In the long run the Euro will survive, in the short term it remains on life support

The trouble with the Euro Zone is that the plan is a long term restructuring program with very few measures to help ease the pain in the short term. But as we all know, “We’re all dead in the long run.”

In the long run, the EZ will be much better structured as every time the crisis crescendos to the brink, the German’s agree to edge closer towards what needs to be done. The SPD, Germany’s main opposition, are more pro euro than Merkel and have a good chance of winning next year’s election. There’s a by-election in May in Germany’s biggest state and this could help push Merkel towards a more pro Euro stance if her coalition partners do badly and the SPD do well.

The decision to save the Euro has been delayed for the last couple of years because it is so unpalatable to the Germans. They do not want to be on the line for the rest of Europe’s mistakes and, therefore, Eurobonds and a central eurozone finance ministry have been dismissed. But when push comes to shove and the ground beneath the euro looks ominously unstable, the euro powers have converged towards a closer Euro, not a more disintegrated one. This will be the path that follows. Europe’s leaders have a high pain threshold and will not be forced into doing things they don’t want to do unless a gun is pointed at their heads. The euro crisis gun is reloading and eventually greater integration will follow.

I’m worried that too much austerity is driving the eurozone into a negative growth spiral and this is the biggest danger. If you have no growth, you can’t reduce your debt. Low interest rates are not sufficiently offsetting the fiscal tightening. But there are signs of hope. Ireland is doing a great job and is still growing. Spain’s exports are doing well and its competitiveness and productivity is very good compared with Germany. One of the reasons for such high unemployment is because its productivity is so good. But Spain’s problem is the housing market and how the rising number of dodgy loans has weakened the banking sector. France is a mess, resolute in the belief that it is different to all other countries and that its big, statist economy can continue to perform without undergoing reform.

Much is being done to deliver growth in future years in countries such as Spain, Italy, Portugal  and even Greece, with labour market reforms while restructuring the big, overweight state-owned enterprises which have acted as a brake on the economy for years in Portugal, are an important part of the plan. But these reforms take time to take effect and there is very little being done to ease the pain as wages are squeezed to make these countries more competitive i.e. the internal devaluation.

In five years time I’m convinced these countries will be growing much more strongly but the question is will the Euro still be there. I think yes because it is too important and significant for German and French politicians to give up on. The peripheral countries want to stay part of the Euro still despite the tough measures being handed out because they realise that outside the euro, things would be much tougher. The Greeks have almost no exposure to the markets now and although another bailout is most likely, it’s not anything for the market to panic about. The Portuguese will need another bailout of about EUR30billion probably agreed sometime in the next 6 months. Portugal is due to return to the bond market in September 2013, at this point it’s unlikely this will happen because market rates will still be too high. But that’s only EUR8 billion so not much in the big picture, easily covered by the EC.

The core problems of the Euro are still there, i.e. no central ministry of finance but programs such as the European Stability Mechanism are bringing this closer. The IMF are telling Germany that eurobonds are needed. Will they listen? Unlikely but step by step we will get there.

It’s not a great time to be holding this Euro survival view at the moment with Spanish and Italian bonds selling off recently but these yields won’t go above 7%. The ECB made sure of that before Christmas and if nothing was done to support them at these levels then they would be wasting all the previous good work.

As I said in my earlier post ECB’s Rate Cut And Liquidity Analgesic, the LTROs acted like analgesics,  taking the pain out of the crisis, easing the widening interbank rates allowing banks to finance themselves at more normal levels. They entered in carry trades on higher yielding Italian and Spanish bonds but unlike QE where new cash keeps coming month after month, the market was hit by a wall of money and the momentum has been lost, not helped by the German’s inability to agree to a bigger, more suitable firewall. A lot of what goes in the market is about maintaining the momentum but momentum has run out and has begun to go the other way until the policymakers again decide to take control of the situation and push momentum in the right direction.



