Links & comments 20 December 2011

The plight of the 1% – some good quotes here with respect to the upper echelon’s ignorance over the likely deteriorating quality of their own pies: upper echelon wealth depends on the health of the pyramid, something which many fail to understand.  In other words, the wealthy have more to lose if the supporting structures collapse.

Eurozone crisis hits US mortgage securities – Euro banks may be selling US asset backed (mortgage backed) paper causing a fall in the pricing of these assets( which incidentally may further influence Fed buying of mortgage based assets).  The dynamics of this activity can better understood by reading a recent paper by Hyun Song Shin, Global Banking Glut and Loan Risk Premium discussed in an earlier post of mine -   Light on the Euro Zone banking crisis.

Can Italy survive the financial storm? An article from Vox that suggests yes by providing a positive spin on recent developments in Europe.  I am not sure that I share these sentiments which depend on falling wage costs, stability in the banking system through the ECB longer term refinancing operations and a belief in the implementation and effectiveness of austerity measures:

“The Italian government is pushing a strong and credible fiscal adjustment through Parliament. “

“The stability of the Italian banking system now seems assured given that the ECB has made three-year funding available “

What has to start yet is to make the Italian economy competitive again by reducing labour costs……Provided the real sector of the economy can be shielded from the worst effects of the financial storm the country should have enough time for the real adjustment to bear its first fruits.”

With regard to wage costs, Germany has indeed benefitted from lower growth in wage costs, but its wage costs are still relatively high (higher than Italy’s) and a larger component of gross wages in Italy are non wage costs, which means non wage costs need to fall, itself implying in part further austerity.  Not only will wage costs and non wage costs need to fall if they are to compete with lower cost Eastern European countries, but productivity and skills will need to rise if they are to compete with the likes of Germany and the US.   It is not so much wage costs, but the wage costs relative to the added value produced by labour in the industries in which they are employed and hence a refocus and restructuring of capital employed which also depends on so many other factors.    This is a very long term outcome, and these are usually characterised by barely perceptible incremental changes along the way.  It may be hard to discern any benefit for some time and certainly not in sufficient time to assuage deflationary risks currently embedded in the economy..

As far as austerity measures, there is no guarantee that the short term impact of such measures will be negligible in economic terms, especially when combined with European, if not global austerity imperatives.   Finally, is the stability of the Italian banking system really assured, as suggested, by the new LTRO measures introduced by the ECB?  

Labour_cost_index_-_recent_trends/ Economic boom barely lifts German labor costs / EU-Comparison of labour costs and non-wage costs /LABOUR DEMAND IN GERMANY: AN ASSESSMENT OF NON-WAGE LABOUR COSTS / Problems of International Labour Cost Comparisons/ / The margins of Labour Cost adjustment./ This Is The Chart That Really Makes The Germans Furious / After the Election: Germany Will Continue to Obstruct Global Economic Rebalancing/ What Explains the German Labor Market Miracle in the Great Recession?*/ Wage setting in Germany – new empirical findings /The economy of Germany: powered by reform

Britain is best left out of this European ”Road to Hell”!

It is my opinion that the present deal risks sealing an end to the European dream: a united Europe cannot exist in the midst of a framework designed to lead to appalling intra regional inequality and hence democratic subservience and injustice.

We now have agreement that debt and deficits will be met with greater focus on austerity, but we have no agreement as to how fiscal policy will take account of regional differences. I just do not see how this can work unless there is some policy to provide for greater financial support to weaker regions (i.e. some regions may forever be in deficit while others will forever be in surplus) and this does not seem to be on the cards. The only positive “for the markets” is that the EU has not agreed to disband the Euro and precipitate, immediately, the next step of the crisis.

This is at best a deal to keep the German nation within the Euro, nothing else.  The UK is best left out of “this road to hell”!

….enhanced governance to foster fiscal discipline and deeper integration…a new “fiscal compact”….General government budgets shall be balanced or in surplus….annual structural deficit does not exceed 0.5% of nominal GDP…..Member States ….shall submit….for endorsement, an economic partnership programme detailing..structural reforms to ensure ..correction of excessive deficits..implementation…and yearly budgetary plans ….. will be monitored by the Commission and the Council…..ex ante reporting by Member States of their national debt issuance plans…

..Member State…in breach of the 3%…automatic …unless..majority of euro area Member States..opposed. ……debt reduction (1/20 rule) for Member States with a government debt in excess of 60% needs to be enshrined in the new provisions.

