Thursday, June 30, 2011

Retail Sales and Fiscal Policy in Europe

In May retail sales in Spain fell 6.6% over the year and on a working-day adjusted basis. Retail sales in Spain haven't posted positive annual gains since June 2010. In its own right, this is horrendous.

Marshall Auerback is concerned, as he highlighted in an E-mail exchange:
These declines in retail sales in Spain have been accompanied by double digit declines in credit to households and significant declines in real estate collateral. Spanish home prices fell another 1.8% in the second quarter.

Finally the Spanish central bank has conceded that private consumption for the second quarter in Spain has been “rather weak”. Right now, with the celebration over the Greek parliament kicking the can down the road, signs of economic deterioration in the rest of Europe and especially in Spain do not matter. Someday they will.
My response to this was 'yes, we know that domestic demand it just horrendous'. But there's more: look at this data in a panel and note the deleterious nature of fiscal austerity amid the strong desire to save on the part of Spanish households. Marshall's right, this is 'economic deterioration', plain and simple.

(click to enlarge)
The chart illustrates the path of seasonally-adjusted real retail sales. The Italian and Spanish data are constructed as follows. Spanish real retail sales are released on a working-day but non-seasonally basis. I adjust the data for seasonal factors using the Census X12 ARMA method in Eviews. The Italian retail sales data are converted into a real series using the harmonised CPI, as released by Istat. The German and US data are available directly.

There's not a lot to explain here. As proxied by retail sales, the Spanish domestic consumer is imploding. Fiscal policy is driving retail sales through the ground, literally, amid a high household desire to save (recovering/deleveraging following a collapse in credit markets). The X12 adjustment may have issues - but there's no sampling error that can discredit this clear trend downward.

Spanning the previous six months, real retail sales in Italy and Spain - those countries actively engaged in fiscal tightening - dropped 2.0% and 3.3%, respectively, on a seasonally and working-day adjusted basis. In the US, where the government has yet to succumb, seasonally-adjusted real retail sales are up 0.9% over the same period.

Spanish consumers are essentially being squeezed by fiscal austerity. Notice that real retail sales in Spain appeared to stabilize spanning late 2009 through May 2010. The next leg down perfectly correlates with the outset of austerity in Europe.

The austerity will end eventually the easy way (as the German domestic economy is allowed to expand and inflation overshoot) or the hard way (missing deficit targets and being forced to choose between further deflationary austerity or leaving the Euro area). Randy Wray tells us the outcome.

Rebecca Wilder

Monday, June 27, 2011

What do you want to wager that the IMF's a bit overly optimistic on the outlook for Greek nominal GDP?

These jokers have no idea what they're doing.

The IMF has overshot the ex-post path of Greek nominal GDP in each and every one of their World Economic Outlook forecasts since April 2009. What do you want to wager that they're wrong about 2011, too? And now they want more fiscal austerity...

The French are devising a plan to compel bondholers to rollover Greek debt by enhancing the bonds. The new bond rate would be equal to Greece's current borrowing rate on the EU/IMF/EFSF programs plus a variable factor linked to 'an indicator such as GDP'.

Just amazing.

Rebecca Wilder

Friday, June 24, 2011

Will someone please explain to me why the ECB is hiking in July

I've gotta say, I have absolutely no idea why the ECB is hiking. If I look at key monetary variables (forget about the real economic data for a minute), they should be on hold.

(1) inflation expectations has dropped off precipitously across key countries in Europe, as measured by the 10-yr swap linker. One could argue that it's simply market sentiment and oil - which could very well bounce back - but the same measure of US inflation expectations is sticky at 2.7%. Chart 1 below.

2) key monetary variables, the annual growth in the money supply (M3) and lending to euro area residents have tapered off at levels not seen since 2003, with exception to recent history. On a 3-month annualized basis, growth rates have slowed markedly from peak levels earlier in Q1 2011 (MFI loans) and Q3 2010 (M3 growth). Charts 2 and 3 below.

