It is striking how many of those most alert to the deflation danger are either veterans of Japan’s Lost Decade or close students of it

TO BE NOTED: From A Fistful Of Euros:

"David Takes On Goliath and Loses: The Ferguson - Krugman Exchange by Edward Hugh

“As long as excessive debt is not digested, both monetary and fiscal policies are inefficient. There is not much of an alternative. Either to let the economy collapse, in order to reduce debts, and then use fiscal policy to revive it, or inundate the insolvent economy with public credit, to avoid the collapse, and loose the ability of fiscal policy to pull it out of a prolonged lethargy. Either a horrible end or an endless horror.”
After the Crisis: Macro Imbalance, Credibility and Reserve-Currency: André Lara Resende

Well, I think the title to this post makes my view on the high-profile shenanigans we are currently witnessing on the part of two widely respected contemporary intellectuals clear enough, even if Paul would probably respond that he is perfectly well able to take care of himself, thank you very much. Nonetheless, looking at the way the tone of his most recent and most public debate with Niall Ferguson has deteriorated (yes, it is Niall I’m talking about here, and not Sir Bobby, although sometimes even I have my doubts), let me confess, I am not entirely convinced on this point (Niall Ferguson’s argument can be found summarised in his Financial Times Op-Ed here, and in his rejoinder letter to Martin Wolf reproduced by the FT Alphaville’s ever interesting Izabella Kaminska here, while Paul Krugman’s “input” to the debate can be found here, here, and here).

So, since the thunder and lightening that such high profile exchanges generate tends to obscure more than it reveals, let me be so bold as to add my own 2 centimes worth - even if, apologies in advance, the whole affair ends up being most terribly “wonkish”. If you want to save yourself a good deal of trouble, and heart searching, the central point is a simple one: are long term US interest rates rising because investors are worrying about having to buy so much public debt (as K would point out, what else were they thinking of doing with the money - which isn’t really “money” at all, but, oh, never mind), or are they rising because investors expect the time path of US short term interest rates to move steadily upwards? It’s as easy, or as hard, as that. So now, you decide!

Someone To Watch Over You

Amidst so much disagreement one point is, at least, agreed common ground: Paul Krugman is a macro economist, while Niall Ferguson is a historian, one who believes, if we are to take him at his word, that cats may sometimes look at kings, and live to tell the tale. Let’s see if he’s right.

The other point we are all agreed on, I think, is that yields on 10 year US treasuries have been rising of late, and this phenomenon lies at the heart of the debate. Indeed, if I read him aright, this is Niall’s main point of current concern.

On Wednesday last week, yields on 10-year US Treasuries – generally seen as the benchmark for long-term interest rates – rose above 3.73 per cent. Once upon a time that would have been considered rather low. But the financial crisis has changed all that: at the end of last year, the yield on the 10-year fell to 2.06 per cent. In other words, long-term rates have risen by 167 basis points in the space of five months. In relative terms, that represents an 81 per cent jump.

Where we are not agreed - the economists and the historians among us that is - is over the significance to be placed on this evident fact. Although, having said this, Niall does rather seem to suggest that the development is some sort of litmus test for his view, since he argues it “settled a rather public argument between me and the Princeton economist Paul Krugman”. Now what was it they used to say about rushing in where angels fear to tread!

Of course, Niall is no fool, he is an excellent historian, and I greatly enjoy reading his books, but he really, really should know better than to get himself involved in the kind of technical argument which his experience and background ill equips him for. Citing the Chinese central bank as authority for your monetary views (see below) may go down well with the after dinner port-and-stilton set, but it is hardly rigorous argument, and Niall must surely well know that.

It’s The Expectation On Long Term Yield, Silly!

The Fed probably won’t make any adjustments to the size of the Treasury purchase program before its next policy meeting on June 23-24, in part to avoid reinforcing perceptions policy is reacting to swings in yields, according to Jim Bianco, president of Chicago-based Bianco Research LLC.

“The Fed wants to operate in predictable ways,” Bianco said. “They are also trying to not just look arbitrary, which makes people think ‘I can’t ever go to the bathroom because there could be a press release that the Fed changed the buybacks.’ That’s been a real concern: ‘Wow, I just went to the bathroom and lost $2 million dollars.’”

The thing you should always bear in mind when you enter the fray in areas where others have the benefit of the expertise is that there may be more than one available interpretation for the phenomena, and, as is so often the case in science, the counter intuitive explanation may have more going for it than the layman may grant at first sight (wasn’t that the sun I just saw hurtling past across the sky). In this sense, the recent rise in long term US treasury interest rates has just provided some of us with a fascinating example of a phenomenon that those economists who have busied themselves studying the use of quantitative easing in Japan have been flagging for some time, and that is, that long term interest rates may indeed be unduly influenced by longer term inflation expectations, but not necessarily in the way a layman Niall and others may imagine they are.

Longer term inflation expectations - or so it is argued by a broad spectrum of monetary economists - may work against the fluid operating of a quantitative easing regime in or on the boundary of a liquidity trap not because investors fear that a country like the United States is about to become the new Zimbabwe, but precisely because they know it won’t. Indeed, as I frequently find myself saying of late, the United States is not Argentina, gee, it isn’t even Italy, by which I mean that investors know perfectly well how Ben Bernanke and his colleagues over at the Federal Reserve will react to a situation where inflation is perceived as rising above their target range - they will start to raise short term interest rates, and it is this expectation of future increases in short term rates which ironically cause longer term interest rates to rise, in just the way they are doing right now, in what is almost a text book case study in the United States. As Krugman’s former PhD student Gauti Eggertsson put it in one highly relevant paper (Eggertsson and Ostry: 2005, see references below).

A central bank following a Taylor rule raises interest rates in response to inflation above target and output above trend. Conversely, unless the zero bound is binding, the central bank reduces the interest rate if inflation is below target or output is below trend (an output gap). If the public expects the central bank to follow the Taylor rule, it anticipates an interest rate hike as soon as there are inflationary pressures in excess of the implicit inflation target. If the target is perceived to be price stability, this would imply that quantitative easing has no effect, because commitment to the Taylor rule would imply that any increase in the monetary base would be reversed as soon as deflationary pressures had subsided.

Indeed talking of the Taylor rule, none other than John Taylor himself recently came out and argued that -applying his rule - the Federal Reserve would need to start once more to raise interest rates in the near future, “My calculation implies we may not have much time before the Fed has to remove excess reserves and raise the rate,” he said recently at an Atlanta Fed conference. And if John can do the calculations so too can other investors.

Of course the United States Federal Reserve is not at this point following a Taylor-type rule (although Bernanke is a known supporter of some sort of inflation targeting) but let us not get bogged down in that minor, rather technical detail, the key issue is that long term interest rates are influenced more by the expected time path of short term rates than by any other single factor, and if, instead of beating about the bush, we go right to the heart of the matter, what do we find, well Lo & Behold, only last Friday:

The dollar advanced the most against the yen in more than three months and rose versus the euro as economic data showed evidence the U.S. recession is easing, boosting demand for the nation’s assets. The greenback climbed this week as a government report indicated slower deterioration of the labor market, supporting bets dollar-denominated assets will gain as the U.S. leads the global economy out of its slump…..

The dollar also gained against the yen on speculation the Federal Reserve will raise interest rates later this year, reducing the advantage of borrowing in the U.S. to fund purchases elsewhere. Traders added to bets the central bank will increase its target rate for overnight loans between banks by its November policy meeting, according to futures traded on the Chicago Board of Trade. The contracts show a 66 percent chance of a rate increase by then,compared with 24 percent odds a week ago.

Well, there you are, investors (I have no idea whether they are being rational or not) simply act as theory predicts, and chaffe at the bit (sometimes called “getting ahead of themselves”) to take positions in anticipation of expected future hikes in US interest rates, something which sends rates rippling upwards all along the yield horizon. Incidentally, can someone kindly tell me where I have to write to become a formal member of the “Thank God For Bloomberg” brigade, since where would we really be without those dedicated scribes, who will, incidentally, obviously provide so much material for future generations of historians? (Incidentally, you can find a very good summary of just what a headache the volatility in US government bonds is proving to be for Bernanke in this Bloomberg article, from which the Bianco quote above was taken).