….committed to working towards a common economic policy….all major economic policy reforms…..coordinated at the level of the euro area, with a view to benchmarking best practices….

Eurozone– plethora of data implies ongoing stress and significant risk to GDP and economic infrastructure..

Ordinarily the type of data we are seeing would not be considered negative, in the sense that poor GDP growth and falling orders and industrial production alongside low interest rates would imply a potential for a significant future rebound in activity.  Today we cannot really look at this data in the same light: global debt levels imply significant threats to aggregate demand and hence financial system and sovereign debt default.   The worse the data becomes, the deeper debt hole we are in.  In prior recessions we could realistically look forward to a strong rebound in activity someway forward.  This type of fact of life certainty is no longer as solid a foundation and we are left questioning, when will we eventually regain the necessary traction.

Third quarter GDP for the Euro 17 rose by 0.2%, but this excludes data for Italy, which could well drag growth below this figure.   Household final consumption expenditure, after falls in the second quarter, contributed mostly to GDP growth while the contribution provided by net exports weakened considerably.   0.2% is a painfully slow rate of growth, and a rate incompatible with the sovereign debt risks of the Eurozone area.

Retail sales growth remains weak, despite a September rebound: retail sales volume rose a meagre 0.4% over the year to September.  Monthly volume growth rose by 0.4%, which failed to erase the 0.6% September decline.  Again, data excludes Italian retail sales, and Spain and Portugal registered significant declines (no data for Greece).

With respect to recent PMI data, according to Markit Economics:The Eurozone private sector economy contracted for the third month running in November. At 47.0, up from 46.5 in October, the final Eurozone PMI® Composite Output Index signalled a slight easing in the rate of decline, but was weaker than the earlier flash estimate of 47.2. Output of the combined manufacturing and service sectors declined across all of the big-four nations for the first time since July 2009.”

With respect to Germany, which registered its first composite decline since July 2009, apparently the main reason the services sector PMI remained marginally above 50 (50.3) was because the index was “supported by the completion of outstanding work across the sector. Consequently, latest data highlighted the fastest reduction in work-in-hand (but not yet completed) since July 2009.New business received by services firms continued to decline in November, extending the current period of contraction to four months. This is the longest period of continuously falling new work since the 2008 / 2009 downturn”  The only component at odds with the malaise was the employment index which has grown for 22 months.

One wonders with respect to the employment index given the analysis from the Markit productivity PMI for Europe that “German companies recorded the strongest deterioration in productivity of the largest EU economies.”.  

With respect to sovereign debt issues, the PMI responses for Italy and Spain are also worrying.  Spain’s rate of decline, in particular, is steeper than during 2008/2009.

Euro area unemployment rates edged up to 10.3% in October, higher than at any time since the formation of the Eurozone.   Add these figures to the declines in service and manufacturing PMI and Eurozone productivity and we have an increased risk of further declines in employment.    French unemployment stands at 9.8%, Spanish at close to 23% and German at 5.5%.

Recent German industrial production data showed a seasonally adjusted increase of 0.8% in September following on from monthly falls of 2.8% and 0.4% in the prior two months.  Unadjusted data showed a decline of 5.7% on the month following a weak unadjusted September increase of 9.4%.   Year over year unadjusted data shows a much more pronounced decline in output than the seasonally adjusted year over year figures.

Markit European Productivity PMI

The Eurozone productivity PMI has been declining since the start of the year and is now at a 32 month low.   The latest contraction, according to Markit Economics, was the sharpest since March 2009.  Declining productivity, at this pace, implies that firms are holding onto employees, in the face of declining economic activity, rather than adding them to the unemployment queues. 

“To boldly go where no man has gone before….”

