Brothers Holdings Inc. and the government’s
bailout of insurer American International Group Inc. When the
panic receded, the index fell 14 percent to 76.885 today as
investors focused on deficits in the U.S. and interest rates.
Investor appetite for dollars may benefit from the growing
gap between short- and longer-term borrowing costs in the U.S.,
according to Yuki Sakasai, a foreign-exchange strategist at
Barclays Bank Plc in Tokyo.
Yields on 10-year Treasuries ended last week at 2.44
percentage points more than two-year notes, the third-widest
spread of any Group of 10 nation after the U.K. and Sweden. The
so-called yield curve in Japan is 1.10 percentage points.

Rate Outlook

Policy makers may also help the dollar appreciate, at least
against the euro. The European Central Bank will wait until the
final quarter of 2010 to increase its benchmark rate from 1
percent, according to Euribor interest-rate futures. The odds
that the Fed will raise its target rate for overnight bank loans
as soon as the second quarter are almost 59 percent, fed funds
futures on the Chicago Board of Trade show.
For now, the U.S. currency is weakening after the budget
deficit expanded to $1.27 trillion in the first 10 months of
fiscal 2009 that ends Sept. 30. The gap will widen to $1.6
trillion in 2010, according to the Congressional Budget Office.
The Obama administration has pushed the nation’s marketable
debt to an unprecedented $6.78 trillion to spur growth, support
the financial system and service record deficits. The Fed is
pumping in $1.75 trillion to keep credit flowing by purchasing
Treasuries and mortgage bonds.
Last week, Standard Chartered reiterated its call for the
dollar to weaken to $1.55 per euro by year-end, from $1.4571 on
Sept. 11. Zurich-based UBS AG, the world’s second-largest
currency trader, lowered its forecasts last week for the dollar.

Yen Volatility

Royal Bank of Scotland Group Plc in Edinburgh will probably
raise its year-end yen forecasts to “the order of 88 versus the
dollar and 122 versus the euro” Greg Gibbs, a foreign-exchange
strategist in Sydney, wrote in a report last week. The yen ended
Sept. 11 at 90.71 to the dollar and 132.17 to the euro.
Yen volatility may increase after the Democratic Party of
Japan and two other political parties take power in Japan for
the first time this week, according to Hidetoshi Yanagihara, a
senior currency trader at Mizuho Corporate Bank in New York.
The DPJ needs to find 7.1 trillion yen ($78.3 billion) to
fund its election pledges in the year starting April 1, and the
amount would swell to 16.8 trillion yen in 2013, according to
its campaign manifesto. The new administration, led by Prime
Minister-designate Yukio Hatoyama’s, has said it will increase
funds for child care, education and employment partly by
diverting as much as 5 trillion yen of stimulus spending already
approved.
“People are watching what this new government will do in
this new era,” said Yanagihara. “That will cause higher long-
term interest rates and maybe the budget deficit will inflate.”

ECB Makes Profit on Funding

ECB nets €900m from crisis lending
By Ralph Atkins in Frankfurt

Published: September 13 2009 16:20 | Last updated: September 13 2009 16:20

The European Central Bank has made up to €1bn in extra profits from crisis-related emergency lending, but its caution on unconventional policy measures has curbed potential earnings, analysts estimate.

Extra liquidity pumped into the eurozone banking system since the collapse of Lehman Brothers last year has probably generated an extra €900m ($1.5bn, £780m) in profits so far, according to calculations by Goldman Sachs.

Some €300m of the total has been generated since June, when the ECB provided €442bn in one-year loans in its biggest liquidity providing operation.

The extra profits are on top of the sums that the ECB normally makes on its market operations. Although the interest rate currently charged by the ECB – 1 per cent – was the lowest in its 11-year history, revenues “remain juicy because of the quantity of liquidity that banks keep hoarding”, said Natacha Valla, European economist at Goldman Sachs in Paris.