So, far from the position being as Niall imagines it is, with investors demanding enhanced premiums for holding US assets due to their fear of impending inflation, what we have here is a kind of see-saw process, whereby bad economic data, which leads investors to anticipate interest rates being held low in the US for some considerable time, raises risk sentiment (see this post: Don’t Get Carried Away Now) and sends them off into riskier emerging market assets (with Big Ben playing sheet anchor) in the process sending the grenback to ever lower levels, while positive economic news makes playing carry with the USD as one of your currency pairs increasingly riskier, and thus leads the punters themselves to retreat, sending the dollar cruising back up again. All of which is very counterproductive, since given the knife edge character of the current US “recovery” all it does is slow things down (since the cheaper USD is good for exports) and ramp up the deflationary pressure.

But this story about investors being nervous about holding US Treasuries due to the high inflation risk, well, as far as I am concerned, go tell it to the marines, or at least to the those people over at the Chinese central bank (you know, the ones who have been running up all those dollar reserves) who Niall seems to regard as his economic authority in these matters.

“Monetary expansion in the US, where M2 is growing at an annual rate of 9 per cent, well above its post-1960 average, seems likely to lead to inflation if not this year, then next. In the words of the Chinese central bank’s latest quarterly report: “A policy mistake … may bring inflation risks to the whole world.””

What we have here, is what the late Niklas Luhman would have termed a “narrative discourse”. Repeating the same arguments ad infinitum may produce a pleasing to sensation among the theory’s adherents, but that does not make them “true”, nor is it a substitute for rigourous economic analysis, or a basic understanding of what is actually going on. It does go down well with the port and stilton set though, and would undoubtedly make one VI Ulyanov (aka Lenin) turn merrily over in his mausoleum, since evidently he was right: “every cook can and does govern”.

But back to the basic thread, putting all this pressure on public officials at this point is a completely counterproductive exercise, since the surge in long term interest rates - produced by the rise in expectations that the central bank will move to reign-in inflationary pressures sooner rather than later, simply leads to further signs of weakness in the US economy, which means the expectation once more grows that rates will stay lower longer, and on and on we go. But of course, as Niall Ferguson points out, it is none other than Bernanke himself who has most recently and most evidently been expressing concern about the future size of the Federal deficit, and again this would seem to me to be a reflection of the political pressure that this mistaken narrative is exerting. Accodring to the Wall Street Journal:

The Fed must decide, perhaps as soon as its June 23-24 policy meeting, whether to increase its purchases of Treasury bonds. It is on course to buy $300 billion worth of bonds by September. If investors perceive the Fed’s actions as an effort by the central bank to facilitate bigger deficits, they could conclude inflation is coming and flee Treasurys, pushing interest rates up. Mr. Bernanke’s comments were aimed at thwarting that perception.

Counter intuitively, the only real way to break this spiral is for Bernanke to commit to holding rates near the zero bound for an extended period of time - or to “commit to being irresponsible” in the immortal words of Eggerston and Woodford. At this point I find myself asking if it isn’t ALL Princeton monetary economists - including Lars Svennson - Niall doesn’t like rather than his simply Krugman holding in bad rather odour, which I could have understood more as a dislike of his fairly well known political views than as a rejection of a far more technical corpus of economic analyses, which I am sure Niall would have to admit he is insufficiently equipped to really get to grips with.

Personally, I have no idea whatsover as to the properties semi-conductors may exhibit at temperatures below absolute zero, but then I would not join issue with a theoretical physicist who mentioned preposterous sounding processes by starting off saying “well when I heat milk in a saucepan, eventually it boils” Still, if you are foolish enough to stick your neck in the noose, in the noose it will go!.

As Eggertsson points out in the Japan context long-term interest rates depend on expectations about future short-term interest rates and the risk premium, and neither of these depends on the quantity of long-term bonds in circulation or on the monetary base at zero interest rates (my emphasis thoughout), and this is a technical finding - which may ultimately be right or wrong, but I doubt that the opinion over at the Chinese central bank counts as evidence one way or another, nor does it seem reasonable to say that a growth in M2 of 9 per cent a year “seems likely to lead to inflation if not this year, then next” without a much more rigourous technical analysis, since if Niall can be so sure of this, the people over at the Bank of Japan would almost certainly like to know how.

And then, gettinmg horribly wonkish, we have the so called portfolio channel, and how this can undermine government attempts to steer down interest rates at the long end of the yield curve by purchasing longer term bonds (see Bernanke and Reinhart: 2002), since as Eggertsson and Woodford found, making the normal assumptions implicit to a general equilibrium model, purchases of long-term government bonds have no effect on long-term yields if expectations about future interest rates remain constant.

It has been suggested that the irrelevance results outlined above can fail due
to a portfolio channel (see, e.g., Meltzer, 1999; McCallum, 2000; and Coenen and
Wieland, 2003). If the monetary base is expanded by purchasing assets other than
short-term governments bonds, the BoJ may be able to change the prices of those
assets. One example is purchases of long-term government bonds, a policy the BoJ
has in fact adopted. Eggertsson and Woodford (2003), however, cast doubt on the
effectiveness of such a portfolio channel, arguing that in a general equilibrium
model, purchases of long-term government bonds have no effect on long-term
yields if expectations about future interest rates remain constant.

The reason is that the long-term interest rate depends on expectations of future
short-term interest rates and a risk premium. Neither of these, however, depends on the quantity of long-term bonds in circulation or on the monetary base at zero interest rates. Open market operations involving purchases of long-term bonds, but which provide no credible indication about the duration of the quantitative easing policy, are thus unlikely to be effective.

Of course, all of this is highly obscure and technical. Fortunately the debate does have its lighter moments, as for example when Niall cites Krugman as the point of reference for the savings glut idea:

“Did I not grasp that the key to the crisis was “a vast excess of desired
savings over willing investment”? “We have a global savings glut,” explained Mr
Krugman, “which is why there is, in fact, no upward pressure on interest rates.”

In fact, as those of us who have been following the liquidity debate over the last years well know, the global savings glut thesis is famously an idea which was first initially advanced not by Krugman but by none other than Ben Bernanke, and even more to the point the whole issue goes back well before the onset of the present crisis. Or this point:

“It is hardly surprising, then, that the bond market is quailing. For only on Planet Econ-101 (the standard macroeconomics course drummed into every US undergraduate) could such a tidal wave of debt issuance exert “no upward pressure on interest rates”.”

Well I’m sorry Niall, but there is another place where a tidal wave of debt issuance has exerted “no upward pressure on interest rates”, and that place is planet Japan. And

Even A Stopped Clock Is Right Twice a Day

Which takes me over to the rather historical issue of stopped clocks, and what has now been happening to Japan over the last decade and a half. At times even Daily Telegraph economics correspondent Ambrose Evans Pritchard has something interesting to say, since, of course, even stopped clocks are not wrong all the time. The point he makes here is very, very relevant:

“It is striking how many of those most alert to the deflation danger are either veterans of Japan’s Lost Decade or close students of it: Albert Edwards at Société Générale, Russell Jones at RBC Capital, Nobel laureate Paul Krugman, the Fed’s Ben Bernanke, and Athanasios Orphanides, who helped draft the Fed’s study on the Japan trap. “People always thought Japan’s bond yields had to rise, but they kept falling and Japan is still not really out of deflation,” said Mr Edwards. Indeed, 20 years after the Nikkei peaked at over 39,000 it stands today at 9,280. Interest rates are 0.01pc. The yield on two-year state bonds is 0.34pc. Still there is not a whiff of inflation.”

And guess what, Japan gross debt to GDP is about to push its way skywards through the 200% mark in the next year or two, which makes this retort to the FT’s Martin Wolf (who had the temerity to question Niall’s arguments):

Mr Wolf blithely writes: “Historically well-run economies are certainly able to support higher levels of public debt very comfortably.”His favourite macroeconomics textbook may make this claim. But the annals of history provide very few cases of economies with public debts in excess of 100 per cent of gross domestic product that were either well-run or very comfortable.

look frankly quite ridiculous, since while it may well be the case that Japan is neither well run nor a comfortable place to be (no comment, I have no opinion), it is still the world’s second largest economy, so hardly an irrelevant comparison, and the Japanese government has been shoveling JGBs onto the market for years without the much predicted surge in interest rates.

So what exactly are we being offered here, an empirically testable prediction, or just another load of old waffle?

At the end of the day what I think is, if I were a historian and not an economist, then I might like to be just a bit more modest in what I had to say (and even more modest in how I said it), be a bit more prepared to listen, and if at the end of the day if I still found I wanted to differ from the experts I would at least try to understand what exactly it was they were trying to say first. Otherwise, I might find myself worrying that I was being more of a Xenophon than a Thucidydes, since while both were reputedly excellent generals, the latter stuck to what he was good at (writing history) while the former offered us a version of philosophy in his life of Socrates which frankly made the man look more of a port and stilton bufoon than anything else. And it would worry me to think that over two thousand years later people might still be remembering me more for what I was bad at than for anything else.