This is my fourth attempt at a suitable tag line to the current post: the first one was “mindless cue to buy..again”; “Hansel and Gretel get totally lost (again)” was another.  I thought Star Trek was a good one, because no matter what happened at the end of each episode, the good ship always ended up back in the ordure in the next episode.   What the world lacks, though, are the scriptwriters and the budget to keep this particular story going.

I personally am beginning to feel like Hansel and Gretel here though: each time we go deeper into the forest we need to be careful to identify the thread that takes us back to the core of the problem.  And so it is with the current intervention that has fuelled another 3% to 4% rise in markets.  

Just what does the current central bank action do though?  Does it solve the European problem, or does it solve one of the consequences, and does it really buy any time at all to deal with the real problem per se?   The real problem being that we have too much debt that needs to be written off, and too much money that needs to be borrowed to keep the global economy on an even keel. 

As such the heart of this particular matter is the inability to borrow US dollars in sufficient amounts and at rates that make it commercially viable: in other words the ability to finance foreign assets (ostensibly US denominated assets) with foreign currency (ostensibly USD).

The problem exists because of the mismatch between the duration of foreign currency liabilities (short term deposits, commercial paper, repo agreements and or FX swaps), and the supply of those liabilities, relative to the duration of European bank’s foreign US denominated assets:  liabilities are deposits and other sources of funding (these are monies a bank has borrowed) and assets are loans (you receive an interest payment like you would with a bond).  

If you are financing longer term loans via short term financing then you have to keep re-borrowing the money until the loan is paid back.   What is happening is that the providers of US dollar finance (and other currencies presumably) are either unwilling to provide these loans/asset swaps, or are asking for far higher rates of interest: in this case there is a risk that the bank becomes insolvent (a de facto run on the bank) or the margin between the return on the loan and the return on the assets impacts the bank’s ability to make money. 

In the case of US dollar (and likely borrowing in other currencies) European banks appear to have reverted to foreign exchange swaps (swapping domestic deposits for foreign currency to fund their foreign based lending) and it is the cost of these swaps, apparently, that has been one of the thorns in the side of European banks.   

The only avenue left now to borrow foreign currencies in the amounts needed and at reasonable rates are the central banks.   Central banks are due to cut the rate they charge lending/swapping US dollars to 50 basis points on top of the Overnight Index Swap rates: this provides both supply and supply at a lower cost. 

But, you still need collateral to swap, and ultimately European banks must still decide whether they want to continue to incur the financing risks of lending money.   European banks have an excess of assets relative to domestic GDP, and it could be that all the central bank intervention will do is to allow European banks to delever further.  

The provision of USD finance does not solve the problem and the risk of a banking system that has too many assets, rather than not enough.

A good paper to read on this subject matter is the BIS paper: European banks’ US dollar funding pressures1 from the BIS quarterly June review 2010

In principle, a non-US bank can finance its foreign currency assets in two ways. It can borrow foreign currency outright from the interbank market or from nonbank market participants or central banks, using retail (ie deposits) as well as wholesale (eg commercial paper or repurchase arrangements) instruments. 

Alternatively, the bank can use FX swaps to convert liabilities in its domestic or third currencies (which will themselves be from either retail or wholesale sources) into the desired funds for the purchase of foreign currency assets.

Either way, it will seek to match the level of its foreign currency investments with on- or off-balance sheet liabilities in the same currency to avoid taking open FX exposures. Yet, to the extent that these assets and liabilities have different maturities, the bank will be exposed to embedded maturity mismatch and, hence, face funding (or rollover) risks.

…The funding patterns documented in this article point to an ongoing, large-scale reliance of European banks on sources of wholesale cross-currency funding. As a result, banks are required to roll over significant parts of their funding at relatively short maturities, which are bound to become even shorter if conditions deteriorate. Reduced access to outright funding in individual currencies could then force banks to rely even more strongly on FX swap markets for any additional foreign currency funds or require the transfer of collateral across jurisdictions (for use in repo or other transactions).

Other links to this topic are noted below:

Central banks augment currency swap capabilities

Central banks move to ease European dollar crunch

Dollar funding — central banks intervene

DERIVATIVES: Basis swaps reveal dollar funding stress

The collateral limits of coordinated action

The ‘dollars for euro collateral’ crunch

So much for that impact on currency basis swaps

The Pain In Spain

Retail sales fell by a brutal 6.9% (inflation adjusted) in the year to October.  After what appeared to be an amelioration of conditions up to August (-3.8% real decline), it is clear economic conditions have deteriorated significantly since the onset of the current round of the crisis.  