From last October the ECB has been meeting, in full, eurozone banks’ demand for liquidity. Ms Valla argued, however, that by sticking largely to using policy instruments already in its armoury the ECB had forgone potentially far higher margins.

Profits on the ECB’s programme to buy €60bn in covered bonds – low risk assets issued by banks and backed by public sector loans and mortgages – could be dwarfed by those on schemes launched by other central banks, which have involved higher risk. The Financial Times reported last month that the US Federal Reserve had made a $14bn profit on its crisis loan programmes, with its purchases of commercial paper among its most lucrative operations.

Instead, the ECB has created arbitrage opportunities for eurozone banks, which have used liquidity provided by the central bank to buy large amounts of government bonds, including from some of the smaller eurozone countries and riskier assets. These, in turn, can be used as collateral to raise fresh funds from the ECB. Eurozone banks’ holdings of euro-denominated government bonds have increased by more than €200bn since last year.

The ECB would not comment on its likely profits, saying its annual accounts would be published in March. Jean-Claude Trichet, ECB president, said last week in an interview with the European parliament’s television service that making money was not the bank’s goal, adding: “The goal is to ensure that markets are working properly and to allow eurozone commercial banks to do their job.”

A priority for the ECB had been to ensure its political independence was not undermined by financial losses, said Gilles Moec, European economist at Deutsche Bank. By generating additional profits on its liquidity-providing operations, “the risk of going cap in hand to governments is much less”, he said.

Beyond that, the ECB’s decision not to embark on large-scale asset purchase programmes put it under less pressure than other central banks. “The amount of risk that they are taking is much less than in the UK and US, so in a way they don’t have to make as much of a profit as a buffer against potential losses.”

What Is The Real Level Of Unemployment In Germany And Japan?

With Japan having elections today and Germany facing election next month, I though now might be as good a time as any to have a look at a topic which could turn out to be very important in the months to come: the real underlying rate of unemployment in both these countries.

While the present focus of most press attention is on the fact that GDP in Germany and Japan nudged upwards between April and June (over Q1), we should never forget that this increase follows substantial falls in output. Japan’s real GDP fell at a record pace in Q4 2008 and Q1 2009 (annualized declines of 13.5% and 14.2%, respectively), and German GDP fell by a quarterly 3.5 percent in Q1 and an annual 6.7% - making for the fourth consecutive quarter of negative growth. In both cases the fall in output was accompanied by only a much more moderate decline in employment.

Part of the explanation for this lies in the fact that both countries have very substantial stimulus and employment protection programmes in place, and these to some extent mask the extent of the slump. At the same time both countries are now facing elections, and deteriorating gross debt to GDP positions. It is therefore highly likely that the positive stimulus programmes will wane somewhat after October, and the problem is to know just how far the labour markets can deteriorate further in these countries as a result. Fortunately Nomura (for Japan) and Societe Generale (for Germany) have this week produced timely studies which help us get a better picture.


Japan

The news coming out of Japan at the moment is almost uniformly bad. The unemployment rate is now at a record high, data showed today, raising even more doubts about the sustainability of the economic recovery there piling pressure on embattled Prime Minister Taro Aso just two days ahead of an election which he looks set to lose.

The jobless rate rose to a worse than expected 5.7 per cent in July, up from 5.4 per cent in June. By Spanish or Latvian standards this may seem very tame, but if you take into account the extent of government subsidised "hidden unemployment" the true underlying rate may be nearer 12 or 13%.

And adding insult to injury for Aso, Japanese core consumer prices fell at the fastest annual pace on record in again in July, potentially putting pressure on a reluctant Bank of Japan to rein in deepening deflation. Core consumer prices - the bank of Japan's preferred measure - which exclude volatile fresh food prices but include oil costs, fell 2.2% in the year to July.