Appendix

Extract From - Monetary policy with a zero interest rate, Lars E O Svensson, speech at SNS, Stockholm, February 17, 2009

Why not just increase the money supply in order to create expectations of a higher future price level? As long as the interest rate is zero then households and firms, as we have already seen, are indifferent about the choice between money and securities such as Treasury bills or bonds. An increased supply of money will then have no effect other than households and firms holding more money and fewer bills and bonds. However, at some time in the future the economy will return to normal, the interest rate will be positive and households and firms will no longer be indifferent when choosing between money and these securities. Somewhat simplified, we can say that the money supply will once again become approximately proportional to the price level. A larger money supply in the future will lead, all else being equal, to a higher price level in the future. If the central bank could thus credibly commit to a permanent and lasting increase in the money supply, the expected future price level would rise. The problem here is, however, that there is no way for the central bank to make a credible commitment to a larger money supply in the future. There is nothing to prevent the central bank from reneging on such a commitment and reducing the money supply in the future in order to reduce future inflation and keep it in line with the inflation target.

Experience from Japan’s period of “quantitative easing” also shows that the extreme expansion of approximately 70 per cent of the monetary base between March 2001 and March 2006 did not noticeably affect expectations of inflation and the future price level.17 For example, the yen did not depreciate as it should otherwise have done. Firms and households clearly believed that the expansion of the monetary base was temporary and not permanent, which subsequently proved to be true. The monetary base fell back to normal levels when the interest rate was later raised to above zero.

Even if short-term interest rates are zero or close to zero, bond rates at longer maturities may still be positive. If the central bank therefore buys long-term bonds it may perhaps be able to squeeze down the long-term interest rates somewhat, which should stimulate the real economy. The central bank can also promise to keep the policy rate at zero for a prolonged period in
order to create expectations of lower future interest rates and a more expansionary monetary policy in the future.

Bibliography

Paul Krugman: It’s Baaack! Japan’s Slump And The Return Of The Liquidity Trap

Ben S. Bernanke and Vincent R. Reinhart, Director, Division of Monetary Affairs, Federal Reserve. Conducting Monetary Policy at Very Low Short-Term Interest Rates. Paper Presented in the form of a Lecture at the International Center for Monetary and Banking Studies , Geneva, Switzerland, 2002.

Ben S. Bernanke, Japanese Monetary Policy: A Case of Self-Induced Paralysis?, University of Princeton, Working Paper, 1999

Athanasios Orphanides, Board of Governors of the Federal Reserve System, Monetary Policy in Deflation: The Liquidity Trap in History and Practice, December 2003.

Kobayashi, Takeshi, Mark M. Spiegel, and Nobuyoshi Yamori. “Quantitative Easing and Japanese Bank Equity Values.”, Journal of the Japanese and International Economies, 2006

Oda, Nobuyuki, and Kazuo Ueda. 2005. “The Effects of the Bank of Japan’s Zero Interest Rate Commitment and Quantitative Monetary Easing on the Yield Curve: A Macro-Finance Approach.” Bank of Japan Working Paper Series, No. 05-E-6.

Baba, Naohiko, Motoharu Nakashima, Yosuke Shigemi, Kazuo Ueda, and Hiroshi Ugai. 2005. “Japan’s Deflation, Problems in the Financial System, and Monetary Policy.” Monetary and Economic Studies 23(1), pp. 47-111.

Gauti Eggertsson and Jonathan D. Ostry, Does Excess Liquidity Pose a Threat in Japan?, IMF Working Paper, April 2005.

Gauti B. Eggertsson, How to Fight Deflation in a Liquidity Trap: Committing to Being Irresponsible, IMF Working Paper, March 2003

Gauti B. Eggertsson, and Michael Woodford, 2003, “The Zero Bound on Short-Term Interest Rates and Optimal Monetary Policy,” Brookings Papers on Economic Activity, No. 1, pp. 139–
211.

Paul Krugman: It’s Baaack! Japan’s Slump And The Return Of The Liquidity Trap

Lars E.O. Svensson, “The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap,”, Monetary and Economic Studies 19(S-1), February 2001."

liquidity provision is very likely to exit the first world looking for yield, and where better to go than to those high yld emerging market economie

TO BE NOTED: From A Fistful Of Euros:

"Don’t Get Carried Away Now! by Edward Hugh

As Paul Krugman recently pointed out, one of the key points to be found in the latest IMF World Economic Outlook was that recessions caused by financial crises tend to get resolved on the back of export-lead booms, with countries normally emerging from the crisis with a trade balance of more than 3 percent of GDP. The reason for this is simple, since consumers are so laden-down with debt from the boom period, they are naturally more obsessed with saving than borrowing during the initial crisis aftermath. So much for the typical crisis then, and the typical exit. But musing on this point lead Krugamn to a rather the disturbing conclusion: given the truly global character of the present financial crisis, the habitual exit route to recovery will only work after we are able to identify another planet to send all those exports to (shades of Startreck IV). The joke may seem a rather exaggerated one, in poor taste even, but behind it there lies a little more than a grain of truth.

But not everywhere is gloom and doom at the moment, and on the other side of the world they woke up reeling from another kind of bounce last Monday morning, the one they experienced on learning that India’s outgoing government had been not only been re-elected, but had come back into power on a much more stable basis. And that was not the only pleasant surprise in store for those reading the morning newspapers in London, Madrid or New York, since India’s main stock index - the Sensex - shot up as much as 17% during early trading on receiving the news, while the rupee also surged sharply. So just one more time we find ourselves faced with the prospect of living in a rather divided world, where on one side we have growing and deepening pessimism, while on the other we see a burst of optimism, with someone, somewhere, getting a massive dose of that “let a thousand green shoots bloom” kinda feeling. Perhaps we should ask ourselves whether there is any connection?

Well, and to cut the long story short, yes there is, and the connection has a name, and it’s called sentiment. Indeed sentiment is precisely why the recent (and highly controversial) US bank stress tests were so important. Their real significance was not for any relevance they may have from a US banking point of view (which was, of course, highly contested), but for the reassurance they can give market participants that there will not be another financial explosion in the United States (as opposed to a protracted recession, and long slow recovery), or put another way, to show the days of “safe haven” investing are now over. Risk is about to make a comeback, and the only question is where?

Which brings us straight back to all that earlier talk of coupling, recoupling, decoupling, and uncoupling which we saw so much of a year or so ago. And to the world as we knew it before the the demise of Lehmann brothers, where commodity prices were booming like there was no tomorrow on the one hand, while credit- and housing-markets markets were steadily melting down in the developed economies on the other, where growth was being clocked up in many emerging economies at ever accelerating rates, while the only shoots we could see on the horizon in the US, Europe and Japan were those of burgeoining recessions.

The point to note here is not just that a significant group of investors and their fund managers were busily adapting their behaviour to changed conditions in the US and Europe, but rather that a very novel set of conditions began to emerge, as the credit crunch worked its way forward and property markets drifted off into stagnation in one OECD economy after another. Just as they were finally announcing closing time in the gardens of the West almost overnight it started “raining money” in one emerging economy after another - as foreign exchange came flooding in, and the really hard problem for governments and central banks to solve seemed to be not how to attract funding, but rather how to avoid receiving an excess of it. Thailand even attained a certain notoriety by imposing capital controls with the explicit objective of discouraging funds not from leaving but from entering the country.

Then suddenly things moved on, and day became night just as quickly as night had become day as one fund flow after another reversed course, and the money disappeared just as quickly as it had arrived. Behind this second crunch lay an ongoing wave of emerging-market central bank tightening (during which Banco Central do Brasil deservedly earned its spurs as the Bundesbank of Latin America) which lead one emerging economy after another to wilt under the twin strain of stringent monetary policy and sharply rising inflation. By November all those previous positive expectations were being sharply revised down, with the IMF making an initial cut in its global growth estimate for 2009 - to 2.2 percent from the 3.7 percent projected for 2008. The World Bank went even further, and by early December was projecting that world trade would fall in 2009 for the first time since 1982, with capital flows to developing countries being expected to plunge by around 50 percent. By March 2009 they were estimating that the volume of world trade, which had grown by 9.8 percent in 2006 and by 6.2 percent in 2007, was even likely to fall by 9 percent this year.