Posted in Austerity, ECB, Euro Zone, France, Germany, Greece, Ireland, Italy, Portugal, Spain | Tagged , , , , , | Leave a comment

The UK’s Top Export Markets

The UK’s top export markets are dominated by both US and European countries as would be expected. The US is the UK’s biggest export market in terms of individual countries so any improvement in the US economy should be beneficial to the UK economy.

Figure 1: UK’s Top 25 export markets. Source: ONS.

Together, the Euro-Zone countries in the list above account for 44.2% of UK exports. Although China is the biggest export market outside of the US and Euro Zone, it still only accounts for 2.9% of UK exports.

With the Euro-Zone economy slowing, any gains from the US are likely to be more than offset by Euro-Zone weakness but even US growth isn’t forecast to be stellar in the coming years, as Figure 2 shows.

Figure 2: IMF Forecasts for UK’s biggest export markets. Source: IMF.

So with the IMF downgrading growth forecasts in all of the UK’s major export markets, where is demand going to come from?

Austerity domestically and in 44% of the UK’s export markets provides a bleak outlook but as is becoming common these days, hopeful eyes are looking East to take up some of the slack.

Posted in Asia, Austerity, China, Euro Zone, France, Germany, Holland, Ireland, Italy, Spain, UK, US | Tagged , , , | Leave a comment

The Trials and Tribulations of the UK Economy

No real surpises accompany the latest UK GDP figures. The UK economy is in bad shape, shrinking by 0.2% in the last quarter of 2011, but with the government intent on its austerity path and the UK’s biggest trading partner, the Euro Zone, seemingly determined to prolong its debt crisis, what more could we hope for?

One of the most worrying aspects of the data is that real GDP has still not recovered to the 2007 high, see Figure 1. Instead of showing signs of climbing towards and beyond the previous peak, the economy has turned lower again.

Figure 1: UK real GDP and GDP growth since 1998. Source: ONS.

The Bank of England has done what it can to provide stimulus through monetary measures, with ultra low short-term interest rates and large swathes of government bond purchases pushing long-term rates lower too but the transmission to the wider economy beyond the banking system is still not evident.

However, one advantage of this is that new issuance has been at historically low coupons ensuring that ongoing government financing costs will be relatively low so when the UK economy does strengthen, a lower proportion of income will be spent on financing the debt and more can be spent on paying off the debt as well as investing in the economy.

Loose monetary policy has also weakened sterling but this has failed to boost manufacturing, leading instead to a fall of 0.9% in Q4 despite reports of some exporters enjoying greater sales to Asia.

Figure 2: UK manufacturing has struggled to grow for years. Source: ONS, BOE.

Although UK manufacturing was boosted initially after the financial crisis, the weaker pound has failed to boost the sector by as much as hoped. Even in the pre-crisis years, manufacturing growth oscillated above and below zero while the latest figures show manufacturing growth for the whole of 2011 to be back at zero again.

Figure 3: The changing contributions of manufacturing and services to GDP (% of GDP) since 1997 in the UK. Source: Eurostat.

Figure 3 clearly shows how the UK economy has changed since 1997. In Germany by comparison, the manufacturing industry has remained roughly the same size relative to GDP.

The government talks of rebalancing the economy but given the decline over the years, a reversal of this trend will be much more of a long-term initiative than anything that can be achieved in the next year or so.

Figure 4 breaks the service sector into three segments and shows the growth of these segments since 1997.

Figure 4: Contributors to UK service growth since 1998. Source: ONS.

Figure 5 (a)

Figure 5 (b)

Figures 5 (a) and (b): The change in UK GDP contributions since 1997. Source: Eurostat.

The short term depends on household budgets. Higher inflation, unemployment and stalling wage growth have squeezed household budgets leaving less disposable income and this is hitting GDP growth.

The UK has had an external trade deficit for many years and it  is now much harder for exports to take up the slack of weak  domestic demand especially when the UK’s major trading partner is also tightening purse strings.