Average monthly Japanese household spending fell in July by a price adjusted 2.0 percent from a year earlier to 285,078 yen, down for the first time in three months,

Also, Japan’s July exports fell 1.3 per cent on a seasonally adjusted basis from June, amid concerns about the sustainability of the country’s recovery. Provisional data out today showed that shipments in July fell 36.5 per cent b...y value year on year, outpacing the 35.7 per cent decline in June.

Japanese exports slid in July at a faster annual rate than June, raising fears the effects of global stimulus measures are starting to decline..meanwhile average salaries keep falling and unemployment keeps rising as Japan sinks deeper and deeper into deflation.




Under the scheme, as a rule the government provides two thirds of the wages paid by businesses in such circumstances. As of June 2009, some 2.383mn workers had applied for employment adjustment subsidies for 2009 onward (see chart). Although only 1.891mn had been approved as of June, Nomura expect this figure to grow closer to the number of applicants.



Nomura found that when indexing the number of those employed and real GDP to the output peak of Q4 2007 the result showed a considerable gap. Based on a simple calculation and assuming this gap to represent the amount of “hidden underemployment”, they arrive at a figure for “hidden jobless” in Q1 2009 of 4.7m. This is far higher than the June unemployment figure of 3.48m. If the hidden jobless are included together with the registered “unemployed”, they calculate that the unemployment rate would leap from 5.4% to 12.2%.



This chart shows estimates made by Nomura of the hidden jobless during past economic downturns. In the majority of cases the number of hidden jobless did not rise at all or employment fell more than GDP, suggesting that employment adjustments
were quite swift. Comparatively substantial numbers of hidden jobless rose in Q4 1973, triggered by the first oil shock and in Q2 1997, due to the Asian currency crisis, financial system concerns and a consumption tax hike. The number of hidden jobless, estimated at about 4.7m in Q1 2009, is well above the figures associated with these two downturns, according to Nomura.



However, as Nomura point out, even if the difficult labour market conditions are not fully reflected in the unemployment figures, a deterioration in adjusted labor supply-demand could easily lead to major declines in wages even while companies keep the number of hidden jobless down, thanks to government support. In fact, according to Nomura it would be hard to explain the fact that the decline in wages (total cash earnings of full-time employees) in H1 2009, at 4.7% y-o-y, was far bigger than the equivalent declines in annual average wages of 2.3% in 2002 and 0.4% in 2003, when unemployment also reached new highs, if you don't take the hidden jobless factor into account (see chart). Pressure on wages and household income could thus become a serious impediment to any genuine fully fledged economic recovery.




As of June 2009, payments under the government's subsidy scheme for employment adjustment totalled ¥101.14bn. If the number of approvals grows to meet the number of applicants, Nomura estimate total payments will increase to ¥127.42bn, placing some additional strain on fiscal finances. We think that dividing the cost of the hidden jobless and in-house unemployed between companies, households and government would be a major policy challenge for the new administration when it takes office in September. Given the seriousness of the social and political problems that result from sharp rises in unemployment, we think that while the next Japanese government may strengthen the employment adjustment subsidy scheme by, for example, further relaxing its terms and conditions, it is unlikely to try to limit the number of eligible cases by tightening conditions.

Despite the huge number of hidden jobless, however, Nomura think the unemployment rate is unlikely to rise much beyond 6.0%, largely because the government has established a subsidy scheme for employment adjustment.




The Ministry of Health, Labour and Welfare says that the aim of the scheme is to prevent unemployment by partly subsidizing wages for companies in trouble. This includes wages of staff that may be temporarily transferred and providing allowances if a business temporarily shuts down. Businesses that temporarily transfer employees (or place staff in training programs) or shut down operations after having been forced to scale back for economic reasons, or other factors such as industry realignment, for example, are also eligible.


Germany






The German job machine ran out of steam last autumn, and since that time has been adding jobs at an ever slower pace. Now it has turned negative, and less Germans are employed every month than they were a year earlier.