Having said this, and while fully recognising that the future is never an exact rerun of the past - and especially not the most recent past - given that emerging economies have been the key engines of global growth over the last five years, is there any really compelling reason for believing they won’t continue to be over the next five? Could we not draw the conclusion that what was “unsustainable” was not the solid trend growth which we were observing between 2002 and 2007, but rather the excess pressure and overheating to which the key EM economies were subjected after the summer of 2007? And if that is the case, might it not be that the “planet” we need to find to do all that much needed exporting isn’t so far away after all, but right here on this earth, and directly under our noses, in the shape of a growing band of successful emerging economies.

According to IMF data, the so called BRIC countries actually accounted for nearly half of global growth in 2008 - China alone accounted for a quarter, and Brazil, India and Russia were responsible for another quarter. All-in-all, the emerging and developing countries combined accounted for about two-thirds of global growth (as measured using PPP adjusted exchange rates) . Furthermore, and most significantly, the IMF notes that these economies “account for more than 90 per cent of the rise in consumption of oil products and metals and 80 per cent of the rise in consumption of grains since 2002”.

But behind the recent emerging market phenomenon what we have is not only a newly emerging growth rate differential, alongside this we have also seen large scale and ongoing currency re-alignment taking place, a realignment driven, as it happens, by those very same growth rate differentials. The consequential rapid and dramatic rise in dollar GDP values (produced by the combination of strong growth and a declining dollar) has meant that a convergence in global living standards - at least in the cases of those economies who have been experiencing the strongest acceleration - has been taking place much more rapidly than anyone could possibly have dreamed back in the 1990s, even if the long term importance of this is currently being masked by the recent collapse in commodity values and the downward slide in emerging currencies associated with this and the wekening in risk appetite.

Carry On Trading

But now we have a new factor entering the scene. The US Federal Reserve, along with many of the world’s key central banks, has so reduced interest rates that they are running only marginally above the zero percent “lower bound”, and the Fed is far more concerned with boosting money supply growth to fend of deflation than it is with restraining it to combat inflation. Not only that, Chairman Ben Bernanke looks set to commit the bank to maintain rates at the current level for a considerable period of time.

In this situation, and given the extremely limited rates of annual GDP growth we are likely to see in the US and other advanced economies in the coming years, such liquidity provision is very likely to exit the first world looking for yield, and where better to go than to those high yield emerging market economies.

The Federal Reserve could thus easily find itself in the rather unusual situation of underwriting the nascent recovery in emergent economies like India and Brazil , just as Japan did during the period of its experiment with quantitative easing between 2001 and 2006. And the mechanisms through which the money will arrive? Well, they are several, but perhaps the best known and easiest to understand of them is the so called carry trade, which basically works as follows.

Stimulus plans and near-zero interest rates in developed economies boost investor confidence in emerging markets and commodity-rich nations who have interest rates which are often in double figures. Using dollars, euros and yen these investors then buy instruments denominated in currencies from countries like Brazil, Hungary,Indonesia, South Africa, New Zealand and Australia - which collectively rose around 8% from March 20 to April 10, the biggest three-week gain for such trades since at least 1999 . A straightforward and simple carry-trade transaction would be to borrow U.S. dollars at the three-month London interbank offered rate of 1.13% and use the proceeds to buy Brazilian real and earn Brazil’s three-month deposit rate of 10.51%. That would net anannualized 9.38% - as long as both currencies remain stable, but the real, of course, is appreciating.

Other options are Turkey, where the key interest rate is currently 9.25 percent, Hungary (9.5 percent) and Russia’s (12 percent). The cost of borrowing in euros overnight between banks reached 0.56 percent last week from 3.05 percent six months ago as the European Central Bank cut interest rates while pledges of international aid reduced concern the global recession would worsen. The London interbank offered rate, or Libor, for overnight loans in dollars fell to 0.22 percent from 0.4 percent in November.

Indeed Deustche Bank last week specifically recommended buying Hungarian forint denominated assets, and according to the bank the Russian ruble, the Hungarian forint and the Turkish lira are among trades offering investors the best returns over the next two to three months. Deutsche Bank recommends investors sell the euro against the forint on bets the rate difference will help the Hungarian currency gain 10 percent to 260 per euro in two to three months from 286.55 today. Investors should also sell the dollar against the lira and buy the ruble against the dollar-euro basket, the bank said. And it isn’t only Deutsche Bank, at the start of April Goldman Sachs also recommended investors to use euros, dollars and yen to buy Mexican pesos, real, rupiah, rand and Russia rubles. And Barclays joined the pack this week saying Brazil’s real, South Africa’s rand and Turkey’s lira offer the “largest upside” as investors return to the carry trade. A global pickup in investor demand for higher-yielding assets and signs the worst of the global recession is over “bode very well for the comeback of the emerging-market carry trade,” according to analyst Anfrea Kiguel in a recent report from New York. In part as a result of the surge in carry activity the US dollar declined beyond $1.40 against the euro on Friday for the first time since January. Evidently the US may now be headed down a path which is already well-trodden by the Japanese yen.

India on The Up and Up.

But some of these trades are much riskier than others. Many of the countries in Eastern Europe who currently offer the highest yields are also subject to IMF bailout programmes, so they are with good reason called “risky assets”. But others look a lot safer. Take India for example. As Reserve Bank of Indian Governor Duvvuri Subbarao stressed only last week, India’s “modest” dependence on exports will certainly help the economy weather the current global recession and even stage a modest recovery later this year. Of course, “modest” is a relative term, since even during the depths of the crisis India managed to maintain a year on year growth rate of 5.3 percent (Q4 2008), and indeed as Duvvuri stresses, apart from the limited export dependence, India’s financial system had virtually no exposure to any kind of “toxic asset”.

As mentioned above, the rupee rose 4.9 percent this week to 47.125 per dollar in Mumbai, its biggest weekly advance since March 1996, while the Sensex index rallied 14 percent for its biggest weekly gain since 1992.

And, as if to add to the joy, even as Indian Prime Minister Manmohan Singh began his second term, and stock markets soared, analysts were busy rubbing their hands with enthusiasm at the prospect that the new government might set a record for selling off state assets, and thus begin to address what everyone is agreed is now India’s outsanding challenge, reducing the fiscal deficit.

Singh, it seems, may well sell-off anything up to $20 billion of state assets over the next five years as he tries to reduce the central govenment budget shortfall. At the present time India’s Congress party-led coalition faces a central government fiscal deficit which is running at more than double the government target - it reached 6 percent of gross domestic product in the year ended March 31, well beyond the 2.5 percent government target. The prospect of a wider budget gap prompted Standard & Poor’s to say in February that India’s spending plans were “not sustainable” and the nation’s credit rating may be cut again if finances worsen. But simply raising 100 billion rupees from share sales and initial public offerings in the financial year that began last April 1 would cut the fiscal deficit by an estimated quarter-point.

As a result of this perception that the new Indian government will seriously address the fiscal deficit situation, stocks rose sharply this week, with the benchmark index posting a 14 percent rise, its largest weekly gain in 17 years, on speculation the ruling party will accelerate economic reforms.

And it isn’t only India which is exciting investors. Brazil’s central bank President Henrique Meirelles went so far as to warn this week against an “excess of euphoria” in the currency market, implicitly suggesting the bank may engage in renewed dollar purchases to try to slow down the three-month rally in the real. The central bank began buying dollars on May 8, while Meirelles’s comments this week were seen as an additional measure to upgrade the level of verbal intervention. The real has now climbed 20.5 percent since March 2, the biggest advance among the six most-traded currencies in Latin America, as prices on the country’s commodity exports rebounded and investor demand for emerging-market assets has grown. The currency is up 14 percent this year, more than any other of the 16 major currencies except for South Africa’s rand, reversing the 33 percent drop in the last five months of 2008.

Conclusions

Despite a number of outsanding worries about the emerging economies in Eastern Europe, the general idea that countries like India, Brazil, Turkey, Chile, Peru are up towards the top of the list of economies where growth conditions are, relatively, the most favorable seems essentially sound. Additionally if this sort of argument has any validity at all, it is bound to have implications for one of the key problems which we will face in the context of the next global upturn: what to do with the financial architecture which we have inherited from the original Bretton Woods agreement (or Bretton Woods II as some like to call it).