(3) A cursory view of the history of ECB rate targets, US Fed rate targets, and the monetary variables suggests a high correlation between US Federal Reserve policy and Euro area monetary variables. In fact, on a 3-month annualized basis, MFI lending to Euro area residents has a 70% correlation to US Fed policy, a much greater correlation than with ECB policy (50%) - this same correlation is more balanced at the % Y/Y level. Chart 3 below.

(4) The money supply has a high correlation to ECB policy using either the Y/Y or the 3-month annualized growth measures. Money supply is a lagging indicator (one of the lengthier lagging indicators) - I would go so far as to deduce that this high correlation is further indication that the ECB is a 'reactive' bank.

It's going to be very tough for the ECB to eke out another 25 bps, let alone 50 bps by year end (the market is pricing in roughly 40 bps of hikes by year end). The economic (not this article) plus monetary data don't even support it.

Accompanying Charts

Rebecca Wilder

Wednesday, June 22, 2011

Little evidence of convergence across the Euro area 12 after adopting the euro

Eurostat released measures of annual per-capita GDP expressed in Purchasing Power Standards for the European Union. Purchasing power standards corrects for price differentials in nominal income and is useful for cross-country comparison (Eurostat data).

Given the economic dispersion across Europe (a recent article highlighting this using Q1 GDP growth), I wanted to investigate 'convergence' among the Euro area 12 countries. Specifically, are the lower income countries benefiting from the single currency policy more so than the higher income countries and thereby 'catching-up' to the average?

The chart below illustrates the per-capita income bases across the Euro area 12 - those countries that adopted the single currency in 1999 plus Greece (they adopted in 2001).

The chart illustrates 2001 per-capita GDP measured in PPP euros across the Euro area 12 (now called average income). Luxembourg, Netherlands, and Ireland had the highest average incomes, while Spain, Portugal, and Greece had the lowest. If income disparities among the Euro area (12) countries were to converge over the following decade, then the lower income countries should grow more quickly than the higher income countries, and average income differentials should fall.

The chart below illustrates the average catch-up rates for the Euro area 12 (excluding Finland which averages 234% from 2001-2008, so distorts the chart) both before adopting the euro (1996-1999) and after (2001-2008). They are calculated as in Péter Halmai1 and Viktória Vásáry, Real convergence in the new Member States of the European Union (Shorter and longer term prospects).
Note: I did not include the years 2009 and 2010 to avoid distortions created by fiscal austerity in key countries. Furthermore, the year 2000 is omitted since Greece didn’t adopt the euro until 2001.

The catch-up rate is essentially the average annual rate of change of the difference between country average income and that of the Euro area (12). A positive number represents an average increase in this differential, while a negative number indicates a decline in the differential. For convergence, you would expect for these rates to be negative among the lower income countries and some of the higher income countries as well.

The discrete shift in convergence is quite striking. Basically, the Euro area went from generally converging before the formation of the Euro area, as illustrated by 6/11 shown negative catch-up rates spanning 1996-1999, to generally diverging, as illustrated by just 3/11 shown negative catch-up rates spanning the 2001-2008 post Euro area formation. Only Belgium and Spain demonstrate convergence across both time periods.

Following adopting the euro, the income differentials grew markedly in France, Italy, Germany, and Ireland, and often not for the better (i.e., the income differential widened). In Italy’s case, the income differential went from positive PPP700 in 1995 to –PPP2,400 in 2010 (not illustrated in chart); this differential turned for the worse in 2002.

According to this measure, there's little evidence of convergence. Here's a thought exercise: I'm one of the countries that are set to adopt the euro (see light blue countries here) - why would it be in my best interest to do so if history tells me that adopting the euro leads to rising income differentials?

Rebecca Wilder

Tuesday, June 21, 2011

Italy: a growing credit risk lurking in the shadows

Markets and global economists are focused on Greece, where all the while there are growing non-Greek credit events lurking in the shadows. Specifically, recent news flow out of Italy ensures that the volatility in Europe will follow any near-term Greek resolution.