German unemployment rose again in July. The number of people out of work increased 52,000 to 3.46 million on an unadjusted basis. The seasonally adjusted total actually fell by 6,000, according to the statistics office due to statistical changes. Without the impact of the changes, the office estimates unemployment rose by 30,000. German unemployment began to increase in November after falling steadily for more than three years. The seasonally adjusted jobless rate was unchanged at 8.3 percent in July.



Societe Generale, take the German case, and point out that while official unemployment in Germany has in fact only risen moderately in the current recession. The unemployment rate (using the ILO measure) has risen by just 0.6ppt from its 7.1% low in Q4 2008, while in the euro area as a whole, the rate is up by 2.2ppt to 9.4% from its March 2008 low of 7.2%. As they say, it is also quite clear that this relative stability owes much to the widely-used practice of so called short-time working (Kurzarbeit).



The Societe Generale interpretation is broadly supported by survey evidence which suggests that the rate of contraction in employment has eased, pointing to a slower increase in unemployment in coming months. For example, the employment component of the PMI surveys in manufacturing has risen to 37.9 in July from a low of 32.9 in April, and in the services sector to 49.0 from a low of 45.2 in May. Employment intentions (in the European Commission survey) have also come off the lows in all sectors, but remain in negative territory, implying further job losses. That tallies with the recent evidence from official unemployment data, which have unemployment up by an average of 8,000 per month in May-July, a big shift downward from the average monthly increases of nearly 60,000 in Q1. That degree of improvement will, according to Societe Generale not be sustained, but they do not expect to see a return to the pace of unemployment gains witnessed earlier this year. Of course, as SocGen point out, company employment intentions could easily deteriorate again if growth expectations get revised down, but for the nearer term, the evidence suggests that unemployment in Germany will rise at slower rates than observed earlier this year.




They also point out that this short-time working arrangement has a "sell by" date, and can't run forever, hence there is widespread concern that a major increase in unemployment in Germany is merely a matter of time. Socgen then go on to ask themselves how wellfounded these concerns actually are, and take the view, that they are not as justified as they seem.

First of all, they note that German legislation has already extended the period for which companies can run short-time working from 18 to 24 months. Looking at the evolution of the numbers on short-time working they find that the vast majority of companies only resorted to the programme in the very recent past, so that the 24 month limit will not bite until late-2010. Until the turn of the year 2008/09, the recourse to short-time working was very small indeed; aside from the seasonal increases in the first quarters of 2007 and 2008, the numbers were small at around 50K. To put that in context, that is 0.1% of the labour force and equivalent to the monthly gains in unemployment that were recorded this year. Since then, the numbers have indeed exploded: by March of this year (latest available data), there were 1.3m workers with shortened hours, and according to official estimates, that has probably risen to around 1.4m more recently. These are clearly big numbers, amounting to about 3% of the labour force. If they were added to unemployment figures, total unemployment would rise to the previous historic peaks of around 5m. However, given that this increase only began in the final two months of 2008, these schemes could easily run for another 18 months, at least as far as the administrative rules are concerned. Whether the German fiscal position will allow this once the new government is installed is another question entirely.

Spain's deficit target a polite fiction

Repeats story transmitted on Friday)

By Paul Day

MADRID, Aug 14 (Reuters) - Spain has little chance of meeting its oft-repeated promise to cut its budget deficit to European Union limits by 2012, but economists believe the government is right to pay lip service to the target.

As a massive public works scheme, designed to stop the Spanish economy slipping into a coma, threatens to push the deficit close to 12 percent of GDP in 2009, the government has tried to reassure debt markets that it will swiftly return to fiscal prudence.

"When we make a promise, we like to keep it," said Economy Secretary Jose Manuel Campa last week, asked whether the country would really rein in the deficit to the 3 percent of gross domestic product limit, called for by Europe's Stability Pact, within three years.

"This goal is linked to cyclical (economic development) and we expect cyclical growth of above 2 percent in 2012. A deficit of 3 percent is consistent with this," Campa said.