The limitations of the current financial architecture have become only too apparent during the present recession, since with both the Eurozone and the US economies contracting at the same time, the currency see-saw between the dollar and the euro has failed to provide any adequate form of automatic stabiliser. And since Japan is in an even more parlous state, deep in recession, and desparate for exports, it is having to live with a yen-dollar parity which is at levels not seen since the mid 1990s. This has lead some analysts to start to talk of a new and enhanced role for China’s currency, the yuan, and obviously beyond the yuan we could also consider the real and the rupee, but I would like to suggest the problem we now face is a much broader one, and it concerns how to conduct monetary policy in an age of global capital flows.

The euro hit 1:40 to the USD yesterday (at a time when Europe’s economies are in deeper recession than the US one is), while Brazilian central bank President Henrique Meirelles felt the need to come out and warn against an “excess of euphoria” in the local currency market following an 18% rise in the real over 3 months. Turkey’s lira was also up and has now advanced 10 percent in the last three months, while South Africa’s rand is up 22 percent, making it the best performing emerging-market currency over the past three months.

All good “carry” punts these, since Turkey’s benchmark interest rate stands at 9.25 percent, compared with a range for overnight loans between banks of zero to 0.25 percent in the U.S. Brazil’s benchmark interest rate is 10.25 percent. Even the ruble is up sharply, as Russia’s economy struggles to handle growing default rates. The currency climbed to a four-month high against the dollar yesterday, making for its longest run of weekly gains in almost two years, hitting 31.0887 per dollar at one point, its strongest level since Jan. 12. The currency was up 3.2 percent on the week, thus closing its sixth weekly advance and extending its longest rally since September 2007. The ruble has in fact now climbed 16 percent since the end of January. Russia’s has cut base interest rates twice since April 24 in an attempt to revive the economy, but the refinancing rate is still 12 percent - well above rates in the EU, the U.S., Japan and even quite attractive in comparison with those on offer in other emerging markets. The basic point here is that carry trade players can leverage interest rate differentials and benefit from the changes in currency valuation that these very trades (along with those made by other participants) produce. So all of this is truly win-win for those who play the game, until, that is, it isn’t.

The issues presented by what is now happening are in many ways related to the one I started this article with: namely, who it is who will run the trade and current account deficits and do the necessary consuming which will make all those export lead recoveries possible. Evidently the main problem generated during the last business cycle was associated with the size of the imbalances it threw up. If I am right, we are just about to generate a further, and possibly even larger, set of such imbalances if we let the process rip in an uncordinated and unrestrained fashion. Floating Brazil and India is a very attractive and very desireable proposition. Consumers in those countries can take on more leveraging, and the countries can to some extent support external deficits as they develop. But they do not need distortions, and we do not need more Latvias, Estonias, Irelands or Spains. So policy decisions are now urgently needed to impose measures and structures which help avoid a repeat of the same in the near future."

a “silent tsunami” of bad debt still threatens to stall a recovery in the world’s largest energy-exporting economy

TO BE NOTED: From A Fistful Of Euros:

"The Russian Government Forecasts A Possible 8% GDP Contraction For 2009 by Edward Hugh

Of course, with all these large negative numbers doing the rounds at the moment, we are all in danger of going rapidly dizzy, but some pieces of data still have the power to shock, like this morning’s announcement from Russia’s Economy Minister Elvira Nabiullina that the economy may shrink as much as 8 percent this year.

“The specific contraction numbers could be 4 percent or 6 percent or 8 percent,” Nabiullina said in an interview with Bloomberg Television in Moscow today. “We’re doing various calculations, pessimistic and optimistic. We believe much depends on how efficient we are.”

So the Russian Government is still running through the scenarios, and the ministry now promises to submit new growth forecasts by the end of the month, but it is worth bearing in mind that, as recently as last January, the most probable estimate stood at minus 2.2 percent. And the Economy Ministry aren’t the only ones with the excel sheets and calculators out - Alfa Bank, Russia’s largest private bank, Goldman Sachs, Citigroup and the International Monetary Fund have all revised their 2009 growth forecasts down recently, with Alfa this week cutting its outlook to minus 5.7 percent from an earlier anticipated drop of 3 percent. Nabiullina’s deputy, Andrei Klepach, recently described the International Monetary Fund’s estimate for a 6 percent annual drop as “realistic.”

Sharp Fall In Q1 GDP

Russia’s Q1 gross domestic product slumped back by an incredible 23 percent from the last three months of 2008, according to the latest (non seasonally corrected) preliminary data from the Federal Statistics Service.

“The big dip in industrial production jumps in your face,” said Tatiana Orlova, a Moscow-based economist with ING Groep NV, who plans to lower her forecast for a 2.7 percent contraction this year. “The government should be worried. It’s very easy to come up with headlines announcing bailout measures, but the situation shows that you have to adjust them. It’s hard to do these thingsfast.”

Yet despite the very bad first quarter numbers, and the pessimism which currently emanates from the Economy Ministry, a number of recent data points have been rather better (in the sense of less bad) than those were were seeing in January and February.

Both the PMIs and the GDP indicator were registering improvement, although the March Index of key economic activities - at minus 12.4% - was not that far off the February low of minus 12.6%, while April’s fall in industrial output was the worst to date.

Russian retail sales also fell again in March - at an annual 4 percent rate - registering their biggest decrease since September 1999.

Services PMI Shows Contraction Weakening

Russia’s VTB Bank services industries PMI came in at 44.4 last month, compared with 43.9 in March, suggesting some slight improvement in condition from one month to the next.

“The sector’s performance is still under pressure from the deteriorating business conditions on the back of weakening demand,” Svetlana Aslanova, an analyst at VTB Capital, said in the report.

While the index declined for the seventh consecutive month, the rebound from December’s record drop of 36.4 continued, with the rate of decline in new orders easing for the third consecutive month after registering a record contraction in January.

And inflationary pressures are weakening, with prices charged by companies declining for the first time since VTB started compiling the survey as providers competed by offering lower tariffs and discounts, the bank. In addition input prices advanced at the slowest pace on record.

The Contraction Softens In April

VTB Bank manufacturing PMI continued to signal that the sector remained in a strong downturn in April, although, as elsewhere, the rate of decline slowed again (for the fourth straight month) hitting the almost respectable level of 43.4 (in comparison with what is being seen elsewhere). This was the highest level in six months, although (in terms of historical comparisons) the latest results provide further evidence that the sector is experiencing a longer and more pronounced contraction than that seen during the financial crisis of 1998. At that time the PMI spent seven successive months in negative territory. In comparison the current run already extends to nine months - and we are still far from the end of the process - and in addition the rate of contraction has been much more pronounced.

According to VTB the largest component of the headline PMI – new orders – showed a weaker rate of decline in April. The rate of contraction in new business has now moderated continuously since hitting a survey record in December. However, new export business declined at a faster rate in April compared to March, suggesting that while the Russian administration’s stimulus plan may be having some impact, the devaluation of the ruble is yet to make any real impact, possibly due to the hefty rate of continuing internal price inflation and also due to the sorry state of international trade.

Worthy of note is the fact that a number of survey respondents linked lower output levels to payment problems at clients as credit conditions remain challenging.

Average input costs continued to increase in April, although at a weaker rate than that seen in the previous two months. Energy prices and exchange rate fluctuations were reported by firms to have increased costs, but this was partly offset by pressure on suppliers to discount rates as underlying demand remained weak. VTB reported that competitive pressure in the manufacturing sector was evident in April as firms cut output prices for the fifth time in six months. Manufacturers also continued to cut back their workforces in April, and employment in the manufacturing sector has now fallen continuously since May 2008, and the rate of job shedding remained marked despite easing for the third month running.

And The GDP Indicator Reflects The PMIs

Thus it is hardly surprising to find that the VTB Capital GDP Indicator showed the Russian economy contracting for the fifth month in a row in April, although again at a weaker rate. The indicator showed the economy contacting 4.7 percent year-on-year in April, after shrinking by a record low of 5.4 percent in March.

“The April PMI surveys suggest that stocks of finished goods were back to their long-run trend, and according to the GDP Indicator the pace of economic contraction already slowed in April”, VTB Capital senior economist Aleksandra Yevtifyeva said in the report. “The most encouraging trend in the recent survey is the moderation in unemployment growth in the manufacturing and services sectors……..This might lead to some stabilisation in consumption which has shown an increasingly rapid decline in the past two months…………Costs are increasing at a lower rate, while prices charged are falling. The latter is particularly important for the services sector, which recorded a drop in prices for the first time in the past seven years”.