Figure 6: Expenditure side UK GDP contributions. Source: Eurostat

Figure 6 shows the contributions of the expenditure side GDP components as a percentage of total GDP. The purple sector is above 100% for most of the period back to 1997 indicating the negative external trade balance of the UK i.e. exports of goods and service is less than imports.

During the recession in the early 1990s, the weakness of sterling in the aftermath of the ERM exit helped to boost the UK economy but with the slump in global demand, currency weakness is not providing the catalyst this time around.

With inflation expected to fall this year, consumer woes should marginally ease but for a more serious attempt to boost growth the Chancellor must “bend” his austerity pledge and fiscally stimulate the economy.

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UK Olympics: Not All Tourists Are The Same…

Ah, the big question, will the Olympics boost the UK economy in 2012? Well, possibly but I’m not optimistic.

London is already the most visited city in the world, the Olympics may just substitute sport-mad tourists for regular sightseeing tourists who have decided to avoid the sky high hotel prices in favour of another year.

It reminds me of a little trip I once made to Chamonix in the French Alps where my mountain guide explained to me that although more people visited the resort in July and August, the bars and restaurants were busiest in the winter skiing months.

The summer months generally consisted of sporty tourists who spent less time filling up on “refreshments” and more time in the mountains for days on end while the apres-ski in winter attracted a different type of athlete!

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Inflation: Dr. Jekyll and Mr. Hyde

It has been said over the past few years, that the presence of elevated inflation in the economy can help to reduce the debt burden. One way to do this is monetising debt by using the Bank of England printing presses to boost demand.

However, although monetary easing is at full tilt, demand in the UK economy remains weak while CPI and RPI over the last year have averaged 4.5% and 5.2%, respectively.

Figure 1 shows that elevated inflation does often go hand-in-hand with strong GDP, falling unemployment and a reduction of debt-to-GDP but sharp spikes in inflation can also have a detrimental effect.

Figure 1: Charting UK debt-to-GDP, the budget deficit, RPI, GDP growth and the unemployment rate. Source: OECD.

The key is to differentiate between “good” and “bad” inflation where good inflation represents an increase in consumer demand while bad inflation represents an increase in international commodity prices and/or VAT. Good inflation is easier for the central bank to control since it can influence domestic demand through monetary policy while bad inflation is usually due to global macro events and international markets.

The oil spikes of the 1970s can clearly be seen to have had a detrimental effect on GDP, debt-to-GDP, the budget deficit and unemployment, a clear example of bad inflation. But between 1982 and 1990, RPI averaged 5.6% while real GDP growth averaged 3.5%. Furthermore, debt-to-GDP fell from 50.8% to 32.3% and unemployment fell from a peak of 11.9% to 7.2%. Interestingly, debt-to-GDP fell during this period despite the budget remaining in deficit for all of this period except for one year, 1989.

By fast forwarding to the last two years, it can be seen that the inflation rise coincides with rising debt-to-GDP, slowing GDP growth and rising unemployment. Higher inflation in the last two years can be put down to effects that squeeze consumer spending such as higher commodity prices, higher import costs due to weaker sterling and the VAT rise.

In the UK, household consumption expenditure makes up a significantly larger proportion of GDP than in Germany, as can be seen in Figure 2.

Figure 2: Household consumption expenditure is a significantly higher component of UK GDP than in Germany. Source: Eurostat.

Furthermore, the strength of household consumption expenditure has overshadowed the growth of industrial production since before 1999 whereas in Germany the behaviour of these two variables is reversed, as can be seen in Figure 3.

Figure 3: A comparison between quarterly household consumption expenditure growth, industrial production growth, GDP growth, unemployment and effective exchange rates. Source: Eurostat.

The important point to make here is that consumer expenditure has failed to recover to pre-financial crisis levels in the last two years and this not only coincides with weaker GDP growth but also higher unemployment and higher inflation. Furthermore, industrial production has failed to significantly boost GDP, slowing in recent quarters to close to zero growth as the effects of the initial stimulus have worn away despite the drop in the value of sterling.