But therein lies a fallacy, economists say. If Spain withdraws fiscal stimulus (to cut the deficit) while it still lacks a motor of growth to replace the subsiding construction industry, it can't hope to grow above 2 percent.

On top of that, 2012 is an election year in Spain, a period seldom associated with spending cuts.

"The bottom line is all the European countries have got to pay lip service to these rules, but it's a nonsense," says economist at Commerzbank Peter Dixon.

"When you have the situation that we are in now, allowing the deficit to rise is the least worst option."


WORST CASE SCENARIO FADES

Over the last month, credit rating agencies Fitch and Moody's have expressed doubt that Spain's deficit target is achievable while at the same time restating the country's top triple-A sovereign-debt rating.

For Moody's, this marked a more optimistic attitude towards Spain, where recent data, including second quarter GDP and unemployment, has shown some improvement thanks to one of the worlds' largest stimulus plans in relative terms.

In January, Moody's had tagged Spain as "vulnerable" amid fears surrounding the global economy and the local housing market. It now believes such worries have dissipated.

"Moody's immediate concerns in this regard have been largely allayed," Moody's said in its press note in July.

"Although there is a good chance that the government will fail to get the deficit down to 3 percent of GDP by 2012 ... it should be able to do so roughly a year or so later."

Markets, so far, seem unconcerned by the speed with which Spain's public debt is rising.

The government says that its debt as a proportion of GDP will jump by 15 percentage points to 60 percent by the end of 2010.

Yet the spread on 10-year bonos against German bunds dropped to around 42 basis points last week, the lowest level since the time of the collapse of Lehman Brothers.

"The deficit's high, but debt in relation to GDP is expected to rise to around only 70 percent (over the next few years), which is relatively low compared to other European countries," said economist at Capital Economics Ben May.

"We certainly feel the fears of a Spanish default at the start of the year were overblown. The decline in bond yields has shown this worry is unfounded," said May.

Nonetheless, while markets are expected to be tolerant of Spain's actual fiscal performance, they still expect the government to talk the talk.

"A 3 percent deficit by 2012 would be difficult, but it doesn't really matter (if they meet it). What's important is the trend," said Standard and Poor's Senior Director of Sovereign and Public Finance, Myriam Fernandez.


DON'T TURN OFF LIFE SUPPORT

Spain is especially vulnerable to a sudden withdrawal of state-support because the downturn has been largely due to domestic, structural failings and, as such, it won't find immediate relief from a global recovery.

Aggressive moves by the government to counter the downturn over the last six months, including around 15 billion euros ($21.40 billion) of infrastructure projects and tax breaks, has helped stem lay offs and encouraged talk of the green shoots of recovery.

Pull this life-support away too soon and the ailing economy could relapse.

"Public finances should be geared toward the medium term but tighten too quickly and you won't get what you're hoping for. A double dip recession could easily occur if you tighten too early," said economist at BNP Paribas Dominic Bryant.

From Original Sin To The Eternal Triangle

The non-biblical concept of original sin, as Claus Vistesen notes in this post, when propounded in its standard Obstfeld & Krugman textbook version refers to the situation where many developing economies who are not able to borrow in their own currencies feel forced to denominate large parts of their sovereign and private sector debt in non-domestic currencies in order to attract capital from foreign investors - as evidenced most recently in the countries of Central and Eastern Europe. Well, piling insult upon injury, I'd like to take Claus's point a little further, and do so by drawing on another well tried and tested weapon from the Krugman armoury, the idea of the "eternal triangle".

As is evident the reality which lies behind the current crisis in the EU10 is complex, and has its origin in a variety of causes. But one key factor has undoubtedly been the decisions the various countries took when thinking about their monetary policy and currency regimes. The case of the legendary euro "peggers" - the three Baltic countries and Bulgaria - has been receiving plenty of media attention on late, and two of the remaining six (Slovenia and Slovakia) are now members of the Eurozone, but what of the other four, Romania, Hungary, Poland and The Czech Republic? What can be learnt from the experience of these countries in the present crisis.