One of the brighter areas of the economy is foreign tourists, mainly from Europe: if European economic conditions worsen expect fewer tourists in the coming months.

ECB Bank lending and monetary aggregates go skew whiff in October

It would appear that the crisis is drawing and keeping liquidity and credit within the financial system and not out and about as it would need to in order to maintain a healthy monetary framework.

The annual growth rate of the broad monetary aggregate M3 fell to 2.6% in October from 3% in September. With inflation running at 3% in the year to October, real annual M3 growth fell by 0.4%. 

M1 and M2-M1 annual growth rates both decelerated in October, while M3-M2 accelerated to 7.8% annual growth.  This latter component was heavily influenced by the annual growth rate in Non-Monetary Financial Intermediary deposits of 9.8%, whereas household and non financial corporate annual deposit growth rates fell to 2.1% and 1.8% respectively. 

On the asset side of the balance sheet, lending to euro area residents fell to an annual 1.6% growth rate in October (-1.36% in real terms) from 2.3%, the growth rate to households fell to an annual 2.2% and to non financial corporations rose to an annual 1.9%.  All were below the rate of inflation meaning negative real rates of growth. 

The annual growth rate of loans to non monetary financial intermediaries grew by 8.7% in October from 4.5% in the year to September. 

Interesting points from the monthly monetary data are as follows

  • M1 has declined for 2 months in a row.
  • All monetary components, including M2-M1 and M3-M2, declined in October
  • net external assets fell by 73.4bn in October or close to 8% of September’s stock of external assets.
  • Loans adjusted for securitisations were almost double loans to euro area residents before adjustment.
  • Components of monetary aggregates (excluding currency in circulation) with only two exceptions (deposits with an agreed maturity over 2 years and redeemable at notice of up to 3 months) declined in October.
  • Repos grew by 34% in the year to October but fell by 4.3% in the month to October.
  • On an annual basis loans to other financial institutions dominate loans to government, households and non financial corporations: in the month to October loans to all bar Other Financial Institutions fell – unadjusted data.


Uncertainty alone could be killing us: all the weak links could come crashing down before a sovereign default in Italy or Spain….

In the FT’s Alphaville blog the issue of the banking system’s liquidity and funding needs were discussed via the limited availability of collateral and constrained terms for lending on different collateral in the European repo market – The German bond market is all about ‘buy and hold’.   Banks need liquidity to finance day to day operations and new sources of funding to lend.  With limited access to new sources of funding, European banks are not going to be able to lend to the economy, and with limits to the type of collateral accepted and the terms in which collateral is accepted for repurchase agreements, the ability to manage the liquidity needs of daily operations is becoming, one would assume, inestimably difficult.  

While we understand the technical nature of many of the problems, we do not have a clear and integrated picture as to the calculus of the mechanics.  But we need to know in order to assess which aspect of the European financial and capital markets is presently most at risk:

  • Is it the Sovereigns first and hence everything that depends on government expenditure and sovereign debt ratings second.
  • Or is it the banks and every aspect of the economy that depends on access to money, as the sovereign debt crisis hits wholesale funding, economic activity, prospective defaults etc.
  • Or, is it certain individual components of the demand for money that are being impacted, that could result in a back door impact: it may be that small companies, companies with high levels of debt and other weaker counterparties may be presently being starved of liquidity and finance. 

It is possible that all the weak links in the economy will come crashing down long before we have a default in the areas that are uppermost in everyone’s minds.  If everyone fears the collapse of a tall building, activity in the surrounding area will be long gone before it eventually falls.

New Reports Warn of Escalating Dangers From Europe’s Debt Crisis

Moody’s: Rising Severity of Euro Area Sovereign Crisis Threatens EU Sovereign Ratings

Europe: the imagery takes shape

Like the impending death of a seriously ill parent, the whole slow motion collapse of the Eurozone seems unreal.