Inflation Falls Back

Russia’s inflation rate fell more than expected in April, dropping to 13.2 percent after rising in March to 14 percent, and consumer-price growth slowed to 0.7 percent in the month, the Federal Statistics Service said yesterday, compared with 1.3 percent in March. Food price growth slowed to 0.6 percent in the month from 1.7 percent in March, according to the statement. In the year the rate eased to 14.5 percent from 23 percent in April 2008.

Allowing The Central Bank To Cut Rates

Russia’s central bank cut its main interest rates for the second time in less than a month last week. The bank cut its rates for the first time since 2007 on April 24. Bank Rossii lowered its refinancing rate to 12 percent from 12.5 percent and adjusted the repurchase rate charged on central bank loans to 11 percent from 11.5 percent.

The reduction is only the second since it made two increases in the refinancing rate and four in the repo during last autumn’s financial crisis. Borrowing costs were increased to arrest a 30 percent drop in the currency since August, spurred by falling oil prices after investors pulled money out of ruble- denominated assets.

Bank Rossii has also said it plans to raise the mandatory reserve requirements for banks by a half-point every month between May 1 and Aug. 1. The requirement currently stands at 0.5 percent for reserves held in rubles and 0.5 percent for bank’s foreign currency reserves. The move seems to signal that the central bank is gradually phasing out the aggressive reserve requirement easing steps it implemented last October in order to relieve banks of ammunition to bet on the ruble’s devaluation. Along with the rate cuts, this suggests that the central bank is confident that inflation will slow.

“Probably for the first time in our new history, we’ll be better than our official target” of 13 percent inflation, First Deputy Chairman Alexei Ulyukayev said in an interview yesterday. As inflation slows, possibly to 11 percent, “we can talk about the continuation of cutting the policy rate.”

Ulyukayev also suggested it was “probable” the bank would cut the key rates by a total of 1.5 percentage points this year.

Industrial Output Slides At Record Annual Pace In April

Russian industrial production fell at a record pace in April. Output dropped an annual 16.9 percent, the sixth consecutive decline and the biggest since the Federal Statistics Service moved to a new methodology in 2003, compared with a 13.7 percent annual drop in March. Production fell 8.1 percent from March, when it was up by 11.1 percent on February.

“The situation in manufacturing didn’t improve at all,” said Vladimir Tikhomirov, the chief economist at Moscow’s UralSib Financial Corp., before the report. “Companies were still under a big strain to try to attract capital and were diverting a lot of their investment money to repaying current debt. Investment programs had to be postponed.”

Manufacturing output was down by an annual 25.1 percent in April, up from the 20.5 percent drop registered in March. Cement and brick output fell 34.7 percent and 39.9 percent respectively in April while production of trucks and vans fell 68.1 percent. Car production fell through the floor - dropping an annual 55.9 percent.

Mixed Signals All Round

Despite some positive indications in April (or should I say, some less negative ones) the April industrial output number is a shocker, and especially the strong fall from March (although this may well not be working day corrected, and remember there was Easter in the middle). This continuing decline in manufacturing is sure to hit employment, and Ford began talks this week with the union at its plant near St. Petersburg to cut the workweek to four days to avoid overproduction, citing an anticipated 47 percent 2009 slump in what is now Europe’s second-biggest car market.

In a further sign the contraction may have picked up speed again, Russian producer prices fell by an annual 4.1 percent in April after falling 2.8 percent in March, according to the Federal Statistics Service in Moscow said today, although prices actually rose 2.4 percent from March. This was the fifth consecutive month of year on year price reduction.

Obviously a lot now depends on the evolution in oil prices, and Urals crude, Russia’s principal oil export blend, shot up 6.2 percent in April to $49.61 a barrel. However many analysts are question just how sustainable this surge in prices will prove to be given the very large current global capacity overhang.

Th ruble jumped to its strongest level in four months against the dollar today (Tuesday) as oil rose above $60 a barrel in New York trading. Some analysts, however, pointed to the fact that banks were also buying local currency to repay state loans and make tax payments. Russian banks need to pay back about 181 billion rubles ($5.7 billion) in unsecured loans plus interest by tomorrow, and 408 billion rubles in taxes must be paid by the end of May, according to Evgeniy Nadorshin, senior economist at Moscow’s Trust Investment Bank in a research note. Banks gained access to unsecured loans from the central bank in November as the government sought to bolster liquidity in the financial sector. Lenders have till tomorrow till tomorrow to repay the loans plus yield issued in auctions on April 13, Feb. 16 and on Nov. 17, according to Nadorshin.

Another possible reason for the firming of the ruble was pointed to by Deutsche Bank analysts in a recent research note: the juicy picking to be had from carry - juicy as long as the ruble doesn’t change course - given the high yield differential offered by Bank Rossii rates:

Currency deals that profit from the difference in interest rates globally are returning to favor on speculation the worst of the credit crisis may be over, spurring investors to buy eastern European assets, Deutsche Bank AG said. The Russian ruble, Hungarian forint and Turkish lira offer investors the best returns in the next two to three months thanks to the highest rates in the region, said Angus Halkett, a strategist at Deutsche Bank in London.

What this points to is the danger of “lock-in” here. The risk that the Russian central bank may not be able to reduce rates even as the economy contracts and inflation falls, since lowering beyond a certain threshold will almost certainly produce another bout of devaluation, and with it the danger of more conversion of rubles into dollars and general capital flight. This could be called “being stuck up a gum tree”.

Whatever the reasons - and high central bank interest rates will be one of them - the ruble has now clawed back some 13 percent of its 35 percent devaluation against the dollar in the six months preceding the end of January.

The Putin rescue programme does not seem to have worked as envisaged , and according to President Dmitry Medvedev (who may well have his own axes to grind) $9 billion slate of state guarantees “failed” to kick-start lending to strategic companies. The World Bank warned in their March report that a “silent tsunami” of bad debt still threatens to stall a recovery in the world’s largest energy-exporting economy, and as a growing number of companies default on loans, the government may need to provide as much as $50 billion for bank bailouts, more than twice the amount pledged to banks in this year’s budget, according to estimates by analysts from UniCredit’s Russian unit.

Finally, one of the reasons for the disparity between the more positive movement in the GDP indicator and the deterioration in general operating conditions may well be that the former does not include the key construction industry. Billionaire Mikhail Prokhorov, Russia’s richest man, said Russian property developers may suffer more as the country slides into the worst economic slowdown in a decade. “The crisis hasn’t hit developers in full yet,” Prokhorov told reporters in Yelets, Russia, on May 15. “The worst is yet to come.”

the continued increase in unemployment may well weaken consumer spending and help prolong the recession

TO BE NOTED: From Euro Watch:

"German GDP Falls At An Incredible 15.2% Annualised Rate

Official figures from the Federal Statistics Office this morning show that Germany's recession worsened considerably in the first quarter, with the economy shraning by 3.8 percent compared with the previous three-month period - that is equivalent to a 15.2% contraction as an annualised rate. This is the fourth consecutive quarter of contraction, and is the worst performance by the German economy since at least 1970 - when the German statistics office started the present time series. It is also the first time since reunification in 1990 that the German economy has experienced so many quarters of negative growth. GDP has was dragged down by the drop in export and and the consequent weakness in investment.

Year on year GDP fell by 6.7%, following a 1.7% reading in the fourth quarter of last year. Corrected for working days, GDP fell by 6.9% year on year. Last month the government revised its forecasts and is now expecting an annual contraction of 6%.



The 16-nation euro zone also slumped by a record of 2.5 percent quarter on quarter in the first there months. This is worse most analysts had been predicting as recently as a few days ago, when forecasts were pointing to a decline of around 2 percent. While Germany, Europe's largest economy saw the deepest slump, Austria was not far behind with a drop of 2.8 percent and Italy with its 2.4 percent contraction in the first quarter. Meanwhile, Europe's second largest economy, France, also saw negative growth, sliding by 1.2 percent. The 27 member European Union shrank by a quarterly 2.5 percent.

The sharpness of the German GDP contraction in the first quarter of this year is unlikely to be repeated during the rest of 2009, according to German government spokesman Thomas Steg, and given the ferocity of the downturn he is surely likely to be right. But not shrinking so fast is not the same as growing, and there is evidently a lot more pain in the works yet.

There are a number of signs of just this slowing down in the contraction already emerging. Retailer slaes in Germany fell at the slowest pace in the current 11-month sequence of decline in April, according to the Bloomberg retail PMI. Sales were down only modestly in marked contrast to the steep declines recorded at the start of the year. Month-on-month the index for Germany picked up from 44.4 in March to 48.9.