On Friday, Moody's placed Italy's Aa2 local and foreign currency bonds on negative outlook, citing a possible downgrade within 90 days. The drivers for the review are the following: (1) challenges to potential growth, (2) implementation risks surrounding fiscal consolidation efforts; and (3) risks posed by funding conditions for European sovereigns with high levels of debt.

Moody's states that the above are the 'main drivers' (no link); but how I've interpreted recent shifts in credit outlooks is that (2) above, via rising political risk, is the last straw. If the economic cyclical indicators become somewhat challenged, this would surely require further austerity measures in the case of European sovereigns; and if further austerity measures become less certain in expectation on rising political risk, then the country goes on 'review'.

The political risk has sharply increased in Italy as of late...

1. Local elections went against Berlusconi's coalition.
2. Then there was the vote against water privatization, further burdening Italian public finances.
3. And recently, previous political allies are pushing for tax cuts and new immigration rules.

...while Italy's cyclical outlook has worsened at the margin. In Q1 2011, Italy contributed just over 2% to Euro area quarterly GDP growth but is a massive 16% of of total GDP. Italy is lagging key core countries, like France and Germany.

And it's not just a relative decline. Italian GDP plunged 7% during the recession and recovered just 2% since its trough in Q2 2009: fall hard, rise slowly. When indexed to the GDP low in Q2 2009, imports have retraced the farthest with exports and gross fixed capital formation bouncing as well. But the real data are indexed to the cyclical lows following a 7% net decline in GDP. Better put, if I had indexed the data to before the recession, the recovery across GDP spending components would look much less buoyant.

I know that this is just one indicator; but higher frequency indicators are not looking good. Please see Edward Hugh's post at Roubini Global Economics for a nice review of Italian economic indicators.

Unless the economy picks up markedly, the government deficit is bound to surprise to the downside of official forecasts. Ultimately, this begs the question of how sustainable is Italy's debt burden, really? Is 189 basis points over German bunds (as of 6/20/11) a sufficient premium to warrant the credit risk?

Going forward, it wouldn't surprise me if Moody's did downgrade Italy unless the political situation improves markedly over the next 12 months. Italy's growth fundamentals are just too baked in for near-term change. (If you have a subscription to the Economist, please see the June 11-17th issue for a special report on Italy). Furthermore, I would expect the other rating agencies, S&P (A+u) and Fitch (AA-), to follow suit in either the outlook downgrade (S&P) or an outright rating downgrade (Fitch, possibly S&P).

Given Italy's high base of government debt, 119% of GDP in 2010, ratings downgrades that lead to shifts in real borrowing costs could have a profound impact on Italy's debt trajectory. Yes, this will be a problem in the world's third largest bond market - see the IMF GFSR 2009 data.

Greece is not the end game.

Rebecca Wilder

Friday, June 17, 2011

Is internal devaluation enough for Europe? Probably not, very unlikely...No

The IMF produced an interesting paper, "Euro Area Export Performance and Competitiveness", that could have policy implications for the effectiveness of internal devaluation on intra-Euro area export demand. As I interpret Table 1, page 13, intra-Euro area exports are less sensitive to foreign demand (like German demand for Spanish exports, for example) and more sensitive to measures of 'competitiveness' than are extra-Euro area exports.

One could argue the following: these results demonstrate that internal devaluation has a better chance of working for trade within the Euro area than it would for other countries that aren't part of a single-currency union. The policy implication is that gained relative competitiveness via fiscal austerity in Spain, Greece, and Ireland has a fighting chance to produce a positive growth outcome. (If you want to skip to the end of this article, I present another interpretation of the results.)

We are seeing some evidence already of the link between internal devaluation and the rebalancing of trade within the Euro area (data link). The chart below illustrates the shift in the trade balances on a rolling 12-month basis and as a share of GDP across key Euro area countries (click to enlarge).