The FT in “Investors shun Europe’s big banks” raises the spectre of nationalisation and shareholder losses and suggests that much is at stake with little clarity as to how this is all going to end, ugly or otherwise.

Prepare for riots in euro collapse, Foreign Office warns: this link is to an article in the Telegraph that states the Foreign office is starting to prepare for the worst case in Europe. Unthinkable really!

Yves Smith at naked Capitalism opines “the news reports seem more anesthetized than shellshocked” and rightly points out that the downgrades of Portugal and Hungary to junk would one point in time have moved markets in their own rights, yet appear to be only footnotes to the history being written.

Flash Euro PMIs

A good review of the flash Euro PMIs can be found at FTs Alphaville.

Suffice it to say, the French composite PMI is signalling a significant deterioration in GDP in the coming quarters based on the historical relationship between GDP and the PMI readings, while the German measures are signalling zero to negligible growth.   What is worrying is the sharp decline in manufacturing PMIs, especially in Germany where exports form such a large component of GDP and the fact that it was manufacturing that led the way in the first phase of the crisis.   The risks of a deep recession, and not just a minor downturn could be presaged by the very steep decline in non core Eurozone PMI: as the graphs in the link show, the last time there was such a gap between the core and the non core, it closed in dramatic fashion. 

Euro Zone and French GDP

So much rests on Euro zone growth: but what of the growth numbers of the three largest Euro Zone members.   Germany registered 0.5% growth, France 0.4%, and Italy has yet to report.  Excluding Italian GDP, Eurozone growth rose by a weak 0.2% in the third quarter.

While German details are not yet available, it was understood that part of the contribution came from corporate investment in the gross fixed capital formation component of GDP and from private consumption expenditure.

French GDP on the other hand saw a decline of 0.3% in non financial corporate gross fixed investment.   GDP growth in the quarter was dependent on a meagre 0.3% technical increase in household consumption expenditure (driven by a recovery in demand for energy, water and waste and barely eating into a 0.8% Q2 decline), a 1.4% increase in household gross fixed capital investment, a 0.5% increase in government gross fixed capital investment, 0.2% increase in government consumption expenditure and a meagre 0.1% increase in foreign trade.  

Overall, excluding inventories, internal domestic demand rose by 0.3%, the same rate it fell by in the second quarter.  In other words, the economy, excluding inventories has not grown since the first quarter, and based on provisional data is below the first quarter GDP level (0.232% below). 

Going forward government austerity programs are likely to remove government expenditure as a +ve component to growth and demand within the Eurozone for French exports could weaken going into the fourth quarter.   3rd quarter French growth was not impressive and hints at weakness to come.  

German GDP–the dilemma of an export driven economy and the Eurozone crisis..

Third quarter GDP rose by a real 0.5% in the third quarter led apparently be private consumption expenditure and corporate investment, with little or no boost from net exports as imports expanded.   Annual real GDP growth was some 2.6% year on year, which compared to historical growth rates, was respectable.


An increase in PCE is a welcome boost from an economy where private consumption expenditure generates, on average some 58% of GDP, but where the contribution of changes in PCE to GDP growth has been well below this in the last 10 years.  Please note all German data is sourced from the Federal Statistics Office.


The chart below shows rolling 5 year changes in the PCE contribution to changes in GDP (5 year rolling). 


Germany in the last decade has depended to a much greater extent on exports, with net exports generating more than 30% of GDP growth between 2004 and 2007.   The following graph shows the 5 year change (rolling) in exports as a % of the 5 year (rolling) change in GDP.


Weakness in global demand would put a major source of growth in GDP, over the last 10 years especially, under pressure.   Exports to the Euro area had weakened in the second quarter, according to the Bundesbank August monthly report (issued September), while exports to the non Euro area increased.   Detailed data for the third quarter are not yet available.     

However, just focussing on net exports ignores the wider German picture.  As of the second quarter of 2011, exports were worth almost 50% of GDP.  Compare this to the US where exports are less than 14% of GDP (US data sourced from the BEA), currently.