Manufacturing Contraction Eases

German manufacturing contracted for the ninth month running in April, though the pace of the downturn eased to its slowest since last November. The headline manufacturing PMI in Europe's largest economy registered 35.4, still a very low level, but nonetheless up significantly from March's reading of 32.4.

"April's survey provides hope that the German manufacturing downturn has passed its nadir, as the PMI moved further above January's record low," according to Tim Moore, economist at Markit Economics. "However, output still fell at a rate unprecedented prior to the fourth quarter of 2008, prompting firms to trim employment and inventories to the greatest extent in the survey history," he added.

New orders declined for the tenth successive month but at a much slower pace than in March, with the sub-index rising to 37.0 from 28.9 - a series record month-on-month rise. The improvement in the PMI results fits in with other recent sentiment indicator readings in German, with the Ifo institute's business climate index improving in April to its best level in five months, while the ZEW investor sentiment gauge rose to its highest level in almost two years. However, we are still a far cry from a return to output growth in Germany, with most observers anticipating a GDP contraction of between 5% and 7% for 2009, and given the export dependence we should be looking for an increase in imports in main customer economies before we start thinking about any expansion in German manufacturing output.

Industrial Output

German industrial production held more or less steady in March, for the first time in six months. Output was unchanged from February, when it dropped 3.4 percent, according to the latest data from the Economy Ministry in Berlin. Manufacturing industry continued to contract however, and was down 0.4% on the month, and by 22.8% year on year.



That being said, German industrial output levels are now very low (see chart below), and are roughly comparable with those registered in 1999/2000.




Exports Recover Slightly In March


German exports were up for the first time in six months in March, adding to signs that the pace of the economic contraction slowed slighly as we entered the spring. Exports, adjusted for working days and seasonal changes, were 0.7 percent from February, when they fell 1.3 percent, according to the latest data from the Federal Statistics Office. Year on year exports were down 15.8% following a 23.5% drop in February and a 23.2% drop in January.




German imports increased 0.8 percent in March from the previous month, when they dropped 4.8 percent. The trade surplus widened to 11.3 billion euros from 8.6 billion euros in February. The surplus in the current account, the measure of all trade including services, was 10.2 billion euros, up from 6.8 billion euros. On a seasonally adjusted basis exports were up by 0.4 billion euros from February, which means you can just barely notice the change on the chart below: ie there is still a very long way to go here.


Services Contraction Also Slows


Activity in Germany's private sector shrank for the eighth month running in April, though as elsewhere the pace of the contraction eased, in the German case to the slowest rate since last October. The services sector PMI edged up to 43.8 from 42.3 in March, while the business expectations sub index jumped to 44.4 from 39.0, and the headline composite PMI reading rose to 40.1 from 38.3 in March.

Markit reported that "Pessimism about the year ahead outlook for activity was the least marked since June 2008. This partly reflected the support given to business sentiment from the government's economic stimulus plans, as well as hopes that overall market conditions will begin to stabilise". These firmer expectations are consistent with the rise in the April Ifo reading for German corporate sentiment, which hit its strongest level in five months.

However, despite the more positive business expectations, the German government has slashed its forecast for the economy, projecting a record 6-percent contraction this year. Previously it had not shrunk by more than 1 percent in any year since the second world war.

In harmony with this more sober assessment, the sub-index on employment fell to 40.6 from 42.3 in March. "We are now seeing the labour market feel the full force of the economic downturn, with the latest wave of private sector job losses the steepest for at least 11 years," according to Tim Moore, economist at Markit Economics. "This provides advance warning that April's spike in official unemployment numbers will be repeated during the months ahead ... firms are likely to make further substantial job cuts even after the worst of the recession has passed," he added. German unemployment rose for the sixth month running in April to hit its highest level since late 2007 despite government subsidies designed to prevent mass layoffs.

Consumer Confidence Holds Steady

German consumer confidence remained steady for a third consecutive month in April as slower inflation boosted household purchasing power and the pace of the economic contraction slowed slightly. GfK AG’s forward looking confidence index for May, based on a survey of about 2,000 people, remained unchanged from April's revised 2.5 percent reading.

Investor Sentiment Continues To Rise

The ZEW Indicator of Investor Sentiment continued to improve in April, and rose by 16.5 points to stands at 13.0 following a reading of minus 3.5 in March. For the first time since July 2007, The indicator was positive for the first time since July 2007, although it is still well below its long term historical average of 26.1.

According to ZEW the indicator has been positively affected by the German government stimulus packages. Furthermore, investors seem to be taking the view that low inflation rates may give some support private consumption. They also felt that the economic outlook for the United States has improved, and responded to some vaguely positive signals emanating from China.

“Along with other indicators, the ZEW sentiment indicator reveals that there are well-founded expectations that the downward dynamics of the business cycle are bottoming out. It is even becoming more likely that the economy will slowly recover in the second half of this year.”, says ZEW President Prof. Wolfgang Franz.

Whether Franz is right in this very upbeat assessment really does remain to be seen, since I personally am far convinced that we have the bottom of this anywhere in sight yet, especially given German export dependence and the fact that year on year contractions in imports are still very strong in nearly all the major customers.

But Unemployment Is Headed Steadily Upwards

German unemployment rose for the sixth straight month in April. The number of people out of work increased a seasonally adjusted 58,000 to 3.46 million, according to the Federal Labor Agency. The seasonally adjusted unemployment rate rose to 8.3 percent from 8.1 percent in March.

So while an increasing volume of data suggest confidence across Europe is stabilizing and the recession slowing, the continued increase in unemployment may well weaken consumer spending and help prolong the recession. And with PMI surveys showing the employment output as bleak both in the service and manufacturing industries further increases in unemployment now seem inevitable.

Job Creation Turns Negative In March


The number of those employed in Germany was down year on year in March for the first time in several years. According to provisional results from the Federal Statistical Office total March employment in Germany was 39.89 million - a decrease of 46,000 (–0.1%) on a year earlier. The last time the number of persons in employment decreased from the same month a year earlier was in February 2006.



Generally employment increases in March due to the usual spring rebound in economic activity. Over the last three years employment was up by an average 138,000 persons from February. This March, however, the increase was only 53,000 (+0.1%). The Federal Statistics Office noted that the significant extension of the short-time work probably rescued the numbers from being even worse.



Seasonally adjusted the total number of employed was 40.18 million in March, a seasonally adjusted decrease by 27,000 persons (–0.1%) on February.

While Deflation Dangers Remain

German producer prices fell for the first time in five years in March, suggesting that the deflation risks are increasing in Europe’s largest economy. Prices were down 0.5 percent from a year earlier following an annual 0.9 percent gain in February, according to data from the Federal Statistics Office. That’s the first annual decline since February 2004 and the biggest drop since September 2002.





Plenty More Downside To Come


Perhaps the worst casualty of all this will be German public finances. German tax revenue for 2009 is now projected to decline by more than an additional 300 billion euros as compared with previous estimates. Germany’s finance minster Peer Steinbruck is reportedly pretty depressed by the estimate, since it makes him the finance minister who presided over the highest borrowing requirement in history (as opposed to the finance minister who balanced the budget, which is what he set out to do). The economics minister, meanwhile, said that the loss in tax revenues was no reason not to cut taxes. The EU Commission now forecast Germany will have a deficit of 3.9% of GDP this year and 5.9% in 2010. As a result gross government debt is projected to climb from 65.9% of GDP in 2008 to 73.4% in 2009 and 78.7% in 2010.

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German GDP Falls At An Incredible 15.2% Annualised Rate

Official figures from the Federal Statistics Office this morning show that Germany's recession worsened considerably in the first quarter, with the economy shraning by 3.8 percent compared with the previous three-month period - that is equivalent to a 15.2% contraction as an annualised rate. This is the fourth consecutive quarter of contraction, and is the worst performance by the German economy since at least 1970 - when the German statistics office started the present time series. It is also the first time since reunification in 1990 that the German economy has experienced so many quarters of negative growth. GDP has was dragged down by the drop in export and and the consequent weakness in investment.

Year on year GDP fell by 6.7%, following a 1.7% reading in the fourth quarter of last year. Corrected for working days, GDP fell by 6.9% year on year. Last month the government revised its forecasts and is now expecting an annual contraction of 6%.