The drop in household consumption expenditure can easily be explained by the fall in real wage growth. Figure 4 shows that in the period before the financial crisis, nominal wage growth was above RPI (used for consistency instead of CPI) but since the crisis, wage growth has been consistently below RPI.

Figure 4: A comparison between average weekly YoY wage growth, RPI and household consumption expenditure in the UK. Source: ONS, Eurostat.

It indicates that household budgets in the last two years have been squeezed by higher VAT and commodity prices, not to mention the rising housing rental rates especially in London. The cost of living is rising but wage growth has failed to keep up.

The good news is that the effect of last year’s VAT rise from 17.5% to 20% will drop out this year, easing inflationary pressures and household budgets to some extent but wage growth still lags behind and needs a boost.

Targeting unemployment is as important, if not more so, than targeting debt and deficit reduction. Lower unemployment means a lower benefits bill for the government and it would increase the income tax generated for the Treasury’s coffers, not to mention the extra money that the previously unemployed will spend in the economy.

But efforts by the Bank of England to stimulate the economy have struggled and M4 money supply growth is negative despite the near zero interest rates and quantitative easing.

Figure 5: A comparison of M4 money supply growth, RPI and GDP growth. Source: BOE, ONS.

The Treasury’s credit easing scheme may improve access to funding for small- and medium-sized businesses and, as can be seen by recent news reports, some exporters are receiving more orders from Asia.

The government’s plans to upgrade infrastructure through the Green investment bank for energy production as well as Crossrail and the proposed high speed rail line are also important.

But Euro-Zone demand is set to drop this year as the debt crisis rolls on without any solution in sight and since the UK does more than 40% of its trade with the monetary union, a Euro-Zone slowdown will continue to effect UK trade.

The uncertainty surrounding the Euro Zone hinders investment and consumption decisions, not to mention the austerity hitting consumers especially in Greece, Ireland, Portugal, Spain and Italy.

In conclusion, the UK economy is suffering from a drop in demand especially from the household consumption sector. Debts and deficit can be repaid more quickly if GDP grows more quickly and if inflation is allowed to rise, at least in the short term, due to increased demand rather than by increased taxes and commodity prices that squeeze budgets.

Chancellor Osborne’s VAT rise in 2011 may have helped slow GDP growth due to its effect on household consumption but in 2012, its inflationary effects will wane and should help reduce the budget deficit.

But, if Iran continues to sabre rattle in the Gulf Oman, fresh pressures from rising oil prices may resurface.

Posted in Austerity, Bank of England, BOE, Debt, Euro Zone, Osborne, Quantitative Easing, Tax, Tax Cuts, UK, Unemployment | Tagged , , , , , , , , , , | Leave a comment

UK Veto Is A Smokescreen For Much Greater EZ Failures

The headlines in the aftermath of last week’s EU summit have largely been focused on the UK veto but surely the more important issue is what Germany is unwillingly to do to save the Euro.

Economists generally agree that two actions are needed to strengthen the Euro Zone. Firstly, an agreement by the 17 Euro-Zone members to create a fiscal union where, as in the UK and US, tax revenue from the stronger members can be redistributed to the weaker members who have been disadvantaged by uncompetitiveness and the ECB’s single interest rate. Secondly, the ECB should be allowed to purchase large quantities of government bonds to help finance the weaker Euro-Zone members especially Italy and Spain.

However, Germany favours a fiscal union in which it lays down the rules in the form of a modified Stability and Growth Pact but it still fails to agree to the one thing that would strengthen the Euro Zone structure into being like a tried and tested currency bloc. In this structure, common Euro-Zone bonds would be issued to raise finance for the Euro Zone as a whole and the funds raised would be distributed via a central fiscal authority or Euro-Zone Treasury. This does not mean that there would not be a place for individual member bonds but this market would then work like the muni bond market in the US.