Generally, the healthy rebalancing is occurring on a trended basis. The intra-Euro area trade deficit is worsening in some of the core countries, like France and even Germany, and improving in key Periphery countries, most notably Spain and Greece. This is what is supposed to happen: capital moves away from the Periphery and into the core, eventually driving the trade flows to a healthier and more sustainable flux.

However, there's another way to read the results of Table 1 (page 13): the elasticities of real export volume with respect to the real exchange rate (i.e., measures of competitiveness, and however you measure it) are all less than one (except for one case). That means, for each 1% increase in relative competitiveness, export volume rises by less than 1% - and in some cases a lot less than 1%.

Simply put: the Periphery countries need an inordinate amount of internal devaluation and fiscal austerity to derive sufficient real export growth. Without the strong impetus to global demand, the necessary internal devaluation then becomes 'infernal'.

I haven't quantified this result; but the illustration above suggests that much more is needed. Furthermore, with global growth slowing - the IMF just today lowered its growth forecast - I'd say the Periphery countries will be showing some serious 'economic holes' in coming quarters.

Rebecca Wilder

Thursday, June 16, 2011

Unemployment rate in Greece: seriously uncharted territory

And you wonder why the Greek citizens are pushing back against austerity. Today the National Statistical Service of Greece released its quarterly labour force figures. From today's release (.pdf):
In the 1st Quarter of 2011 the number of employed amounted to 4,194,429 persons while the number of unemployed amounted to 792,601. The unemployment rate was 15.9% compared with 14.2% in the previous quarter, and 11.7% in the corresponding quarter of 2010
I'll first note that the period (.) at the end of 2010 was not in the release, i.e., even the presentation of the data lacks formality. However, the report doesn't need grammatical bells and whistles for one to see that the economy is disintegrating. According to the labour market, debt deflation, 'infernal devaluation' (as Marshall Auerback puts it) is taking its toll on the real economy.

The unemployment rate is (WAY) higher now than it was even before Greece joined the Euro area (2001).

The release also reports the female unemployment rate, which stood at 19.5% in Q1 2011 and up from 15.5% in Q1 2010. Furthermore, the aged 15-29 unemployment rate stood at 30.9% (35.8% for females) in Q1 2011, up from 22.3% in Q1 2010. Key parts of the labour force are being hit harder than others, i.e., young and female vs. males aged 30-44.

You wonder who's rioting? I bet its those younger citizens, 30% of the labour force, that are not working but WANT TO. This is a problem that's not going to disappear with more austerity.

Rebecca Wilder

Tuesday, June 14, 2011

The downgrade assault by the rating agencies continues - what are the implications for the EFSF?

As the rating agencies trip over themselves to downgrade sovereign credit, Greece yesterday became the 'World’s Lowest Credit Rating by S&P'. This is largely meaningless for bond pricing, since Greece is already trading at very distressed levels - the curve is inverted, and the two year bond is trading at 26%. However, the downgrade of other Euro area countries could have broader implications for the EFSF (and then ESM) liquidity facility.

Ther are two reasons why ratings matter for the EFSF (European Financial Stability Facility):
(1) the 6 triple-A country guarantees facilitate the triple-A rating on the EFSF structure itself.
(2) countries that fall under the umbrella of the EFSF no longer contribute to the guarantee of the structure.

The table below illustrates the current EFSF guarantee structure (part of the credit enhancement to receive a triple-A rating) - details of which can be found here - and their associated foreign currency long-term ratings by the three major rating agencies.

The triple-A countries are highlighted in orange, of which Germany and France contribute the largest shares to the EFSF guarantee structure, 29.1% and 21.9%, respectively. Estonia, a member of the Euro area, is not part of the structure, at this time but will join soon.