Well, one convenient way of thinking about what just happened could be to use Nobel Economist Paul Krugman’s Eternal Triangle” model (see his summary here), which postulates that when it comes to tensions within the strategic trio formed by exchange rate policy, monetary policy, and international liquidity flows, maintaining control over any one implies a loss of control in one of the other two.

In the case of the Central Europe "four", Poland and the Czech Republic opted for maintaining their grip on monetary policy, thus accepting the need for their currency to "freefloat" and move according to the ebbs and flows of market sentiment. As it turns out this decision has served them remarkably well, since the real appreciation in their currencies which accompanied the good times helped take some of the sting out of inflation, while their ability to rapidly reduce interest rates into the downturn has lead to currency depreciation, helping to sustain exports and avoid deflation related issues.

The other two countries (Hungary and Romania), to a greater or lesser degree prioritised currency stability, and as a result had to sacrifice a lot of control over monetary policy, in the process exposing themselves the risk of much more violent swings in market sentiment when it comes to capital flows. Having been pushed by the logic of their currency decision towards tolerating higher inflation, they have seen the competitiveness of their home industries gradually undermined, and as a consequence found themselves pushed into large current account deficits for just as long the market was prepared to support them, and into sharp domestic contractions once they were no longer disposed so to do.

A second problem which stems from this "initial decision" has been the tendency for households in the latter two countries to overload themselves with unhedged forex loans, a move which stems to some considerable extent from the currency question, since in order to stabilise the currency, the central banks have had to maintain higher than desireable interest rates, which only reinforced the attractiveness of borrowing in forex, which in turn produced lock-in at the central bank, since it could then no longer afford to let the currency slide due to the balance sheet impact on households. Significantly the forex borrowing problem is much less in Poland than it is in Hungary or Romania, and in the Czech Republic it is nearly non-existent.

The third consequence of the decision to loosen control on domestic monetary policy has been the need to tolerate higher than desireable inflation, a necessity which was also accompanied by a predisposition which had its origin in the erroneous belief that the lions share of the wage differential between West and Eastern Europe is an “unfair” reflection of the region’s earlier history, and essentially a market distortion. The result has been, since 2005, a steady increase in unit wage costs with an accompanying loss of competitiveness, and an increasing dependence on external borrowing to fuel domestic consumption.

So, if we look at the current state of economic play in the four countries, we find two of them (Hungary and Romania) undergoing very severe economic contractions, to the extent that in both cases the IMF has been called in. At the same time they still have higher than desireable inflation and interest rates. In the other two countries the contraction is milder, the financial instability weaker, and both inflation and deomestic interest rates much lower. Really, looked at in this light, I think there can be little doubt who made the best decision.


Appendix

Here for comparative purposes are charts illustrating the varying degrees of economic contraction, inflation, and interest rates. GDP contraction rates actually present a little problem at the moment, since one of the relevant countries - Poland - still has to report. However Michal Boni, chief adviser to the Prime Minister, told the newspaper Dziennik this week that the economy expanded at an annual rate of between 0.5% and 1% in Q1. So lets take the lower bound as good, it is still an expansion.

The economy in the Czech Republic contracted by an estimated 4.9% year on year in the second quarter.

The Hungarian economy contracted by an estimated 7.4% year on year in Q2.



While the Romanian economy contracted by an estimated 8.8% year on year.


Inflation Rates

Poland's CPI rose by an annual 4.2% in July.


The CPI in the Czech Republic rose by an annual 0.3% in July.



Romania's CPI rose by an annual 5.1% in July.


Polands CPI rose by an annual 5.1% in July.


Interest Rates

The benchmark central bank interest rate in Poland is currently 3.5%.

The benchmark central bank interest rate in the Czech Republic is currently 1.25%.


The benchmark central bank interest rate in Romania is currently 8.5%.


The benchmark central bank interest rate in Hungary is currently 9.5%.