The fiscal regulations laid down at last week’s summit state that countries should keep debt-to-GDP below 60% and budget deficits below 3% of GDP. The below charts show that such a policy would have made no difference to Ireland’s current predicament, for Ireland was the only Euro-Zone member to adhere to these targets until 2008, even Germany broke these limits.

Figure 1: Euro-Zone, German and Irish debt-to-GDP. Source: OECD.

Figure 2: Euro-Zone, German and Irish budget deficit as % of GDP. Source: OECD.

For the Euro Zone to work, a structure is needed that addresses the issues illustrated in Figures 3, 4 and 5 which show how small Euro-Zone economies such as Ireland’s have been ignored by the ECB’s mandate of targeting the Euro-Zone average CPI. Ireland’s CPI was much higher than the Euro Zone’s target of “below, but close to, 2% over the medium term” before 2007.

Figure 3: Euro-Zone, German and Irish CPI rate. Source: Eurostat.

Furthermore, the year-on-year GDP growth was also much higher than both the German and Euro-Zone average.

Figure 4: Euro-Zone, German and Irish year-on-year GDP growth. Source: Eurostat.

Figure 5 shows that Ireland suffers from being subjected to the wrong rate at almost any given time since the inception of the Euro with respect to its CPI and GDP growth. At times when CPI and growth have been high, the real rate in Ireland has been lower than the Euro-Zone average indicating a higher interest rate would have been implemented if Ireland had had its own central bank. While more recently, when CPI and growth have been low, the real interest rate has been above the Euro-Zone average indicating that a lower interest rate and quantitative easing would have been more suitable. This is backed up by a Taylor Rule simulation.

Figure 5: Euro-Zone, German and Irish real rates (ECB rate adjusted for CPI in each country). Source: Eurostat, ECB.

But fiscal restructuring takes time and in the short term only the ECB can bridge the gap by buying the bonds of imperiled countries such as Italy and Spain.

The trouble is, however, that Germany continues to block the ECB from making large purchases of Spanish and Italian government bonds to keep yields at levels where these countries can raise financing in the markets at more affordable levels. The Bank of England and Federal Reserve have both undertaken QE with one of the key targets of the policy being to lower the long-term interest rate i.e. the 10-year government bond yield.

Markets react when they are given a clear signal by policymakers as in the case of the US and UK. When the strength of the central bank is on the bid side, few will attempt to short the market. “Do as the central bank is doing,” was the call from fund managers and gilt traders when QE was announced in the UK in 2009. This is one of the reasons why UK gilt yields are so low and are now seen as a safehaven, together with a flexible currency.

The Euro-Zone leadership is failing to deliver the necessary policies to deal with the crisis and Sarkozy, or any other leader, appears to have very little power to push the Germans off their hardline.

Blaming Britain or any other country for failing to sign up to the “fiscal compact” is a smokescreen and the more serious issue lies in saving the patient.

Moral hazard has been used as the excuse for not implementing credibly large bailout mechanisms. If a bailout fund of EUR3 trillion had been announced in 2010 along with an intent to restructure the monetary union, the market would have been convinced that the  the politicians not only understood the problems facing the Euro Zone but that the leaders were willing to do whatever was necessary to fix the problems as well.

If this had happened, it is highly unlikely that anywhere near the full EUR 3 trillion would have been needed because uncertainty would have eased due to a convincingly large commitment by Euro-Zone leaders to keep the Euro in place.

However, this didn’t happen and credibility has been lost. Now Greece, Portugal and Ireland can no longer raise financing in the bond markets while Italy and Spain are precipitously close to joining them. This is a much more costly course of action because the full cost of providing funding for these countries will either be met by a bailout fund or one or more countries will default on their debt.

Either way, concerns over moral hazard have only escalated the crisis and made it more costly to fix.

Commentators and politicians who support the hard-line German stance do not like the following analogy, perhaps, because it rings too true.

When a patient turns up in a hospital emergency room with a heart attack with a history of eating too much fatty food or not taking enough exercise, the first thing the doctor does is to get the heart going again, first CPR then defibrillation. He does not begin by insisting that the patient sticks to a healthy diet before treating him because the patient’s condition would only deteriorate and be much harder to resuscitate.