It should be clear that with such a large component of the economy dedicated to exports that a much higher % of economic activity is dependent on export industries.  While the US needs to increase exports to grow and restructure, it is not as exposed as Germany is to a global decline in demand for exports.   In a sense, the Euro zone, which has provided a stable source of demand for exports, is critical to German economic stability.  

Industrial production and capacity utilization in Germany has recovered strongly post recession, unlike most other Eurozone economies, and German industry, prior to the recent declines in output and new orders, was operating towards the upper limits of historical capacity constraints. 

Personal savings rates (see graph below) are also higher and consumer debt (61% of GDP) lower than in the US and other economies.  


Government debt (central, state and local) as of the first quarter was some 82% of GDP and the budget deficit some 3.4% as of the second half of 2010.   Current Euro zone risks suggests that government debt to GDP ratios could well rise further, placing additional stress on German economic growth going forward.

Consumer debt in the first quarter of 2011 was close to 61%, which is probably at a close to optimal level for an economy given its current growth rate.   

While it has lower consumer debt, higher savings rates and one of the lowest unemployment rates in the developed world, Germany is far from immune to an economic slowdown, and is to a large extent more exposed to a decline in global demand and a collapse in the Eurozone economy than other economies.

Germany needs Europe, but it needs a Europe that is not going to drive it further into debt.   Here lies the dilemma. 

European Industrial Production

Back in my 13 October post regarding European industrial production, I cast doubt on the significance of strong seasonally adjusted August figures: European Industrial Production.

September Italian IP numbers vindicated this stance with a month on month decline of 4.8%: August figures were revised down to a gain of 3.9%. 

French industrial production also fell by 1.7%, seasonally adjusted, which was the biggest September fall since 1997, so one does wonder, in aggregate, where the August data came from.

German industrial production fell by 2.7% seasonally adjusted in September, following on from an August on July decline of 0.4%.   New orders have fallen by 7.8% since June, the longest and deepest decline since the torrid days of late 2008/early 2009. 

German manufacturing new orders:

These figures are significant at a time when many governments are instituting quite large austerity measures.  A slowdown in Europe will impact Asia and North America, the other key components of the structural growth dilemma.  

Austerity!  Well, nothing like hitting a country while it is down!

The Euro Crisis Will not end this weekend: leaders scared s…..less and fully aware of the consequences!

Earlier in the evolution of the crisis it is quite possible that mistakes were due to a failure to grasp its realities.  I expect that the reality is all too clear now, and that delays are more to do with the fact that any decision will lead down a road with consequences that may prove untenable.   If both roads lead to hell, then it should be a case of the devil you know: this may mean Germany’s preferred option is “constraint” and France’s is “go for it.” 

I also believe that we will need to have a plan and a timeline for a Greece debt default next week, if the proposed plans are to have any credibility, irrespective of how temporary their expected impact.   As far as Europe is concerned, we are in the end game: the time for talking and studying options and outcomes has now passed and the time for a decision and a plan and a timeline for implementation is now.  No more procrastination.  

If we do not have a plan, that is actionable, by Wednesday…….well!

European Industrial Production

I am sorry, I just do not buy the significance of the figures: August is a difficult month in Europe (everyone is on holiday) and seasonal adjustments are difficult to rely on at this present moment in time.  Take Italy, an economy notorious for going nowhere for the last 10 years has apparently recorded a 4% seasonally adjusted monthly increase on July output.

A quick look at Italian industrial production (with no seasonal adjustment) shows the big drops in output around this time of year.   The fact that output did not drop as far as previous years this August does not instil confidence in me.  The numbers may be real, but they bear no relationship to the type of output the economy will need to be able to produce post the August shutdown.  So I think we need to be cautious.


Source of data I.Stat.

Eurozone PMI & Eurozone GDP

According to Markit Economics, Eurozone PMI fell to 2 year lows (Germany, France and Spain 26 month lows) in September to 49.1, a level that would imply third/fourth quarter GDP contraction if the recent close relationship between GDP and PMI is maintained – since 2008 PMI movements have closely tracked GDP movements, whereas in the 2001 to 2003 period movements of PMI below 50 were not followed by a negative GDP reading.  This time is likely to be different, not least because of the sovereign debt crisis and austerity measures being implemented across the Eurozone.  Continue reading