Of the triple-A countries, France is perpetually the weak link, although it's been reaffirmed as stable by the three agencies. However, if France, for example, were to drop below triple-A, the entire structure would likely lose its AAA rating - this would be a problem for overall funding costs.

Greece, Ireland, and Portugal do not contribute, as they are currently under EFSF-funded programs. Before Portugal signed up for austerity (strict austerity is a condition for EFSF loans), it guaranteed 2.6% of the structure. So, as the countries fall under the blanket of the EFSF facility, they consequently fall out of the guarantee structure. The process leaves a hole to be filled by the remaining countries.

Having to cover 2.6% of the guarantee structure is not a big deal - but if Spain, Italy, or even Belgium - Belgium's rating was reaffirmed today by S&P - were to require loans, the burden would fall on fewer countries to cover the loss.

So, although Greece's downgrade is not a 'big deal', the downgrade of a triple-A country or a larger economy that leads to spread widening and perhaps EFSF lending would.

This is not over. Greece will likely get its funding needs covered through loans under the EFSF facility (and even voluntary debt rollover, however, I am skeptical about this prospect), but that will not be the end of the banking crisis.

Rebecca Wilder

Monday, June 13, 2011

Tabled policy options vs. CDS pricing in Europe: similar but not the same

The discord in Europe across policy lines is growing. I thought it prudent to jot down a few notes regarding the different initiatives being tabled out there. The fact is, that betting on default, at this point, is essentially betting on the near-term outcome of an organic policy negotiation process. In my view, that's impossible, so market pricing cannot be predictive of the near- or even medium- term outcomes.

As illustrated above, a hard and possibly quite disorderly restructuring is being factored into credit default swap (CDS) pricing. The chart lists the 5-yr CDS-implied probability of default by included Euro area countries (a credit event that would trigger CDS payments - see 'credit event' under the ISDA glossary). The pricing is based on a 40% haircut to the bond principal, so we're talking a 'hard' debt restructuring. This may occur at some point, especially in the case of Greece, but a hard restructuring is not being negotiated at this time.

Over the near- to medium- term, policy makers are generally tabling the following options: (1) a Vienna Initiative part Deux, a type of voluntary rolling over of Periphery debt, (2) a debt swap now, and/or (3) extending Greek loans via the EFSF.

(1) Vienna Initiative part Deux. (see this working paper for information on the original meetings). This is what the ECB wants - a purely voluntary solution. It would involve (probably) an agreement among the banks and the ECB to A. not sell current Periphery (Greek) holdings, and B. buy new bonds by rolling over existing debt for a period of time (perhaps 5 years). All parties involved would be part of the negotiation process - German and Frence banks, the ECB, and Greek banks - and would involve no haircut to the Greek debt. Roubini writes of "The Nonsense of Purely 'Voluntary' Bail-Ins of Greece's Sovereign Bank Creditors".

(2)Debt Swap. This is what Schauble wants and involves more private-sector involvement up front. A debt swap would be more secure than a Vienna initiative part Deux, since the private sector exchange would occur at the outset of the agreement, rather than as the debt matures in the future. He offers that bond holders will eventually be made whole, but this option would likely trigger CDS contracts so is more contentious (see daily from Eurointelligence blog).

(3) A loan from the Euro area states via the EFSF. How big is this loan depends on (1) and (2).

Now that the economic cycle is mature, I think that policy makers finally realize that fiscal austerity only works when the following conditions are met:

A. Devaluation. Not an option in a single-currency union.
B. Strong global momentum. Has occured to date, although the pace of global economic activity is peetering out now (see Edward Hugh's report on April PMIs).
C. Loose monetary policy. There is clearly a tightening, rather than loosening, bias at the ECB.

So if a country cannot grow and pay its bills, default is likely. But voluntary debt re-profiling requires agreements among all interested parties. That seems like a stretch, given that the Heads of State (still) haven't fully resolved simpler issues at this point, like 'how' to increase the capacity of the EFSF to euro 440bn?

Rebecca Wilder