This is the problem with the “kick-the-can-down-the-road” style of Euro-Zone policy making. Surely, the most important goal is to save the Euro, then when this is guaranteed regulations and long-term policies can be put in place to rebuild the troubled member countries.

The worry now is that it is too late and too costly to save the Euro.

Posted in Bailout, Bonds, Debt, ECB, Economics, Euro Zone, European Central Bank, Germany, Ireland, Merkel, Quantitative Easing, Sarkozy | Tagged , , , , , , , , | Leave a comment

ECB’s Rate Cut And Liquidity Analgesic

The ECB’s latest rate cut and 36 month liquidity operations can ease interbank liquidity problems, but it acts more as a painkiller for a bullet wound and much deeper surgery is needed in the form of Euro Zone restructuring. Since the first shot hit the Euro Zone two years ago, Euro-Zone politicians have only tentatively prodded the wound with their scalpels. Politicians must dig deeper and complete the operation to ensure that the patient can be taken off the critical list.

1) Euro-Zone CPI

Despite the austerity packages unleashed across the Euro Zone, CPI in all except one EZ country is still above the ECB’s target inflation “of below, but close to, 2% over the medium term,” with the EZ average at 3%. Despite this, the ECB have cut rates again from 1.25% to 1% as the sovereign debt crisis rages on and GDP forecasts have been cut. The implication is that demand will fall leading to downward pressure on CPI.

Figure 1: Comparison of CPI across Euro-Zone Countries. Source: Eurostat.

2) Euro-Zone GDP

GDP across the Euro-Zone countries has already begun to dip, as can be seen below. The outlook is even worse given the freezing up of liquidity in the banking system which means less cash is being distributed to the wider economy. High levels of uncertainty in the Euro Zone means consumer spending is more conservative while investors would rather delay investment decisions until the outlook of the Euro Zone is clearer.

Figure 2: Comparison of year-on-year GDP growth rates across Euro-Zone Countries. Source: Eurostat.

3) Euro-Zone Rates

Figure 3: Comparison between Euro funding rates. Source: ECB.

Interbank lending rates, measured by 3-month Euribor, have increased again in the last six months as the Euro-Zone crisis has escalated. Banks with cash are hoarding it and are less willing to lend out to banks who may have large exposures to risky sovereign debt. The stresses in the interbank market can clearly be seen by the 3-month Euribor/Eonia swap spread which is rising as tensions build.

A combination of long-term liquidity provision combined with credible restructuring of the Euro Zone including commitments to fiscal union and importantly, a structure allowing for the transfer of wealth across Euro-Zone countries to aid countries that cannot ease monetarily due to the ECB’s one-size-fits-all repo rate.

4) Demand at ECB Long Term Refinancing Operations and Main Refinancing Operations.

Figure 4: European bank demand for additional funding from ECB. Source: ECB.

Another sign of uncertainty and stress rising in the banking sector. Demand for liquidity from both the LTROs and MROs has again risen in recent months.

5) ECB Deposit Facility

Figure 5: ECB deposit facility where the extra liquidity is deposited on an overnight basis. Although it might appear that banks are hoarding cash, increasing levels of deposit facility usage is merely a sign of increased cash in the system. Banks who have accessed the ECB LTROs may have bought assets from other banks or lent to other nonfinancial borrowers but the end point for these funds would still be the ECB deposit facility. Hence why ECB President Draghi has said that the banks leaving funds at the ECB deposit facility are different to those borrowing cash at the LTRO i.e. the funds are being dispersed in the market. The problem now is will this cash be distributed to the wider economy. Source: ECB.

Posted in Austerity, Banking, ECB, Euro Zone, European banks, European Central Bank, France, Germany, Greece, Holland, Ireland, Italy, Merkel, Politics, Portugal, Spain | Tagged , , , , , , , , | 1 Comment