The 16-nation euro zone also slumped by a record of 2.5 percent quarter on quarter in the first there months. This is worse most analysts had been predicting as recently as a few days ago, when forecasts were pointing to a decline of around 2 percent. While Germany, Europe's largest economy saw the deepest slump, Austria was not far behind with a drop of 2.8 percent and Italy with its 2.4 percent contraction in the first quarter. Meanwhile, Europe's second largest economy, France, also saw negative growth, sliding by 1.2 percent. The 27 member European Union shrank by a quarterly 2.5 percent.

The sharpness of the German GDP contraction in the first quarter of this year is unlikely to be repeated during the rest of 2009, according to German government spokesman Thomas Steg, and given the ferocity of the downturn he is surely likely to be right. But not shrinking so fast is not the same as growing, and there is evidently a lot more pain in the works yet.

There are a number of signs of just this slowing down in the contraction already emerging. Retailer slaes in Germany fell at the slowest pace in the current 11-month sequence of decline in April, according to the Bloomberg retail PMI. Sales were down only modestly in marked contrast to the steep declines recorded at the start of the year. Month-on-month the index for Germany picked up from 44.4 in March to 48.9.




Manufacturing Contraction Eases

German manufacturing contracted for the ninth month running in April, though the pace of the downturn eased to its slowest since last November. The headline manufacturing PMI in Europe's largest economy registered 35.4, still a very low level, but nonetheless up significantly from March's reading of 32.4.

"April's survey provides hope that the German manufacturing downturn has passed its nadir, as the PMI moved further above January's record low," according to Tim Moore, economist at Markit Economics. "However, output still fell at a rate unprecedented prior to the fourth quarter of 2008, prompting firms to trim employment and inventories to the greatest extent in the survey history," he added.

New orders declined for the tenth successive month but at a much slower pace than in March, with the sub-index rising to 37.0 from 28.9 - a series record month-on-month rise. The improvement in the PMI results fits in with other recent sentiment indicator readings in German, with the Ifo institute's business climate index improving in April to its best level in five months, while the ZEW investor sentiment gauge rose to its highest level in almost two years. However, we are still a far cry from a return to output growth in Germany, with most observers anticipating a GDP contraction of between 5% and 7% for 2009, and given the export dependence we should be looking for an increase in imports in main customer economies before we start thinking about any expansion in German manufacturing output.

Industrial Output

German industrial production held more or less steady in March, for the first time in six months. Output was unchanged from February, when it dropped 3.4 percent, according to the latest data from the Economy Ministry in Berlin. Manufacturing industry continued to contract however, and was down 0.4% on the month, and by 22.8% year on year.



That being said, German industrial output levels are now very low (see chart below), and are roughly comparable with those registered in 1999/2000.




Exports Recover Slightly In March


German exports were up for the first time in six months in March, adding to signs that the pace of the economic contraction slowed slighly as we entered the spring. Exports, adjusted for working days and seasonal changes, were 0.7 percent from February, when they fell 1.3 percent, according to the latest data from the Federal Statistics Office. Year on year exports were down 15.8% following a 23.5% drop in February and a 23.2% drop in January.




German imports increased 0.8 percent in March from the previous month, when they dropped 4.8 percent. The trade surplus widened to 11.3 billion euros from 8.6 billion euros in February. The surplus in the current account, the measure of all trade including services, was 10.2 billion euros, up from 6.8 billion euros. On a seasonally adjusted basis exports were up by 0.4 billion euros from February, which means you can just barely notice the change on the chart below: ie there is still a very long way to go here.


Services Contraction Also Slows


Activity in Germany's private sector shrank for the eighth month running in April, though as elsewhere the pace of the contraction eased, in the German case to the slowest rate since last October. The services sector PMI edged up to 43.8 from 42.3 in March, while the business expectations sub index jumped to 44.4 from 39.0, and the headline composite PMI reading rose to 40.1 from 38.3 in March.

Markit reported that "Pessimism about the year ahead outlook for activity was the least marked since June 2008. This partly reflected the support given to business sentiment from the government's economic stimulus plans, as well as hopes that overall market conditions will begin to stabilise". These firmer expectations are consistent with the rise in the April Ifo reading for German corporate sentiment, which hit its strongest level in five months.

However, despite the more positive business expectations, the German government has slashed its forecast for the economy, projecting a record 6-percent contraction this year. Previously it had not shrunk by more than 1 percent in any year since the second world war.

In harmony with this more sober assessment, the sub-index on employment fell to 40.6 from 42.3 in March. "We are now seeing the labour market feel the full force of the economic downturn, with the latest wave of private sector job losses the steepest for at least 11 years," according to Tim Moore, economist at Markit Economics. "This provides advance warning that April's spike in official unemployment numbers will be repeated during the months ahead ... firms are likely to make further substantial job cuts even after the worst of the recession has passed," he added. German unemployment rose for the sixth month running in April to hit its highest level since late 2007 despite government subsidies designed to prevent mass layoffs.

Consumer Confidence Holds Steady

German consumer confidence remained steady for a third consecutive month in April as slower inflation boosted household purchasing power and the pace of the economic contraction slowed slightly. GfK AG’s forward looking confidence index for May, based on a survey of about 2,000 people, remained unchanged from April's revised 2.5 percent reading.

Investor Sentiment Continues To Rise

The ZEW Indicator of Investor Sentiment continued to improve in April, and rose by 16.5 points to stands at 13.0 following a reading of minus 3.5 in March. For the first time since July 2007, The indicator was positive for the first time since July 2007, although it is still well below its long term historical average of 26.1.

According to ZEW the indicator has been positively affected by the German government stimulus packages. Furthermore, investors seem to be taking the view that low inflation rates may give some support private consumption. They also felt that the economic outlook for the United States has improved, and responded to some vaguely positive signals emanating from China.

“Along with other indicators, the ZEW sentiment indicator reveals that there are well-founded expectations that the downward dynamics of the business cycle are bottoming out. It is even becoming more likely that the economy will slowly recover in the second half of this year.”, says ZEW President Prof. Wolfgang Franz.

Whether Franz is right in this very upbeat assessment really does remain to be seen, since I personally am far convinced that we have the bottom of this anywhere in sight yet, especially given German export dependence and the fact that year on year contractions in imports are still very strong in nearly all the major customers.

But Unemployment Is Headed Steadily Upwards

German unemployment rose for the sixth straight month in April. The number of people out of work increased a seasonally adjusted 58,000 to 3.46 million, according to the Federal Labor Agency. The seasonally adjusted unemployment rate rose to 8.3 percent from 8.1 percent in March.

So while an increasing volume of data suggest confidence across Europe is stabilizing and the recession slowing, the continued increase in unemployment may well weaken consumer spending and help prolong the recession. And with PMI surveys showing the employment output as bleak both in the service and manufacturing industries further increases in unemployment now seem inevitable.

Job Creation Turns Negative In March


The number of those employed in Germany was down year on year in March for the first time in several years. According to provisional results from the Federal Statistical Office total March employment in Germany was 39.89 million - a decrease of 46,000 (–0.1%) on a year earlier. The last time the number of persons in employment decreased from the same month a year earlier was in February 2006.



Generally employment increases in March due to the usual spring rebound in economic activity. Over the last three years employment was up by an average 138,000 persons from February. This March, however, the increase was only 53,000 (+0.1%). The Federal Statistics Office noted that the significant extension of the short-time work probably rescued the numbers from being even worse.



Seasonally adjusted the total number of employed was 40.18 million in March, a seasonally adjusted decrease by 27,000 persons (–0.1%) on February.

While Deflation Dangers Remain

German producer prices fell for the first time in five years in March, suggesting that the deflation risks are increasing in Europe’s largest economy. Prices were down 0.5 percent from a year earlier following an annual 0.9 percent gain in February, according to data from the Federal Statistics Office. That’s the first annual decline since February 2004 and the biggest drop since September 2002.





Plenty More Downside To Come


Perhaps the worst casualty of all this will be German public finances. German tax revenue for 2009 is now projected to decline by more than an additional 300 billion euros as compared with previous estimates. Germany’s finance minster Peer Steinbruck is reportedly pretty depressed by the estimate, since it makes him the finance minister who presided over the highest borrowing requirement in history (as opposed to the finance minister who balanced the budget, which is what he set out to do). The economics minister, meanwhile, said that the loss in tax revenues was no reason not to cut taxes. The EU Commission now forecast Germany will have a deficit of 3.9% of GDP this year and 5.9% in 2010. As a result gross government debt is projected to climb from 65.9% of GDP in 2008 to 73.4% in 2009 and 78.7% in 2010.

Posted by Edward Hugh "